Profits arising from the sale of equity shares can be taxed as capital gains or business income, depending on various factors (eg, the taxpayer's intention to invest in the shares, the frequency and volume of purchase and sales transactions undertaken by the taxpayer and the treatment of shares in the taxpayer's books of accounts).
While the classification of gains arising from a sale of shares has previously been litigated, the Bombay High Court recently dealt with the issue of whether gains arising from such sale by a private trust would be taxable as capital gains or business income. After considering various aspects, the court held that such income is taxable as capital gains and not as business income. This latest Bombay High Court ruling is summarised below.
Shri Vineet Nayyar and his wife, Reva Nayyar (the settlors), created the Vernan Private Trust on 24 March 2010 to use the trust corpus and the income generated therefrom for the benefit and maintenance of the trust's beneficiaries and to ensure an effective intergenerational transfer of wealth.
On 26 March 2010 one of the settlors gifted 600,000 equity shares in Tech Mahindra Ltd to the trust. Mr Nayyar received 96% of these shares through an employee stock ownership plan (ESOP) and purchased the remaining 4%.
The trust sold these shares on 30 March 2010 (ie, within seven days of the trust's formation).
While filing its income tax return, the trust claimed the gain on the sale of shares as capital gains as exempt under Section 10(38) of the Income Tax Act on the basis that the shares had been sold on a recognised stock exchange.
The tax officer observed that the shares had been sold within seven days of their acquisition, which was too short a period to treat the activity as an investment; accordingly, the tax officer considered the gains to be business income.
On further appeal, the first appellate authority allowed the taxpayer's appeal and considered the profit to be capital gains.
Tribunal and high court rulings
On further appeal, the Mumbai Income Tax Appellate Tribunal ruled in the favour of the taxpayer. In its ruling, the tribunal noted as follows:
- The objective of the trust was to use the trust corpus and the income generated therefrom in investments to the benefit of the beneficiaries.
- The trust was specifically prohibited from undertaking any business activities.
- The taxpayer's appointment of a portfolio manager had been in line with the intent and objective of the trust.
- The shares acquired by the settlor by way of the ESOP and direct purchase had been held by the taxpayer for more than two years before settling the same into the trust. Hence, the settlors had not intended to resell the shares immediately and make a quick profit.
- The shares had been treated as an investment and not as stock-in-trade in the balance sheet.
- All of the shares had been sold at once to diversify the portfolio and use the proceeds to make secure investments.
- The tax officer had not questioned whether the trust was illegitimate. The validity of the corpus of the trust had also never been in doubt.
In view of the above, the tribunal observed that the sale of shares had been in line with the trust's stated intention and that the trust could not be considered as carrying out any business activity giving rise to business income. Thus, the tribunal considered the profit arising from the sale of shares to be capital gains and accordingly held it to be exempt under the act.
The Bombay High Court upheld this ruling.
The classification of profit arising on a sale of shares has been litigated in judicial forums in the past. To reduce litigation with respect to listed shares and securities, the Central Board of Direct Taxes (CBDT) issued circulars in June 2007(1) and February 2016(2) that provided guidelines for classifying shares and securities as business or capital assets. According to the CBDT, factors such as the treatment of the shares by the taxpayer, the holding period and the nature of the income arising from the transfer will be considered when classifying profit on the sale of such shares as business income or capital gains.
The ruling also highlights the importance of clearly articulating objectives while executing trust documents, since these demonstrate the parties' intentions. The ruling examines not only the treatment of shares, but also the use of sales proceeds to conclusively adjudicate on the intentions behind the sale. Finally, the ruling reinforces the perspective that the taxability of profit from a sale of shares is essentially driven by the facts and circumstances of each case, as well as the taxpayer's intentions and conduct.
For further information on this topic please contact Pranay Bhatia at BDO in India by telephone (+91 22 3332 1600) or email ([email protected]). The BDO in India website can be accessed at www.bdo.in.
Endnotes
(1) Circular 04/2007, 15 June 2007.
(2) Circular 06/2016, 29 February 2016.
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