DOES TRANSFER OF EQUITY SHARES UNDER OFFER FOR SALE (OFS) DURING THE PROCESS OF LISTING TRIGGER ANY CAPITAL GAINS?

The calendar year 2021 was a blockbuster year for Indian primary markets, with 63 companies collectively garnering Rs. 1.2 lakh crore through initial public offerings. The Indian primary market witnessed the largest and most subscribed public offers in this period. A large part of public offering was by way of Offer For Sale (OFS), i.e. promoters offloading (selling) their stake in companies to financial institutions / public. What follows the transfer of equity shares is the determination of capital gains income and income-tax liability thereon.

Finance Act, 2018 brought a paradigm shift in taxation of long-term capital gains arising from the transfer of equity shares and equity-oriented mutual funds. Finance Act, 2018 withdrew the exemption granted on long-term capital gains arising on transfer of equity shares and equity-oriented mutual funds. With the withdrawal of exemption, special provisions in the form of Sections 112A and 55(2)(ac) of the Income Tax Act, 1961 (‘the Act’) were inserted to determine capital gains income.

This article seeks to examine capital gains tax liability arising from the transfer of equity shares under an OFS in an IPO process under the new taxation regime.

BRIEF BACKGROUND OF THE PROVISIONS
Section 112A of the Act provides for a tax rate of 10% in case where (a) total income includes income chargeable under the head capital gains (b) capital gains arising from the transfer of long-term capital asset being equity shares (c) securities transaction tax is paid on acquisition and transfer of those equity shares1.

Section 55(2)(ac) of the Act provides a special mechanism for computation of cost of acquisition in respect of assets covered by Section 112A. Cost of acquisition of equity shares acquired prior to 1st February, 2018 is higher of (a) or (b) below:

(A) Cost of acquisition of an asset.
(B) Lower of:

1. Fair market value of the asset as on 31st January, 2018, and
2. Full value of consideration received or accruing on the transfer of equity shares.

The essence of the insertion of Section 55(2)(ac) is to provide grandfathering in respect of gains up to 31st January, 2018 regarding equity shares. This is with a rider that adopting fair market value does not result in the generation of loss.

CASE UNDER EXAMINATION AND ANALYSIS

In this case, the transfer of shares is covered by Section 112A of the Act since (a) total income of Mr. A includes income chargeable under the head ‘capital gains’; (b) capital gains arise from the transfer of long-term capital asset2 being equity shares; (c) in terms of Section 98 (entry no. 6) r.w.s. 97(13)(aa) of Finance (No.2) Act, 2004, Mr. A is required to pay securities transaction tax on the transfer of equity shares; (d) the requirement of payment of securities transaction tax on acquisition of equity shares is relieved in terms of Notification No. 60/2018 dated 1st October, 20183 as shares were acquired when equity shares of A Ltd. were not listed on a recognised stock exchange.

The provisions of Section 112A cover the case on hand and therefore the cost of acquisition of equity shares shall be determined in terms of Section 55(2)(ac), which requires identification of three components, namely cost of acquisition, fair market value as on 31st January, 2018 and full value of consideration. In the facts of the case, the cost of acquisition of each equity share is Rs. 10, and the full value of consideration accruing on the transfer of each share is Rs. 1,000. What remains for determination is the fair market value of the asset as on 31st January, 2018 to compute the cost of acquisition under Section 55(2)(ac).

Before determining the fair market value of equity shares as on 31st January 2018, one may refer to Section 97(13)(aa) of Finance (No. 2) Act, 2004, which provides that sale of unlisted equity shares under an OFS to the public in an initial public offer and where such shares are subsequently listed on recognised stock exchange shall be considered as taxable securities transaction and securities transaction tax is leviable on the same.

