Thursday, October 23, 2014

A Case Study for Spinoffs

Mergers and acquisitions (M&A) transactions tend to be analyzed mostly from the acquirer’s perspective, whether they involve mergers or takeovers. At the same time, they have enormous implications for the target or the seller. Businesses may have to be downsized, contracted or split due to which companies may have to engage in sale transactions or restructuring of their business undertakings. There are a number of such restructuring options in the form of divestitures, which involve sales of subsidiaries or business divisions by a company. Other sophisticated forms of restructuring predominantly used in the U.S. include equity carve-outs, spin-offs, split-offs, and split-ups, which provide a number of transactional options for corporate restructuring. In India too, such transactions are fairly common in the form of slump sales, spin-offs as well as demergers.

Despite the varied nature of these M&A transaction structures, the focus of business and legal literature has largely been on mergers and takeovers, and far less on divestitures. In this context, a brief analysis in Knowledge@Wharton of the proposed spin-off of Hewlett-Packard into two companies is interesting. This transaction seeks to represent a case study in the manner in which corporate spin-offs can be structured and implemented.

On the one hand, there are similarities among the various transactions in that they are undertaken with the expectation of unlocking shareholder vaue. On the other hand, as the study indicates, there are striking dissimilarities between mergers or takeovers as well as spin-offs. While the essence of a merger or takeover involves synergies in the operations due to which the profitability of the combined businesses is greater than the sum of their parts (popularly referred to as the “2+2=5” phenomenon), in a spinoff the value is unlocked by separating the businesses because “the whole is worth less than the sum of the parts”. On another count, while the focus in a merger or takeover is on the post-transaction integration, in a spinoff it is on disintegration which must lead to two companies that can be independently freestanding.

These intricacies in the business rationale for different types of M&A transactions is worth noting. Given profile of the company and the size of the transaction (with each of the two resultant companies expected to earn annual revenues of over US$ 50 billion), the HP spinoff is likely to be closely watched as a suitable case study for the busines and legal outcomes of the transaction.


Wednesday, October 15, 2014

Foreign Direct Investment: Trusts as Investment Vehicles

[Vishal Achanta has contributed the following guest post. Vishal is a 5th year student at the National University of Advanced Legal Studies, Kochi]

Recently, two investment vehicles have been introduced that as per the relevant SEBI regulations are to be set up as trusts: Real Estate Investment Trusts (‘REITs’) and Infrastructure Investment Trusts (‘IITs’). Both are intended to be pooling vehicles for domestic and foreign capital, and the Securities and Exchange Board of India (‘SEBI’) indicated that further guidelines regarding foreign investment into these vehicles would be laid down by the Reserve Bank of India (‘RBI’). This turns the spotlight onto a rather dimly lit corner of our Foreign Direct Investment (‘FDI’) policy that will need to be evolved to accommodate these vehicles: that of FDI into trusts. The aim of this post is to explore the rules that currently govern these transactions, and suggest the direction that future regulation might take.

Trusts have been the fund vehicle of choice for Venture Capital Funds (‘VCFs’; these are nowadays better referred to as Alternate Investment Funds or ‘AIFs’[1], and are employed by private equity and venture capital investors) due to their tax efficient nature. Much like REITs and IITs, AIFs are ‘domestic pooling vehicles’: they are regulated by SEBI and situate in India, but will often collect and deploy foreign capital.

An AIF set up as a trust will issue ‘units’ in exchange for contributions from investors; the possession of a unit will make the investor a beneficiary of the trust. Again, like REITs and IITs, an AIF’s units come with some management rights and entitle the holder to a share of the vehicle’s profits (making these ‘units’ similar to a company’s equity).  AIFs set up as trusts essentially twist the trust form to mimic a closely held private company or a limited liability partnership (‘LLP’); the closest analogy for a REIT or IIT would be a listed company with diffused shareholding.

