In the wake of the Covid-19 disruption, many companies have either hit the market or are considering fund raising to strengthen their capital base in order to garner liquidity to safely make it through this crucial year.
Rights issues of shares –where a company offers its shares to existing shareholders – have emerged a preferred fundraising instrument at present.
One of the reasons for the popularity of rights issues is that they are subject to a favourable regulatory regime. In the case of listed companies, the issuer has greater flexibility with the pricing of the issue than they have in pricing, say, a preferential issue or a qualified institutions placement (QIP).
As is often the case, investors need to carefully evaluate the tax issues that may arise when they invest in a rights issue. First and foremost, the issue to consider is related to the pricing of the issue. Typically, issuer companies offer shares under a rights issue at a significant discount to current market price.
This discount could be subject to tax in the hands of shareholders under the deemed gift tax provisions, since for tax purposes the discount could be considered a receipt of shares without adequate consideration. This may appear to be counter-intuitive, especially since the deemed gift tax provisions were introduced with the intention of counteracting under-valued transactions that are either abusive or designed for tax avoidance provisions.
However, genuine and bona-fide transactions such as a rights issue to existing shareholders, where the issuers offer some discount to the fair value to make the rights issue attractive, were not intended to be counteracted under those provisions.
One may also wonder if the shareholder really gains when the company issues shares at a discount. This is because in the case of a rights issue where shares are offered at a discount, there is a corresponding fall in the value of existing shares held by the shareholders. Therefore, even if the shares are offered at a discount, there is no real benefit or gain that accrues to the shareholder.
Unfortunately, the law does not provide a specific exemption to rights issue. Nevertheless, the income-tax appellate tribunal has recognised the manner in which the value of existing shares falls following the issue of shares under a rights issue, and has held that the income-tax department cannot tax the discount offered by a company to its shareholders in a rights issue where the shares allotted to shareholders are not disproportionately high.The issue gets slightly more complicated in a real-world scenario. The above principle of existing shares falling in value following an issuance under a rights issue applies only to cases where the share allotment is done proportionate to one’s existing holding.
However, disproportionate allotment is quite common in practically all listed companies. For instance, a disproportionate allotment can happen when there is an under-subscription or part-subscription compared with each shareholders’ entitlement, and that can result in other shareholders automatically receiving higher proportions of shares than they should.
There are also situations where shareholders, typically promoters, are able to subscribe to the unsubscribed shares or where additional shares are subscribed to and allotted according to the purchase of rights entitlements. All of these situations lead to disproportionate allotment and in such cases the argument that there is a fall in the value of existing shareholding is not applicable.
Such an investor would not have recourse to the argument concerning the reduction in the value of existing shares and, therefore, the shareholder’s potential exposure under deemed gift tax provisions would require evaluation. In such a case, if the investor acquires the rights entitlement for a consideration, it will need to be determined whether the amount paid to acquire the rights entitlement can be considered as the consideration paid for acquiring shares.
It may be noted that for capital gains tax purposes, the amount paid to acquire the rights entitlement can be added to the amount paid to the company to arrive at the total cost of the acquisition of shares; deemed gift tax provisions do not explicitly provide for such an addition.Suffice to say, there are many complications that require careful evaluation and consideration from the standpoint of investors. Interestingly, the government has the power to exempt specific transactions fro ..
A rights issue, especially in the case of a listed company, needs to be immediately notified as an exempt transaction to facilitate fundraising during the unusual times created by the pandemic.(The authors are Partner and Principal at Dhruva Advisors LLP. Views are their own)
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