Penny stocks: The income tax department can now file appeal in tribunals and court if you are found to be using penny stocks or accommodation entries or both to evade taxes

Penny stocks linked tax evasion: Tax dept may take you to tribunal and court for bogus transactions Earlier the tax department could file such appeals only if the tax effect crossed certain thresholds, however now these cases are to be taken on merit irrespective of the tax effect amount

The Central Board of Direct Taxes (CBDT) has decided to increase the scope of the Income Tax Department in filing of appeal cases in tribunals and courts. It has been directed by CBDT via a circular dated March 15, 2024, that the tax department can now file appeals with income tax tribunals and courts without considering the tax effect amount for certain specified cases based on the merit of the case. Among the specified cases, one is about penny stocks which falls under the category of cases involving organised tax evasion including cases of bogus capital gain/loss through penny stocks and cases of accommodation entries.

"Monetary limits given with regard to filing appeal/SLP shall be applicable to all cases including those relating to TDS/TCS under the Act with the following exceptions where the decision to appeal/file SLP shall be taken on merits, without regard to the tax effect and the monetary limits," said CBDT in its circular dated March 15, 2024.

What does this mean for taxpayers?

According to tax experts, the intention behind this circular by CBDT is to catch those taxpayers who are using penny stocks and accommodation entries for tax evasion purposes. The tax department will not catch all individuals investing in penny stocks who have followed all tax law(s) and rules, but only those who have done so purposefully for tax evasion.

"Merely investing in penny stocks through accounted money is no violation of any income tax law and rule. However, declaring huge profits or huge losses, several times of investment may attract the attention of the tax department for investigation. Marginal gain or loss on disposal of penny stock may not attract any inquiry," says D.C Agrawal, retired commissioner of Income tax (CIT) and member of Income Tax Appellate Tribunal (ITAT).

What is meant by 'accommodation entries' and why will the income tax dept catch you if this is done?

According to Mitesh Jain, Partner, Economic Laws Practice, a law firm, accommodation entry is a financial transaction between the two parties where one party enters the financial transaction in its books to accommodate the other party.
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"These transactions are accommodated mostly in lieu of cash of equal amount and commission charged over and above at a certain fixed percentage for providing such accommodation entry. These accommodation entries are taken by various beneficiaries for introducing their unaccounted cash into their books of accounts without paying the due taxes," says Jain.

How are penny stocks being used for tax avoidance or evasion?

According to D.C Agrawal, there are at least two methods of tax evasion/ avoidance by investing in penny stocks.

"One method is purchasing penny stock at a very low price and selling it when its price on the stock exchange is very high. In fact, transactions in selling penny stock are done through brokers who arrange transfer of unaccounted money from the assessee to the person who buys penny stock at high price by paying to the assessee, accounted for money through banking channels. In addition to the listed price some amount is additionally paid as commission for providing accounted for money in lieu of unaccounted money," said Agrawal.

Agrawal explains the second method of using penny stocks for tax avoidance purposes. "The second method is selling penny stock at low price though it was purchased at high price, thus, capital loss is acquired. In this process the purchaser of penny stock pays unaccounted money to the seller for the difference in sale and purchase price. The prices of penny stock shares are rigged by manipulative sale and purchase within the group of the company so that accommodation is provided to the needy," he says.
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What was the earlier rule about the tax department filing appeal cases?

Experts point out in which exact court and tribunal can the income tax department file an appeal, and above which amount. However, none of these rules would apply in cases specified in the new circular dated March 15, 2024.

"In a circular dated August 8, 2019, CBDT issued new guidelines for filing tax departmental appeals before ITAT, High Court, and Supreme Court. It is said in this circular that where the tax effect is Rs 50 lakh or more, Or Rs 1 crore or more, Or Rs 2 crore or more, Revenue will opt to file appeal before ITAT, High Court and Supreme Court respectively. Here the tax will include applicable surcharge and cess. However, in this new circular dated March 15, 2024, CBDT has said that appeal may be preferred on merits irrespective of tax effect if conditions mentioned (a to m in 3.1 point) in the March 15, 2024, dated circular are fulfilled," says D.C Agrawal.

What could be the criteria for defining what is a bogus penny stock transaction?

The tax department can now pursue appeal cases in tribunals and courts if a taxpayer has used bogus capital gain/loss transactions through penny stocks. According to Jain, penny stocks are those stocks which trades at a relatively low price and have a lower market capitalization.

"Income tax department basis information undertakes investigation to identify penny stock companies wherein such bogus transactions have taken place. There are no definite criteria laid down in statue which defines a transaction as a penny stock bogus transaction. These types of stocks are generally considered to be highly speculative and high risk because of their lack of liquidity, large bid-ask spreads, small capitalization and limited following and disclosure. A penny stock bogus transaction is a transaction undertaken with a motive of earning bogus long term capital gains or incurring bogus short term capital loss," says Jain.

According to D.C Agrawal, so long as the held penny stocks are not used for tax evasion purposes, department may not initiate any action but often investment in penny stocks might be done for either acquiring bogus capital loss to be adjusted against other income or to acquire bogus capital gains for availing exemption u/s 10(38) (however such exemption was available only up to March 31, 2018). "A person who wants to earn bogus capital gains pays unaccounted money to the person to whom he sells the penny stock in return of accounted for money as sale proceeds. A person who wants to earn bogus capital loss receives unaccounted money from the person who purchases the penny stock at a low price," he says.

How can retail investors know about fraudulent penny stocks?

Retail investors may fall into the traps of social media apps, get rich quick schemes, and others and end up transacting in penny stocks which are being monitored. Hence, experts urge retail investors to carefully vet the company's stock they are thinking about investing in.

Agrawal advises retail investors that they should examine the balance sheet and the credentials of the company to find out (i) whether the company has any financial base of its own (ii) net profit, capital base, turnover of the company of last several years (iii) volatility in share prices (iv) number of transactions and volume of transaction of such shares (v) action taken by investigating agencies and SEBI whether this company is a paper company or sham company or a dubious penny stock company.

This story originally appeared on: India Times - Author:Faqs of Insurances