Thus, in the context of trusts, the FDI is made in consideration for the issue of trust ‘units’ as opposed to equity or hybrid securities of a company. The transfer or issue of a trust unit for consideration could be regarded as a ‘capital account transaction’ as defined in section 2(e) of the Foreign Exchange Management Act, 1999.

Consequently, the Department of Industrial Policy & Promotion’s (‘DIPP’) Consolidated FDI Policy 2014, and the RBI’s 2014 Master Circular on Foreign Investment lay down that the only trusts that can receive FDI are AIFs[2] set up as trusts, and that such investments will always require a Foreign Investment Promotion Board (‘FIPB’) approval. That trusts are treated with skepticism is apparent from the Consolidated Policy’s readiness to allow AIFs set up as companies to take in FDI through the automatic route, while denying this benefit to AIFs set up as trusts[3].

This discriminatory treatment of trusts is seen in each of the Consolidated FDI Policies released since 2010, and the rationale for this can perhaps be found in the FIPB’s 2009 Review[4]. Therein, the DIPP observed that unlike a company, it was difficult to ascertain with whom the ownership and control of a trust lay; in this connection, there have been news reports of proposals for FDI into trusts being rejected because the identity of the beneficiaries was unknown[5]. The DIPP acknowledged that the application of DIPP Press Notes regarding downstream investment to trusts was difficult, and expressed the concern that trust vehicles were largely unregulated[6].

In the 2009 Review, the DIPP had also insisted that a foreign investment made into the defence sector through a VCF set up as a trust adhere to the sectoral cap and other conditions, interestingly reasoning that the units of that particular trust were nearly akin to equity in a company, since the unit holders (i.e., the investors) were able to exercise a high degree of control over the trust.  The DIPP suggested that the downstream investment made by a trust into investees should itself be regarded as an indirect FDI in terms of Press Note 2 of 2009, implying that the investment into the trust is the ‘upstream’ FDI.

In its 2011-2013 Review[7], the FIPB clarified that investments made by the AIF would be regarded as FDI and would have to confirm to sectoral caps and conditions laid down in the Consolidated FDI Policy. The FIPB also seemed to suggest that an AIF could only raise funds (investment into the trust) from investors registered with SEBI as Foreign Venture Capital Investors (‘FVCIs’; importantly, FVCIs are not subject to pricing restrictions when they buy, sell or redeem trust units). Another condition imposed by the FIPB was that an AIF’s investors must be resident in a country that is a member of the Financial Action Task Force and is a signatory to IOSCO’s Multilateral MoU.

From the above paragraphs, two conclusions may be drawn: Firstly, the FIPB Reviews and the news reports cited above point to the conclusion that the concerns that the DIPP/FIPB have with trust vehicles has engendered an attitude of suspicion; resultantly, they only feel comfortable with trust vehicles if the investors into the trust are themselves regulated (like FVCIs are by SEBI), if the investments are subject to their approval, and if certain safeguards against money laundering, securities fraud and terrorist financing exist. For REITs and IITs, the implications of this may be that investors will be required to go through a lengthy and cumbersome approval process before multiple regulators and/or subjected to heavy regulation.

Secondly, an FDI employing a trust, when permitted, is potentially comprised of two ‘legs’. The ‘first leg’ is the issue of trust units to an investor. In the context of AIFs, this is the ‘pooling’ or ‘fund raising’, which requires an FIPB approval. The ‘second leg’ is the downstream investment by the trust: this is regarded as a direct FDI. Whether the ‘first leg’ is also characterized as a direct FDI, and must comply with FDI rules such as pricing guidelines on purchase and sale/redemption of trust units, is unclear. The Consolidated FDI Policy is silent on this aspect, and it seems strange to suggest that both the ‘first leg’ and the ‘second leg’ should be regarded as direct FDIs.

