More on Share Warrants, Share Certificates and Capital gains

Dear Pramodji,

Mea culpa! :(Actually my understanding of Share warrant was a hangover from my CAIntermediate days! I failed to apply my mind to the problem andquoted Section 114, which section clearly states that share warrantscan be issued only in respect of FULLY-PAID shares. In the instantcase, the assessee had paid Rs 2.50 per share some two-and-a-halfyears back. The shares were partly-paid up. It was only on 20 April2008 when the remainder of the face value was paid that the sharesturned fully paid-up, capable of being converted into share warrantsu/s 114. But till those shares were partly paid-up, Section 114 hadno business being invoked!All the same, I do think the term "Share Warrant" is a misnomerhere. It'd better be avoided. What X Ltd had got in this case was aCall Option like the ESOP. They had an option to or not to buy theshares when the time to exercise that option arrived. If indeed thisis how it was, then clearly, Mr Milind Shah, the original querist,isn't using proper terminology to describe the problem when hesays "X Ltd purchased warrants of Y Ltd on 30.09.2006 for Rs 2.50".It is liable to be interpreted as the price of the shares havingbeen paid in parts over a two-year period—Rs 2.50 being the firstcall and Rs 7.50 being the second call along with a premium of Rs15.Regarding the taxability, let's see what the CBDT in its Circular No9/2007 dated 20 Sept 2007 states in answer to the FAQ 17:[17. Whether ESOPs issued to non-executive directors or non-employees liable to FBT?Answer: Benefit arising out of ESOPs issued to non-employees willnot be liable to FBT. However, in such cases, the taxability of suchbenefits in the hands of the non-employees will be determined inaccordance with the existing law. ]So the taxability of the stock options in the hands of non-employeeswill be determined in accordance with the existing law. What is theexisting law on the taxability of stock options—does the Optionitself constitute a capital asset and therefore liable to be taxedas CG upon its exercise? In the absence of concrete information inthis particular case, I am not sure if X Ltd had the right tofurther transfer that option to a third party. To determine whetherwe have relinquished our rights in a capital asset, first we have toascertain whether we had a Capital Asset to begin with. And as Idiscussed in my previous post, the Option (or Warrant, if you like)had to be a "Marketable security" of the nature like the shares,scripts, the stocks, the bonds, et al. A capital asset in terms ofSection 2(14) of the I T Act can qualify to be so only if it'scapable of being held and transferred like any other item ofproperty. If it isn't, then I don't see how can there be an occasiongiving rise to CG tax when the option to buy shares is exercised.Yet again, there's a need to look more at the substance of thetransaction rather than its form. And without prejudice to what Isaid in my first para, there still could be a possibility that Rs2.50 was merely the first call, the shares—in substance though notin legal form—having been bought on 30 Sept 2006 itself. In thatevent, the gain will be an LTCG.Actually, I am a little skeptical to take the terminology used insome queries at its face value. In many cases, the terms don't meanwhat we traditionally understand them to mean. So it's important tocut through the fog of misleading terms to look at what thetransaction really is.Thanks a lot Sir.CA Sanjeev Bedi--- In ICAI_CIRC_MEERUT_CA@yahoogroups.com, PRAMOD GOENKA wrote:>>> Dear CA. Bedi>> With due respect, I disagree to equating warrants with shares. Awarrant gives one an entitlement to apply and get shares - in thecase cited by Mr. Milind, the warrant holder had to pay Rs. 22.50per share to get the share. The warrant holder could have very wellchosen not to exercise the option - in that case, Rs. 2.50 paid byhim for acquisition of the right to apply for shares would havelapsed and he would have incurred the loss to that extent only. Instock market terminology, both of these are never equated.>> Sec. 114 of the Companies Act talks about a different conceptaltogether, as you have rightly said, making the shares transferableby delivery instead of by registration of transfer deed. There werehardly any companies that issued warrants that way. Presently, theterm warrant is used to describe an entitlement to the apply for theshares, a route initially used by many companies to make their non-covertable debentures attractive by linking such warrants to thedebentures.>> Probably, the confusion is due to use of one term for two entirelydifferent things.>> With the concept of warrants as understood by me, I reiterate thatperiod of holding of shares will commence only on the date whenthese were actually allotted by the company, and there will be aseparate tax issue invovled in taxability of warrants when thesewere extinguished on exercise of option.>> CA. Pramod Goenka>> Hi MKK, Since a Share Warrant is a creature of the Company law, Ithink we need to examine the meaning of a Share Warrant in thecontext of the Companies Act to better understand what it really is.Here's what Section 114 of the Cos Act states:[114. (1) A publiccompany limited by shares, if so authorised by its articles, may,with the previous approval of the Central Government, with respectto any fully paid-up shares, issue under its common seal a warrantstating that the bearer of the warrant is entitled to the sharestherein specified, and may provide, by coupons or otherwise, for thepayment of the future dividends on the shares specified in thewarrant.