Business Income or Capital Gains? Question Resolved!
Rajshree Lohia March 23, 2016
The Central Board for Direct Taxes (“CBDT”) has, vide Letter F. No.225/12/2016/ITA.II dated May 2, 2015 (“Letter”), issued a clarification regarding the characterization of income arising from the transfer of unlisted shares. The clarification has been issued to resolve the oft litigated matter of characterization of income from the sale of shares (i.e., whether such income is business income or capital gains) and in furtherance of the CBDT Circular No. 6/2016 dated February 29, 2016 (“Circular”). The Circular characterized income arising from the transfer of listed shares & securities that are held for more than 12 months as capital gains, unless the taxpayer itself treats such shares as its ‘stock-in-trade’.
There has been a prolonged debate over whether income from the transfer of shares should be treated as profits and gains from business or profession (“Business Income”) or capital gains. Before delving into the reason for such dispute, it is necessary to understand the difference between Business Income and capital gains and the tax treatment of incomes falling under each of these heads.
As per the provisions of the Income-tax Act, 1961, a capital asset is any property held by a person that is not associated with its business or profession and does not include stock-in-trade. When shares are held by a taxpayer as stock-in-trade, income from the transfer of such shares are characterized as Business Income, and the taxpayer has the option to set-off such income with any expenses or losses incurred from its business or profession. When shares are held by a taxpayer as capital assets, income from their transfer is taxed under the head ‘capital gains’. Capital gains refers to the profits earned from the transfer of capital assets, which can be classified into two categories – long term capital gains (“LTCG”) i.e., profits or gains earned from the transfer of capital assets held for a period of more than 36 months, and short term capital gains (“STCG”) i.e., profits from the transfer of assets held for less than 36 months (the holding period for determining whether capital gains is LTCG or STCG has recently been reduced to 24 months). LTCG with respect to unlisted shares is taxed at the rate of 10%, and LTCG with respect to listed shares is exempt from tax.
The absence of proper guidance on the subject led to litigation as taxpayers often experienced difficulty in proving the intention for which the shares or securities were acquired. The characterization of a transfer was a subjective question and decided on a case-to-case basis. Earlier, LTCG was exempted from tax and STCG was taxed at a much lower rate than Business Income. This wide disparity between the tax rates for capital gains and Business Income gave rise to several disputes. In order to reduce their tax burden by treating the income arising from transfer as capital gains, taxpayers resorted to litigation. Also, the uncertainty of being charged a higher tax rate if the income was characterized as Business Income increased the risk factor for investors affecting their decisions for such investments. Clearly there was a need to streamline the provisions and assign a definite category under which income arising from transfer of shares should fall under for the purposes of tax treatment.
In 2007, after the Authority of Advanced Rulings’ observations in the case of Fidelity Northstar Fund and Ors., In re, which laid down parameters for identifying whether the income arising from the transfer of shares was in the nature of capital gains or Business Income, the CBDT issued a circular laying down principles for determining the same. The circular provided certain criteria for characterizing income such as the treatment given to the shares by the taxpayer in its books of accounts, quantum of purchase and sale, intention of the taxpayer when acquiring the shares, holding period and the method of valuation etc. Although, this provided guidance not only to the assessing officers (“AOs”), but to the taxpayer as well, the criteria were essentially subjective, due to which numerous taxpayers contested the matter in courts.
In February 2016, the CBDT issued the Circular, setting out the circumstances under which income arising from the transfer of shares or securities was to be characterized as capital gains, and further stating that the tax authorities were not to challenge such characterization. The Circular provided the taxpayer with a choice to treat the listed shares either as stock-in-trade or capital assets. If the taxpayer opts to treat the shares as stock-in-trade, the income arising from such transfer would be treated as Business Income, and if the taxpayer chose to treat its shares as capital assets, income arising from their transfer would be characterized as capital gains. But once such choice is made, the taxpayer cannot adopt a contrary stand in subsequent years.
Since the Circular did not mention any guidelines for the treatment of income from the transfer of unlisted shares, a lack of clarity remained, and the CBDT issued the Letter in continuation of the Circular, clarifying that income arising from the transfer of unlisted shares would be treated as capital gains, irrespective of the period for which the shares were held. However, AOs have the authority to take an appropriate view regarding the characterization of the transfer (i) where the genuineness of transactions in unlisted shares is questionable, (ii) where a question pertaining to lifting the corporate veil arises and (iii) where there is a transfer of control and management of the underlying business along with the shares.
This is a welcome clarification, in line with the CBDT’s aim to provide uniformity in the characterization, and certainty in the assessment, of income from transfer of shares and securities. It will be highly beneficial for taxpayers to pay tax at a lower rate when their income from transfer of unlisted shares is characterized as capital gains rather than Business Income. In addition, the Letter provides the much needed certainty to private equity and venture capital funds who primarily invest in shares of unlisted companies. Though, on the whole the Letter might substantially reduce litigation, there are some grey areas leaving room for controversy.
The Letter states that it is a clarification for determining the tax-treatment of income arising from transfer of ‘unlisted shares’. The specific mention of ‘unlisted shares’ indicates that it extends only to shares and not other securities such as debentures. Also, the exceptions provided do leave some scope for further litigation. Genuineness of a transaction is a highly fact-specific question leaving grey areas for unnecessary litigation. There could also be substantial disputes regarding characterization of the transaction where the transfer of shares also involves a transfer of control and management of the underlying business.
Generally, with the transfer of a majority of the shares and securities of a company, the transfer of decision making power, control and authority over the management i.e., the transfer of control and management of the business also take place. Such transfer of the control and management of the business is itself a transfer of capital asset. To classify the same as a transfer under business income would be unfair, hence leaving room for confusion and difference in interpretation, which may again lead to litigation.
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