By Jayant M. Thakur
Chartered Accountant
Background
Carrying out
transactions on stock market to avoid tax is practiced. Using capital market
for tax evasion has recently been in news, for example, cases involving
long-term capital gains. A person may, for example, sell shares and book exempt
gains and soon thereafter buy such shares again from the market. At times, such
shares are sold within the family/group and therefore after some time,
transferred to the seller. In particular, what has also been alleged is that
transactions are carried not only with the sole purpose of generating capital
gain but also for manipulating volume and price on stock exchanges. The
question whether such transactions will get concessional tax treatment in tax
assessments is of course an important question. However, in this article, the
question is : how are such transactions treated under the Securities Laws?
Take a common
modus operandi to have been typically employed in the so-called long-term
capital gain transactions. A small listed company with low or non-existent
operations is used. A large quantity of shares is issued by way of preferential
allotment. The quantity of shares may be further increased through bonus issue.
During the period of one year for which such shares have to remain locked-in
(which is also the period of holding for availing of long term capital gains
benefits), the price of the shares is artificially inflated by a small group of
persons who trade within themselves at progressively higher prices. At the end
of this period, by which time the price of the shares is many times (often
50-100 times) more than the original price, the preferential allottees sell the
shares at such higher price. The initial buyer is alleged to have organised all
this. The preferential allottee thus obtains tax free long-term capital gains
(Finance Bill 2018 though seeks to charge 10% capital gains tax). However, in
the process, the capital market system is abused. Fake turnover at artificial
prices is recorded. If unchecked, this not only harms the credibility of the
capital markets but can also result in loss to investors. Several provisions of
Securities Laws specifically prohibit such artificial trading and manipulation.
There were
decisions of the Securities Appellate Tribunal that held, in effect, that the
mere fact that transactions were undertaken for purposes of obtaining tax
benefits, penal action will not necessarily follow. However, while such
decisions could be arguably held to be limited to their facts, it still leaves
an uneasy feeling.
Now, the
Supreme Court has given a detailed ruling. While we will consider the facts
before the Court and also what the Court said, it is important to note that the
Court did not specifically rule on the intent tax planning or even evasion in
such transactions. It did not consider the question whether the capital markets
can or cannot be used for such purposes. It, however, dealt with violation of
Securities Laws that often takes place in such cases and whether and when they
can be said to fall foul of Securities Laws. Hence, the decision has direct
relevance.
Facts of the
case
There were
several parties in the case before the Court but they fell in two broad
categories – the parties who carried out the transactions and the stock brokers
through whom such transactions were carried out.
The parties
entered into transactions that resulted in some persons making profits and
others making losses. This was said to have been done by entering into
transactions in the following manner. In the futures and options markets, one
party (or group) bought futures (or similar derivatives) from the other party
through the stock market mechanism at a particular price. These same parties
then entered into reverse transactions at a higher price, thus resulting in one
side earning profits while the other side was making losses. Take an example. A
transaction in futures of scrip X could be carried out by Mr. A purchasing 1000
futures at a price Rs. 100 each from Mr. B. This transaction would later be
reversed by selling such 1000 futures at a price or Rs. 140. Mr. A would earn a
profit of Rs. 40000 while Mr. B would make a loss of about the same amount.
These
transactions would be synchronised well and rarely, if at all, any other party
would – or even could – transact. Effectively, these persons would be almost
the only persons trading in such scrip.
SEBI found out
what was happening and penalised the parties and the brokers. The parties were
penalised for carrying out artificial trading and price manipulation. The stock
brokers, who are expected to act as gate keepers to the capital market and
exercise due diligence, were penalised for allowing such transactions to happen
through them.
The question
before the Supreme Court was whether such transactions violated the Securities
Laws and whether the parties and their stock brokers could be so punished ?
Ruling of
Court
The Supreme
Court had to deal with several aspects. The Court had to focus on how the
capital markets get affected by such transactions. Even if the purpose was
legitimate, the issue was whether the transactions contravened the Securities
Laws, if so, penal action would follow.