(2) The warrant aforesaid is in this Act referred to asa "share warrant".(3) A share warrant shall entitle the bearerthereof to the shares therein specified, and the shares may betransferred by delivery of the warrant.]So a share warrant ISN'T inmy opinion a Rights Entitlement. It is a Right in itself. The sharewarrant is a kind of a bearer cheque, whilst a share certificate(demat or physical) is akin to an account payee cheque. The holderof a share warrant is an anonymous shareholder. Since the holder ofa share warrant is entitled to dividend on the shares specified onthe warrant, it stands to reason that he's the de facto owner of theshares, though he isn't a member by virtue of Section 2(27). And sub-section 3 above even speaks of how the transfer of the shares may beeffected by mere delivery of the warrant. So clearly a Share warrantconstitutes an asset at least as far as the Companies Act isconcerned. A share warrant seems like a surrogate share certificate.It was invented to get around the cumbersome procedure that involvestransferring shares through a share certificate (although in thepresent-day Demat regime, share warrants seem like things of thepast). I don't see any reason why we should interpret thingsdifferently when we have to judge the taxability of the gains fromthe sale of share warrants under the Income Tax Act. But evenconsulting the Income Tax Act seems to lead us to the conclusionthat a Share Warrant is a capital asset. The proviso to Section 2(42A) that fixes the age of certain capital assets at 12 monthsafter which they turn "long-term", says:[……. in the case of a shareheld in a company or any other security listed in a recognised stockexchange in India…..]A security is defined u/s 2(h) of theSecurities Contracts (Regulation) Act 1956 as follows:[(i) shares,scrips, stocks, bonds, debentures, debenture stock or OTHERMARKETABLE SECURITIES OF A LIKE NATURE in or of any incorporatedcompany or other body corporate; (ii) Government Securities (iia)such other instruments as may be declared by the Central Governmentto be securities; (iii) rights or interests in securities;]So evenif we argue that Share Warrants are Rights, they would still amountto Securities in the view of the (iii) above. Since share warrantstoo are securities in terms of the proviso to Section 2(42A), thetime-clock for determining whether they're long- or short-termcapital asset would start ticking from the date of allotment of theShare Warrant. So as far as the taxation law is concerned, it seemsshare warrants and share certificates are two sides of the samecoin. Mr Goenka, I think no CG will arise at the time of conversionof warrants into shares. The transaction seems a mere ceremony—aKacha shareholder becoming a Pucca, registered shareholder. I can'tsmell anything resembling a relinquishment or exchange orextinguishment of rights in a capital asset. In my view, the CG willbe LTCG in nature and the cost will be indexed with reference to theyear in which incurred.Thanks,CA Sanjeev Bedi--- InICAI_CIRC_MEERUT_CA@yahoogroups.com, "M.K.KRISHNAN" wrote:>> > > Dear Mr.Milind Shah,> > Shares are ordinarily acquiredon the date of allotment and the> period of holding of such sharesbegins with the date of their> allotment. This rule equally applieswhere shares are allotted in> pursuance of the Rights Entitlement.Warrants are in the nature of> Rights Entitlement and the period ofholding of the shares issued in> pursuance of such Rights begin withthe date of allotment This is> confirmed by section 2(42A)(d) whichlays down the period of holding for> such assets as follows:> > "inthe case of a Capital Asset, being a share or any other> security(hereinafter in this clause referred to as the financial asset)>subscribed to by the assessee on the basis of his Right to subscribeto> such financial asset or subscribed to by the person in whosefavour the> assessee has renounced his Rights to subscribe to suchfinancial asset,> the period shall be reckoned from the date ofallotment of such> financial asset "> > Therefore I am of the viewthat on the facts explained by you the> sale of shares will beassessed as Short term Capital Gains only.> > Regards> >CA.M.K.Krishnan> > Vellore> > Tamilnadu> > > > > --- InICAI_CIRC_MEERUT_CA@yahoogroups.com, Milind Shah > wrote:>>> > Sir,> >> > But the warrants are held since 2006.> >> > Whatshould be the effect of that?> >> > Regards> >> > Milind Shah> >> >>> Since the Gains have arisen from the capital asset being theShares> (which> > is held for less than a year) - it would result inShort Term Capital> Gains.> >> > Regards, unni> >>> >> > Friends> >>> I have come across a very typical problem> >> > X Ltd haspurchased Warrants of Y Ltd. on 30.09.2006 for Rs.2.50> >> > Lateron 20.04.2008 the warrants get converted into Shares after> payingthe> > balance Rs.22.5 (F.V. 10 + Premium 15)> >> > Of the abovepart shares are sold on 20.10.2008 for Rs.35 off market.> >> >> >> >1. Now will it be Short Term or Long Term Gain?> > 2. This Gain canbe setoff against what loss?> >> > Please reply.> >> >> >> >Regards> >> > Milind Shah