27 February 2018 EY PAS Alert Finance bill proposes tax on long-term gains arising on sale of listed equity shares Impact on employee stock option plans Tax Alerts cover significant tax news, developments and changes in legislation that affect tax payers in India. Our tax alert is a summary of tax technical developments intended to keep you on top of the latest tax issues. For more information, please contact your EY advisor. Executive summary The Finance Minister of India presented the Finance Bill, 2018 (the Bill) in the Parliament on 1 February 2018. The Bill, inter alia, proposes tax on gains arising on transfer of equity shares listed on a recognized stock exchange in India held for more than 12 months and where Securities Transaction Tax (STT) has been paid. The objective of this alert is to discuss the possible impact of the proposed long-term capital gains tax regime for listed equity shares on the taxability of gains from shares acquired under employee stock options plans (ESOPs). A summary of the impact is given below: There would be an additional tax burden of 10% on the sale of listed equity shares (compared to the existing nil tax regime) which may impact potential wealth realization of employees. There is uncertainty on whether the benefit of grandfathering in the form of stepped up cost of acquisition based on FMV as on 31 January 2018 would be available for equity shares that were unlisted on 31 January 2018. If the sale of listed equity share results in a loss, such loss would be allowed to be set-off or carried forward for set-off against future long-term capital gains as per the provisions of the Income-tax Act, 1961 (the Act). There might be an unanticipated tax burden on ESOP trusts at the time of sale of listed equity shares that were allotted pre-ipo.
Page 2 Background and existing provisions As per existing provisions of Section 10(38) of the Act, long-term capital gains arising from transfer of, inter alia, equity shares of a company are exempt from Income-tax. The exemption from tax under Section 10(38) of the Act can be claimed if: such equity shares are held for a minimum period of 12 months from the date of acquisition; and STT is paid at the time of transfer. However, in case of equity shares acquired after 1 October 2004, STT is required to be paid even at the time of acquisition (subject to notified exemptions 1 ). Notification no. 43/ 2017 dated 5 June 2017 issued by the Central Board of Direct Taxes (CBDT) provides exemption for certain modes of acquisition of equity shares to which the requirement of payment of STT at the time of acquisition does not apply for the purpose of claiming tax exemption under Section 10(38) of the Act. The modes of acquisition to which the exemption applies includes acquisition of shares under ESOPs framed under the guidelines issued by the Securities and Exchange Board of India (SEBI) 2. Based on this, long-term capital gains arising from sale of listed equity shares allotted under an employee stock option plan are exempt from tax under the existing provisions even though STT was not paid at the time of allotment of such shares. Further, long-term capital loss from such shares cannot be set-off in the current year or carried forward for set-off against future long-term capital gains. Proposed changes The Bill proposes to withdraw this exemption under Section 10(38) of the Act. The proposed provisions would, inter alia, impact longterm capital gains arising from sale of listed equity shares allotted to employees under ESOPs. Gains from sale of equity shares in a company listed on a recognized stock exchange in India held for a minimum period of 12 months from the date of acquisition are proposed to be taxed as long-term capital gains with effect from 1 April 2018. The proposed regime will apply to such shares if STT is paid at the time of acquisition as also transfer. However, this condition may be relaxed for specified nature of acquisition as may be notified by the Government. The Government has also issued Frequently Asked Questions (FAQs) 3 to clarify various questions that may arise in relation to this proposal. As per the FAQs, Notification No. 43/2017 is proposed to be reiterated for the purpose of the proposed regime of taxation of long-term capital gains arising on transfer of listed equity shares. The taxability would occur on gains exceeding INR 1 lakh. The applicable tax rate would be 10 percent without the benefit of indexation and foreign exchange fluctuation (plus applicable surcharge and cess). Tax treatment of shares acquired prior to 1 February 2018 Grandfathering provisions are as follows: For computing gain/ loss in relation to shares acquired prior to 1 February 2018, the cost of acquisition shall be higher of (a) and (b) (a) Actual cost of acquisition (b) Lower of : - Fair Market Value (FMV) of such assets as on 31 January 2018; or - Full value of consideration accruing or arising on transfer of such asset. FMV in relation to a listed equity share means the highest price of such share quoted on a recognized stock exchange on 31 January 2018 or if there is no trading on 31 January 2018, the highest price on the immediately preceding date when it was traded on such exchange. 