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Shares under lock-in period valued as unquoted shares

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unquoted shares

Background

In order to ensure income does not escape assessment, anti-abuse provisions under the Indian Income-tax Act, 1961 (“IT Act”) have been strengthened through multiple amendments. The Finance Act, 2017 introduced two such provisions to the IT Act, i.e., sections 56(2)(x) and 50CA, to bring under the scope of tax any notional gain that arises when shares[1] of a company are transferred for a consideration less than their the fair market value (“FMV”). This was followed by the introduction of a computation mechanism[2] to determine the FMV of the shares being transferred.

The basis of valuation of the shares can differ depending on their characterisation as ‘quoted’ or ‘unquoted’. To determine the value of ‘quoted’ shares, the following two methods are followed: (i) where shares are sold on market, the transaction value recorded in the stock exchange is considered; and (ii) where shares are sold off-market, the last lowest recorded price is considered. Value of ‘unquoted’ (equity) shares is determined based on the adjusted book value of such shares.[3]  Further, section 50CA is only attracted in case of transfer of unquoted shares. Thus, in order to analyse the impact of these anti avoidance provisions, it is pertinent to understand the scope of the terms ‘quoted shares’ and ‘unquoted shares’

The IT Act defines ‘quoted shares’ as shares which are listed and traded frequently on a recognised stock exchange. Accordingly, all shares which are not quoted are considered to be ‘unquoted shares’

Interestingly, similar provisions were present under the erstwhile gift tax and wealth tax regime, which defined quoted and unquoted shares in an identical fashion. Thus, reference may be drawn from the rulings rendered under the erstwhile regime in order to interpret these terms under the IT Act. It may be relevant to note that while delivering its recent ruling in the case of Deputy Commissioner of Gift Tax v. M/s BPL Limited (“BPL Ltd.”),[4] the Supreme Court (“SC”) had an occasion to determine,  whether listed shares with transfer restrictions qualified as quoted or unquoted shares, in the context of erstwhile gift tax regime.

Facts of the Case

In the said case, the taxpayer was an Indian company which transferred shares of its listed sister companies to another Indian company during the financial year 1992-93, for a consideration lower than the FMV of such shares. These shares formed part of the promoter’s quota and were under a mandatory lock-in period. Accordingly, they could not be freely traded during the lock-in period.

Under the provisions of the erstwhile Gift Tax Act, 1968 (“GT Act”) the transfer was deemed to be a ‘gift’ and tax was chargeable on the difference between the market value of the shares and the sale consideration. A debate ensued regarding whether the shares fell in the category of ‘quoted shares’, due to being listed on a recognised stock exchange or ‘unquoted shares’ due to being locked-in at the time of transfer (and thus not being frequently traded). The tax authorities wanted to value the shares as ‘quoted shares’ while the taxpayer argued that they should be treated as ‘unquoted shares.

The first appellate authority considered the shares to be ‘unquoted’. However, on appeal, the Bangalore Tribunal held that since the shares were capable of being transferred even during the lock-in period, they would remain being ‘quoted’ shares. The Karnataka High Court reversed this decision and declared the shares to be ‘unquoted’. Aggrieved, the tax authorities appealed before the SC.

Decision

The SC confirmed the decision of the Karnataka High Court and noted that under the GT Act, ‘quoted share’ was defined as ‘a share quoted on any recognised stock exchange with regularity from time to time, where the quotations of such shares are based on current transactions made in the ordinary course of business.’ Further, an Explanation to the said definition clarified that in the event of any disagreement in establishing whether a share was ‘quoted’ or not, a certificate from the concerned stock exchange would be accepted as conclusive with respect to such determination.

The SC observed that there were no current transactions relating to the impugned shares in the ordinary course of business. Further, the SC held that under the relevant guidelines issued by the Securities and Exchange Board of India, such promoter shares could not be freely transferred in the open market during the lock-in period. Only a restricted transfer amongst the promoter group was permissible. However, such restricted transfer impeded free determination of market price based on current market transactions. Accordingly, it was held that such shares could not be traded during the lock-in period and their value could not have been determined pursuant to prevailing market conditions.

Additionally, the SC noted that the relevant stock exchange had also issued a certificate confirming that the impugned shares were not being transacted on the stock exchange and the price quoted on the stock exchange was only applicable to shares, which were freely tradeable on the said exchange. Thus, the SC concluded that impugned shares could not be considered as being ‘quoted’ in any recognised stock exchange with regularity.

Significant Takeaways

As discussed above, the definition of ‘quoted shares’ under the IT Act is para materia to the definition under the GT Act (as well as the Wealth-tax Act, 1957). Further, even the legislative intent of introducing provisions such as section 56(2)(x) of the IT Act, was to plug in the loopholes created due to abolition of the GT Act. Thus, the ruling in BPL Ltd. may impact the interpretation of the terms ‘quoted shares’ and ‘unquoted shares’ under the IT Act, as well. Even prior to this judgment, various court have clarified that shares that are not frequently traded can be valued as ‘unquoted’ despite being listed on the stock exchange. In this respect the Gauhati High Court (in the context of the erstwhile Wealth-tax Act, 1957) has previously held that if there are no transactions in shares of a company or if there are only a few isolated transactions, then such shares must be regarded as ‘unquoted shares’.[5] In the said case, majority of the shares of the publicly listed company were held by members of the same family and there had been no transactions on the stock exchange within two years prior to the valuation of the said shares.

However, in BPL Ltd., the SC has gone a step ahead and has indirectly clarified that even where the same class of shares of the same company are listed on the stock exchange, they may separately qualify as ‘unquoted’ or ‘quoted’ shares, depending on whether they can be freely traded or transferred in open market owing to specific legal or other restrictions on the shareholder holding such shares. Thus, the SC has analysed and applied the requirement of shares being frequently traded, qua the shareholder and not qua the class of shares in question.

As discussed above, since, the basis for valuation for ‘quoted’ and ‘unquoted’ shares is different, there can be a significant difference between the FMV determined by valuing the shares as ‘quoted’ or ‘unquoted’ shares. For instance, in BPL Ltd., there was a difference of over INR 150 million between the value being traded on the stock exchange and the value determined based on the net-asset value of the shares. Thus, it will be relevant to adequately determine the nature of the shares prior to their valuation, in order to mitigate any risk of the tax department invoking the aforementioned anti-avoidance provisions. Appropriate protections may also be built-in the transaction documents if any additional tax liability is incurred due to incorrect valuation of the shares at the time of transfer.


[1] It may be noted that section 56(2)(x) is not restricted to shares received for inadequate consideration and includes other property such as jewellery, sculptures, land, building, etc. as well. However, the scope of this article is restricted to tax implications arising under the said provision on transfer of shares.

[2] Rules 11UA and 11UAA of the Income-tax Rules, 1962 prescribe the manner for determination of FMV under section 56(2)(x) and 50CA, respectively.

[3] It may be noted that in case of preference shares or convertibles, the valuation can also be determined based on a valuation report obtained by a merchant banker or accountant which estimates the price such share would fetch in the open market on the valuation date. However, for the purposes of this article only equity shares are being discussed since a listed company will not have any such securities.

[4] Civil Appeal No. 3256 of 2016 & Anr., judgment dated October 12, 2022 (SC).

[5] Ajay Kumar Saharia v. Commissioner of Wealth-tax [1994] 206 ITR 98 (Gauhati).

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