SKP Tax Alert
Volume 9 Issue 28 | 27 January 2017
Unlisted share transfer by AIFs to be taxed under Capital Gains irrespective of the shift in control and the management of business
 
There was a lot of uncertainty and litigations in the past on how to characterise income arising from the transfer of shares or other securities, as business income or capital gains.

While recognizing that there is no universal principle that can be laid down in absolute terms to decide how to characterize income from sale of shares or other securities, the Central Board of Direct Taxes (CBDT) issued a circular on 29 February 2016[1] clarifying that income arising from transfer of listed shares and securities (which were held for more than 12 months before transfer) would be taxed as capital gains and not as business income, except where the taxpayer treats the income as a business income or where the genuineness of the transaction itself is questionable.

To maintain a consistent approach, another circular was issued on 2 May 2016[2] to provide the same tax treatment for income arising from transfer of unlisted shares, subject to certain exceptions, one of them being that the transfer of unlisted shares made along with the control and management of underlying business may not be eligible for taxation under the head capital gains.

While the first circular was a welcomed by the market, the second circular made things difficult for Alternative Investment Funds (AIFs) because of the inserted exception as it could lead to gains on the sale of unlisted shares along with control and management of the underlying business being characterised as business income.

SEBI registered Category I & II AIFs invest in unlisted shares of business ventures, many of which are new set-ups or start-ups, and thus, some form of control and management of the underlying business may be required to be exercised by such AIFs to safeguard the interest of the investors. Hence, whenever AIFs end up divesting the interest in such start-ups, it may lead to a higher tax rate in the hands of AIFs as business income compared to capital gain tax.

The CBDT received representations from the AIF community that the exception regarding the transfer of unlisted shares along with control and management of the underlying business should not apply to them.

Accordingly, in order to provide relief to such AIFs, CBDT issued a circular dated 24 January 2017[3] clarifying that such exception would not be applicable in the case of SEBI registered Category I & II AIFs.
 

[3] F.No. 225/12/2016.II dated 24 January 2017
[2] F.No. 225/12/2016/ITA.II dated 2 May 2016
[1] Circular No. 6/2016 dated 29 February 2016
SKP's comments
This circular has come as a major relief to AIFs investing in new set-ups or start-ups. It is a welcome move for encouraging investment from foreign investors investing through AIFs in India. This clarification by the CBDT will go a long way for the foreign investors and also help to fund the start-ups.

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