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Elementary guide for calculating tax on key capital issuances by companies, and transfer of shares

For a conceptual understanding, we are mentioning the cost of acquisition for specific kinds of share issuances below:

i) Tax on issue of shares by investors

Shares are issued by a company if an investor or a promoter invests in it (to take equity), or if a debenture holder converts debentures into equity. Ordinarily, the issuer company does not have to pay tax on issuance of shares (except in case of the ‘startup tax’, discussed below). However, the shareholder has to himself pay a capital gains tax if he sells the shares at a higher price than what he paid for them. Where the shareholder is itself a company (it is common for a company to have investments in other companies), the tax will have to be paid by such company.

ii) Bonus shares

Promoters often decide to issue shares of their company to existing or new shareholders. Shares may be either for raising more money, or sometimes by capitalization of profits (by converting them into share capital without raising any new money. This is done by issuing bonus shares to existing shareholders. (see discussion below to read about bonus shares). Shareholders can make a significant windfall gain if they are able to sell bonus shares to a purchaser (while bonus shares of a company which is listed, say on the NSE or BSE can be sold fairly easily on the stock exchange, selling shares of a private company is much more difficult and involves significant transaction costs, especially in identifying the buyer and in negotiating the terms of the transaction).

For bonus shares, the cost of acquisition is taken to be nil as bonus shares there is no cost incurred for the shareholder. These are issued out of accumulated profits of the company.

Hence, if a shareholder sells the bonus shares issued to him, the entire sale price would be treated as his capital gains.

iii) Rights shares

Rights shares are issued by a company to existing shareholders only. However, these are issued for a price. The cost of acquisition for a shareholder would be the actual price paid to acquire these. 

Capital gains on sale of rights shares would be the difference between the sale price and the price paid to acquire rights shares.

iv) Tax on employee stock option plans (ESOPs)

Understanding of how employee stock options work is necessary to understand their taxation. Details on the incidence of the tax are covered later in the module on Employee Stock Options.

v) Tax on investments

The Income Tax Act was amended from 1st April 2013 to state that if a company issues shares for an amount which is greater than its fair market value, then the difference between the issue price and the fair market value would be treated as its income. The company would have to pay income tax (at the prevailing corporate income tax rate of 30%). This provision will be applicable only if the funds are received from an Indian. 

This provision was introduced with the intention to curb black money circulation in the economy, but could potentially lead to a steep increase in tax impact on startups when they are funded. Although early stage startups have the potential to grow fast, they have few assets and cash flows at the time of funding. Therefore, they issue shares to investors at a huge ‘premium’ (often more than 20 to 30 times of the face value), which is in excess of the fair value of the shares. Levy of tax on this funding would thus reduce the funds available for startups to grow, and make investments more expensive.

The amendment only exempted investments from venture capital funds registered with SEBI. Unfortunately, many angel investors and others who are known to invest as ‘venture capitalists’ in the startup fraternity do not have registrations with SEBI, so the exemption would not be applicable to them.

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