Tax relief on inherited shares: Sebi floats proposal for smoother transfer

Sebi steps in to clear tax confusion over inherited shares, proposing a fix to stop nominees from being wrongly taxed before passing assets to heirs

What happens to your shares after you’re gone? For millions of new retail investors, that simple question has created a thorny legal and tax puzzle. Concerned about the fallout, Sebi has moved to sort it out by making a rare foray into direct tax policy.

 

With retail investors buying shares in large numbers, the market regulator has decided to intercede on their behalf to offer a substantial tax relief. What happens to the shares when the owner dies? The shares pass on to the legal heirs, correct. The market regulator, Securities and Exchange Board of India (Sebi), is not sanguine and instead feels a problem is opening up. It has intervened to sort out the issue.

 

In the process, for the first time ever, the regulator has offered a public opinion on a tax matter, albeit for a very good cause. To make the position clear, Sebi has floated a discussion paper this month on the subject. The issue is as follows: when filling in their demat applications to enter the markets, retail investors often mention as their nominees someone who is not necessarily their legal heir. Yet, the choice of nomination has become mandatory for all demat accounts opened with effect from October 1, 2021. For mutual fund units, the rules have been mandatory since October 2022.

 

In addition, banks and depository companies are sending out mails to investors asking them to populate their folios with the details of their chosen nominees.

 

Under the current tax treatment, if a set of shares passes to the nominee when the shareholder dies, the “transmission of securities from nominee to legal heir may be considered as normal sale of securities and hence capital gain arising out of such transmission may be considered taxable in the hands of the nominee”, the Sebi paper notes.

 

The provisions of both gift tax and capital gains tax could apply whenever such a transfer takes place. “This should not happen,” said Kaushik Dutta, director at fiscal policy think tank Thought Arbitrage Research Institute and former member of the Indian leadership team at PricewaterhouseCoopers.

 

The beneficial interest in the shares does not devolve on the nominee at any stage, he said. So there should be no room for taxation.

 

Yet Sebi has been flagged about the problem by shareholders. It has happened even in cases of transfer of shares from a company owner to their children. Since it is quite possible that when the transfer deed is executed the children may be minors, a nominee is appointed. But this changes when the children come of age.  However Prasenjit Sarkar, Partner, Tax, Regulatory and Consulting, Grant Thornton Bharat welcomed the decision as "a pragmatic step" .

 

The solution Sebi has proposed is neat. A “standard reason code viz. ‘TLH’, transfer to legal heir, shall be used by the reporting entities while reporting the transmission of securities from nominee to legal heir, to the Central Board of Direct Taxes so as to enable proper application of the provisions of the Income Tax Act, 1961,” the discussion paper notes. Instead of issuing a notification, Sebi has floated a discussion paper to debate the decision. Under chairman Tuhin Kanta Pandey, Sebi has decided to always float a discussion paper on any subject before offering a solution.  Sarkar said "The proposal to introduce a distinct ‘TLH’ reporting framework for nominee-to-heir transmissions harmonises securities regulation with succession practices, as it addresses an operational gap that often created uncertainty for intermediaries and investors alike".

 

It is important to point out that the Companies Act makes a distinction between transmission of shares and transfer of shares. While transfer of shares relates to a voluntary act of the shareholder, transmission happens, for example, by “devolution by death, succession, inheritance, bankruptcy, marriage and others”. While clause (iii) of Section 47 of the Income Tax Act, 1961 does not consider such transmission as “transfer”, it is not clear if and when the payment of capital gains is triggered in these cases.

 

It is now up to the direct tax department to include the term TLH in the tax filing options. A Sebi official said the CBDT has come on board to make the change, which the regulator describes as a step that could be classified as Ease of Doing Investment.

 

The solution has salience. Next door, the Reserve Bank of India is still wrestling with a similar problem. There are over Rs 50,000 crore worth of deposits lying with various banks, unclaimed. There are no easy answers, since often those sums are earmarked for nominees to hand over to the legal heirs. Once the nominee steps forward to claim the sum, she is liable to pay tax on it and face legal suits, if there is more than one legal heir in the fray. This is provided there is a contest between them.

 

While the Sebi paper is silent on what would happen if there are similar court cases among heirs, the nominees can at least be spared the tax liability with this interpretation.

 

This naturally also makes for more efficient capital markets. Since death is inevitable and the legal heirs are not always in line of succession, a good percentage of shares remain locked up, estimated at close to 5 per cent of the total shares issued in the country.

 

While the creation of a mandatory nominee has solved one problem for the intermediary companies, the challenges have mounted for the former. As the Sebi paper notes: with the identification of the nominee “the intermediary is relieved of its responsibility once the securities lying with it are transmitted to a nominee after the death of the original security holder (in case the security holder has provided a nominee). It may further be noted that a nominee holds a position of a trustee and appointment of a nominee is not intended to create a third mode of succession.”