Transactions of tax avoidance/evasion on the stock exchange and Securities Laws

It is common to hear that people transact on the stock exchange for tax avoidance. At times the sole purpose of entering into the transaction may be for avoiding tax and there may be no other commercial motive or implication. In other cases, while there may be a motive of tax avoidance, there are other commercial motives and/or implications. For example, a person may have short term capital gains during the year. He may transfer shares through the stock exchange whose price has fallen and thus book short term capital loss thereby avoiding tax on the short term capital gains. He may or may not reverse the transaction thereafter. Then there may be transactions of tax evasion where profits or losses may be “transferred” from one person to another.

The implications of such transactions under income-tax is an interesting, but a separate issue. But, for the purposes of this column, there are two questions to be answered . Are such transactions in violation of Securities Laws? If not, can SEBI still take action against them based on their ostensible motive? The question for the purposes here is limited to the provisions in Securities Laws relating to frauds, manipulative practices, etc. under the Act/Regulations. There is of course the general issue as to whether a transaction that involves an offence or violation of other laws would have implication under other laws. That, however, requires separate consideration.

These questions becomes even more relevant in the context of recent interim orders passed by SEBI in context of alleged massive tax evasion as also discussed in earlier columns (see February and June 2015 issues of the BCAJ). As discussed in those articles, it was allegedly found that bogus long term capital gains was made through increase of price of shares of defunct companies. Shares were allotted/ transferred to “investors” at a low price and the prices were considerably increased by manipulation. On sale at such high prices, the investors made huge long term capital gains which are said to be exempt as long term capital gains for income-tax. SEBI has held such transactions to be in violation of Securities Laws and debarred the parties involved.

Jurisdiction of SEBI
Securities Laws generally frown at transactions that interfere with the normal price discovery mechanism of stock exchanges. This is usually done through provisions prohibiting fraudulent trades and manipulative/unfair trade practices. Thus, a transaction that does not transfer beneficial interest of shares is generally not permitted. Transactions that are carried out not for bonafide purchase/sale are also generally not permitted. This is because they result in false or misleading appearance of trading in shares. The other reason is because price at which such transactions are undertaken also not being a result of normal price discovery process. The question is whether transactions undertaken wholly or partly with the objective of tax avoidance would fall foul of such provisions.

SAT View
The Securities Appellate Tribunal (“SAT ”) had several occasions to examine this issue. It appears that, generally, a benevolent view has been taken in such matters as far as tax avoidance is concerned. SEBI had raised objections to such transactions on grounds that they were fixed in advance, that they were synchronized trades, that they interfered with the normal price discovery mechanism of stock exchanges, etc. SAT has generally rejected such arguments.

In Viram Investment Private Limited vs. SEBI (order of SAT dated 11th February 2005), SEBI had debarred the appellants for six months on the allegations that they carried synchronized/matched deals on the stock exchange. The appellants claimed that the transactions were between related parties for the purpose of tax planning. SAT noted the facts and did not find anything wrong such as price manipulation, etc. by the appellants. It also noted that synchronized transactions by themselves were not barred nor illegal. On the issue that the transactions were for tax planning, the SAT observed as follows (emphasis supplied):-

“Even if we consider transactions undertaken for tax planning as being non genuine trades, such trades in order to be held objectionable, must result in influencing the market one way or the other. We do not find any evidence of that either in the investigation conducted by the Bombay Stock Exchange, copy of which has been annexed to the memorandum of appeal or in the impugned order that there was any manipulation. It is also seen that the impugned transactions have taken place at the prevailing market price. Trading in securities can take place for any number of reasons and the authorities enquire into such transactions which artificially influence the market and induce the investors to buy or sell on the basis of such artificial transactions. This is not even the case of the respondent, therefore it is not possible for us to sustain the impugned order.”

In another case of Rakhi Trading Private Limited vs. SEBI [(2010) 104 SCL 493 (SAT)], there were allegations of synchronized trading in Futures and Options segment of the stock exchange. The suspicion was that such trades were for shifting losses/profits for the purpose of “tax planning”. The SEBI whole-time member in his order had observed that “The range and scope with which such transactions have been carried out seems to suggest that there is a thriving market for such transfer of profits/losses providing the opportunity to avail of favourable tax assessments”. A penalty was levied. In its detailed order, SAT analysed the nature of transactions in Futures and Options and the implications of synchronised trades. Generally, the SAT did not find the appellants guilty of wrongs of price manipulation, etc. On the issue whether transactions carried out for tax planning purposes were in violation of the PFUTP Regulations, SAT observed (emphasis supplied):-

“When we analyse the nature of the trades executed by the appellant, we find that it played in the derivative market neither as a hedger nor as a speculator and not even as an arbitrageur. The question that now arises is why did the appellant execute such trades with the counter party in which it continuously made profits and the other party booked continuous losses. All these trades were transacted in March 2007 at the end of the financial year 2006-07. It is obvious and, this fact was not seriously disputed by the learned senior counsel appearing for the appellant, that the impugned trades were executed for the purpose of tax planning. The arrangement between the parties was that profits and losses would be booked by each of them for effective tax planning to ease the burden of tax liability and it is for this reason that they synchronized the trades and reversed them. They have played in the market without violating any rule of the game.

