Income Tax Probe on Unlisted Stock Transactions in India
Mumbai: The Income Tax (I-T) Department is currently investigating transactions involving promoters, their associates, and anchor investors who purchased unlisted stocks of companies before offloading them during offers for sale (OFS) as these entities approached their listing dates.
Over the past 10 days, the department’s investigation wing has dispatched numerous notices to investors across multiple cities, scrutinizing how they calculated the ‘cost’ of acquiring unlisted shares and the subsequent capital gains from their sales. According to sources familiar with the matter, the tax office suspects many investors reported a purchase cost that was excessively high in terms of fair market value (FMV) instead of the actual amount spent on acquisition. This strategy could potentially lower their capital gains and tax liabilities.
Tax practitioners suggest that the scope of the investigation may expand beyond just tax evasion. The department might also examine the legitimacy of the funds involved and the arrangements underpinning these transactions.
Investors Under Scrutiny
The investors targeted in this investigation include individuals, closely-held firms, limited liability partnerships, certain mutual fund schemes, banks, private equity and offshore funds, in addition to several Hindu Undivided Family (HUF) entities.
Notices have been served to those who subscribed to unlisted shares of companies listed between early 2018 and July 2024, particularly focusing on subscriptions made before February 1, 2018. The budget for FY25 introduced changes to how the acquisition cost is calculated, particularly regarding OFS transactions where promoters and select investors sell shares directly to the public.
There are inquiries about capital gains offered under section 55(2)(ac) of the Act,” confirmed a tax official. Some investors have already settled their tax dues, while others are in the process of updating their returns. For some, a reopening of cases might occur.
Amendments and Capital Gains
The specific section of the Income Tax Act delineates the procedure for calculating the acquisition cost of stocks. Recent amendments allow for the absorption of inflation between the year shares were acquired (e.g., 2025 or 2012) and 2018, when tax on long-term capital gains was imposed.
Investors who utilized the actual amount paid for subscriptions as the cost, or have adjusted it to reflect changes in the cost inflation index, may not face scrutiny from the department. In contrast, those who reported the purchase cost based on FMV using one of the methodologies selected by a valuer may need to justify the inflated figures, which enabled them to minimize their capital gains tax.
There may also be instances of investors who have not paid taxes, claiming uncertainty about the correct acquisition cost.
Taxation Scenarios
Prior to the Finance Act (No.2), 2024, there were four scenarios for computing capital gains from an OFS, using purchase costs that were: (a) pure cost of acquisition; (b) indexed cost of acquisition; (c) fair market value; and (d) indeterminate. The recent amendment has retrospectively introduced a cost of acquisition for OFS under the law, differing from prior methods presumably used by promoters or investors. As it stands, legislation asserts that penalties cannot be enforced, nor can prosecution be initiated based on retrospective amendments. Given that this legal issue arose from a gap in the law, fairness dictates that the government should provide immunity from penalties and prosecution for adjustments made based on these changes, as noted by Ashish Karundia, founder of the CA firm Ashish Karundia & Co.
Investigative Focus on Source of Funds
The tax department has also requested companies to disclose the names of investors, the dates when subscription amounts were paid, and the dates of stock allotment. The interval between the allotment date and the stock transfer date defines the holding period, which dictates tax rates. During the years pertinent to the ongoing investigation, the capital gains tax rates for long-term and short-term holdings were 10% and 15%, respectively (later adjusted to 12.5% and 20%).
In some instances, the department is comparing the allotment dates provided by companies with data from the Ministry of Corporate Affairs (MCA) and the approval timelines from company boards,” stated an industry executive.
In light of prior interactions with the revenue department, tax officers are likely to delve into the origins of funds, investigating whether some transactions were structured as cash-cheque deals. Such arrangements typically involve an investor using cheques or formal banking methods to finance share subscriptions but later receiving cash back from the company, effectively legitimizing unexplained cash flow for the investor. If it is found that the investor lacked the financial capability to make the investment, it could indicate a benami transaction,” one source commented, hinting at the potential ramifications of these practices on tax compliance and regulations.