Taxation of Long Term Capital Gains on Transfer of Unlisted Securities

1.0 Introduction and Background

Section 10 (38) of the Income tax Act, 1961 (Act) provides that long term capital gains (LTCG) arising from transfer of equity shares in a company or units of an equity linked units will be exempt from tax provided Security Transaction Tax (STT) is being paid on such transfer. Essentially, all transactions on a recognised stock exchange are subject to STT. In other words, LTCG on transfer of all listed shares will be exempt. This exemption, is applicable equally to residents as well as non-residents.

In this article, we will restrict our discussion to taxability of LTCG on transfer of unlisted securities in the hands of non-residents. Section 112(1)(c) of the Act deals with taxability of the LTCG in the hands of non-residents.

Proviso to section 112(1), inserted w.e.f. 1-4-2000, provided a rate of tax @ 10% in respect of LTCG on transfer of “listed securities, units and zero coupon bonds”. For the meaning of the term “listed securities”, reference has been made to the Securities Contracts (Regulation) Act, 1956 (32 of 1956) (SCRA). As stated earlier, LTCG, on listed securities, being equity shares, on which STT is paid, is exempt u/s 10(38), and it is assumed that this provision would be useful in respect of other listed securities. However, the unlisted securities continued to be taxed @ 20 %.

In order to bring about parity and encourage investment by Private Equity players in Unlisted Shares, an amendment was made to section 112 (1)(c) vide the Finance Act, 2012 w.e.f. 1-4-2013 to provide for a rate of tax @ 10% on the LTCG on transfer of unlisted securities.

The amendment assumes significance for Private Equity Investors (PEI) who invests in India in large numbers through Private Limited Companies. Even the Memorandum explaining amendment to section 112 (1) (c) refers to extending benefit of reduced rate of 10% to the PEI. Let us examine whether this intention is fulfilled by the amendment to section 112 carried out by the Finance Act, 2012.

2.0 Law as amended

Relevant extract of the section 112(1)(c), as amended, is as follows:

The following sub-clauses (ii) and (iii) shall be substituted for sub-clause (ii) of clause (c) of s/s. (1) of section 112 by the Finance Act, 2012, w.e.f. 1-4-2013:

(ii) the amount of income-tax calculated on longterm capital gains [except where such gain arises from transfer of capital asset referred to in sub-clause (iii)] at the rate of twenty %; and

(iii) the amount of income-tax on long-term capital gains arising from the transfer of a capital asset, being unlisted securities, calculated at the rate of ten % on the capital gains in respect of such asset as computed without giving effect to the first and second provisos to section 48; Relevant extract [Clause 43 & First Schedule] of the Supplementary Memorandum Explaining the Official Amendments Moved per the Finance Bill, 2012 is as follows:

Circular No. 3/2012, Dated: June 12, 2012

Concessional rate of taxation on Long Term Capital Gains in case of non-resident investors

“Currently, under the Income-tax Act, a long term capital gain arising from sale of unlisted securities in the case of Foreign Institutional Investors (FIIs) is taxed at the rate of 10 % without giving the benefit of indexation or of currency fluctuation. In the case of other non-resident investors, including Private Equity investors, such capital gains are taxable at the rate of 20% with the benefit of currency fluctuation but without indexation. In order to give parity to such non-resident investors, the Finance Act reduces the rate of tax on LTCG arising from transfer of unlisted securities from 20% to 10% on the gains computed without giving the benefit of currency fluctuations and indexation by amending section 112 of the Income-tax Act.

This amendment is to take effect from 1st April, 2013 and would, accordingly, apply in relation to the assessment year 2013-14 and subsequent assessment years.

Consequential amendments to provide for tax deduction at source have also been made in the First Schedule and will be effective from 1st April, 2012.” One distinction persisting between taxability of LTCG of listed and unlisted securities @ 10 % u/s. 112 is that, while listed securities (being shares and debentures) will get the benefit of the first proviso of section 48 of the Act (meaning gains shall be computed in the same currency in which the investment was made), such unlisted securities will not get a similar benefit.

 Except for the aforenoted distinction, the intention of the legislature appears to be very clear and that is to give parity in the case of other non-resident investors [other than the FIIs], including Private Equity investors.

However, in fact, the amendment has led to some ambiguity/controversy which is discussed hereunder:

2.0 Meaning of the term “Securities”

Explanation to the section 112 (1), as replaced by the Finance Act, 2012 w.e.f. 1-4-2013, reads as follows:

 (a) the expression “securities” shall have the meaning assigned to it in clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956 (32 of 1956);

(aa) “listed securities” means the securities which are listed on any recognised stock exchange in India;

(ab) “unlisted securities” means securities other than listed securities;

(b) “unit” shall have the meaning assigned to it in clause (b) of Explanation to section 115AB.

As the Act refers to the SCRA, let us examine the definition of “Securities” as defined in section 2(h) of SCRA as follows:
“2(h) ‘securities’ include –
(i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate; (emphasis supplied)

2.1 Meaning of the term “Unlisted Securities”:

Unlisted Securities are defined to mean securities other than listed securities. Listed Securities, in turn, are defined to mean the securities which are listed on any recognised stock exchange in India.

A plain reading of the definition of “Securities” under the SCRA would mean:

“shares, scrips, stocks, bonds, debentures, debenture stock in or of any incorporated company or a body corporate” or “other marketable securities of a like nature in or of any incorporated company or other body corporate”. If the above interpretation is adopted, then there is no issue and one can interpret that the benefit of reduced rate of tax would be available to LTCG arising on transfer of any securities of a private limited company as well.