From a conceptual point of view, an argument might be made that the ‘first leg’ should stand outside the FDI regime, since it is a pooling of capital and not a deployment of it. This would mean that the foreign investment into the trust would be free from FDI conditions such as seeking approvals and pricing guidelines on purchase and sale/redemption of trust units. In the context of REITs and IITs however, the DIPP/FIPB will most likely try to regulate the ‘first leg’ by making it subject to their approval due to the nature of the investment and the vehicle. It would be desirable if REIT and IIT investors were not subject to pricing guidelines.

The law as it currently stands lacks clarity with regard to the rules that govern the ‘first leg’, and is marked by a cautious approach to trusts as vehicles for FDI. The status of the ‘second leg’ also needs to be clarified, given that REITs and IITs may employ special purpose vehicles (‘SPVs’), and that these SPVs may be organized as LLPs. Unless addressed promptly in the correct manner, these might prove detrimental to the success of REITs and IITs. It might be productive to begin from the ground up when laying down rules for investment into REITs and IITs, rather than trying to integrate these rules into the current FDI framework. In conclusion, it is worth noting that the only thing that might dissuade investors as much as an adverse regulatory climate is regulatory uncertainty.

- Vishal Achanta                                                                                 


[1] In 2012, SEBI replaced the Venture Capital Fund Regulations, 1996 with the Alternative Investment Fund Regulations. The latter delineates three categories of AIFs, of which VCFs are one sub-category.
[3] See also, Paragraph 3.10.3.1 of the 2014 Consolidated FDI Policy, which requires FIPB approval to be obtained for FDI into every Indian company that is engaged only in the activity of investing in other Indian companies.
[6] At the time the DIPP made these observations, VCFs set up as trusts could choose to remain unregulated by SEBI. This is no longer the position; VCFs, as a sub-category of AIFs, must register with, and be regulated by SEBI.

Monday, October 13, 2014

Amendments to the Provident Fund and Pension Fund Schemes Under the EPF Act


[The following guest post is contributed by Madhusudan Bose, who is a lawyer and company secretary by profession, at PRA Law Offices, New Delhi. Author’s views are personal]

Pursuant to the proposals made by the Finance Minister in his Budget speech, the Ministry of Labour and Employment introduced a number of amendments to the Employees’ Provident Funds Scheme (“EPF Scheme”) and the Employees’ Pension Scheme (“Pension Scheme”) under the Employees’ Provident Funds and Miscellaneous Provisions Act, 1952 (“EPF Act”). These were through notifications dated August 22, 2014. The said amendments have come into effect from September 1, 2014.

Object of the amendments and implications for employers and employees

The amendments were in effect long overdue.  The Ministry of Labour and Employment had last revised monthly income limits for coverage under EPF Scheme in the year 2001.  The extant EPF Scheme mandated employees with monthly pay[1] of upto Rs. 6,500/- to mandatorily become members of the EPF scheme.  This limit has now been revised to Rs. 15,000/-.  Considering the growth rate of wages and salaries in the past 15 years, it is but a matter of time before even the revised limit of Rs. 15,000/- becomes dated.

Furthermore, minimum PF contributions will now have to be based on the revised cap.  Thus, employees whose PF contributions had been limited to 12% of monthly pay of Rs. 6,500/- will now face an increase in PF deduction of upto Rs. 780/- from their salaries.  Similarly, employers would have to set apart additional funds to match the employee contributions in the above cases. 

An unexpected upshot is the exclusion of new EPF members from becoming members of the Pension Scheme, if their monthly pay exceeds Rs. 15,000/-.  This rule applies to international workers also.  The Pension Scheme is not looked upon with favor by high earning employees, as the diversion to the pension fund is quite meagre (being limited to 8.33% of Rs. 6500/- earlier), and the benefit, howsoever minor, accrues upon superannuation, disablement etc only.  However, the above exclusion applies to new members only.

All employees and employers need to acquaint themselves with the new changes brought about by the aforesaid amendments.  For employees, the nitty-gritties are more, as they have to take into account the difference in treatment, not only for international workers and Indian employees, but also existing members, and new persons joining after September 1, 2014.  This is discussed in detail as under.

