Tuesday, November 29, 2016

Repeal of SICA

[The following guest post is contributed by Mani Gupta, who is a partner at Sarthak Advocates & Solicitors, New Delhi. Views expressed here are personal and do not reflect the firm’s views.]

By way of two notifications dated November 25, 2016 (“Repeal Notification”), the Ministry of Finance has appointed December 1, 2016 as the date on which the provisions of Sick Industrial Companies (Special Provisions) Repeal Act, 2003 (“SICA Repeal Act”) shall come into effect and Section 4(b) of the SICA Repeal Act shall be enforced. With the effectiveness of the SICA Repeal Act, the Sick Industrial Companies (Special Provisions) Act, 1985 (“SICA”) shall stand repealed and the Board for Industrial and Financial Reconstruction (“BIFR”) and the Appellate Authority for Industrial and Financial Reconstruction (“AAIFR”) shall stand dissolved. SICA was a special legislation that was enacted to identify sick and potentially sick companies owning industrial undertakings and for implementation of suitable measures to revive such sick companies, and to ensure expeditious enforcement proceedings against such companies. BIFR was established under SICA as a specialized body for revival, rehabilitation and even winding up of sick industrial companies and wherever necessary, for providing them with financial assistance.   

As the year of SICA Repeal Act suggests, the repeal of SICA has been on the cards for a very long time. Originally, separate provisions were inserted in Companies Act, 1956 (sections 424A to 424L) through the Companies (Second Amendment) Act, 2002 to deal with the revival and rehabilitation of sick industrial companies. These provisions were never notified. The Companies Act, 2013 also contained a new Chapter XIX (sections 253 to 269) to replace SICA as and when the SICA Repeal Act would have been notified. However, these provisions have been deleted with effect from November 15, 2016 by way of Notification No. S.O. 3453(E), 30/7/2016-Insolvency Section, which inter alia notified section 255 of the Insolvency and Bankruptcy Code, 2016 (“Insolvency Code”). The relevant provisions of the Insolvency Code, which provide an alternative mechanism in place of SICA, are yet to be made effective.

It is instructive to note that section 4(b) of the SICA Repeal Act was also amended by section 252 of the Insolvency Code. Section 252 of the Insolvency Code came into effect on November 1, 2016, by way of Notification No. S.O. 3355(E), 30/7/2016-Insolvency Section.[1] The effect of the amended section 4(b) is that from the date notified by the Government all proceedings pending before the BIFR and AAIFR shall abate and will come to an end.  However, it shall be open to the company whose appeal, reference or inquiry has abated to initiate fresh proceedings (that is, the corporate insolvency resolution process under the Insolvency Code) before the National Company Law Tribunal (“NCLT”) in accordance with the provisions of Insolvency Code, within 180 days of the commencement of the Insolvency Code. The Insolvency Code is being notified in a piecemeal manner, with the bulk of the operational provisions yet to be notified. Therefore, it is unclear when sick or potentially sick companies will be able to approach the NCLT and seek the initiation of the ameliorative process and the protection of section 14 of the Insolvency Code.  

It is important to note that the proceedings under the Insolvency Code envisage the role of Insolvency Resolution Professionals. The Insolvency and Bankruptcy Board of India (Insolvency Professionals) Regulations, 2016, notified on November 23, 2016, provide that an individual enrolled with an insolvency professional agency as a professional member may make an application to seek registration as an insolvency professional. The Insolvency and Bankruptcy Board of India (Insolvency Professional Agencies) Regulations, 2016 (“IPA Regulations”) provide that only a company registered under section 8 of the Companies Act, 2013, with the sole object of functioning as an insolvency professional agency under the Insolvency Code shall be entitled to be registered as an insolvency professional agency (“IPA”). Since the IPA Regulations have come into effect only on November 21, 2016, it may still be some time before IPAs are incorporated and registered as such. They process of enrolling professionals as members of the IPA and the subsequent registration of insolvency professionals with the Insolvency and Bankruptcy Board may take some more time. Until then, it appears unlikely that the relevant provisions of the Insolvency Code, which could have effectively replaced the operational provisions of SICA, will be brought into effect. In fact, given the tight timelines under the Insolvency Code for the insolvency resolution process, it will be important that sufficient numbers of insolvency professionals are registered before the Insolvency Code is effectively operationalized. Given the workload that the insolvency professionals may face, if their numbers are limited, then they may find it difficult to meet the timelines prescribed in the Insolvency Code, or they may not able to do justice to their task.

