Punjab and Harayana High Court in the recent case of Sumeet Taneja v CIT has held that the transfer of shares by the promoters is a transfer of business and taxable under the head business income and not capital gains. This decision adversely affects promoters who incorporate companies and have a substantial shareholding in such companies, since on the transfer of such a shareholding, following the above ruling, they could be taxed at 30% rather than at 20%.
The high court observed that there was no innocent transfer of shares, to be treated as a transfer of a capital asset, but a transfer of business with all pervasive control being entrusted to the purchaser for complete and absolute exclusion of the seller whether as a shareholder or for management and control of the business. Thus, there had been a transfer of the management of the company. In addition to the transfer of shares, the seller also had to hand over the databases, employees, etc., to the purchaser. Moreover, the seller had agreed not to carry on business in a similar field for a certain period.
When promoters transfer shares, there is a transfer of their controlling interest also. The characterization of the assets which are subject to transfer determines the taxability in the hands of the promoter. If treated as business income, there is taxability at a higher rate, which adversely affects the tax position of the promoters.
Separate entity principle
The promoters being substantial shareholders are entitled to oversee the management of the company or have control over its affairs. On the transfer of the requisite shareholding, the right to oversee the management along with any controlling interest also gets transferred, even if not specifically agreed. The company’s business or assets are owned by the company and shareholders have no direct proprietary rights in such property. Only the company has control over its business and can transfer its assets to another company.
The separate entity principle applies under corporate as well as tax laws. Under this principle, a company and its shareholders are treated as two different entities. Even though the shareholders, whether individuals or corporate entities, provide guidance to the company in undertaking its business, the company remains independent and is not treated as one and the same along with the shareholders. The company continues to be treated as a separate legal entity capable of transferring assets/property that belong to it.
The Supreme Court recognized the principle of separate legal entity in the case of the Vodafone International Holdings. The company and its shareholders are to be treated as two separate legal entities. Punjab and Harayana High Court by observing that there had been a transfer of business and a not transfer of shares has in a way disregarded the separate legal entity of the company, which goes against the established principles of law.
Another important issue which needs consideration is while treating the share transfer as the transfer of business, whether the cost of acquisition incurred by the promoters to acquire such shares will be allowed as a deduction while computing the business profits. This issue was not addressed by the high court.
Under India’s tax laws, there is a concept of transfer of business (undertaking) by way of slump sale and the profits arising from such a transfer of business are taxable under the head capital gains and not business income. If the view of the high court is accepted, even then, the profits arising from transfer of shares/business should be taxable under the head capital gains and not business income. The high court has failed to address these issues while pronouncing the above decision.
Even though the decision of Punjab and Harayana High Court does not clarify certain issues, the decision is binding on all tribunals and tax officers until another high court pronounces a conflicting decision.
The decision has failed to appreciate that the shareholding in a company gives a bundle of rights to a shareholder such as right of management, control, dividends, etc. Such bundle of rights is also transferred on the transfer of shares, even if not specifically agreed between the parties, since it forms part of the shareholding, which cannot be separated. If the decision of Punjab and Harayana High Court is followed, then every promoter transferring its majority shareholding in a company will be subject to tax under the head business income and not capital gains, since on such a transfer of shares, the bundle of rights will also be transferred.
Economic Laws Practice is a full-service law firm with headquarters in Mumbai and offices in New Delhi, Pune, Ahmedabad, Bengaluru and Chennai. Pranay Bhatia is a partner at the firm and Vidushi Maheshwari is an associate.
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