From the above, it is pertinent to note that when the equity shares are transferred under an OFS, such shares are unlisted and are listed on a recognised stock exchange only subsequent to the transfer. Further, the practical experience of applying for shares under an IPO suggests that consideration for equity shares is paid, and equity shares are credited to the purchaser’s account, prior to the date of listing of equity shares on a recognised stock exchange. This also corroborates that when the promoter transfers the equity shares under an OFS, such shares are still unlisted.

Determination of fair market value of equity shares as on 31st January, 2018

Clause (a) of Explanation to Section 55(2)(ac) of the Act provides a methodology for the determination of fair market value.

Sub-clause (i) of clause (a) of Explanation to Section 55(2)(ac) provides that where equity shares are listed on a recognised stock exchange as on 31st January, 2018, the highest price prevailing on the recognised stock exchange shall be the fair market value. In the present case, shares will only be listed post the IPO in February, 2022 (i.e. Equity shares were not listed on a recognised stock exchange as on 31st January, 2018). Accordingly, the case is not covered by said sub-clause.

Sub-clause (ii) of clause (a) of Explanation to Section 55(2)(ac) does not apply to the present case as the subject matter of transfer is equity shares and not units of equity-oriented mutual fund/business trust.

Sub-clause (iii) of clause (a) of explanation to Section 55(2)(ac) provides that where equity shares are not listed on any recognised stock exchange as on 31st January, 2018, but listed as on the date of transfer, the fair market value of equity shares shall be the indexed cost of acquisition up to F.Y. 2017-18.

The literal reading of sub-clause (iii) of clause (a) of Explanation to Section 55(2)(ac) of the Act suggests that the case of Mr. A will not be covered by said sub-clause as equity shares are not listed as on the date of transfer.

Considering the above, an important issue arises that when the fair market value of an asset cannot be determined basis the methodology provided in clause (a) of Explanation to Section 55(2)(ac), what shall be the impact of the same?

TAX AUTHORITIES MAY PUT FORTH FOLLOWING ARGUMENTS
With the withdrawal of exemption under Section 10(38) of the Act, the intent of insertion of Section 55(2)(ac) of the Act is to provide grandfathering of gains on equity shares up to 31st January, 2018. The legislature, in its wisdom, may provide the grandfathering in any manner.

In respect of equity shares, which are not listed on a recognised stock exchange as on 31st January, 2018, legislature has provided for the benefit of indexation in terms of sub-clause (iii) of clause (a) of Explanation to Section 55(2)(ac) of the Act.
In the case under consideration, Mr. A’s equity shares were unlisted as on 31st January, 2018 and the transfer of shares took place subsequently. And although the equity shares held by Mr. A were not listed as on the date of transfer, considering the legislative intent, the case of Mr. A shall be covered by sub-clause (iii) of clause (a) of Explanation to Section 55(2)(ac) of the Act. Accordingly, capital gains computation does not fail. In this regard, reference may be made to Supreme Court (‘SC’) ruling in the case of CIT vs. J. H. Gotla [1985] 156 ITR 323. In this case, the taxpayer had suffered a significant business loss in the earlier assessment years, which were carried forward. The taxpayer gifted certain oil mill machinery to his wife. A partnership firm was floated where the wife and minor children were partners. Income earned by wife and minor children from the firm was clubbed in the hands of the taxpayer, who claimed set-off of clubbed income against the business losses carried forward. Tax authorities denied such set off on the ground that for setting off losses business was required to be carried on by taxpayer and in this case, business was carried out by the firm and not the taxpayer. SC allowed the set-off of losses in the hands of the taxpayer against the clubbed income and made the following observations on interpretation of the law:

“Now where the plain literal interpretation of a statutory provision produces a manifestly unjust result which could never have been intended by the legislature, the Court might modify the language used by the legislature so as to achieve the intention of the legislature and produce a rational construction. The task of interpretation of a statutory provision is an attempt to discover the intention of the legislature from the language used. If the purpose of a particular provision is easily discernible from the whole scheme of the act which, in the present case, was to counteract, the effect of the transfer of assets so far as computation of income of the assessee was concerned, then bearing that purpose in mind, the intention should be found out from the language used by the legislature and if strict literal, construction leads to an absurd result, i.e., result not intended to be subserved by the object of the legislation found out in the manner indicated above, then if other construction is possible apart from strict literal construction, then that construction should be preferred to the strict literal construction. Though equity and taxation are often strangers, attempts should be made that these do not remain so always so and if a construction results in equity rather than in injustice, then such construction should be preferred to the literal construction.”