This creates a peculiar situation: with the repeal of SICA, the protections that were available to companies under the provisions of SICA, in particular under section 22 of SICA, are no longer available. At the same time, the corresponding provisions of the Insolvency Code under which the relevant proceedings could have been initiated are yet to be notified. Such companies whose references/ appeals will abate on December 1, 2016 may face uncertainties as various proceedings initiated against such companies in various forums (such as recovery suits in civil courts or Debt Recovery Tribunals or winding up proceedings), which were suspended in view of section 22 of SICA may get revived or filed fresh. The problems of the sick/ potentially sick companies will be compounded if courts/ tribunals pass orders against them while the uncertainty around notification of the remaining provisions of Insolvency Code continues. The confusion and uncertainty could have been avoided if the SICA Repeal Act was brought into effect simultaneously with the provisions of Insolvency Code.   

- Mani Gupta




[1] The amended Section 4(b) of the SICA Repeal Act provides as follows:

“(b) On such date as may be notified by the Central Government in this behalf, any appeal preferred to the Appellate Authority or any reference made or inquiry pending to or before the Board or any proceeding of whatever nature pending before the Appellate Authority or the Board under the Sick Industrial Companies (Special Provisions) Act, 1985 (1 of 1986) shall stand abated:

Provided that a company in respect of which such appeal or reference or inquiry stands abated under this clause may make reference to the National Company Law Tribunal under the Insolvency and Bankruptcy Code, 2016 within one hundred and eighty days from the commencement of the Insolvency and Bankruptcy Code, 2016 in accordance with the provisions of the Insolvency and Bankruptcy Code, 2016:

Provided further that no fees shall be payable for making such reference under the Insolvency and Bankruptcy Code, 2016 by a company whose appeal or reference or inquiry stands abated under this clause.”

Monday, November 28, 2016

Essay Competition on Arbitration Law

[The following announcement is posted on behalf of the Nani Palkhivala Arbitration Centre, Chennai]

Satya Hegde Essay Competition 2016-2017: Submit by Dec 26

Nani Palkhivala Arbitration Centre, Chennai (NPAC) is pleased to announce an essay competition on arbitration law, inviting essays from current students of Law in any College or University in India. 

Topic: Arbitrability of Fraud - Maestro to Ayyasamy

Deadline for Submission: December 26, 2016.

Prizes
First Prize - Rs 10,000/-
Second Prize - Rs 7,500/-
Third Prize - Rs 5000/-

Prize winners will be awarded their prizes at the NPAC Annual International Conference, 2017 in New Delhi on February 18, 2017. [Details of the Conference will be posted here shortly]

For more details please click here 

Contact 
Nani Palkhivala Arbitration Centre
+91 44 2498 6697/ +91 44 2498 7145 / +91 44 2498 7745


The Hubtown Case: Supreme Court on the FDI Policy

[The following guest post is contributed by Tanavi Mohanty, who is a corporate lawyer practising in Mumbai]

The decision of the Bombay High Court in the summary suit of IDBI Trusteeship Services Limited (ITSL) v. Hubtown Limited (Hubtown), better known as the Hubtown case has received a lot of attention for being the Bombay High Court’s pioneering judgment which unearthed a colourable structure deployed by a non-resident investor to wriggle out of the foreign exchange laws and ensure an assured return on its investment in India. The judgment was briefly discussed in an earlier post on this Blog as well. Recently, a ruling of the Supreme Court, which disposed off an appeal on the Bombay High Court’s decision, has brought the issue to the forefront again. This is particularly because the Supreme Court came to a different conclusion from that of the Bombay High Court.

The transaction in question involved a two-pronged investment structure. In the first step, the investment was by FMO, a Netherlands based non-resident investor in Vinca Developer Private Limited (Vinca), by way of subscription to equity shares and compulsorily convertible debentures (CCDs) and, in the second step, the investment was by Vinca in its wholly owned subsidiaries, Amazia Developers Private Limited (Amazia) and Rubix Trading Private Limited (Rubix) by way of subscription to optionally partially convertible debentures (OPCDs).

