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Advocate Paras S. Savla has explained the modus operandi used by unscrupulous taxpayers to launder their unaccounted black money with the aid of bogus capital gains from Penny Stocks. He has also explained the relevant statutory provisions and discussed all the important judgements on the point. He has, however, cautioned that all cases of capital gains from penny stocks cannot be branded by the authorities as bogus and offered advice on what precautions taxpayers should take to avoid being wrongly assessed to tax <\/strong> <\/p>\n Humans! We keep bringing new ideas and creations to simplify our lives and yet end up creating an intricate and complicated web which is anything but simple. We graduated from bartering to commerce and trading to make our lives easy and then to complicate the whole thing, we invented an abstract entity called “company” to limit our risk. <\/p>\n <\/p>\n A legal notion of Corporate personhood backed by various legislations across the globe, legalizing companies created a corporation, separate from its associated human beings (like owners, managers, or employees), has at least some of the legal rights and responsibilities enjoyed by natural persons (physical humans). This notion was blessed by House of lords in famous case of Salomon v. A. Salomon and <\/em>Co.<\/em> Ltd. (1897) AC 22.<\/em> These brought about rise of trading of shares and thus formation of Stock Exchanges. In this paper my discussion is restricted to tax implications on penny stocks. <\/p>\n The word “penny stocks” comes with a lot of connotations. However, it’s a common term that simply refers to stocks that trade at low prices per share off of major national exchanges. Penny stocks are defined by the US Securities and Exchange Commission (SEC) as a security that trades for less than $5 per share, is not listed on a national exchange, and fails to meet other specific criteria. In the UK, they’re called penny shares, and they’re categorised in a similar way (although the stock price limit is £1). Other countries call them cent stocks.<\/p>\n Over the years, the term “penny stock” has become synonymous with scams and “get rich quick” schemes. One Google Search will reveal thousands of results promising to make you the next penny stock multimillionaire. Not all penny stocks are a scam. However, penny stock markets are abound with low-quality companies, shadow organisations, and pump-and-dump schemes – and a few legitimate companies mixed in for good measure. Penny stocks have existed in some form or another for as long as stock markets have existed. There’s very little information about the early history of penny stocks. After the 1929 Stock Market Crash, however, the US Federal Government realised it needed to overhaul securities regulation and bring an end to the unbridled speculation surrounding penny stocks. In the Government’s eyes, the speculation was what caused the stock markets to crash in 1929. Increased regulation would help investors avoid low-quality, value-less stocks while promoting stocks from more reputable companies – or at least, that was the idea.<\/p>\n Starting in the mid-1990s, penny stock trading exploded with growth, fuelled by the spread of the internet around the world. Prior to the internet, the only real way to trade penny stocks was by phone or over the counter at a stocks exchange floor. Now, with the internet, penny stock discount brokers emerged, offering online platforms where traders could buy and sell penny stocks at discount rates. Investors were lured to penny stocks by the promises of cheap trading fees and the chance of making enormous profits on tiny investments. Throughout the 1990s, new investors entered the stock market. <\/p>\n Penny stocks in the Indian stock market can have prices ranging from ` 5 to 20. These stocks are very speculative in nature and are considered highly risky because of lack of liquidity, smaller number of shareholders, large bid-ask spreads and limited disclosure of information. Considering the nature of penny stocks, they are susceptible to frauds and scams. Hence one has to be cautious while investing in such stocks.<\/p>\n Government is making continuous efforts to curb black money and to stop various schemes being tools used to convert black money, one may still see various and continuous advertisement are made for penny stocks, which can be seen as under: <\/p>\n a) https:\/\/rakesh-jhunjhunwala.in<\/a><\/u> dt.21st February, 2018<\/p>\n RadhakishanDamani endorses PorinjuVeliyath’s “Chor” Theory & Buys Recommended stock.<\/a><\/p>\n PorinjuVeliyath’s theory with regard to buying stocks of “Chor” promoters has been cold-shouldered by investors. However, the endorsement of the theory by none other than billionaire RadhakishanDamani means that we can no longer ignore it but have to pay attention and implement it.