Summary of important amendments made to the provident fund and pension schemes under the EPF Act

1.    Eligibility limit for membership to EPF scheme increased to Rs. 15,000: Earlier, only employees whose monthly pay was Rs.6,500/- or less were required to become a member of the EPF Scheme. Now, this limit has been increased to Rs. 15,000/-.

It is pertinent to note that the said limit does not apply to ‘international workers’.  ‘International workers” (“IWs”) of countries with whom India has not executed a social security agreement (“SSA”) and working for a covered establishment in India are required to become a member under the EPF scheme irrespective of amount of their monthly pay. 

2.    Increase in cap on employees’ / employers’ contribution:  In line with the above amendment, the maximum contribution by an employee / employer, where monthly pay of the employee exceeds Rs. 15,000/-, has been capped to the amount payable on monthly pay of Rs. 15,000/- (the earlier cap was Rs. 6,500/-).  Of course, the employee / employer can choose not to restrict their contributions to the above limits.

As before, the aforesaid caps do not apply to ‘international workers’ and there is no cap on monthly pay on which contributions are payable by employer / employee in respect of IWs from non-SSA countries.

3.    New employees having monthly pay more than Rs. 15,000/- excluded from Pension Scheme:  On and from September 1, 2014, the Pension Scheme will apply only to those persons who become a member of the EPF Scheme and whose pay on such date is less than or equal to Rs. 15,000/-.

Persons who were members of the Pension Scheme before September 1, 2014 would continue as such members, and contribute 8.33% of their monthly pay to the Employees’ Pension Fund.

Pertinently, the above rule is also applicable to IWs from non-SSA countries who are otherwise required to become members of the EPF Scheme.  In other words, with effect from September 1, 2014, if an IW from a non-SSA country, becomes a member of the EPF scheme, and his monthly pay is more than Rs.15,000/-, then, he would not be required to contribute any amount towards the Pension Scheme (as in case of his Indian counterpart).  However, this does not apply to IWs who are already members of the Pension Scheme before September 1, 2014. 

4.    Increase in cap on amount of monthly pay to be diverted to Pension Scheme: Paragraph 3(2) of the Pension Scheme has been amended to specify that where monthly Pay of a member covered under the Pension Scheme exceeds Rs. 15,000/-, the contribution payable by the employer would be limited to the amount payable on his pay of Rs. 15,000/- only (earlier the limit was Rs. 6,500/-).

The above cap does not apply to IWs from non-SSA countries, who are otherwise required to become or are a member of the Pension Scheme.  In other words, pension will be payable on 8.33% of total monthly pay for such employees.

5.    Option to contribute pension on basis of higher salary: Prior to September 1, 2014, a resident employee could choose to contribute to Pension Fund under the Pension Scheme, beyond the amount payable on a monthly pay of Rs. 6,500/, by virtue of proviso to Paragraph 11(3) of EPS Scheme. 

The said proviso has now been omitted. Accordingly, the option to contribute to Pension Fund on a monthly pay higher than Rs. 15,000/- is no longer available to new resident members. 

This provision does not affect persons who were already contributing to Pension Fund on a higher salary before September 1, 2014. Such persons may continue to contribute on salary exceeding Rs. 15,000/- per month, subject to the following:

(a)   Such option must be exercised by the existing member by February 28, 2015 (extendable by RPFC by 6 months, on sufficient cause shown by member);

If the member exercises no option within such period (or extended period), it would be deemed that member has not opted for contribution over wage ceiling of Rs. 15,000/-. 

(b)   Such members would have to contribute @1.16% of monthly pay exceeding Rs.15,000/- as an additional contribution, from and out of the contributions payable by the employees for each month. 

6.    Increase in cap on amount of monthly pay for purposes of contribution to the Employees’ Deposit Linked Insurance Scheme (“EDLI Scheme”): As in the case of Pension Scheme, the EDLI Scheme has been amended to provide that contribution under EDLI Scheme shall be limited to a monthly pay of Rs. 15,000/- only, if monthly pay of employee exceeds said amount. The above cap applies to international workers also.   

