The Finance Act 2018 brought a paradigm shift in the taxation of Long-term Capital Assets (LTCA)- being equity shares by the withdrawal of tax exemption of Long-term Capital Gains (LTCG) on the transfer of such shares and by inserting section 112A along with clause (ac) to section 55(2) to the Income-tax Act, 1961 (the Act) to determine capital gains income for shares acquired before 1 February 2018. Notably, such clause (ac) contains an Explanation, having an exhaustive definition of Fair Market Value (FMV), which is imperative to arrive at the Cost Of Acquisition (COA) of such LTCA, as defined in section 112A of the Act.
Backdropping the above, a question remains on how to compute the COA of unlisted shares acquired before 1 February 2018 and which were transferred as an Offer For Sale (OFS) being part of the Initial Public Offer (IPO) process i.e., before the listing of such shares on a recognised stock exchange. To illustrate, an individual, who is a promotor in an unlisted company, has subscribed to equity shares before 1 February 2018 at ₹100 per share and is contemplating transferring shares in the year 2023 at ₹1,000 per share under the IPO process as an OFS.
Let’s analyse first whether the requirements of section 112A of the Act are satisfied in the above illustration:
The period of holding of equity shares under consideration is more than 24 months – Here LTCA meets the condition and income on transfer would be chargeable under the head ‘Capital Gains’.
Security Transaction Tax (STT) is paid on acquisition – Since shares are unlisted when subscribed, STT is not required to be paid on the acquisition, in view of CBDT notification No. 60/2018 dated 01 October 2018.
STT is paid on transfer – Paid in view of section 98 (entry no. 6) read with section 97(13)(aa) of Finance (No. 2) Act, 2004.
Since the conditions of section 112A of the Act are satisfied and shares are acquired before 1 February 2018, the COA is to be determined pursuant to section 55(2)(ac) of the Act. On a plain reading of provisions of section 55(2)(ac) of the Act, it is clear that to determine the COA, the following components should be identified:
Actual COA of the shares, which is ₹100 (as illustrated above)
FMV as on 31 January 2018, to be evaluated as per clause (a) to explanation to section 55(2)(ac) of the Act
The full value of consideration on the transfer of shares, which is ₹1,000 (as illustrated above)
The term FMV as defined in Explanation to section 55(2)(ac) of the Act has the following three limbs:
Sub-clause (i) considers a scenario where shares are listed on a recognised stock exchange on 31 January 2018. Since the equity shares are not listed on 31 January 2018, hence FMV in accordance with clause (i) cannot be computed
Sub-clause (ii) refers to the fair market value of units. Since capital assets are not units, and hence clause (ii) is not applicable in the above illustration
Sub-clause (iii) refers to the FMV of equity shares, which are listed on the date of transfer. Since equity shares are transferred under OFS as part of the IPO process, the same is unlisted on the date of transfer, hence the FMV in accordance with clause (iii) cannot be computed.
In the absence of such a formula determining ‘FMV’ as on 31 January 2018, applying the rule of strict construction of taxing statute, a view emerges that no capital gains would be payable by an individual promoter, as the capital gain computation mechanism fails. This view is also supported by the decision of the Honorable Supreme Court in CIT vs. B C Srinivasa Setty  128 ITR 294 (SC).
However, in the spirit of the law, the above view may not be a correct view as the purpose of the insertion of sections 112A and 55(2)(ac) of the Act was not to exempt the capital gains but to grandfather the gains up to 31 January 2018 and tax balance capital gains.
Given the above and considering that IPOs are in vogue for the last 1-2 years, it becomes a mindful exercise to evaluate the capital gain tax implications, where the equity shares are offloaded by the promotors as part of the IPO process under OFS. Though the above-cited judicial pronouncement may be relied upon to take an aggressive view, a better view could be to determine the FMV from a professional valuer as on 31 January 2018 and treat it as a COA for the shares to be sold under OFS, until clarity is provided by way of an amendment to section 55(2)(ac) of the Act.
It is expected that Budget 2023 will bring in a necessary amendment in the explanation to section 55(2)(ac) by expanding the definition of ‘FMV’ in the scenario illustrated above.