<\/em><\/p>\n Porinju explained that there is a world of a difference between a “good company” and a “good stock”, implying that even a “bad company” can be investment worthy if it has the necessary virtues. <\/p>\n b) https:\/\/multibaggerpennystocks.in<\/a><\/u> dt. 10th February, 2018 <\/p>\n 20 multibagger penny stocks which cost less than <\/em>` 10 give gains of up to 750% in 2017<\/a><\/em><\/p>\n c) Business standard dt. 8th February, 2018 <\/p>\n CAG seeks SEBI explanation on losses due to long term capital gains benefit. <\/p>\n “The Comptroller and Auditor General of India (CAG) has written to the Securities and Exchange Board of India (Sebi) seeking an explanation on the loss incurred by the exchequer from misuse of the long-term capital gains (LTCG) exemption. According to sources, the market regulator has identified loss worth Rs 150 billion due to price manipulation on the stock market platform to avail the LTCG benefit. So far, Sebi has passed nine interim orders in the matter. Besides, the CAG has sought details of the manipulators. Currently, LTCG is exempt from taxes. The Union Budget 2018-19 proposed to levy a 10 per cent tax on such gains, starting April 1. The regulators have come across several cases were shares of penny stocks and shell companies were jacked up to convert black money into white by showing LTCG. <\/p>\n “The audit authority wants to know the size of the preferential allotment and whether it would be equal to the size of the LTCG violation, especially when the allottee sold the shares,” said a person in the know. In the last one year, the regulator has examined over 14,000 persons but could not establish the trail of fund movement. It was yet to gather sufficient evidence and references to conclude the cases, sources said. Even the information provided by the tax authorities was not sufficient to establish connections among the promoters of these companies, the beneficiaries and the ‘last traded price’ providers and ‘exit’ providers, said the person cited above. In January 2017, the regulator had informed the income tax (I-T) department that there was not enough evidence to establish charges against the manipulators. Sebi, in one of its board information memorandums in 2017, had pointed out practical problems in dealing with these cases. “Enforcement proceedings against such a large number of entities will involve issuing a show-cause notice, inspection of documents, personal hearing and passing of orders. <\/p>\n This is when preliminary examination of cases revealed that collusion among the entities was weak or absent, since most of the transactions were settled in cash. Thus, a further probe based on weak evidence will clog the system and could also result in a futile exercise,” it had said. Official data suggests the I-T department had referred 361 scrips to Sebi for investigating the LTCG manipulation. Of these, Sebi had identified 144 scrips for investigation and concluded investigation in 94 cases during that time. Accordingly, it had barred 1,500 people from trading in the securities market. <\/p>\n Further investigations revealed that over 14,000 people were involved in price manipulation to avail the tax exemption. These were apart from the 64,000 entities identified by the taxman as having evaded taxes worth ` 380 billion. The regulator is examining if the price of shares was manipulated, since it could proceed under Section 11B of the Sebi Act. This allows it to impound or retain the sale proceeds of the company or entity in question. Sebi is of view that it is bound to check only for market manipulation and not the tax evasion angle in these cases.”<\/em><\/p>\n d) https:\/\/economictimes.indiatimes.com<\/u>dt. 13th January, 2018 <\/p>\n Why investing in low priced penny stocks is not a good idea<\/em><\/p>\n e) https:\/\/economictimes.indiatimes.com<\/u>dt. 21st February, 2018 <\/p>\n 37,000% return!!! This is what a penny stock can do to your wealth <\/em><\/p>\n f) https:\/\/thewire.in\/120384\/penny-stocks-bogus-claims-sebi dt. 31st March 2017 <\/p>\n SEBI Cracks Down on Misuse of Penny Stocks<\/p>\n g) https:\/\/economictimes.indiatimes.com dt. 6th March, 2017 <\/p>\n Beware of these 774 rising penny stocks; stock exchanges up vigil <\/em><\/p>\n “Mumbai: Stock exchanges have stepped up vigil on movements of smaller and penny stocks in the wake of the sharp surge in their prices. The <\/em>Bombay<\/em> Stock Exchange and the National Stock Exchange of <\/em>India<\/em> have included 774 lesser-known companies under a graded surveillance measures framework, which is aimed at checking whether the recent advancement in their stock prices was commensurate with their financial health and fundamentals.” <\/em><\/p>\n h) https:\/\/www.moneycontrol.com\/news\/business\/markets\/i-t-department-sebi-begin-crackdown-on-penny-stock-firms-in-pmo-led-push-2442315.html<\/u> dt.20th November, 2017<\/p>\n I-T Department, SEBI begin crackdown on penny stock firms in PMO-led push. <\/em><\/p>\n The Prime Minister’s Office apprised the CBDT of 80 scrips earlier this month. The taxman and SEBI are working together to clamp down tax evasion and tighten the norms.<\/em><\/p>\n There are various previous instances where Department investigated in penny stock matters. Not once but twice, Investigation has been conducted on Mr. MukeshChokshi and one may notice many judicial decisions wherein shares dealings took place through his broking firms. On analyzing those decisions one may see that the information collected by the department was not foolproof and the government lost badly in those cases. This turned out a fight for the department to nail down illegal and fraudulent practices in and around penny stocks. <\/p>\n The Directorate of Investigation, Kolkata had undertaken the investigation on a much larger scale than earlier and as a result, they identified a very large number of beneficiaries who may have together taken a huge amount of bogus entries of LTCG. A detailed investigation report dt. 24-7-2015 named “Project bogus LTCG\/STCL through BSE listed penny stocks” was made. The span of investigation can be gauged from the fact that they identified 