Blog Details

Author -Ankur Tyagi 

Introduction

The Financial Budget 2018 has withdrawn tax exemption provided under Section 10 (38) of Income Tax Act, 1961 (herein after the ”Act”) in which long term capital gain (herein after LTCG) arising from the sale of listed equity securities were exempted. Now Section 112A has been inserted which seeks to levy tax on LTCG exceeding INR 1 lakh from the sale of these listed equity shares or units of equity oriented funds held for atleast 1 year at the rate of 10% (plus additional surcharge or cess). However the investments made on or before 31st January 2018 have been “grandfathered” under Section 112A. But the investors in companies who have undergone merger will not be able to take advantage of this grandfathering benefit and may have to pay higher tax on such gains which could be five to six times higher than normal.

Grandfathering under Section 112A explained

Grandfathering clause - in a tax law is a provision according to which when a new law is implemented then the investors who have made investments under the old law continued to be assessed according to provision of same until the time frame of that old law expires.    

In the financial budget 2018 there was a grandfathering clause attached to Section 112A on LTCG. The investors who bought listed equity shares or equity mutual funds before 1st February 2018 were exempted to pay 10% tax on gains made upto 31st March 2018. In other words all the past gains were “grandfathered” for them.  

Section 112A - According to this new provision in the Act if there is “capital gain” for more than INR 0.1 million from the sale of listed ”capital assets” which includes (i) Equity share in a company  (II) unit of equity oriented funds or (iii) unit of business trust where STT( Securities Transition Tax) has already been paid and such capital assets has been held by the investor for more than 12 months.  Then the CoA (Cost of Acquisition) for the purpose of computing  such Capital gains to the capital assets mentioned above shall be deemed to higher of the following:

1. the actual cost of acquisition of such asset; and
2. the lower of
   1. FMV( fair market value ) on jan 31st 2018 and
   2. actual sale consideration received for the assets i.e. the sales price 

Capital Gain = Sale Price – Cost of Acquisition on 31.1.2018

This clause is applicable from 1st April, 2018. Under this clause all the capital gains accrued by the investor by sale of assets before such date is exempted under Section 10(38) of the Act.

Ambiguity w.r.t. methodology to calculate taxable capital gains in context of mergers 

In a merger one or more company merges into another company or two or more company merges to form one company. The company or companies which merges to new company is called amalgamating company and the new company is called amalgamated company. 

The Provisions of Income tax Act that applies to Mergers are:

• Section 47(vii)- when shares are transferred from amalgamating company by its shareholders in consideration of shares of amalgamated company such transfer is not regarded as transfer and hence no capital gain arises on such transfer.
• Section 49(2)-the Cost of Acquisition (CoA) of the shares of amalgamating company shall be deemed to be the Cost of Acquisition (CoA) of the shares of amalgamated company.
• Section 2(42A)- the period of holding the shares of amalgamated company shall also include the period of holding the shares of amalgamating company.     

Illustration

A holds 100 shares each having a value of INR 1000 in XYZ Ltd, an Indian Company since 2011. Hence the total cost of his shares become 0.1 million. XYZ Ltd enters into a scheme of amalgamation with ABC Ltd (also an Indian Co.). Shareholders of XYZ Ltd receives 50 shares of ABC Ltd as consideration against shares held in XYZ ltd.

Now, as per the provision of Section 47(vii) the receipt of shares in ABC ltd as a consideration against the shares held in XYZ ltd is not considered a transfer and hence no capital gain tax arises on the receipt.

The cost of acquisition of shares of ABC Ltd shall be deemed to be INR 100,000. (Section 49(2))

If Mr A sells the shares of ABC Ltd within the half year, the long-term gains shall be applied as it is deemed that Mr A has held the shares for more than 1 Year  (1 year of holding period of XYZ Limited + 6 months of holding period of ABC Limited)(as per the provision of Section 2(42A))

Computation of capital gain considering the Section 112A

If on 31 January, 2018, the FMV of shares of XYZ Ltd is INR 2000 and that of ABC Ltd is INR 4000. XYZ Ltd enters into a scheme of amalgamation with ABC Ltd and Mr A receives 50 shares of ABC Ltd on 1 April, 2018 (or any time on or after 1 February 2018).

The provisions of 112A come into effect from 1 April, 2018 onwards. Now the confusion that arises is as follows:

Whether the Cost of Acquisition of shares in ABC as per Section 112A shall be the actual FMV of shares of ABC on 31st January 2018 i.e.4000 or the cost of acquisition of XYZ in 2011 according to Section 49(2) i.e INR 1000 per share?

Conclusion

Due to lack of grandfathering benefit to merged entities there can be significant outgo of Tax on sales of equity stocks. Suppose an investor holds shares worth INR 1 million since 2010 of company A. After 31st Jan 2018 it was merged with Company B and holds shares of B worth 50 million post merger. If he sells his shares in B post 1st April 2018 for 55 million, LTCG of 10%  shall be levied on INR 54 million(Selling Price of 55 million - actual cost of acquisition of shares). If merger had not happened tax would have been levied only on INR 5 million (the selling price of 55 million – grandfathered cost of INR 50 million as on 31st January). The computation of Fair market value becomes even more complicated when a listed company merges with an unlisted one as there is no frame work provided for computation of unlisted stocks under 112A. The law seeks to keep arrangements such as mergers to be tax neutral in order to encourage economic development and growth and improving business environment. It is imperative that the corporate arrangements such as mergers, demergers should be brought within grandfathering framework.