Taxation on sale of unquoted shares had been, till recently, a fairly simple matter. Such gains were taxed as short-term capital gains or long-term capital gains, depending upon the period of holding, with the actual sale price taken as the consideration for computation of capital gains. This position has undergone a significant change—applicable from the current year—due to the insertion of a new provision in the tax law, section 50CA, by the last Union Budget.
For capital gains computation, the actual sale price was considered, except in the case of sale of land or building. In case of sale of land or building, if the valuation as per the stamp duty ready reckoner or circle rates is higher, then the higher valuation is deemed to be the sale consideration. Therefore, by a deeming fiction, the capital gains are taken to be higher than warranted by the actual sale price. The justification for this is that immovable property transactions often involve a black money component, which results in understatement of the actual sale price, and resultant tax evasion. The courts have, therefore, upheld the validity of such a deeming fiction in the case of sale of land or building.
This deeming fiction has now been extended to unquoted shares, where the fair market value (FMV) of the shares has to be substituted for actual sale price, if the FMV is higher. Unquoted shares would mean not just unlisted shares, but also listed shares that are not quoted regularly. So, if you happen to sell an illiquid listed share, which is a short-term capital asset, on the stock exchange, this deeming provision could apply, resulting in a higher tax outgo.
From the language of the provision, it is clear that the deeming fiction would not apply to gifts of shares made by a person. However, at the same time, there is no exemption for a transfer made to a close relative. For instance, if you were to transfer such an unquoted share to your wife or son at a nominal price, you would end up paying capital gains tax on the basis that the FMV is the sale price. It is, therefore, far better to just gift the shares, and not receive any consideration at all, rather than receive even a small consideration.
As in the case of immovable property, there is a double whammy for such transactions. While the seller would pay capital gains tax on the basis of the FMV, the purchaser would also be taxed on the difference between FMV and purchase price, as a deemed gift under income from other sources, at normal rates of tax.
What is FMV? Is it merely the book value (net asset value) of the shares, determined on the basis of the balance sheet, as was so far applicable to computation of deemed gifts? The rules in this regard were notified on 12 July. The existing valuation rule for deemed gifts has been amended, and would apply to all transactions from April 2017 onwards. It now applies both for deeming capital gains as well as for deemed gifts.
The amended rule now provides that FMV has to be determined by taking FMV of immovable property, shares and jewellery or works of art held by the company, and adding to this the value of other assets, deducting liabilities, and spreading such net worth over the number of shares.
In effect, to value unquoted shares of a company, you would need to value its underlying assets (immovable property, shares, jewellery or works of art). Not only that, if the company also owns unquoted shares, you would need to value those shares as well on the same basis.
This may involve multiple levels of valuation, all on the valuation date, which is the date of the transaction, and not the last balance sheet date. This would create immense practical difficulties for such selling shareholders, as it may not be possible for them to compel companies to prepare interim balance sheets, just because a shareholder, who could be holding a negligible stake, transfers some of his shares.
How fair is such an FMV? In taking such FMV, one is also not allowed to factor in the fact that sale of any such asset would attract capital gains, and therefore a deduction should be allowed for such notional capital gains tax. One also cannot factor in contingent liabilities, such as an ongoing litigation, which could result in a potentially large liability to the company in the future. One is also not allowed to factor in an illiquidity discount, which is normally applied to unlisted shares, since they cannot be easily sold.
Therefore, by this deeming fiction, one may end up paying far more tax than is really justified by the intrinsic value of the shares.
What is the logic behind introduction of this provision? In the Budget, the ostensible reason stated is that this is a measure to rationalize the provisions relating to deeming full value of consideration, which till then applied only to immovable property. Is this really rationalization? By that measure, would such a provision be gradually extended to all other assets?
These deeming provisions go against the basic principles of taxation that a person can be taxed only on his real income. He cannot be taxed on a notional income, which he could have earned, but did not. Such a deeming fiction can possibly be justified for immovable property, but there seems to be no such compelling reason for extending it to unquoted shares. In chasing FMV, our tax laws are going further away from what is fair.
Gautam Nayak is a chartered accountant.