64,811 beneficiaries involving bogus LTCG of nearly ` 38,000 crore. <\/p>\n As per the report, the illegal business of bogus LTCG involves three different personalities. The promoter of ‘Penny stock’ companies (also known as syndicate member), the share brokers & the entry operator who purchases the shares through paper companies by taking cash. Many a times the three categories of individuals perform overlapping roles and, at times, a single individual may perform all the three functions. <\/p>\n In the earlier investigations, the approach was to target the individuals and through them identify the penny stocks and beneficiaries. This method yielded results on a limited scale emanating only from individual \/ individuals targeted. However, keeping in mind the rampant nature and exponential growth of alleged illegal business in recent times and to cast the net wide, during Kolkata investigations, Department reversed the methodology of investigation. ‘Penny Stocks’ were first identified and then department started targeting the individuals who dealt in them. As a result, department was able to virtually uncover almost all Kolkata based operators in one investigation itself. It was an on-going process, which acquired the character of a project that continued for quite some time, unlike usual investigation which ends with the statement of the individual involved. <\/p>\n As per the report the business of providing entries of bogus LTCG over the years has become much more organised and with economy of scale in full operation the stakes involved had become huge. Before the actual transaction starts taking place, there were brokers in different towns who contact prospective clients and took paper booking for entries. The commission to be paid to the operators was decided at this stage however, no money was paid. Once the booking is complete, the operators have a reasonably good idea of how much LTCG is to be provided along with the break-up of individual beneficiaries. This data is essential to decide which penny stock or companies to use for the job and which beneficiary to buy how many shares.<\/p>\n Broadly speaking there are two types of companies.<\/p>\n a) An old already listed company, the entire shareholding of which is bought by the syndicate to provide LTCG entries. These are generally dormant companies with no business and with accumulated losses.<\/p>\n b) A new company which is floated just for the purpose giving LTCG entries. Such new companies are often floated after the initial booking is complete and the capital base is decided keeping in mind the entries to be provided.<\/p>\n As mentioned earlier there are three categories of individuals who are involved in the transactions.<\/p>\n a) Syndicate Members<\/strong><\/p>\n They are the promoters of the Penny Stock companies who own the initial shareholding mostly in the name of paper companies either in a fresh IPO or purchased from the shareholders of a dormant company. They are usually a group of 4-5 individuals who are also referred to as Syndicate Members and are sometimes also referred to as Operators. Their nominees are directors of the Penny Stock companies which are indirectly controlled by them through such dummy directors. The whole operation is managed by them. They get the net commission income from the transactions. Their name however, seldom appear in the actual transactions.<\/p>\n b) The Brokers<\/strong><\/p>\n These are registered brokers through whom shares are traded both online and offline. They are fully aware of the nature of transactions and get paid a commission over and above their normal brokerage. Some of the big broking houses are also indulging in such transactions mostly through sub-brokers. Even Calcutta Stock Exchange has registered itself as a broker with BSE and has given a large number of terminals to sub-brokers who are dealing into this type of transactions. In the said investigation, some of the sub-brokers of big broking houses like Anand Rathi, Religare Securities, SMC etc. were also uncovered. As a standard modus operandi,<\/em> the brokers often compromise on KMC norms of the clients to help the Syndicate Members.<\/p>\n c) The Entry Operators<\/strong><\/p>\n These are individuals who control a large number of paper\/shell companies which are used for routing cash for the transactions as well as buying and selling shares during the process of price rigging. They work for commission to be paid by the Syndicate Members. To cut cost sometimes in smaller operations, the same group perform more than one function.<\/p>\n The transaction involves three legs.<\/p>\n a) Purchase of share by the beneficiary <\/strong><\/p>\n In this the beneficiary is sold a fixed number of shares at a nominal rate. The price and the number of shares to be purchased are decided on the basis of the booking taken and the value up to which price would be rigged. This leg of the transaction mostly is offline. This is done to save on STT using the loophole in Section 10(38) of the IT Act which places restriction of trading by payment of STT on sale of shares and not on purchase.<\/p>\n b) Price rigging <\/strong><\/p>\n After the shares have been purchased by the beneficiaries, the syndicate members start rigging the price gradually through the brokers. In these transactions the volume is almost negligible. Two fixed brokers, who are in league with the Syndicate, buy shares at a fixed time and at a fixed price. These low volume transactions are managed through paper companies of entry operators.