The above interpretation derives strength from two old decisions of the Bombay High Court and one decision of Kolkata High Court as discussed in the subsequent paragraphs:

2.2    Judicial Interpretation

In the case of Dahiben Umedbhai Patel And Others vs Norman James Hamilton and Others [(1983) 85 BOMLR 275, 1985 57 CompCas 700 Bom.], the Division Bench of the Honourable High Court interpreted “marketable securities” as appearing in SCRA as follows:

“Now, it is difficult for us to accept the argument of the appellants that the definition of “securities” must be so read that the words “other marketable securities of a like nature” were not intended to indicate an element of marketability in so far as the preceding categories were concerned. A reading of the inclusive part of the definition shows that the Legislature has enumerated different kinds of securities and by way of a residuary clause used the words “or other marketable securities of a like nature”. The use of these words was clearly intended to mean that the earlier categories of securities had to be marketable and any other securities of “like nature”, that is to say, like those which were categorised or enumerated earlier were also to be marketable before they could be held to fall within the definition of “securities”.

In Webster’s Third New International Dictionary, “marketable” is stated to mean “fit to be offered for sale in a market; being such as may be justly or lawfully sold or bought”. In order that securities may be marketable in the market, namely, the stock exchange, the shares of a company must be capable of being sold and purchased without any restrictions. In other words, the transfer of a share in a company must vest title in the purchaser and this vesting of title in the purchaser should not be made to depend on any other circumstance except the circumstance of sale and purchase. A market, therefore, contemplates a free transaction where shares can be sold and purchased without any restriction as to title. The shares which are sold in a market must, therefore, have a high degree of liquidity by virtue of their character of free transferability. Such character of free transferability is to be found in the shares of a public company. The definition of a “private company” in section 3 of the Companies Act, 1956, speaks of the restrictions for which the articles of the private company must provide. The articles of a private company must :

“3(1)(iii)(a) restricts the right to transfer its shares, if any;

(b)    limits the number of its members to 50, not including –

(i)    persons who are in the employment of the company, and

(ii)    persons who, having been formerly in the employment of the company, were members of the company while in that employment and have continued to be members after the employment ceased; and

c)    prohibits any invitation to the public to subscribe for any shares in or debentures of, a company.”

“It is thus clear that the shares of a private company do not possess the character of liquidity, which means that the purchaser of shares cannot be guaranteed that he will be registered as a member of the company. Such shares cannot be sold in the market or in other words, they cannot be said to be marketable and cannot, therefore, be said to fall within the definition of “securities” as a “marketable security”. On the other hand, in the case of a sale of share of a public company, the transfer is completed and even if the transfer is not registered, the transferor holds the shares for the benefit of the transferee”.

Based on the above observations, the Court Ruled that “it is thus clear to us that the definition of “securities” will only take in shares of a public limited company notwithstanding the use of the words “any incorporated company or other body corporate” in the definition.”

In the case of Norman J. Hamilton vs. Umedbhai S. Patel and Ors. [(1979) 81 BOMLR 340, (1979) 49 CompCas 1 Bom], also the single bench judge held a similar view that “the definition of “securities” would exclude from its purview shares which are not marketable, such as shares in a private limited company.”

In yet another case of B. K. Holdings (P.) Ltd. v. Prem Chand Jute Mills [1983] 53 Comp. Cas. 367 (Cal.), the Kolkata High Court held as follows:

“Whatever is capable of being bought and sold in a market is marketable. There is no reason whatsoever for limiting the expression “marketable securities” only to those securities which are quoted in the stock exchange.” Therefore, transaction of purchase and sale of shares of public limited company would be covered by the provisions of the Act even if the shares are not quoted in stock exchange.

2.3 Summary of Judicial Pronouncements

The rationale or the principles laid down by the above judicial pronouncements can be summarised as follows:

i)    The term “Marketable” when used in conjunction with the word “securities”, connotes that the securities which are to be termed as marketable possess a high degree of liquidity;

ii)    A private limited company by its very definition restricts the right to transfer its shares. Hence, its shares cannot be said to be “marketable”, as normally interpreted or understood.

iii)    The words “other marketable securities of a like nature” are words of a general character which would apply to all the preceding words, namely, “shares, scrips, stocks, bonds and debentures, applying the principle of “Noscitur a sociis”, which means that “the meaning of a word to be judge by the company it keeps”.

The sum and substance of the above interpretations could be that the amendment carried out by the Finance Act, 2012 has little or no effect as far as securities of the Private Limited Companies are concerned. However, the restrictions on transfer of shares of Private Limited Companies as provided in section 3 of the Companies Act, 1956 are not applicable to an unlisted public company and therefore, one can take a view that the reduced rate of 10 % will be applicable only in respect of LTCG on transfer shares of unlisted public company.
 
Table: Summary of Tax Implication under Different Situations

The moot point dealt with herein is : What is the intention of amending the expression “unlisted securities”. If we apply the restrictive meanings applied by the Bombay and Kolkata High Courts as discussed above, then it would not include securities of a private limited company. In that scenario, the amendment to section 112 would be meaningful only to the extent of unlisted securities of a public limited company. This does not seem to be the intention of the legislature as flowing from the Explanatory Memorandum explaining amendment of section 112 by the Finance Bill, 2012 wherein it is clearly mentioned that the intention of amendment is to bring about parity in taxability of LTCG in the hands of NRs other than FIs, including Private Equity Investors @ 10% who also invest heavily in private limited companies.

In the light of the foregoing, a suitable retrospective amendment is imperative to remove doubts, if any, and obviate avoidable litigations. After all, the intent of the legislative and the words conveying the said intent need to be synchronised.