This article has been written by Saswata Tewari, pursuing a Diploma in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho.
Mergers and acquisitions (“M&A”) have a significant impact on a country’s economic status; in other words, the more M&As that occur, the greater the impact on the country’s economic status. However, leaving anything unregulated can be dangerous for any country in the world, so to be safe and get the best out of these M&As, governments have implemented regulatory and policy reforms to monitor domestic and foreign M&A activity.
Taxation has always played an important role in controlling and guiding the shape of M&As in India, and these M&As can be structured in several ways, with different tax implications depending on the framework chosen for a particular transaction. These tax provisions are governed by the Income Tax Act, 1961. This article attempts to address the tax implications of share purchase agreements in India.
A share purchase agreement is an arrangement made especially when a shareholder of a company wants to sell his equity shares to a buyer and exit the company. The agreement lists out how the sale of shares will take place between an individual or organisation with the selling shareholder of the company. There are a few things to keep in mind when learning about tax implications in share purchase agreements, which are covered in the next part of this article.
Share sale occurs in the method of share acquisitions where the acquirer acquires the shares of the company in which the target business is vested. The business and all of its components are sold entirely to the acquirer. Now coming to the tax implications of the share sale, there are majorly two parts to focus on. They are:
- Liability to tax on capital gains.
- Liability under Section 56(2)(x) of the Income Tax Act, 1961.
When a share transfer happens, it makes the existing shareholders realize whether it is a gain or loss on such a transfer of shares. Now, the taxation of the gains on the transfer of shares would rely on the factor of whether the transferred shares are held as capital assets or as stock-in-trade. Now if the shares are held as stock-in-trade, the taxations charged on the profits and gains from the transfer of the shares will be calculated under the heading of ‘profits and gains from business and profession’. But if the shares are held as capital assets, the profits and gains that will come from the transfer of shares will be chargeable to tax under the head ‘capital gain’ in compliance with Section 45 of the Income Tax Act, 1961. Section 2(14) of the Income Tax Act states that the word ‘capital asset’ comprises of all kinds of property held by the taxpayer, irrespective of whether it is connected with the business or profession of the taxpayer, but it excludes any stock-in-trade or personal assets of the taxpayer according to certain conditions.
Now identifying whether the nature of investment is a capital asset or a stock-in-trade has been debated for a long time and has led to the confusion many times. The Central Board of Direct Taxes using circulars and notifications have defined the following principles for the classification of income arising from the selling of securities:
- The first principle is concerned with the income that comes from selling the listed shares and securities that are held for more than twelve months, the taxpayer is allowed the one-time option for choosing to treat the income as either business income or capital gains. It is to be noted that once the taxpayer has selected his option, the decision will be irreversible.
- The second principle talks about the profit and gains that arise from the sale of unlisted shares which are held as capital gains, regardless of how long the shares have been held unless there are special circumstances where :
- There is a doubt regarding the genuineness of the transaction.
- The transaction is linked to a problem concerning the listing of the corporate veil.
- The underlying business is transferred along with control and management.
The Central Board of Direct Taxes states that in such cases, the Indian tax authorities would make an appropriate decision based on the facts of the case. It has been stated by the Central Board of Direct Taxes that the above mentioned third exception related to the transfer of unlisted shares is done in conjunction with transferring the control and management of the underlying business, would not apply to unlisted shares transferred by Category-I and Category-II Alternative Investment Funds registered with the Securities and Exchange Board of India (“SEBI”).
As per Section 2(14) of the Income Tax Act, if the shares are held as capital assets then the profits and gains coming from the transfer of shares will be taxable under the capital gains tax liability. According to Section 45 of the Income Tax Act, capital gains tax must be determined at the time of transfer of the capital asset, not when the consideration is paid by the transferor or when the agreement to transfer is signed. To put it in another way, a taxpayer should pay the capital gains tax due in the year in which his or her right to receive payment accrues, even though that right to receive payment is postponed in full or in part.
Section 48 of the Income Tax Act states that the capital gain is calculated by subtracting the following considerations from the total consideration received gained on the sale of a capital asset:
- The total amount of money spent solely and exclusively on such transfer of shares.
In India, the capital gain tax rate will be determined by several factors. These factors are:
- Identifying whether the capital gains are long-term capital gains or short-term capital gains.
- Identifying whether the target company is a public listed company or a public unlisted company or a private company.
- Identifying whether the transaction has taken place on the floor of the recognized stock exchange or by way of a private arrangement.
- Identifying whether the seller is a resident or a non-resident for taxes.
Also, in the case of a cross-border share sale, the related ‘Double Taxation Avoidance Agreement’ will decide whether capital gains are taxable in India, or the other country, or both.
The common rule is that the short-term capital gain results from the transfer of a capital asset held for less than 3 years whereas the long-term capital gain results if the capital asset is held for more than 3 years. It has to be noted that the gains that result from the transfer of listed shares held for more than 12 months would be considered as long-term capital gain and in any other case, it would be considered as a short-term capital gain. In addition, gains resulting from the sale of unlisted securities held for more than 24 months are known as long-term capital gain; otherwise, they are considered as short-term capital gain.
Section 115AD of the Income Tax Act talks about the preferential rates for Foreign Portfolio Investors related to capital gains resulting from the sale of shares. Although the long-term capital gain rate remains unchanged, the short-term capital gain is taxable at 30% for the Foreign Portfolio Investors under Section 115AD (except for the short-term capital gain from the selling of listed equity securities on the recognized stock exchange’s floor where Securities Transaction Tax is charged at 15%).
Section 56(2)(x) of the Income Tax Act states that if any individual receives any property other than immovable property including shares in a company, without consideration or for a consideration less than the fair market value of the property by more than rupees fifty thousand, the difference between the FMV and the consideration is taxable in the hands of the recipient under head ‘income from the other sources.’ To determine the rate at which such income will be charged for taxation it is important to know the tax status of such individual :
- For individuals – the tax rate is based on the individual’s applicable slab rate.
- For domestic corporations – corporate tax rates for domestic corporations range from 15% to 30%, depending on the situation.
- 30 percent for Indian companies.
- 40 percent for foreign firms.
Securities transaction tax
The securities transaction tax is imposed on the turnover from share sales if they take place on the floor of a recognized stock exchange in India. The seller must pay a securities transaction tax of 0.025 percent on intraday transactions and 0.10 percent on delivery-based sales.
The selling of shares is exempt from GST because securities are expressly excluded from the definition of “goods” and “services” as per the Central Goods and Services Tax Act.
When holding in physical form, transfers of shares in a company are subject to stamp duty at a rate of 0.25 percent of the value of the shares. However, as of July 1, 2020, transfers of shares are subject to stamp duty at a rate of 0.015 percent on the value of the shares transferred, as amended by the Finance Act, 2019. Previously, there was no stamp duty if the shares were owned electronically (dematerialized) with a depository (and not in a physical form). However, the Finance Act of 2019 amends this exemption to only apply to transfers of securities from an individual to a depository or from a depository to a beneficial owner.
Both parties in a share sale need to be aware of the tax implications of the share purchase arrangement ahead of time so that they can devise a strategy to mitigate any risks. The significance of the tax implications cannot be overstated in any way. Potential tax ambiguity and litigation can be avoided if these tax concerns are addressed thoughtfully early in an M&A deal. Tax policies, procedures, and litigation are also essential to the overall success of M&A transactions, as they can be used to add value, reduce costs, and minimise risks.
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