1 Notification No.43/2017 dated 5 June 2017 2 It is important to note that though Notification No. 43/2017 mentions schemes framed under the Securities and Exchange Board of India (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999, the said guidelines have been replaced by Securities and Exchange Board of India (Share Based Employee Benefits) Regulations, 2014 effective 28 th October 2014 3 F. No. 370149/20/2018-TPL dated 4 February 2018
Page 3 Impact on listed shares acquired under ESOPs Our analysis Additional tax burden on sale of listed equity shares The proposed amendment impacts taxability of listed equity shares acquired by employees under ESOPs irrespective of whether shares were listed or unlisted at the time of acquisition/ allotment. Where the listed equity shares are sold after 1 April 2018, long-term capital gains exceeding INR 1 lakh will be subject to tax at 10 percent without indexation benefit and foreign exchange fluctuation as per proposed Section 112A, though the benefit of grandfathering based on FMV as on 31 January 2018 would be available. Therefore, based on above, there is an impact on potential wealth realization of employees under ESOPs of listed companies due to additional tax burden at the time of sale of shares. The taxability arising on sale of shares would vary depending on whether shares were listed or unlisted at the time of allotment of shares. The taxability under various scenarios has been summarized in Annexure 1. Long-term capital loss from sale of listed equity shares Under the existing provisions, long-term capital loss from sale of listed equity shares cannot be set-off in the current year or carried forward for set-off against future long-term capital gains. However, under the proposed provisions, if the sale of listed equity share results in a loss, such loss would be allowed to be set-off or carried forward for set-off against future long-term capital gains as per provisions of the Act. Therefore, in case the employees are expecting a loss on sale of listed equity shares, they may plan to sell shares after 1 April 2018 to avail the benefit of set-off and carry forward of long-term capital loss. The proposed Section 112A specifies the manner of calculation of FMV for the purpose of computation of the capital gains, inter alia, arising from sale of listed equity shares. However, the said section or FAQs are silent on the manner of calculation of FMV in case of shares which were unlisted as on 31 January 2018 but which are subsequently listed. This has resulted in uncertainty on whether the benefit of grandfathering in the form of stepped up cost of acquisition based on FMV as on 31 January 2018 would apply in such cases. In case benefit of grandfathering is not available, it may result in a higher tax burden for individuals who were planning to liquidate/ sell the unlisted shares allotted to them under ESOPs. There is a need for the Government to come up with a clarification to cover the shares which were not listed as on 31 January 2018 (but have been subsequently listed) under the grandfathering provisions. Unlisted shares subscribed by an ESOP trust Typically, a lot of companies allot shares to a trust pre- IPO under an ESOP which are later sold by the trust post listing. Under the existing provisions, sale of listed equity shares by the trust is exempt from tax under Section 10(38) of the Act. However, under the proposed provisions, where unlisted shares were acquired by the trust (no STT paid), long-term capital gains arising on of sale of listed shares by the trust may be taxable under Section 112A at 10% if the Notification issued in context of Section 10(38) is reiterated. << This space has been intentionally left blank >> Shares allotted by companies pre Initial Public Offering (IPO) There is an ambiguity in calculation of long-term capital gain on equity shares which were allotted pre-ipo before 31 January 2018 but would be sold on or after 1 April 2018 after being listed.