The structure is alleged to be illegal because it is designed to provide FMO an assured return at the rate of 14.5% on its investment of INR 418 crores in India, in violation of the Indian foreign exchange laws which prohibit non-resident entities from investing in instruments that provide a guaranteed rate of return. The structure is questionable because of two principal features: (i) a clause in the articles of association of Vinca giving a veto right to FMO with respect to matters relating to the OPCD document, and (ii) a stipulation in the investments documents executed for FMO’s investment in Vinca that the investment amount be specifically invested by Vinca in OPCDs of Rubix and Amazia.

In a summary suit filed by the debenture trustee, ITSL, for enforcement of rights under the corporate guarantee provided by Hubtown for securing due payment by Amazia and Rubix (Guarantee), the courts dissected the investment structure and observed that the summary suit, if decided in favour of ITSL, would validate the illegal structure. The rationale was that the guarantee, although prima facie a contract amongst Indian parties, was still a part of the entire (allegedly illegal) transaction involving FMO’s investment.

The Bombay High Court in its judgment dated May 5, 2015 held that the investment structure is a colourable device to circumvent the foreign exchange laws, and the Guarantee as a part of the entire transaction was unenforceable. As regards the principal issue of Hubtown’s leave to defend, the court found that Hubtown raised triable issues in its defence, and therefore, granted an unconditional leave to Hubtown to defend the suit.  

A division bench of the Supreme Court, while disposing off the appeal in its judgment dated November 15, 2016, evaluated the terms of the guarantee on a standalone basis, and examined the defences raised by Hubtown in further detail. Upon analysis, the Supreme Court disagreed that Hubtown had raised any substantial defence to ITSL’s claim in the suit, and placed Hubtown’s defence in the realm of plausible but improbable, which is a departure from the finding of the Bombay High Court that Hubtown raised triable issues. Further, in light of an amendment to the Civil Procedure Code, the court granted Hubtown a conditional leave to defend the suit, requiring Hubtown to deposit the principal sum of INR 418 crores or provide adequate security for the said sum, within 3 months from the date of the judgment. The court also ordered for an expeditious trial of the suit, within 1 year from the date of the judgment. The Supreme Court relied on the fact that the Guarantee per se was not an illegal instrument and the invocation of the Guarantee, including the default in payment or the obligation to pay by Hubtown, were admitted facts.

While the Supreme Court’s judgment has reversed the finding of the Bombay High Court, thereby brightening the spirits of the foreign investor community, it has failed to express any definitive view on whether a non-resident entity can indirectly secure assured return on its investment in India by routing the investment through an Indian entity which in turn invests through otherwise impermissible debt instruments. It is also unclear if the said investment structure devised by FMO is legally compliant and permissible under Indian law.

As long as these questions remain unanswered, the judgment does little to provide solace to non-resident investors looking to employ varied investment structures, and lends ambiguity to Indian exchange control laws.

- Tanavi Mohanty


Friday, November 25, 2016

Foreign Portfolio Investments in Unlisted Non-Convertible Debentures

[The following post is contributed by Amitabh Robin Singh, who is a corporate lawyer practising in Mumbai.]

Last month, the Reserve Bank of India ("RBI") allowed Foreign Portfolio Investors ("FPIs") to invest in unlisted non-convertible debentures ("NCDs"). This has been done by way of an amendment to the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 ("FEMA 20").

Earlier, FPIs were permitted to invest only in NCDs which are either listed or to be listed. Where they are to be listed, such listing must take place within 15 days of investment made in them. There was a carve-out to this rule which permitted FPI investment in unlisted NCDs in the infrastructure sector (as defined in the guidelines governing external commercial borrowings).

Under the new provision which amends Schedule 5 of FEMA 20, FPIs will be allowed to invest in unlisted NCDs irrespective of the sector in which the issuing company operates. The RBI circular announcing the new regime lays down certain end use restrictions, being investment in real estate business (as defined in FEMA 20), capital markets and purchase of land.