7.    Furthermore, the benefits payable under Paragraph 22 of the EDLI scheme on death of an employee etc have been increased by 20%. 

8.    Summary of contributions under EPF Act consequent to the above amendments is specified separately for normal employees and for international workers as under:

Domestic employees

(a) Employee’s contribution to PF - 12%[2] of ‘monthly pay capped at Rs.15,000/-’, for existing members, and non-members who take up employment on or after 01/09/2014

(b) Employer’s contribution to PF - 12% of ‘monthly pay capped at Rs.15,000/-’,  for existing members and non-members who take up employment on or after 01/09/2014

(c) Proportion of employer’s contribution in (b) above, which is to be diverted to Pension

- For non-member who has joined on or after 01/09/2014: Nil if monthly pay > Rs. 15,000/-, else same as for existing members below;

- For existing members of PF or Pension Scheme - 8.33% of monthly pay capped to Rs. 15,000/-[3]

(d) Employers’ contribution to EDLI - 0.50% of ‘monthly pay capped at Rs.15,000/-’, for existing members, and non-members who take up employment on or after September 1, 2014.

Note that the employer and employee can choose to contribution to Provident Fund in excess of monthly pay of Rs. 15,000/-.

International workers from non-SSA countries

(a) Employee’s contribution to PF - 12% of monthly pay, for existing members, and non-members who take up employment on or after September 1, 2014.

(b) Employer’s contribution to PF - 12% of monthly pay, for existing members, and non-members who take up employment on or after September 1, 2014.

(c) Proportion of employer’s contribution in (b) above, which is to be diverted to Pension

-         For non-member who has joined on or after September 1, 2014: Nil if monthly pay > Rs. 15,000/-, else same as for existing members below;

-         For existing members of PF or Pension Scheme - 8.33% of monthly pay;

(d) Employers’ contribution to EDLI - 0.50% of ‘monthly pay capped at Rs. 15,000/-, for existing members, and non-members who take up employment on or after September 1, 2014.

- Madhusudan Bose



[1]Pay’ includes basic wages with dearness allowance, retaining allowance (if any) and cash value of food concessions.
[2] This will be 10% in case of specified establishments notified by the Central Government.
[3] No option to contribute to Pension Fund beyond cap after 01/09/2014.  Existing members who had earlier exercised this option may however continue to contribute in excess of the cap as before (please refer discussion above).  

Sunday, October 12, 2014

Bombay High Court Ruling in Favour of Vodafone in Share Issue Case

Over the last couple of years, Indian subsidiaries of multinational companies have been faced with the unique tax issue pertaining to the issuance of shares to their parent companies. The tax department has questioned the valuation on which shares have been issued by the Indian subsidiaries and sought to apply the transfer pricing provisions under the Income Tax Act, 1961 (the Act) to impute additional tax burden through a recharacterization of the transactions. This has resulted in considerable litigation.

Of recent significance is the judgment of a division bench of the Bombay High Court on October 10, 2014 in Vodafone India Services Pvt. Ltd. v. Union of India, which is subject to a preliminary analysis in this post. In this case, Vodafone India (the subsidiary), a wholly owned subsidiary of Vodafone Tele-Services (India) Holdings Limited (the holding company) issued shares of a face value of Rs. 10 each at a premium of Rs. 8,509 per share to the holding company. The price was arrived at based on the methodology prescribed by the Controller of Capital Issues (CCI). However, the income tax department questioned the transaction on the ground that Vodafone India ought to have valued each share at Rs. 53,775, and on that basis there was a shortfall in premium to the extent of Rs. 45,256 resulting in an aggregate shortfall of Rs. 1,308.91 crores for all of the shares so issued. The income tax department sought to treat the aggregate shortfall as income of Vodafone India as income, as a consequence of which the amount was to be treated as a deemed loan given by the holding company to Vodafone India upon which interest was chargeable as income.

