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THIS ARTICLE WAS WRITTEN BY MANSI KHURANA, A STUDENT OF VIVEKANANDA INSTITUTE OF PROFESSIONAL STUDIES.
Penny stocks are the scrips belonging to the companies having small market capital base, usually under Rupees 100 to 200 Crore. Such stocks are usually traded at a very low price often below Rupees 10. These stocks are illiquid and usually traded very thinly unlike the stocks of the companies having big capital base. The term penny stock was first coined in US for describing shares that are traded below 1 dollar. But the same has now come to include the shares of below 5 dollar.
The SEBI has been looking into the individuals and companies which could have heavily invested in penny stocks to launder black money. These stocks are prone to speculation and insider trading. Price rigging often happens wherein the stock may rise or fall without any fundamental reason. Another drawback is that limited information may be available about the company & its promoters.
As per various press articles, the SEBI has been taking effective actions where it has identified more than 200 shell companies and the same were suspended. Also, more than 1300 entities had been banned from the market for allegedly using the path of LTCG for converting unaccounted money into the accounted money. Also, the ministry of corporate affairs had identified more than 331 shell companies. The prima facie amounts involved in tax evasion were quoted as being over Rupees 15000 crore.
As per SEBI orders, while doing investigation of the preferential allotment of shares by certain companies, SEBI found out that the route of LTCG is being misused for the conversion of unaccounted income into accounted income and subsequent tax evasion by taking exemption under section 10(38) of the Income Tax Act, 1961 for the LTCG.
As per the order of SEBI, The modus operandi followed in such cases has been on the following lines:
“Pursuant to the inquiry, it was observed that despite having poor financials during FY 2010-11 and FY 2011-12, all these companies raised funds through series of preferential allotments during the said period. Further, immediately after issuing shares on preferential basis, Eco, Esteem and CNE issued bonus shares in the ratio of 1:3 and HPC issued bonus shares in the ratio of 1:1. Consequent to the preferential allotments and bonus issues, the share capital of these companies increased manifold. Once the companies substantially increased their respective equity share capital base through preferential allotment(s) and bonus issues, they came out with Initial Public Offers (“IPOs”) in the year 2013 in the SME segment of BSE. It was observed that a set of common entities (“Funding Group”) financed the subscription of several IPO allottees either by directly transferring the amount in the escrow account of the companies on behalf of those allottees or by transferring the amount to the concerned allottees’ bank accounts, who, in turn, applied for shares in the aforesaid 4 IPOs and the subscription monies received in the said IPOs were routed back to the entities of Funding Group by respective company. It was also noticed that a set of entities related/connected amongst themselves and with Funding Group (hereinafter to be referred as “Trading Group”) was found to be influencing the price of all the scrips primarily through positive last treaded price (“LTP”) contribution by putting 1 or 2 trades per day with negligible/ very less quantity of buy order. It was observed that after the release of compulsory lock-in period, the preferential allottees and the Pre IPO Transferees were provided exit at a high price by Trading Group entities. In the process Trading Group and allottees artificially increased the volume of the scrip and misused the securities market system for making illegal gains and to convert ill-gotten gains into genuine one to avail fictitious long term capital gains. The modus operandi used by these entities is as under:
- a) All the companies had very small share capital prior to the year 2011. In the year 2011 and 2012 the companies increased their capital base by issuing shares to several entities, (hereinafter referred to as “preferential allottees”), by way of preferential allotment and later by issuing bonus shares. Certain preferential allottees transferred their shares in the respective company to several entities (hereinafter referred to as “pre IPO transferees”).
- b) Thereafter, all the companies came out with IPOs and the entities belonging to Funding Group funded substantial portion of the IPOs. IPO proceeds of the respective IPO were immediately routed back to the entities of the Funding Group by the concerned companies and thus they financed their own IPO and allotted shares without receipt of consideration to the extent they returned the subscription monies to the Funding Group from the IPO proceeds.
- c) The respective companies had actively concealed the deviation in utilisation of IPO proceeds as they deliberately did not make any disclosures as required under clause 46 of SME Listing Agreement.
- d) Once the shares were listed on the exchange, Trading Group entities started pushing up the price of the scrip through manipulative trades and increased the prices of the scrips astronomically.
- e) The said price movement was not backed by fundamentals or any announcements made by the companies.
- f) Trading Group entities consistently and repeatedly placed buy orders at higher prices than LTP in four fundamentally weak newly listed companies. After the expiry of the lock-in period, Trading Group entities further purchased shares from preferential allottees and pre-IPO transferees at artificially increased prices.
- g) In the whole process, entities of Trading Group provided a hugely profitable exit to the preferential allottees and pre IPO transferees.
- h) Consequently, all the preferential allottees and pre-IPO transferees have collectively made a profit of Rupees 614 crore.”
From the above, it is observed that the way of preferential allotment was used as a tool for the implementation of the dubious plan where the company and preferential allottees made illegal gains and converted their ill gotten gains into genuine one by using securities market system and artificially increasing volume and price of the scrip.
As per Section 10(38) of the Income Tax Act, 1961 which is as follows:
“(38) any income arising from the transfer of a long-term capital asset, being an equity share in a company or a unit of an equity oriented fund or a unit of a business trust where—
(a) the transaction of sale of such equity share or unit is entered into on or after the date on which Chapter VII of the Finance (No. 2) Act, 2004 comes into force; and
(b) such transaction is chargeable to securities transaction tax under that Chapter:
Provided that the income by way of long-term capital gain of a company shall be taken into account in computing the book profit and income-tax payable under Section 115JB :
Provided also that nothing contained in sub-clause (b) shall apply to a transaction undertaken on a recognised stock exchange located in any International Financial Services Centre and where the consideration for such transaction is paid or payable in foreign currency.”