This is a welcome move and may spur investments in the Indian corporate bond market, due to the fact that the company which is issuing the NCDs will not be required to undergo the listing process nor will it need to comply with the applicable chapters of the Securities and Exchange Board of India ("SEBI") (Listing Obligations and Disclosure Requirements) Regulations, 2015.

Another benefit to the investee company is that it will no longer be required to comply with certain provisions of the Companies Act, 2013 ("Companies Act") which apply to listed companies. sections 177 and 178 of the Companies Act mandate that "every listed company" constitute an audit and nomination and remuneration committee respectively. Under the status quo, this even includes private companies which have listed only their NCDs. However, the Companies Law Committee in its report of February of this year suggested that this anomaly be remedied by modifying sections 177 and 178 to exempt private companies which have listed NCDs as per SEBI guidelines. Pursuant to this, the Companies (Amendment) Bill, 2016 ("Amendment Bill") (which is currently pending in parliament) proposes to amend sections 177 and 178 to change the threshold to "every listed public company". Hence, if the Amendment Bill becomes law in its present form, the (private) investee company that is listing only its NCDs will be relieved from the obligation to constitute the abovementioned committees. An interesting point to consider here is that the Amendment Bill does not intend to exclude a public company which has not listed any of its securities other than NCDs.

Hence, as we can see, the issuer of the NCDs will be relieved from certain listing costs and compliances such as submitting financial results to the relevant stock exchange, etc. Also, pending passage of the Amendment Bill, exemption from certain Companies Act compliances will be had due to the fact that the NCDs are not listed.

However, one significant stumbling stone for this policy may be related to the ability to avail of certain benefits under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 ("SARFAESI"). It may be noted that the Enforcement of Security Interest and Recovery of Debts Laws and Miscellaneous Provisions (Amendment) Act, 2016 was lauded for extending the benefits available to a "secured creditor" to debenture trustees registered with SEBI appointed by any company for secured "debt securities". However, the definition of the term "debt securities" is restricted to debt securities listed in accordance with SEBI guidelines. Now, while investors who have subscribed to or purchased listed NCDs will be able to avail of the quicker and more effective process of enforcement of security contemplated under Section 13 of SARFAESI, the holders of unlisted debentures will have no such benefits.

In pursuance to the amendment to FEMA 20, SEBI's board, in its meeting of November 23, 2016 has decided to amend the SEBI (Foreign Portfolio Investors) Regulations, 2014 to make unlisted NCDs a permissible instrument for FPI investment. This will be done by amending Regulation 21 (Investment Restrictions,) of the said regulations to reflect the new position.

Therefore, while this move to allow FPI investment in unlisted NCDs is a step in the right direction to garner the interest of foreign investors in the Indian corporate bond market, it may fall short on the aspect of enforcement of security interest. As a result of this, it may be unable to generate the amount of inbound investments as envisaged.

- Amitabh Robin Singh


Wednesday, November 23, 2016

Regulation of invoice discounting start-ups: Is RBI proposing a disproportionate regulation?

[The following guest post is contributed by Srinivas Medisetty, who is presently working as a legal counsel in Ola (ANI Technologies Private Limited) advising on the regulatory and litigation aspects of the company. Views expressed are personal.]

The Securities and Exchange Board of India (“SEBI”) as the capital market regulator rightly stepped in to regulate crowd funding through investment in securities, whether equity, debt or fund based. The Reserve Bank of India (“RBI”) being the money market regulator, anticipating a disruption in the financial sector, has evinced interest (through a consultation paper issued in April this year) to regulate the on-line platforms engaged in peer-to-peer (“P2P”) lending which is also a form of crowd funding.

The RBI steps in to regulate the P2P lending platforms treating them akin to non-banking finance companies (“NBFCs”), very well recognizing the business of financial intermediation. However, it is not yet objectively supported by any legal considerations, apart from the likelihood that these platforms may rapidly grow, resulting in high value transactions and thereby being disruptive.