In particular,
it elaborately discussed the issue of synchronised trading. This is trading
where buyers and sellers match their transactions very closely in terms of
timing, volume and price. Thus, the net result is generally that, though the
market is open to all, the transactions get executed between connected parties.
The Court, discussed in detail certain decisions of SAT and ruled that
synchronised trading is not ipso facto illegal or violative of
Securities Laws.
However, it
noted that on the facts before it, the transactions were manipulative. The
price at which purchases and sales of futures and other derivatives was carried
out was not market driven but was pre-determined and therefore artificial. The
buying and selling price of such derivatives are usually related to the
underlying price of the shares/index with which they are linked. While of
course parties can buy at prices far away from such underlying price of the
scrip/index, if their judgement of the future tells them so, the Court found
that this was not so on the facts before it. The purchases and sales were
carried out at widely different prices on the same day and between the same
parties in a synchronised manner in terms of timing and volume. The conclusion
was only that the transactions for all practical purposes were bogus.
Interestingly,
a curious argument was advanced. Whether trading on the derivatives markets
could affect – and hence manipulate – the trading and price in the cash market?
For example, by manipulating say, the price of futures in Scrip X, can the
price of trading of Scrip X in the spot/cash market be affected? The SAT had
held that this was generally not possible in the type of transactions involved
in the present case. This was one of the reasons why SAT overturned the order
of Securities and Exchange Board of India. However, it is submitted the Supreme
Court, rightly pointed out that this was not the issue at all. It was not
SEBI’s case that the transactions in the derivatives markets were carried out
to manipulate the price in the spot/cash markets. SEBI’s case was that the
trading in the derivatives markets itself was artificial, bogus and
manipulative and this by itself was a violation of Securities Laws.
The Court also
rejected the argument that in case of futures, no delivery took place and hence
the transactions did not violate the provisions which prohibit dealing without
change of beneficial interest.
The Court
further described the meaning of unfair trade practices in securities particularly
in the context of the case. It stated, “Contextually
and in simple words, it means a practice which does not conform to the fair and
transparent principles of trades in the stock market. In the instant case, one
party booked gains and the other party booked a loss. Nobody intentionally
trades for loss. An intentional trading for loss per se, is not a
genuine dealing in securities. The platform of the stock exchange has been used
for a non- genuine trade. Trading is always with the aim to make profits. But
if one party consistently makes loss and that too in preplanned and rapid
reverse trades, it is not genuine; it is an unfair trade practice.”. The
Court pointedly noted that, “The non-genuineness of these transactions is
evident from the fact that there was no commercial basis to suddenly, within a
matter of minutes, reverse a transaction when the underlying value had not
undergone any significant change”. Once it held this, it was not difficult to
take the argument to the logical conclusion to hold that the trades were
violative of Securities Laws and uphold the penal action by SEBI.
The Court also
rejected the ruling of SAT that “only if there is market impact on account of
sham transactions, could there be violation of the PFUTP Regulations”. The
court held that fraudulent and unfair trade practices have no place whatsoever
in the capital market.
As far as the
stock brokers were concerned, the Court held that they could not be held liable
unless their own involvement could be demonstrated or it could be shown that
they acted negligently or in connivance with such traders.
Thus, the Court
upheld the penal actions against the traders but not against the stock brokers.
Tax
planning/avoidance/evasion through capital markets
The Court
steered clear of giving a specific and direct ruling on whether tax planning
through transactions in capital markets was by itself violative of Securities
Laws. However, it is submitted that it has given enough guidance on what the
approach should be. As discussed above, transactions that are manipulative or
fraudulent or apparently fake will by themselves be violative of Securities
Laws.
Conclusion
The decision
makes it clear that SEBI can examine transactions in light of how they are
carried out and whether they are violative of Securities Laws, irrespective of
whether or not the objective was tax planning, etc. Some tests are given on
whether such transactions would be held to be violative. The penal action under
Securities Laws will be in addition to any findings and consequences under tax
law.