Page 4 Illustration Impact of proposed amendment Ref Particulars Taxability pre-budget a Date of allotment of shares b c d e f g h i Exercise price FMV of shares on date of exercise Perquisite value on allotment of shares (c-b) FMV of shares on 31 January 2018 Date of sale of shares Sale consideration Cost of acquisition Indexed cost of acquisition (Note 1) Taxability post-budget 1 Jan 2015 1 Jan 2015 80 80 100 100 20 20 200 200 31 March 2018 1 April 2018 250 250 100 113 (100*272/240) j Long-term capital gains 137 k Tax Exempt under Section 10(38) 200 [Higher of c and (lower of e and g)] Indexation not available 50 5 Summary The proposals in the Bill would become law once approved by the Parliament and on receipt of assent of the President of India. Companies with ESOPs and employees granted options/ allotted shares under such plans should take note of these proposals and review the tax impact. The summary of the impact is given below: There would be additional tax burden of 10% on sale of listed equity shares (compared to a nil tax regime) because of which the employees who were allotted shares under an ESOP will pay tax at the time of sale of listed shares which will impact their potential wealth realization. Accordingly, the employers would need to factor in tax impact while designing their ESOPs or while determining the quantum of future grants. There is uncertainty on whether the benefit of grandfathering in the form of stepped up cost of acquisition based on FMV as on 31 January 2018 would be available for equity shares which are unlisted as on 31 January 2018. Under the proposed provisions, if the sale of listed equity share results in a loss, such loss would be allowed to be set-off or carried forward for set-off against future long-term capital gains as per provisions of the Act. There will be unanticipated tax burden on ESOP trusts at the time of sale of listed equity shares which were allotted pre-ipo. Note 1: Cost Inflation Index (CII) for tax year 2014-15 = 240 and for tax year 2017-18 = 272
Page 5 Annexure 1 Tax implications at the time of sale of shares acquired under ESOPs S.No Scenario 1 Shares were listed at the time of allotment prior to 31 January 2018 Transfer of shares prior to 1 April 2018 Transfer of shares after 1 April 2018 Short-Term Long-Term Short-Term Long-Term Capital gains on shares held for 12 months or less on which STT is paid on transfer are Capital gains are exempt if the shares have been held for more than 12 months and STT is paid at the time of transfer. Losses, if any, arising from such transfer cannot be set-off or carried forward. Capital gains on shares held for 12 months or less on which STT is paid on transfer are If shares have been held for more than 12 months and STT is paid on sale, capital gains exceeding INR 1 lakh are taxable at 10% without indexation and foreign exchange fluctuation. However, capital gains accrued up to 31 January 2018 will be grandfathered. 2 Shares were unlisted at the time of allotment but got listed after 31 January 2018 and such shares are transferred after listing Capital gains on shares held for 12 months or less on which STT is paid on transfer are Capital gains are exempt if the shares have been held for more than 12 months and STT is paid at the time of transfer. Losses, if any, arising from such transfer cannot be set-off or carried forward. Capital gains on shares held for 12 months or less on which STT is paid on transfer are Change in taxability If shares have been held for more than 12 months and STT is paid on sale, capital gains exceeding INR 1lakh are taxable at 10% without indexation of cost and foreign exchange fluctuation. There is lack of clarity on whether grandfathering of capital gains up to 31 January 2018 is available (refer to discussion on page 3 under the heading Shares allotted by companies pre-ipo) 3 Transfer of unlisted equity shares of Indian company or shares of foreign company Capital gains on shares held for 24 months or less are taxable as per regular slab rates. Capital gains on shares held for more than 24 months are taxable at 20% with indexation. For a non-resident, such gains are taxed at 10% without indexation and adjustment for foreign exchange fluctuation. Capital gains on shares held for 24 months or less are taxable as per regular slab rates. Change in taxability Capital gains on shares held for more than 24 months are taxable at 20% with indexation. For a non-resident, such gains are taxed at 10% without indexation and adjustment for foreign exchange fluctuation. No change in taxability Notes: a. In relation to the requirement of payment of STT for concessional rate of tax or exemption, the exceptions provided in the Act and Notification No. 43/2017 will apply, as applicable. b. Applicable surcharge and education cess need to be considered on the tax rates mentioned above.
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