SEBI’s New Price Discovery Framework: Navigating the Tax Implications

[Parv Jain is a 3rd-year B.A., LL.B. (Hons.) student at the Institute of Law, Nirma University, Ahmedabad]

Recently, the Securities and Exchange Board of India (‘SEBI’) led the way and proposed a unique price discovery method for listed Investment Companies (‘ICs’) and listed Investment Holding Companies (‘IHCs’) through its consultation paper on “Framework for Price Discovery of Shares of listed Investment Companies & listed Investment Holding Companies”. The purpose of this paper is to solicit public opinion on the formation of a framework for the fair price discovery of shares of certain listed companies that are trading at a substantial discount to book value. There is sufficient literature available on the merits and demerits of the framework, with various suggestions on the price band and minimum required traders for the completion of a special call-auction.

This post analyses the different tax implications for the investors of these companies after a special call-auction. It starts with a comprehensive examination of the current provisions on the computation of capital gains based on fair market value. Further, the author explains how some investors might face a higher tax burden, using a fictional scenario. Lastly, the author touches upon SEBI’s frame of reference and concludes with certain suggestions, including revising the tax regulations to ensure fairer tax burdens and a more efficient trading environment.

Assessing the Legal Framework

SEBI came up with this mechanism to address investors’ interest as these ICs and IHCs are trading way below their book value mainly because of a lack of operational activities or because these companies hold investments in various asset classes, including shares of other listed companies. This leads to a significant difference between market value and book value, as there are no transactions of buying and selling, and thus the fair price is not reflected. The special call-auction would provide the best match between buyers’ and sellers’ bids. Now, a question arises: when the bids are matched and a fair price is discovered, how is the computation of the tax liability of investors on these capital gains determined?

The issue arises only if the share is frequently traded, which is defined under SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (the ‘SAST Regulations’) as shares of a company in which at least 10% of the total number of shares of that class have been traded on a recognised stock exchange during the 12 months before the month of the acquisition and transfer. Hence, if a share is infrequently traded, then section 50CA of the Income Tax Act is applicable, which addresses the problem of undervaluation of shares during the transfer of shares of a company. It states that the full value of consideration of capital gains for an infrequently traded share would be based on its fair market value. Therefore, even if a share is trading below its fair market value, then that difference would be added to the transferor’s income. For example, “A” transfers her unquoted shares purchased at Rs 10 lakhs to “B” at Rs 20 lakhs, whereas the fair market value of the share as determined by the prescribed manner is Rs 50 lakhs. Then, section 50CA would be applicable, and the entire amount of Rs 50 lakhs would be taken into consideration for the computation of capital gains of “A”.

The prescribed manner for calculating fair market value is provided under rule 11UA of the Income Tax Rules, 1962. In the current scenario, all of the 70 recognised ICs and IHCs are trading way below their book value and are not frequently traded. For example, Elcid Investments’ 6-month VWAP is Rs. 3.37, whereas its book value is Rs. 5,84,329, which makes the percent of book value to VWAP per share 1,73,39,139%, which is an absurd gap. If the special call-auction is opted for, then the fair market value would be based on the unquoted equity shares formula, as the shares are acquired through a transaction that is different from normal trading through stock exchanges.

Fair market value of unquoted equity shares =  (Assets−Liabilities)×(PE)/PV


  • PE = Paid-up equity share capital as per the balance sheet;
  • PV = Paid-up value of such equity shares;

In this case, price discovery would occur, but it is unlikely to be equal to or near the book value of the share. These shares would also be infrequently or minimally traded. Thus, the investor would have to pay tax on the fair market value, which is higher than the price discovered through the special call-auction. This will create a gap and the investor will be obligated to pay more tax on the capital gain, despite not benefiting from the fair market value but only from the price discovered through the special call-auction.

Tax Implications and Market Dynamics

Let us consider a hypothetical example. The shares of ABC Investment Company Limited trade below their book value. SEBI calls for a special call-auction where several buyers and sellers bid to discover a fair price. Here are three possible cases:

  • Market Value = Rs 100
  • Book Value = Rs 500
  • Fair Market Value (according to rule 11UA) = Rs 400

Firstly: The Ideal Scenario

Before a special call auction could be called upon, the ABC’s shares became frequently traded, i.e., at least 10% of the total number of shares have been traded in the last 12 months on a recognised stock exchange before the month of transfer in terms of the SAST Regulations. Thus, there will not be any need to call for an auction. Here, the tax liability will be based on the trading value, i.e., Rs 100. Since the market value itself reflects the fair value of the frequently traded share, there would be no need to calculate the fair market value as per rule 11 UA.

Secondly: The Optimistic Scenario

Let us assume that the price discovered through the special call-auction is Rs 200. In this case, an optimistic assumption is taken that after the fair price is discovered through the special call-auction, the shares will become frequently traded post-auction based on the rationale that this price was agreed upon by both buyers and sellers. Hence, the tax liability will be based on the new market value, i.e., Rs 200. There would be no need to calculate the fair market value in terms of rule 11 UA.

Thirdly: The Realistic Scenario

Let us assume that the price discovered through the special call-auction is Rs 200. But even after the price discovery, the shares remain infrequently traded, mainly due to a lack of market interest or perceived value discrepancy because of huge differences in market value and book value. Here, the tax liability on the investor would be based on the fair market value, i.e., Rs 400, placing a higher tax burden on the investor despite a lower discovered price of Rs 200. This can adversely impact individual and institutional investors and would undermine SEBI’s efforts to provide for fair price discovery and improve market efficiency. Further, this could discourage investors due to unnecessary financial strain and a reduction in the overall return on investment. As a consequence, fewer transactions would lead to reduced liquidity and undermine market stability.

The Way Forward

Overall, this is a great initiative by SEBI, as it would finally reward the investors of these listed ICs and IHCs and provide them with a better and fairer exit on their investments. Practically, it must be noted that SEBI can only provide new frameworks and price discovery mechanisms to address the issues of investors, but it cannot provide a solution for every ancillary problem they face. SEBI must have taken the rationale that these shares would soon become frequently traded, thereby saving them from increased tax liability and, even if these shares remain infrequently traded, the newly discovered price through a special call-auction would provide them with substantial profit on their investment so the tax burden would be feasible.

However, it is important to amend the tax regulations to ensure that the framework benefits these ICs with fair price discovery. Rule 11UA of the Income Tax Rules, 1962 can be amended to ensure that the full value of consideration for computation of the capital gains in certain special cases, like in a special call-auction, to be the fair price discovered and not the fair market value as per the rule. This will ensure that the tax liability does not become excessive, and investors’ interest will increase as they would be paying for the fair price discovered through call-auction rather than the fair market value.

In conclusion, implementing these measures will lead to a fairer and more efficient trading environment and enhance the advantages of the special call-auction system. Additionally, it would ensure that investors are better protected and more willing to participate in the market, thereby increasing market liquidity and transparency.

Parv Jain

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