Gains From Penny Stocks Should Be Treated As Capital Gains, Says Bombay High Court

In a relief for investors, the Bombay High Court has ruled that gains from penny stocks have to be treated as long-term capital gains as opposed to unexplained cash credits.

This is significant as long-term capital gains are taxable at 10%, while unexplained cash credits are taxed at a flat rate of 60%.

The recent order affirms a 2016 order of the Income Tax Appellate Tribunal that allowed proceeds from penny stocks to be treated as long-term capital gains as long as payment and delivery of shares are made. Exemption from long-term capital gains cannot be denied just because there is a SEBI investigation into the irregularities of the scrip, the tribunal held.

The revenue authority had contended that several taxpayers misused the exemptions provided under the Income Tax Act for sale proceeds from listed equity shares to declare their unaccounted income, leading to tax erosion.

These entities, in collaboration with stockbrokers, buy penny stocks from predetermined companies selected by the brokers. The broker then gradually rigs the price of these shares. When the price reaches the desired level, the entity sells the shares it purchased to a paper company owned by it. The purchase is completed using unaccounted money from the taxpayer.

Prior to 2018, taxpayers were exempt from paying long-term capital gains tax as long as the gains arose from the sale of listed securities. The provision was intended to encourage long-term investment in the securities market.

However, considering the misuse, the government, through the Finance Bill of 2018, made all such gains taxable at 10% as long as they exceeded Rs 1 lakh. The present case dates back to the pre-amendment period.

In the present case, it was the revenue authority's argument that the gains Indravadan Jain (Hindu undivided family) earned from the sale of shares of Ramakrishna Fincap Ltd. should be treated as unexplained cash credit as the scrip was revealed to be a penny stock in the assessment officer's investigation.

It was alleged that the transactions were bogus as the broker who dealt in the shares was found to have indulged in price manipulation by SEBI for the very same scrip.

However, according to the court, since the shares were purchased on the floor of stock exchanges and not from any broker, and as payments were made and deliveries taken, the exemption accorded to listed securities under long-term capital gains should be extended to penny stocks as well.