    We hold that the impugned transactions in the case before us do not become illegal merely because they were executed for tax planning as they did not influence the market. The learned counsel for the respondent Board drew our attention to Regulation 3(a), (b) & (c) and Regulation 4(1) and 4(2)(a) & (b) of the Regulations to contend that the trades of the appellant were in violation of these provisions. We cannot agree with him. Regulation 3 of the Regulations prohibits a person from buying, selling or otherwise dealing in securities in a fraudulent manner or using or employing in connection with purchase or sale of any security any manipulative or deceptive device in contravention of the Act, Rules or Regulations. Similarly, Regulation 4 prohibits persons from indulging in fraudulent or any unfair trade practices in securities which include creation of false or misleading appearance of trading in the securities market or dealing in a security not intended to effect transfer of beneficial ownership. Having carefully considered these provisions, we are of the view that market manipulation of whatever kind, must be in evidence before any charge of violating these Regulations could be upheld. We see no trace of any such evidence in the instant case. We have, therefore, no hesitation in holding that the charge against the appellant for violating Regulations 3 and 4 must also fail.”

However, such cases must be distinguished from cases where price of the securities are manipulated and profits or gains are literally created for tax purposes. As discussed earlier, recently, SEBI has alleged in five recent cases that
the prices of the shares were manipulated for tax purposes. The following observations in the matter of Pine Animation Limited (SEBI Order dated 8th May 2015) highlight the findings, concern and allegations of SEBI (emphasis supplied):-

“31. Since prior to the trading in its scrip during the Examination Period, Pine did not have any business or financial standing in the securities market, in my view, the only way it could have increased its share value is by way of market manipulation. In this case, it is noted that the traded volume and price of the scrip increased substantially only after the Exit Providers, preferential allotees and Promoter related entities started trading in the scrip. The average volume increased by 4433 times during the Examination Period i.e. from 62 shares per day to 2,74,922 shares per day. It is further noted that on the days when Pine Group was not trading, the traded volumes in the scrip were very low and the substantial increase in traded volumes as observed in this case was mainly due to their trading. I further note that Exit Providers, Preferential Allottees and Promoter related entities traded amongst themselves as substantiated by their matching contribution to net buy and net sell in Patch 3. There was no change in the beneficial ownership of the substantial number of traded shares as the buyers and sellers both were part of the common group and were acting in concert to provide LTCG benefits to the Preferential

Allottees    and    Promoter    related    entities.    In view of the above, I prima facie find that Exit Providers, Preferential Allottees and Promoter related entities used securities market system to artificially increase volume and price of the scrip for creating bogus non taxable profits (i.e. LTCG).

    In addition to the above, it is noted that after the preferential allotment and transfer of shares by the promoters to the Promoter related entities, about 92.52% of the share capital of Pine was with the Promoter related entities and Preferential Allottees. During the period from Mary 22, 2013 to June 19, 2013, the price of the scrip increased from Rs. 472 (unadjusted and Rs. 47.2 adjusted to share split) to Rs. 1006 (unadjusted and Rs. 100.6 adjusted to share split) in a matter of 19 trading days, with the trading volume as meager as 62 shares per day. The trading volume suddenly increased to 2,74,922 shares per day during the period from December 17, 2013 to January 30, 2015, when Exit Providers, Preferential Allottees and Promoter related entities started trading in the scrip. The prima facie modus operandi appears to be same as that used in the matter of Radford Global Limited where the stock exchange mechanism was used for the purpose of availing LTCG tax benefit and Pine was found actively involved in the whole design to misuse stock exchange mechanism to generate bogus LTCG. ?

    I am of the considered view that the scheme, plan, device and artifice employed in this case, apart from being a possible case of money laundering or tax evasion which could be seen by the concerned law enforcement agencies separately, is prima facie also a fraud in the securities market in as much as it involves manipulative transactions in securities and misuse of the securities market. The manipulation in the traded volume and price of the scrip by a group of connected entities has the potential to induce gullible and genuine investors to trade in the scrip and harm them.

As such the acts and omissions of Exit Providers, Preferential Allottees and Promoter related entities are ‘fraudulent’ as defined under regulation 2(1)(c) of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 (‘PFUTP Regulations’) and are in contravention of the provisions of Regulations 3(a), (b), (c), (d), 4(1), 4(2)(a), (b), (e) and (g) thereof and section 12A(a), (b) and (c) of the Securities and Exchange Board of India Act, 1992.

…In my view, the stock exchange system cannot be permitted to be used for any unlawful/forbidden activities.”

    Conclusion

The SAT has thus held that transactions in securities on stock exchange that have avoidance of tax as its objectives may not by themselves be in violation of Securities Laws. However, transactions that involve price manipulation, false dealing in shares, etc., would generally be in violation of Securities Laws. SEBI also seems to have taken a view that transactions for tax evasion, for such reason itself, are in violation of such laws. It is very likely that these recent Orders of SEBI will see appeals. Thus, courts may consider and rule on whether and under what circumstances would transactions of tax avoidance/evasion be deemed to be a violation of Securities Laws.