In the present case, legislative intent for providing grandfathering benefit in respect of equity shares which are not listed as on 31st January, 2018 and transferred subsequently can be gathered from the language employed in sub-clause (iii) of clause (a) of Explanation to Section 55(2)(ac) of the Act and accordingly, the said sub-clause covers the case of Mr. A.

AS AGAINST THE ABOVE, THE TAXPAYER MAY SUBMIT AS UNDER
The computation of capital gains is carried out in terms of Section 48 of the Act. The computation of capital gains begins with the determination of full value of consideration which is reduced by (a) expenditure incurred wholly and exclusively in connection with transfer, (b) cost of acquisition of capital asset, and (c) cost of improvement of a capital asset. Accordingly, the before mentioned are four important elements of computing capital gains.

Section 55(2) of the Act provides for the determination of the cost of acquisition of capital assets for the purpose of Sections 48 and 49 of the act. Section 55(2)(ac) is a special provision for determining the cost of acquisition in certain specified cases. Unlike Section 55(2)(b) of the act4, Section 55(2)(ac) of the Act is not optional. Once the taxpayer’s case is covered by provisions of Section 55(2)(ac), the cost of acquisition of a specified asset has to be determined under that Section.

Clause (a) of Explanation to Section 55(2)(ac) defines the term ‘fair market value’ in an exhaustive manner, and accordingly, no other methodology can be read into Section 55(2)(ac) of the Act to determine the fair market value.

In order to determine the cost of acquisition under Section 55(2)(ac), one of the important components is the fair market value of the asset as on 31st January, 2018. In the absence of a determination of the same, the exercise of determination of cost of acquisition under Section 55(2)(ac) of the Act cannot be completed.

The SC, in the case of CIT vs. B. C. Srinivasa Setty [1981]128 ITR 2945, held that since the cost of acquisition of self-generated goodwill cannot be conceived, the computation of capital gains fails. On failure of computation provision, it was held that such asset is not covered by Section 45 of the Act and hence not subjected to capital gains. Similarly, in the case of Sunil Siddharth Bhai vs. CIT [1985] 156 ITR 509 (SC)6, where the taxpayer had contributed capital asset to a partnership firm, it was held that full value of consideration accruing or arising on transfer of capital asset cannot be determined and accordingly such asset is beyond the scope of capital gains chapter. Also, in the case of PNB Finance Ltd. vs. CIT [2008] 307 ITR 757, on the transfer of undertaking by the taxpayer pursuant to the nationalisation of the bank, SC held that undertaking comprises of various capital assets and in the absence of determination of cost of acquisition of undertaking, the charge fails and accordingly, capital gains cannot be charged.

Reference may also be made SC ruling in case of  Govind Saran Ganga Saran vs. CST [1985] 155 ITR 144 rendered under Bengal Finance (Sales Tax) Act, 1941 (‘Sales Tax Act’) as applied to the Union Territory of Delhi. The case revolved around the interpretation of Sections 14 and 15 of the Sales Tax Act. Cotton yarn was classified as one of the goods of special importance in inter-state trade or commerce as envisaged by Section 14 of the Sales Tax Act. Section 15 of the Sales Tax Act provided that sales tax on goods of special importance should not exceed a specified rate and further that they should not be taxed at more than one stage. The issue arose because the stage itself had not been clearly specified, and accordingly, it was not clear at what stage the sales tax shall be levied. The Financial Commissioner held that in the absence of any stage, there was a lacuna in the law and consequently, cotton yarn could not be taxed under the sales tax regime. The Delhi High Court reversed the decision of the Financial Commissioner. However, SC held that the single point at which the tax may be imposed must be a definite ascertainable point, and in the absence of the same, tax shall not be levied. While rendering the ruling, SC has made the following observations which are worth quoting:

