From Physical Shares To Mandatory Demat: Amid intensified efforts to curb illicit fund flows, the Government has made it mandatory for unlisted public companies to compulsorily issue new securities in dematerialized form beginning October 2, 2018. The Ministry of Corporate Affairs (MCA) has issued Companies (Prospectus and Allotment of Securities) (Third Amendment) Rules, 2018 on September 10, 2018 requiring unlisted public companies to issue securities (Equity/ Preference shares, Debentures) only in dematerialized form. Besides, transfer of securities by these companies has to be done only in demat or electronic form. Press articles suggest phased implementation of this move and similar rules for private companies may follow soon. Parallel to this, the Securities and Exchange Board of India (SEBI) had announced that while investors could still hold shares in physical form after December 5, 2018, they may not be able to transfer them in that form after the December deadline
It would be interesting to note few income tax implications, which are inextricably linked with dematerialisation of securities. With respect to physical shares, capital gains is computed by reducing cost of acquisition (could be indexed) and related expenses for transfer from the full value of consideration. When shares held in physical form are sold, it is generally possible for the shareholder to identify the lot to which such shares belong. The amount of capital gains/ losses is computed on the basis of the period of holding and cost of acquisition of such shares. Thus, it is effectively possible that the amount of capital gains is reduced by tendering shares with highest cost of acquisition.
Alternatively, it may also be possible that amount of capital gains is increased by tendering shares with lowest cost of acquisition and such increased gains could be set off against available losses. For instance, bonus shares, where the cost is nil (resulting in a higher profit) could be chosen to be sold along with those which would result in a substantial loss [this exercise essentially optimises tax outgo]. However, in the dematerialized environment, Section 45 (2A) of the Income Tax Act, 1961 comes into play – it specifies that for shares that are sold in demat form, First In, First Out (FIFO) method needs to be applied.
When the shares are held in demat form, there is no way to distinguish one from the other as these are just merely numbers (or book entries), unlike the position in physical form where different distinguishing certificates and distinctive numbers exist. Hence, it is assumed that shares that come in first are the ones that are sold first. Circular No 704 dated April 28, 1995 issued by the Central Board of Direct Taxes (CBDT) stipulates FIFO system to be followed when it is not possible for the shareholder to identify the lot from which the shares are tendered.
CBDT Circular No 768 dated June 24, 1998 explains working of FIFO method. The 1998 circular envisages three situations – (i) When an investor holds part of holding in dematerialised form, FIFO method would be applicable only in respect of the dematerialised holding. This is so because in such a case, sale of dematerialised shares cannot be mixed with sale of shares held in physical form (ii) When an investor holds dematerialised shares in more than one account or depository, FIFO method will be applied account-wise as securities lying in another account of the same investor cannot be construed to have been sold as they continue to remain in that account, and (iii) Where there is an existing account of dematerialised stock, old physical stock is dematerialised and entered at a later date, the securities first credited to the account, will be deemed to have been sold.
The date from which this is held will, however, be reckoned, not from the date of dematerialisation, but from the date of purchase. Hence, for computing capital gain chargeable to tax, cost of acquisition and period of holding of any security is to be determined basis the FIFO method. No discretion is available to select the specific lot of the scrip to be sold – the one that is dematerialized first would be deemed to have been sold first. Rationally, shares with a higher cost could be dematerialised first as the rate of income tax on short-term capital gains is higher than long-term capital gains.
Alternatively, in case where the shareholder has brought forward losses, shares with a lower cost could be dematerialised first since the gains could be offset by available losses. A different order of dematerialisation could also be chosen to achieve other results. It is also worthwhile to note that FIFO system is to be applied account wise. In the depository system, an investor could have multiple demat accounts and may have part shares of the same scrip credited to another account. In such a case, FIFO is to be applied per account individually and not collectively to all demat accounts of a particular investor. An apposite strategy on the order of dematerialisation or the need to have multiple demat accounts should be made upfront at the time of complying with new requirements under the Companies Act.
In the last four years, a number of legislative amendments and regulatory measures have targeted shell (or letterbox) companies, benami holdings, black money transactions, financial reporting by banking institutions and various means of tax evasion. Demonetisation and the subsequent digitalisaton and dematerialisation now are surely opportunities to move towards a policy superstructure that’s truly regulatory in nature.
New KYC process is likely to eliminate many ghost directors from the system. The beneficial ownership disclosure has been introduced to prevent misuse of corporate vehicles for tax evasion and money laundering. Media reports suggest that the MCA may soon ask companies to geo-tag the location of their registered offices in the statutory filings with the RoC. Attaching the data of the exact location of the registered office would help identify cases where one building houses multiple of shell companies. Looks like the reforms overdrive isn’t going to slow down soon!
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