The question of whether the operations of the P2P lending platforms (that are pure play intermediaries with minimal overlap of financial functions) may be regulated like NBFCs, as the RBI presently intends to do, is difficult to be answered in the affirmative. For instance, some of the startups functioning in this space act as invoice discounting market places, where investors may invest in the invoices of cash strapped small and medium enterprises (“SMEs), which are raised against blue chip companies, but remain unpaid. The investor invests at a discounted value of the invoice and achieves returns when the blue chip company finally pays the outstanding dues. The platform only acts as an intermediary, which enables an investor and an SME meet over its platform. All other ancillary services such as the credit worthiness check, legal or accountancy services are provided though separate entities (assuming that the platform has entered into separate agreements with such entities) which are already regulated through statutes such as Credit Information Companies (Regulation) Act 2005, the Companies Act 2013 or the respective bodies governing professionals such as lawyers and chartered accountants.

The following are certain noteworthy points in the consultation paper:

1.         P2P lending “can be defined as the use of an online platform that matches lenders with borrowers in order to provide unsecured loans”. By this definition, asset backed loans against accounts receivables cannot be treated as P2P lending. Further, defining the usage of on-line platforms as P2P lending is itself misconstrued. The platform is merely a facilitator and the actual lending happens between the participants of the platform i.e. the borrower and the investor.

2.         Fixing the Interest rate – the consultation paper highlights the risk that the platform may fix interest rates.  An intermediary should ideally not transgress its function. If the online platform fixes the interest rate to be paid by the borrower, the regulators may attribute such functions to be financial. A majority of startups in this space do not determine the discount rate and it is market driven. However, the regulator may be interested in understanding how the market driven discount rate is determined by the platform.

3.         The platforms provide the service of collecting loan repayments and carrying out preliminary assessment of the borrower’s creditworthiness. The platforms do the credit scoring and make a profit from arrangement fees and not from the spread between lending and deposit rates, as is the case with normal financial intermediation. This a clear differentiation between financial intermediary and an intermediary providing services in accordance with the Information Technology Act 2000, and the intermediaries guidelines.[1]

4.         The issues regarding the need for regulating the platform are as follows:

(a)            the financial services made available through the platform, are provided by credit information/banking/accountancy firms or the legal services provided by law firms, which are already regulated under various statutes. The electronic platform, which brings these regulated institutions and the platform-participants together, need not be separately regulated;

(b)            as no cash transactions are contemplated, there is no scope for un-accounted transactions;

(c)            disproportionate regulation of the platform may trickle to the investor and deter them from investing thereby affecting the working capital requirements of MSME’s; and

(d)            even if any unregulated P2P platform adopts an unhealthy practice it would be an anti-competitive practice which the other participants can address to the Competition Commission of India within the present competitive ecosystem.

This ensures that the end users of the platform stay benefitted without disproportionate regulatory interference.

5.         The platform facilitates receipt of post-dated cheques from the borrower in the name of the lender as a proxy for repayment of the loan. The P2P platform, in general, also helps in the recovery process and as part of this, follows up for repayments and if need be, employs recovery agents too. Several platforms collect cheques from the borrowers. If the recovery process only involves collection of cheques, then in results in the platform acting in the capacity of an agent of the investor. However, if it also engages recovery personnel or adopts other coercive measures, then any related criminal actions of such recovery will be dealt with by the application of penal laws.

6.         In case of NBFCs involved in accepting deposits and lending, the RBI is clearly interested in regulating the deposits and the lending activity of such NBFCs. As the P2P platforms by themselves are neither engaged in the acceptance of deposits nor lending, the regulation should not overstep the purpose.

As mentioned above, any disproportionate regulation may severely impact the technology-based platforms. The intermediaries may however be guided by prescribing the standards of due diligence which is required to be undertaken before providing access to the participants and the relevant stakeholders on to the platform to avoid any illegal or unscrupulous transactions. The following are certain instances, which may require selective regulation:

1.         The platform is to ensure that during the registration process it shall allow only those investors and SMEs who do not fall within the purview of section 45(s) of the Reserve Bank of India Act 1934 (“RBI Act”). This section intends to regulate certain non-deposit accepting financial institutions or individuals or firms engaged in receiving deposits and lending in any manner. The facilitation exercise should not allow participation by the aforesaid players.

