Bogus Penny Stocks Capital Gains | Bombay High Court Judgment

This Tax Alert by Ernst & Young summarizes the ruling of the Nagpur Bench of Bombay High Court (HC) in the case of Smt. Shantidevi Bimalchand Jain (Taxpayer) v. ITO [ITA No. 18/2017; Order dated 10 April 2017] wherein the HC upheld the denial of the long-term capital gains exemption for the sale of a listed company’s shares through a stock exchange in view of the Taxpayer’s inability to justify the genuineness of the transactions. In the facts of the case, the Taxpayer had purchased shares of two private limited companies, for a petty amount. These companies merged into a listed company after a short while. In the next year, the Taxpayer transferred the listed company’s shares for an exorbitant sum and claimed the resultant income as long-term capital gains eligible for capital gains exemption under section 10(38) (Section) of the Indian Tax Laws (ITL). The Tax Authority and the lower appellate authorities denied the exemption and taxed the gains as business income. The Taxpayer appealed to the HC.

The HC upheld the denial of long-term capital gains exemption and approved treatment of transactions as an “adventure in the nature of trade”, liable to be taxed as business income, considering that the acquisition of shares was with a clear intention to exit after making a super-natural profit. The lack of evidence on the genuineness of transactions and inability of the Taxpayer to explain the sudden spurt in the share price also led to the denial of the exemption.

Background

• Section 10(38) of the ITL, inter alia, provides that any capital gains arising from transfer of listed equity shares held for a period of more than 12 months is not taxable if the sale is subject to securities transaction tax (STT).

• The exemption is not available if transactions in listed equity shares are part of a business carried on by the taxpayers. The definition of “business” under the ITL includes inter alia any trade or “adventure in the nature of trade”.

• Recently, it was observed by the Central Government (CG) that the benefit of above exemption was misused for routing unaccounted money through the medium of long-term capital gains. In order to deal with such a menace, the Finance Act, 2017 amended the Section and made above exemption subject to fulfilment of specified conditions.

Post the amendment, the capital gains exemption is not available if the shares are acquired on or after 1 October 2004 and such acquisition was not chargeable to STT. However, with an intent to protect capital gains exemption for genuine acquisitions, the CG was empowered to notify the transactions which will continue to be exempt under the Section and not be hit by the amendment. The CG vide Notification No. SO 1789 (E) [7] issued final Notification providing the negative list of transactions for which the benefit of capital gains exemption will not be available. Alongside the negative list, the Notification also provided carve-outs to insulate genuine acquisitions, for which exemption will continue to be available [Refer EY Alert titled “Central Government notifies the transactions of listed equity shares not eligible for Long Term capital gains exemption” dated 6 June 2017].

Facts

• In tax year 2003-04, the Taxpayer, a senior citizen, on advice of her tax counsel, purchased equity shares of two penny stock companies namely SMPL and SZDPL for approximately INR 4 to 5 per equity share.

• In tax year 2004-05, both the investee companies merged into a listed company KL pursuant to which the Taxpayer was allotted one equity share in KL for every four shares held in SMPL and SZDPL.

• In tax year 2005-06, the Taxpayer, through another stock broker, sold all equity shares of KL at an exorbitant rate of approximately INR 486 per equity share. The sale transaction was subjected to STT and sale proceeds were directly remitted by the stock broker to the Taxpayer’s bank account.

• In tax return of tax year 2005-06, the Taxpayer claimed exemption from long-term capital gains arising on transfer of investment in listed equity shares of KL.

Having regard to the Taxpayer’s inability to adduce evidence to justify the sale at an exorbitant price, the Tax Authority and lower appellate authorities considered the dealings in question as an “adventure in the nature of trade” and taxed the gains as business income. Consequently, the benefit of long-term capital gains exemption was denied to the Taxpayer. Alternatively, the second Appellate Authority, the Income Tax Appellate Tribunal, observed that the receipt of sale of equity shares could also be taxed as unexplained credit.

• Aggrieved, the Taxpayer appealed further to the Bombay HC.

HC’s decision

• Having regard to the following facts as gathered from the order of lower appellate authorities, the HC dismissed the Taxpayer’s appeal and upheld the denial of long-term capital gains exemption. The HC also upheld the characterization of purchase and sale transactions as “adventure in the nature of trade” and their consequent taxation as business income.

• The Taxpayer, a senior citizen, had acquired shares of SMPL and SZDPL solely on the suggestion made by her son’s friend and was herself not aware of any other details of the investee companies. The acquisition was made in anticipation of super-natural profits. There was no motive to earn regular income by way of dividend on investment but investment was made with a motive to earn profit.

• The payments for the above acquisition were made in cash. Both the investee companies viz. SMPL and SZDPL were located at the same address. Authorized signatory of both the investee companies was also the same. Further, their address coincided with the address of the stock broker (through whom the Taxpayer acquired the shares).

• KL, the listed company in which both the investee companies had merged was suffering huge losses. Despite a weak financial position, the shares of KL were quoted at a high price on the stock exchange.

• The stock broker through whom the Taxpayer had sold shares of KL did not respond to the notice issued by the Tax Authority requesting the name, address, and bank account of the person who had purchased shares of KL from the Taxpayer

• The purchase of shares of SMPL and SZDPL for a petty amount shortly followed by their merger into KL and sale of shares of KL at an exorbitant price without any reasons to support the sudden spurt in share price and without cogent evidence to prove the genuineness of sale transaction lead the Tax Authority to believe that the transactions were actually an attempt to legitimize unaccounted money through the medium of long-term capital gains exemption. The mere routing of the money through a bank account was not regarded sufficient to prove the genuineness of the transactions.

Ernst & Young Tax Alert

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