Sucheta Dalal :Must secondary ADRs avoid capital gains?
Sucheta Dalal

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Must secondary ADRs avoid capital gains?  

Feb 7, 2005


Companies planning a secondary American Depository Receipt (ADR) issue have raised an interesting demand that investors offering their shares in the ADR should be exempt from capital gains tax and be allowed to pay the tiny Securities Transaction Tax (STT) levied on secondary market transactions instead.


The issue first came up at the Extraordinary General Meeting (EGM) of Infosys Technologies called to clear the sponsored ADR issue of approximately $1 billion. Shareholders wanted the Infosys management to seek government approval for treating domestic shares sold in the secondary ADR as a capital market transaction eligible for STT of 0.05 per cent.


A secondary ADR issue is one where domestic investors offer their shares into a pool that is sold to foreign investors through the intermediation of investment bankers. Since the shares are sold abroad, and they usually realise a significant premium to the domestic market, investors stand to make a bigger profit than they would on Indian bourses. However, the entire deal is an off-market transaction in India, which means that the profits would be subject to a 10 per cent long-term capital gains tax and STT applicable to trades settled on stock exchanges will not apply to it.


In deference to shareholders’ wishes, Infosys wrote to the Finance Minister seeking preferential tax treatment for the ADR offering. Its officials have also spoken to stock exchanges and senior finance ministry bureaucrats to explain their stand.


In these discussions, it has also been suggested that the process of offering shares for the secondary ADR be conducted like a ‘reverse book-building’ transaction that the Securities and Exchange Board of India (Sebi) now mandates for companies seeking to delist their shares from bourses. That would make it a legitimate secondary market transaction and justify the application of STT instead of capital gains tax.


The Infosys plea raises several interesting questions that have a broader implication for the government’s tax collection effort and the capital market. Finance ministry and stock exchange officials believe that loss of tax revenue through such a concession maybe in the region of Rs 400 crore. Infosys however claims that the tax loss will be only Rs 74 crore because foreign and institutional investors don’t pay any tax.


Their calculation is as follows: ‘‘The estimated size of the sponsored ADR issue is around $1 billion. Of this, Foreign Institutional Investors (FIIs) and mutual funds hold 44 per cent of Infosys shares listed in India and they do not pay any taxes. Thus, we are talking of approximate proceeds of $560 million on which amount the capital gains is to be computed. Assuming that there is a premium of 30 per cent (We consider only the premium of ADR over the Indian share price since if the share had been sold in India, there would have been only STT liability and no capital gains at all), the taxable income would be around $168 million. Since it is likely that most of it will be subject to long-term capital gains, the total tax is $16.8 million or Rs 74 crores..’’


Infosys has assumed that shares tendered in the ADR will be in the same proportion of their current holding. But the tax loss to government may be higher if foreign and Indian institutional investors tender less shares than retail investors. Even if we were to assume that the tax loss may be only between Rs 74 to Rs 100 crore, the bigger issue is that such a concession will trigger similar demands from investors of ICICI and Satyam, which are also planning sponsored ADRs as well as several other classes of investors.


If STT is applied to the sponsored ADR of Infosys, then investors tendering shares in open-offers under the takeover code, non-market share buyback transactions and even reverse book building deals by companies delisting their shares from stock exchanges are legitimately bound to make a similar demand. Today, these investors are all expected to pay capital gains tax. Infosys has argued, ‘‘The mode of sale of shares should not determine the taxability of the transaction. We are not asking for any new concession but are only requesting that an anomaly in the notification be addressed.’’


In fact, there is no anomaly. Tendering shares in a sponsored ADR, an open offer or even a share buyback usually fetches a premium to the secondary market price, sometimes a significant premium. Why should these investors grudge a 10 per cent capital gains tax on their profit and demand parity with secondary market deals? After all, nothing stops them from ever selling their shares on the secondary market at the prevailing price and avoiding the capital gains tax.


Also, my recollection is that the STT wasn’t born out of ‘‘an effort to encourage investors’’ (as claimed by Infosys) but out of the perception that there is large-scale tax evasion on secondary market transactions. It was felt that a small transaction tax, collected through the stock exchanges would ensure that the government gets definite tax revenue out of the huge trading volumes generated on bourse. And this has worked well over the last year. However, non-market transactions such as open offers, sponsored ADRs or reverse book-building issues are usually one-time deals that offer little scope for tax avoidance. These transactions also have no price risk and usually generate a higher profit than ordinary market transactions, so there is no reason for a cash-strapped government to reward these investors with tax concessions. Thirdly, if STT is made applicable to one-time profit opportunities for capital market investors, why should similar concessions be denied to those who invest in property, jewellery or other investments?


As a good corporate citizen, Infosys has done the right thing in representing the views of its retail investors to the finance ministry. After all, who doesn’t like a tax break? But it is for the government to consider the various demands that would be triggered by such a concession and weigh it against the high taxes and surcharges that it already levies on other categories of investors.


When seen in this broader perspective, a concession to Infosys shareholders will be unfair and untenable unless the government is so comfortable about its revenue position that it is willing to scrap capital gains tax altogether.


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-- Sucheta Dalal