Demonetization to help check tax evasion through penny stocks

Ban on Rs500, Rs1000 currency notes will curtail tax evasion through trading in penny stocks, and thus black money, because such transactions are mostly cash deals


An investigation by the tax debt last year uncovered a trail of Rs38,000 crore involving manipulation in 84 BSE-listed penny stocks and through 5,000 listed and unlisted firms. Photo: Mint
An investigation by the tax debt last year uncovered a trail of Rs38,000 crore involving manipulation in 84 BSE-listed penny stocks and through 5,000 listed and unlisted firms. Photo: Mint

Mumbai: A significant number of transactions used to evade taxes by trading in penny stocks were cash deals.

The withdrawal of higher denomination notes is likely to deal a blow to such tax evaders, especially because the capital markets regulator has banned only a fraction of entities involved in such scams, said an income-tax official on condition of anonymity.

An investigation by the tax department last year uncovered a trail of Rs38,000 crore involving manipulation in 84 BSE-listed penny stocks and through 5,000 listed and unlisted firms, many of them shell companies. The taxman’s report said at least 64,811 entities evaded taxes through such fraudulent methods.

So far, the Securities and Exchange Board of India has barred only about 1,500 entities.

Last Friday, a member of Parliament wrote to the finance minister questioning the regulator’s selective orders. Mint has reviewed a copy of the letter.

ALSO READ | Penny stocks may come under long-term capital gains tax net

“The cash economy is a crucial element of this tax evasion scam. With the current stock of large denomination notes being banned, at least these scammers will not be able to use their hoard of cash and prevent future loss of revenue,” said the tax officer cited earlier.

In this type of tax evasion, penny stock companies would allot preferential stocks to non-promoters who are seeking to evade taxes. Their associates would drive up the price of the stocks, whose ownership is concentrated in a few hands, through circular trading (buyers and sellers are connected).

After a year, the preferential allottee cashes out at a much higher price. Any capital gains from shares held for more than a year are fully exempt from taxes. Typically, the entity buying the stock would be funded by the preferential allottee, thus allowing this entity to bring its black money into the system.

The promoter of penny stocks, the share brokers and other operators purchasing the shares transacted in cash, said the income-tax department report. In some cases, investors made gains of as much as 25 times their original investment, the report added.

“The purchase consideration is again provided in cash by the investor, which is laundered to the buyer’s account through a maze of shell companies,” said the report.

In the case of 16 companies, the tax department has been able to trace the full cash trail worth Rs1,575 crore, the report said.

“This shows how unaccounted/undisclosed cash of beneficiaries is being routed through this modus to convert black money into LTCG (long-term capital gains tax),” the report said.

After the tax department forwarded its report to the capital markets regulator, the Securities and Exchange Board of India, through interim orders in 2014 and 2015, had suspended over 200 firms and barred close to 1,500 entities.

But these pertained to trading in only seven penny stock firms compared with the 84 companies investigated by the taxmen.

On 14 November, Mint reported that the government was considering a plan to remove penny stocks from the long-term capital gains tax exemption. The applicability of LTCG depends on whether securities transaction tax (STT) was paid at the time of the sale of shares. LTCG will be tax-exempt only if the investor had paid STT at the time of sale of shares on a recognized stock exchange.

STT is a tax payable on the value of securities transacted through a recognized stock exchange. As of 2016, it is 0.1% for delivery-based equity trading.

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