Capital Gain Taxation On Conversion Of Convertible Preference Share Into Equity Shares And Subsequent Sale Of The Equity Shares Converted

Segregation of Transactions for assessment under income tax:

• Conversion of Convertible preference share into Equity Shares
•  Sale of Compulsorily Converted Equity Shares

I. Conversion of Convertible Preference Share into Equity Shares:

• Conversion of Compulsorily Convertible Preference Shares (CCPS) into equity shares is not considered as a taxable transfer under Income Tax Law.
• This is accordance with Section 47 clause (xb) of the Income tax law which outlines that “any transfer by way of conversion of preference shares of a company into equity shares of that company not considered transfers for taxation purposes”. 

And hence the client has no implication of capital gain taxation under the Income Tax law for conversion of CCPS (Compulsorily Convertible Preference Shares) to Equity Shares.

II. Sale of Compulsorily Converted Equity Shares:

Sale of Equity Shares requires consideration on three factors

1.Classification based on holding period

2.Applicable Tax Rate

3.Determination of Cost of Acquisition

Classification based on holding period:

• Provision: Capital gains tax on the sale of equity shares depends on the duration for which the shares are held. If the shares are held for more than 12 months, it falls under the category of long-term capital gains (LTCG), while if the holding period is less than or equal to 12 months, it’s considered short-term capital gains (STCG).

Section 2(42A) (hf) of Income Act,1961 defines in the case of a capital asset, being equity shares in a company, which becomes the property of the assesse in consideration of a transfer referred to in clause (xb) of section-47, there shall be included the period for which the preference shares were held by the assesse.

• Contrast: Hence the converted equity shares will hold the period of holding of preference shares also into consideration. And thereby the holding period of the equity shares so sold started on December 2022 and ends on the date of sale of such equity shares.

To conclude, gain on sale of such converted equity share will be falls under the category of Long term capital gain.

Applicable Tax Rate:

• Provision: 

1. Long Term capital gains on equity shares under Section 112A are taxed at the rate of 10% subject to the fulfillment of conditions specified below. On the other hand, short-term capital gains on equity shares under Section 111A are taxed at a rate of 15%. Capital gain tax under section 112A will be levied only if the below-mentioned conditions are fulfilled:

• Sale must be of equity shares or units of an equity oriented mutual fund or units of a business trust.
• The securities should be long-term capital assets i.e. having more than 1 year of holding.
• Capital gains is more than Rs.1 lakh.
• The transactions of purchase and sale of equity shares are subject to STT (Securities Transaction Tax). In the case of equity-oriented mutual fund units or business trusts, the transaction of the sale is liable to STT. For long-term capital gains on equity shares, the tax rate is currently 10% without indexation as per Section 112A.

2. The Central Government has issued the final notification (in accordance with the notification under section 10(38) of the Act).

The notification provides a negative list of transactions of acquisition in respect of which the condition of STT being paid on acquisition and transfer will have to be satisfied. Certain exclusions (in accordance with the notification under section 10(38)) to this negative list have also been

` provided. The negative list includes the following:

• Acquisition of existing listed equity share in a company whose equity shares are not frequently traded on a recognized stock exchange of India by way of a preferential issue
• Acquisition of existing listed equity share in a company, not entered through a recognized stock exchange of India.
• Acquisition of equity share of a company during the intervening period starting from the date on which the company is delisted and ending on the date on which the company is relisted on a recognized stock exchange, in accordance with the Securities Contracts (Regulation) Act, 1956 read with Securities and Exchange Board of India Act, 1992 and any rules made there under.

1. However, it is to be noted that in some transactions of acquisition of equity shares, STT could not have been paid at the time of acquisition. In order to give the benefits of section 112A to such genuine cases, power was vested in the Central Government to notify such exceptional cases of acquisitions.
2. One among such exception includes Acquisition by mode of transfer referred to in section 47 (transactions not regarded as “transfers”) or section 50B (slump sale) or 45(3) (capital contribution in firm/ AOP/ BOI) or 45(4) (distribution on dissolution of firm/ AOP/ BOI) of the Act if the acquisition by the previous owner was not covered under the negative list in this notification

• Contrast: Though the sale of converted equity shares doesn’t attract the applicability of 112A as such, however vide the notification issued by the central government stating the e exclusions are also in accordance with the notification issued under section 10(38) of the Act. It is to be noted that there is a specified exemption for share acquired via Section 47 and hence the gain on sale of such converted equity share will be taxed under Long term capital gain u/s 112A at flat 10% on amount exceeding Rs.1 lakh.

Determination of Cost of Acquisition:

• Provision: Section 49(2AE) of the Income Tax Act deals with the deemed cost of acquisition of equity shares. It states that where the capital asset, being equity share of a company, became the property of the assessee in consideration of a transfer referred to in clause (xb) of section 47, the cost of acquisition of the asset shall be deemed to be that part of the cost of the preference share in relation to which such asset is acquired by the assessee.
• Contrast: The cost of acquisition of the converted equity shares is the cost incurred on purchase of compulsory convertible preference share.

Summary of the query is mentioned as under:

• There is no capital gain on conversion of compulsorily converted preference share into equity shares.
• Capital gain on sale of converted equity shares will be taxed under long term capital gain at 10% in excess of Rs.1 lakh as the holding period considers the period it is held as compulsorily converted preference shares and
• Cost of acquisition for the purpose of computation of capital gain takes the cost incurred for the purchase of original preference shares.