2.         Any regulations around the confidentiality, use and processing of data collected from the participants of the platform and the activity of the platform such as (a) custody of documents; (b) disclosure requirements to the investors about the borrowers and (c) assured returns on investment etc. may streamline the operations of these platforms.

3.         Any further regulation beyond the participation on the platform should only be undertaken under section 45 (JA) of the RBI Act (to regulate the financial system of the country) only after any tangible effect of the P2P lending on the financial system is statistically established.

4.         Any regulation under section 45(L) of the RBI Act, which solely seeks information and statements, may be adhered to. The regulatory intent appears to be only to gauge the exposure of NBFCs (also when P2P platforms are treated as NBFCs) to volatility and the likely impact on the markets. While the information sharing with the regulator may be seemingly harmless, any direction, which may follow, is unknown territory for a P2P platform.

In addition to the above and to put things into perspective, we are directed towards a question whether operating a platform for trading the receivable of an SME is actually unregulated or if the Guidelines for setting up of and operating the Trade Receivables Discounting System (TReDS) are applicable.

These Guidelines are issued by the RBI under section 10(2) read with section 18 of Payment & Settlement Systems Act, 2007. Further, the intent behind regulating a trade receivable discounting system appears to be the fact that the platform is a payment and settlement system and not an NBFC.

Objectively, there is a likelihood of drawing parallels between the mode of operation of these platforms and the applicants under the TReDS scheme. However, the significant difference appears to be the fact that under the model followed by the start-ups, the financier is an individual investor or an institutional investor, whereas under the aforementioned guidelines a conventional bank or NBFC is contemplated to be the party investing in the receivable (invoice). Evidently, the platforms have not opted to be applicants for an in-principle approval under the guidelines. The relationship also depends on the kind of contractual obligations that these platforms have undertaken with each of the platform participants.

Conclusion

There is a strong likelihood that these platforms may be asked to assist in ensuring the compliance with the settlement cycle as prescribed by the RBI as there are payment obligations by an investor to the SME and subsequently between the blue chip company and the investor. If a platform is also facilitating the payment process, it may also be required to keep a track and record of all payments made between the participants and also to coordinate between the banks of the participants.

As the platforms operate currently, the information whether these platforms assist in the settlement process between the participants on the platform, which is usually done through the banking channels of the participants, is not known. If these platforms are is engaged in the same, though they are not applicants under the aforementioned guidelines, any of the successful applicants who themselves stand regulated as a payment and settlement system may also want other similarly functioning entities to also be regulated, thereby requesting the RBI to act to bring such platforms within the regulatory net.

- Srinivas Medisetty




[1] Information Technology (Intermediaries Guidelines) Rules, 2011

Tuesday, November 22, 2016

Empirical Analysis of CSR Requirements in India

Professors Dhammika Dharmapala and Vikramaditya Khanna have posted an interesting paper on SSRN that is titled “The Impact of Mandated Corporate Social Responsibility: Evidence from India’s Companies Act of 2013”, the abstract of which is as follows:

Firms’ Corporate Social Responsibility (CSR) activity has become the subject of a large literature in recent years. This paper analyzes CSR activity using quasi-experimental variation created by Section 135 of India’s Companies Act of 2013, which requires (on a “comply-or-explain” basis) that firms satisfying specific size or profit thresholds spend a minimum of 2% of their net profit on CSR. We examine effects along a number of different dimensions including firm value, CSR spending, and other outcomes, as well as exploring broader theoretical implications. Our analysis uses financial statement and stock price data on Indian firms from the Prowess database, along with hand-collected data from firms’ disclosures of CSR activity. By combining a regression discontinuity (RD) framework (based on a nonparametric local polynomial regression approach) with a standard event study, we find a negative and substantial effect on the value of affected firms (relative to unaffected firms) around the crucial event date. This effect seems to be concentrated among firms that are less customer-facing, as indicated by low advertising expenditures. Using a difference-in-difference approach, we find significant increases in CSR activity among firms affected by Section 135, especially in the fraction of firms engaging in CSR spending. The fraction of firms subject to Section 135 that engage in advertising expenditures appears to have declined, consistent with substitution between advertising and CSR. There is no robust evidence of any significant impact on sales or accounting performance, although a modest decline in the return on assets cannot be ruled out. For a subset of large firms, we hand-collect comprehensive CSR data and find that while firms initially spending less than 2% increased their CSR activity, large firms initially spending more than 2% reduced their CSR expenditures after Section 135 came into effect. We explore various explanations for this presumably unintended consequence of Section 135, and also seek to derive some wider implications of this analysis for understanding the role of CSR.

