Penny stocks may come under long-term capital gains tax net

Mumbai: The government plans to withdraw tax exemption on long-term capital gains (LTCG) made on the sale of penny stocks to end the use of stock markets for tax evasion as part of a series of steps to eradicate black money, two people familiar with the development said.

“The government had called for a meeting last week that was attended by market participants including fund managers, exchanges and consultants to gauge whether securities transaction tax (STT) can be removed from low-value stocks or penny stocks. This would take away the LTCG benefit, which was being misused to evade taxes,” said one of the two people cited above on condition of anonymity.

The Narendra Modi government has already withdrawn high-value bank notes to crack down on people holding unaccounted cash and counterfeiters. Blocking the penny stock loophole may potentially end the misuse of stock markets to launder black money and check corruption.

Currently, any capital gains from shares held for more than a year are fully exempt from paying taxes. The taxability of LTCG depends on whether STT was paid at the time of sale of shares. LTCG will be tax-exempt only if the investor had paid STT at the time of sale of shares on a recognized stock exchange. STT is a tax payable on the value of securities transacted through a recognized stock exchange. As of 2016, it is 0.1% for delivery-based equity trading.

Current rules, the tax department claims, were being misused by entities to book fake LTCG gains and manipulate markets. Income tax department investigations estimate a sum of Rs45,000 crore may have been evaded by manipulating trading in penny stocks, said an income tax official, who is the second person cited earlier in the story. The person declined to be named.

Many of these entities have declared their income under the Income Declaration Scheme (IDS), 2016, and they would receive immunity from the tax department. However, others are being assessed to pass penalty orders, which could be up to 120% of the tax payable.

Stockbrokers, market operators and promoters of penny stock companies are among entities being investigated by the capital markets watchdog, Securities and Exchange Board of India (Sebi), Mint reported on 20 October. This group has declared at least Rs5,000 crore worth of illegal income under the scheme. That is about 8% of the total Rs65,000 crore declared under the income declaration scheme.

Sebi, through interim orders in 2014 and 2015, had suspended over 200 firms and barred close to 1,500 entities for using the stock exchange platform to evade taxes.

Typically, penny stocks are used for tax evasion and market manipulation by first allotting preferential stock to non-promoters who are trying to evade taxes. Their associates would then drive up the price of these shares through circular trading, where buyers and sellers are connected.

After a year, the preferential allottee cashes out at a much higher price. The entity buying the stock is generally funded by the preferential allottee, thus helping in bringing black money into the system.

“Such provision could help in reducing instances of tax evasion using the stock market route. However, the classification of penny stocks itself is not clear. One way to do it would be to declare a threshold, say, for instance, a stock whose price is less than Rs5 would not attract STT and, thus, can’t get LTCG benefit,” said Riaz Thinga, partner, Grant Thornton LLP.

A penny stock trades at a very low price, usually below Rs10, or is issued by a firm whose market capitalization is less than Rs100 crore, according to market participants.