“The components which enter into the concept of a tax are well known. The first is the character of the imposition known by its nature which prescribes the taxable event attracting the levy, the second is a clear indication of the person on whom the levy is imposed and who is obliged to pay the tax, the third is the rate at which the tax is imposed, and the fourth is the measure or value to which the rate will be applied for computing the tax liability. If those components are not clearly and definitely ascertainable, it is difficult to say that the levy exists in point of law. Any uncertainty or vagueness in the legislative scheme defining any of those components of the levy will be fatal to its validity.”

The SC ruling in the case of Govind Saran Ganga Saran (supra) has been approved by Constitution Bench of SC in case of CIT vs. Vatika Township (P.) Ltd. [2014] 367 ITR 466. In the facts of the case, the measure or value to which the rate will be applied is uncertain in the absence of determination of cost of acquisition, and accordingly, a levy will be fatal.

The cardinal principles of interpreting tax statutes centre around the observations of Rowlatt J. In the case of Cape Brandy Syndicate vs. Inland Revenue Commissioner [1921] 1 KB 64, which has virtually become the locus classicus. In the opinion of Rowlatt J.:
“. . . . . . . . . in a Taxing Act one has to look merely at what is clearly said. There is no room for any intendment. There is no equity about a tax. There is no presumption as to a tax. Nothing is to be read in, nothing is to be implied. One can only look fairly at the language used.”8

AUTHOR’S VIEW
Considering that: (a) in terms of a literal reading, fair market value of equity shares as on 31st January 2018 cannot be determined, (b) computation provision and charging provision both together form an integrated code, and on the failure of computation provision, charge fails, (c) judicial precedents holding that uncertainty or vagueness in legislative scheme lead to the levy becoming invalid, and (d) requirement of taxing provisions to be construed in terms of language employed only, in the view of the author, the taxpayer stands on a firm footing that in the absence of a determination of the fair market value of equity shares as on 31st January, 2018 in terms of methodology supplied in Section 55(2)(ac) of the act, cost of acquisition of equity shares cannot be determined. In the absence of a determination of the cost of acquisition, the computation mechanism fails. Accordingly, one may vehemently urge that the equity shares transferred under the OFS are beyond the capital gains chapter.

One may also note that the issue discussed herein may not be restricted in its applicability to promoters transferring their equity shares under an offer for sale. It may equally apply to private equity players, institutions, financial investors, individuals etc., who have either subscribed to the shares of an unlisted company or have purchased the shares of an unlisted company from the market and are selling the shares under an offer for sale.

One shall note that courts may be slow in adopting a position of total failure of charge and transfer of capital asset falling beyond the provisions capital gains chapter. Further, considering the impact of the position stated above, one may expect high-rise litigation.

[The views expressed by author are personal. One may adopt any position in consultation with advisors.]

________________________________________________________________
8    The above passage has been quoted with approval in several SC rulings. Illustratively, refer PCIT vs. Aarham Softronics [2019] 412 ITR 623 (SC), CIT vs. Yokogawa India Ltd. [2017] 391 ITR 274 (SC), Orissa State Warehousing vs. CIT [1999] 237 ITR 589 (SC), Smt. Tarulata Shyam vs. CIT [1977] 108 ITR 345 (SC), Sole Trustee, Loka Shikshana Trust [1975] 101 ITR 234 (SC), CIT vs. Ajax Products Ltd. [1965] 55 ITR 741 (SC), CIT vs. Shahzada Nand and Sons [1966] 66 ITR 392 (SC).