Vodafone India challenged the income tax department’s position through a writ petition before the Bombay High Court on the principal ground that the shortfall does not constitute income and also that Chapter X of the Act relating to transfer pricing was not applicable to this case due to which the transfer pricing officer (TPO) did not possess jurisdiction. The High Court referred the jurisdictional issue to the dispute resolution panel (DRP) which was already seized of the matter. After consideration of the issues, the DRP passed an order dated February 11, 2014 holding that the income tax department had the jurisdiction to consider the issue of shares by Vodafone India to its holding company and also to tax the shortfall as income. It is against this order that Vodafone India preferred a writ petition to the Bombay High Court that resulted in its present judgment.

The primary question before the Court related to the applicability of Chapter X of the Act. This is because that chapter in certain circumstances permits the revenue to impute an “arm’s length price” in case of an international transaction. The Court began by observing that a “plain reading of Section 92(1) of the Act very clearly brings out that income arising from an International Transaction is a condition precedent for application of Chapter X of the Act”. Hence, the narrow issue was whether the issue of shares by Vodafone India to the holding company gave rise to “income”: whether the nature of the transaction made it one of a capital transaction or revenue transaction.

On this basis, the Court embarked on an analysis of the meaning of “income”, especially where it involved capital receipts. It found based on an interpretation of section 2(24) of the Income Tax Act that “income will not in its normal meaning include capital receipts unless it is so specified, as in Section 2(23)(vi) of the Act”. Since an issue of shares is a transaction on the capital account, the premium cannot be treated as income. The Court also drew a contrast with Section 56(2)(viib) of the Act where a capital transaction is deemed by legal fiction to amount to income. However, that provision applies only to premium received from a resident and that too where that premium is in excess of the fair market value of the shares. The Vodafone case was far from that scenario because the premium was less than the alleged fair value of the shares, and that too received from a non-resident. One can glean from the analysis of the Court another difference which is that in Section 56(2)(viib) there is an actual receipt of the excess of amount, whereas in this case there is only an imputed amount of the difference without any actual receipt. On this ground, the Court unequivocally concluded that neither the capital receipts in the form of the issue price (par value plus premium) nor the imputed difference with the fair market value could be considered income for the purpose of the Act.

Given the absence of “income”, which expression was supplied with a narrow interpretation by the court (consistent with reading of tax statutes), the Court was able to quickly conclude on the inapplicability of Chapter X of the Income Tax Act relating to transfer pricing and arm’s length determination of income from international transaction. While a number of arguments were made by counsel representing both Vodafone India as well as the tax department on the interpretation of Chapter X (particularly the definition of International Transaction in Section 92B(1)), the Court dealt with those arguments in a more concise  fashion given its conclusion as to the absence of “income”, which is a prerequisite for the application of the Chapter.

This pronouncement of the Bombay High Court is welcome. First, from a legal perspective, issuance of shares and infusion of funds into companies constitute a capital transaction. In case such a transaction is to be taxed, the charging provision must be clear to extend to such. It is not permissible for the revenue to stretch the law to subsume such transactions within its fold.

Second, the judgment also induces a level of certainty in the taxability of such transactions. The ability of the revenue to tax them has caused consternation among foreign investors. As we have previously discussed on this Blog, the power of courts to recharacterize transactions must be exercised very carefully so as to preserve certainty to the extent feasible. If courts adopt a carefree approach to altering the substance of the transaction (for example in this case from equity to part-debt), that would affect a conducive atmosphere for business. It is only in cases where there is blatant abuse of policy that courts must embark upon such approach, that too in a careful and considered manner.

Although some clarity has emerged for share issuances by Indian subsidiaries of foreign parent companies, it may very well be temporary in case the tax department decides to prefer an appeal against the ruling to the Supreme Court. But, for now, the ruling may benefit several other companies that have found themselves in a similar predicament.