According to the guide provided by the Income tax department, LTCG arising on transfer of equity share or units of equity oriented mutual fund or units of business is not chargeable to tax in the hands of any person, if following conditions are satisfied:
- The transaction i.e. the transaction of sale of equity shares or units of an equity oriented mutual fund or units of business trust should be liable to securities transactions tax.
- Such shares/units should be long term capital asset.
- Transfer should have taken place on or after October 1, 2004.
In other words, if LTCG is covered under section 10(38), then it is exempt from tax. Exemption for LTCG shall be available w.e.f. April 1, 2017 even where STT is not paid, provided that:
- Transaction is undertaken on a recognized stock exchange located in any international financial service centre, &
- Consideration is paid or payable in foreign currency.
Principles developed by the Courts while dealing with the cases involving LTCG from penny stocks:
In The Income Tax officer v. Smt. Aarti Mittal, the tribunal observed that the income tax officer is not entitled to make a pure guess and make an assessment without reference to any evidence and mankind at all. There must be something more than suspicion to support the assessment. A suspicion however may strong cannot take place of proof. The conclusions which are based on surmises and conjectures cannot take the place of proof. Therefore, the assessment made by the AO which is predominantly influenced by the suspicion is liable to be set aside. Once the shares were in respect of a listed company and transaction was through DEMAT account which was as per the recognized stock exchange quoted price, then there was no reason to hold such nature of transaction as non-genuine.
In Shri Pankaj Raj shah v. Department of Income tax, the deletion of amount relating to share transaction was challenged on the ground of not genuine. It was alleged that shares prices were manipulated from Rupees 5 to Rupees 159 (Price Rigging). It was held that transaction is genuine because purchases were made from the market on the value as it was on the date of stock market. Shares were put in DEMAT account. Sales were put in DEMAT account. Sales were made after expiry of one year from the date of purchase or even from the date of DEMAT of share. Sale of shares was subject to Securities transaction tax (STT) & sold through Stock exchange. Those shares were reflected in balance sheet of the assessee. The assessee also furnished the bank receipt note, statement of security transaction note, contract note etc. Therefore, transaction was genuine & the LTCG on sale of shares was rightly claimed as exempt u/s 10(38) of the Income Tax Act, 1961 because the assessee fulfilled both the conditions for claiming exemption u/s 10(38) of the Act.
In ACIT v. Smt. Rajbala Agarwal, the tribunal considered the adversity against the brokers of the stock exchange and for that matter the stock exchanges cannot be considered against the assessee. The SEBI was controlling the issues governing the trading of shares with the brokers in stock exchange duly licensed by them. Therefore, the authorities below could not find fault in holding that the purchase of shares and sales thereof at an exorbitant price was against the principle of natural justice.
In Kum Saumya Agarwal v. ITO, it was held that when the enquiry has been made on the back of the appellant without providing any opportunity to cross examine the broker, the addition made cannot be sustained.
In CIT v. Arun Kumar Agarwal, the Jharkhand high court held that merely because the broker has violated the bye laws of the SEBI and has been fined cannot be the reason for treating genuine transactions as bogus and the consequent benefit thereon.
In ITO v. Smt. Bibi Rani Bansal, the tribunal held that burden of proving the transaction is always on the person asserting the transaction to be bogus and this burden has to be strictly discharged by adducing legal evidence of character, which would either directly prove the fact of bogus or establish the circumstances unerringly and reasonably raising an inference to that effect. The assessee made payment for the purchase through proper banking channel. The shares were transferred in the name of the assessee and were held by her for more than 1 year. There is no relationship between the party from whom the assessee has purchased the shares and the party to whom these shares were sold. The shares were delivered after its sale and the assessee did not remain in the possession of those shares.
Recently, in Surya Prakash Tosniwal v. ITO, the tribunal held that LTCG claimed u/s 10(38) of the Income tax Act cannot be treated as sham or bogus if the papers shown by the assessee for proving that the transactions are genuine are in order. Further it was held that faults on the part of the company whose shares are being traded do not mean that the assessee is at fault. It was also held that fault on the part of the buyer to whom the assessee has sold his shares to file the financial statements as asked by the SEBI does not mean fault on the part of the assessee.
It is often noticed that tax officials generalize their view towards different matters but the tribunal orders very clearly held that investigation into penny stocks cannot necessarily mean that all transaction are bogus. The transaction does not change its nature just because there is an investigation going on or because it is a penny stock. The assessee is not concerned with the broker because as per the contract of sale the payment was made by account payee cheque and delivery of shares was taken and the contract is complete. Just because the investigation was done by the SEBI against the broker, the assessee is not concerned with the activity of the broker and has no control over the same.
 See: WTM/RKA/ISD/65/2016 dated June 14th, 2016
 Available at: http://www.incometaxindia.gov.in/tutorials/15-%20ltcg.pdf
 The Income Tax officer v. Smt. Aarti Mittal [MANU/IH/0378/2013]
 Shri Pankaj Raj shah v. Department of Income tax [ITA No. 330/Jodh/2011]
 ACIT v. Smt. Rajbala Agarwal [ITA No. 106, 107, 105 & 108/CTK/2010]
 Kum Saumya Agarwal v. ITO [MANU/ IA/030/2008]
 CIT v. Arun Kumar Agarwal [2013 (1) J.L.J.R 141]
 ITO v. Smt. Bibi Rani Bansal [2010 (43) DTR 279]
 Surya Prakash Tosniwal v. ITO [ITA No.1213/Kol/2016]