<\/p>\n c) Final sale by the beneficiary <\/strong><\/p>\n This is done after the beneficiary has already held the shares for one year. The period of holding may be a little more to match the amount of booking with the final rate. The beneficiary is contacted either by the Syndicate member or the Broker (Middle man) through whom the initial booking was done. The beneficiary provides the required amount of cash which is routed through some of the paper companies of the entry operator and is finally parked in one company which will buy the shares from the beneficiary. The paper company issues cheque to the beneficiary.<\/p>\n The above mentioned methodology is referred to as Conventional Method<\/strong>. <\/p>\n Another method which also used quite often is called Merger Method<\/strong>. The methodology adopted in Merger Method is as under:<\/p>\n In this method the operators first form a Private Limited Company and the shares at par are allotted to beneficiary individuals. This private limited company is then amalgamated \/ merged with a listed penny stock company by a High Court order. Depending on the capital of the amalgamating and amalgamated companies, the investors are allotted stock of the listed companies in the same proportion. The capital of the Penny stock listed company and the private limited company are so arranged that the beneficiaries post-merger, get shares of listed company in the ratio 1:1, thus the investor gets equal number stocks of the listed company. The promoters of the listed penny stock companies run the syndicate, the brokers and the entry-operators through whose paper\/shell company’s cash are routed are merely commission agents. The penny stock listed company is such that though its capital base is small its market capitalisation is many times its capital base. This is managed again through small volume predetermined transaction amongst members of the syndicate. The prices of shares are thus manipulated at 20 to 25 times the face value. For example the quoted price of such a company would be around ` 250 with minor fluctuations synchronised with rise and fall in the market to avoid regulatory glare. One such company is quoted on CSE. The investors hold these shares in the penny stock listed company which it got as a result of merger for one year (statutory lock-in period for exemption under IT Act) and then sell it to one of the shell private limited companies of the operator. The investor thus makes a LTCG of 25 times its original investment. The purchase consideration is again provided in cash by the investor which is laundered to the buyers account through a maze of shell companies as mentioned in the previous method. <\/p>\n Though LTCG is booked while the share price is going up, the downward journey is used by the operators for booking bogus losses. People who have huge profit take the Short Term Capital loss (STCL) to set-off their profit. The methodology used is the same. The beneficiary who wants loss buys the share at a high rate from the beneficiary who is taking LTCG. The loss taking beneficiary pays cheque to the LTCG taking beneficiary and the cash provided by the LTCG beneficiary is returned to the Loss taking beneficiary. The operator deducts his commission before payment by cash. As prices crash the loss taking beneficiary sells these shares bought at high value for small value resulting in artificial loss.<\/p>\n In the report department identified the 84 BSE listed penny stocks which have been used for generating bogus LTCG from individual \/ individuals targeted. Post that number of search and surveys were conducted in the office premises of more than 32 Share broking entities, which accepted that they were actively involved in the bogus LTCS\/STCL Scam. Surveys were also conducted in the office premises of many accommodation entry providers and their statements recorded. As per the report all had accepted their role in the scam. The report further stated that beneficiaries of more than ` 38 thousand crore were identified. <\/p>\n A Total of more than 60 thousand PAN numbers of the beneficiaries were identified. The report further covered more than 5000 paper\/shell companies, also known as “Jamakharchi” companies, which are involved in providing bogus accommodation of various kinds. Statements for most of the directors of companies had been recorded under oath. The department also prepared cash trail of ` 1570 Crore. The case trail reflected how unaccounted\/undisclosed cash of beneficiaries was being routed through this modus to convert black money into LTCG. The investigating team had followed the money trail from the point it is being deposited to the undisclosed proprietorship bank accounts, to the accounts of share brokers. Then they recorded statements of share brokers where they have accepted that cash has been used for providing accommodation entry of bogus LTCG. <\/p>\n1. What are penny stocks?<\/h2>\n
2. News and web-articles<\/h2>\n
3. Search, surveys and the investigation report<\/h2>\n
3.1 Kolkata Investigation report<\/h3>\n
3.2 Modus operandi as per the report<\/h3>\n
3.2.1 Types of Penny stock companies<\/em> <\/h4>\n
3.2.2 The entities involved in the transactions<\/em> <\/h4>\n
3.2.3 The Transaction<\/em> <\/h3>\n
3.2.3.1 Conventional method <\/em> <\/h4>\n
3.2.3.2 Merger method:<\/em> <\/h3>\n
3.3 Results of Kolkata investigations <\/h3>\n
3.3.1 Capital gain side or sale side beneficiaries (as per the report)<\/em>
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