(Photographer: Jerome Favre/Bloomberg)

Long-Term Capital Gains Tax: How Useful Is The Indexation Benefit For Unlisted Shares?

In allowing for inflation indexation on shares of an unlisted company sold on or after April 1, the government has partly addressed the impact of the new long-term capital gains tax introduced in the Union Budget 2018. But experts said the relief is marginal for investors such as promoters and private equity funds.

Earlier this month the Lok Sabha cleared the Finance Bill, 2018 but with some tweaks to the version proposed by the finance minister on Feb. 1 and tabled during the first half of the parliamentary session. Among those tweaks, the most important one relates to long-term capital gains tax to be levied on unlisted shares.

The proposed amendment relates to Section 55 of the Income Tax Act that lays down cost of acquisition of capital assets. Now, a provision has been added to this section to say that the fair market value for shares that were not listed as on Jan 31 but that get listed on or after April 1 will be indexed for the period up to financial year 2017-18.

Amrish Shah, M&A tax practice head at Deloitte India explained the working of this benefit by way of an illustration. Consider an unlisted company which was incorporated in 2006 and lists on or after April 1, 2017. If an investor, say the promoter of the company, were to sell shares in the initial public offer on or after April 1, he would get indexation benefits, that is, the 2006 purchase cost of his shares would be enhanced by the tax department’s annual cost index for every year of holding. On sale of shares, the new 10 percent long-term capital gains tax would be be levied on the difference between the increased cost price and the selling price. This long term capital gains tax applies to sale of all shares after April 1, 2018.

Prakash Nene, managing director of Multiples Private Equity said the amended finance bill provision offers insignificant relief to long term investors such as private equity and promoters. Instead, the government should have extended the same grandfathering benefit given to listed shares. That is, treat the Jan. 31, 2018 value of the unlisted shares as the cost price.

Private equity investors who are based out of, say Mauritius or Singapore and who have the treaty protection for them, except for the last year, it is neutral because they are in any case protected. Thereafter, people who have made investments, for them indexation benefit of 1-2 year is available. But those are hardly any benefits because primarily when private equity investors invest, they are looking at 30-50 percent per annum kind of growth. In inflation, indexation is just 5 percent. So, it is not material from that perspective.
Prakash Nene, Managing Director, Multiples Private Equity

The real challenge will be for promoters, Nene added, as they are the original investors in the company and the cost indexation provided will not enhance their acquisition cost in any significant way. Consider the example of a promoter who started his business 10 years ago and for whom the initial investment cost could have been as low as Rs 1 crore whereas the business today could be worth several hundred crore, he said by way of illustration. Enhancing that promoter’s cost price by allowing him 5 percent inflation indexation, even for 10 years, won’t make much difference, Nene pointed out. The long-term capital gains tax liability in such a situation would be huge, he added.

Instead the government should have allowed the grandfathering of the fair market value as on Jan. 31, 2018, calculated using discounted cash flow or some such method and that would have made a real difference to the cost price and tax liability. Implying that the tax would be levied on the fair market value as on Jan. 31 and the sale price.

Clarity For Tax Neutral Transfers

The proposed amendment has offered the same relief, cost indexation benefit, in the case of amalgamations, conversion of preference shares etc... where unlisted shares are substituted for listed shares on the date of transfer.

If an investor gets a listed share post January 2018 as a result of a merger of an unlisted company and a listed company the cost price of that share would be calculated using the cost inflation index, Shah explained.

It is to cover such situations that they have said we will go back to your unlisted shares. We will go back to the formula of cost inflation index as of Jan. 31 and give you that benefit while calculating your capital gains, even though your shares were not listed as on January 31, 2018. 
Amrish Shah, Head- M&A Tax, Deloitte India