A longer summary of the paper is available on the Oxford Business Law Blog.


Monday, November 21, 2016

Demonetization and the Income Tax Act

[The following guest post is contributed by Kailash Nath P S S, who is a lawyer and a chartered accountant, and is currently associated with Wadia Ghandy & Co., Mumbai. Views expressed here are personal and do not reflect the firm’s views.]

Introduction

The recent move of the Central Government exercising its powers u/s 26(2) of the Reserve Bank of India Act, 1934 (“RBI Act”), to withdraw the legal tender character of existing bank notes in denominations of Rs. 500 and Rs. 1000 (“Specified Notes”) issued by the Reserve bank of India is unprecedented. As the Specified Notes cease to be legal tender, a scheme has been formulated under which the Specified Notes can be deposited or exchanged across bank branches and other places designated by the Reserve Bank of India (“RBI”) up to 30 December 2016 (and in exceptional cases, 31 March 2016). While there has been a lot of hue and cry over the many aspects related to this move, the most baffling aspect has been the nature of treatment of such deposit under the Income Tax Act, 1961 (“Act”).

As announced by the Revenue Secretary, Rules 114B and 114E (corresponding to Section 285BA of the Act relating to Annual Information Reports) were amended to enable banks to report cash deposits of over Rs. 250,000 (previously Rs. 10,00,000) to the Central Board of Direct Taxes (“CBDT”). It is further announced that any cash deposits made from undisclosed sources would attract penalty of 200% of tax payable, even if they are subject to tax at the maximum marginal rate of 30%. While there have been varied interpretations regarding imposing the penalty, the legal position and the procedure that should be adopted under the Act to impose any penalty under the Act has been discussed below.

Assessment Procedure under the Act

Under section 139 of the Act, every person with taxable income is statutorily required to file a return of income on or before the due date. Such a return of income would either be summarily processed under section 143(1) to compute the total income or to check for any arithmetical adjustments, disallowances, or inclusion of any additional income not included in computing the total income. The same may also be selected for scrutiny (under the computer assisted scrutiny selection (“CASS”) system) under section 143(2) of the Act by the Assessing Officer (“AO”) by calling for information (asking the assessee to produce books of accounts, bank statements, statements of assets and liabilities, sources of funds, etc.). Also, if the AO has circumstances to believe that any income chargeable to tax has escaped assessment, a notice can be issued under section 147 to re-assess such income under section 148. The AO can re-open assessments by issuing notices up to 6 years from the end of the assessment year in which the income was first assessable.

Introduction of Section 270A with effect from 1 April 2017

Presently, section 271(1)(c) provides for levy of penalty for concealment of income or for furnishing inaccurate particulars of income. The initiation of penalty proceedings under section 271(1)(c) is subject to controversy, as AOs regularly initiate penalty proceedings as soon as assessment under Section 143(3) is complete. The Supreme Court in CIT, Ahmedabad v. Reliance Petroproducts Pvt. Ltd.[1] stated: “If we accept the contention of the revenue then in case of every return where the claim made is not accepted by the Assessing Officer for any reason, the assessee will invite penalty under Section 271(1)(c). That is clearly not the intendment of the legislature”. Moreover, the Income Tax Simplification Committee headed by Justice R.V. Easwar has recommended that no penalty should be levied for concealment if assessee has taken a bona fide view of a provision enabling a claim etc. or on the basis of any judicial ruling and if any addition or disallowance is made ad hoc on assumptions or without evidence.

Disregarding the above, the Parliament by way of the Finance Act, 2016 introduced section 270A under the Act and repealed section 271, both with effect from 1 April 2017. The section deals with penalty for underreporting and misreporting of income. The penalty in the event income is ‘underreported’ is 50% of the tax payable on such underreported income, and in case of misreporting, the penalty is 200% of the tax on such amount. Hence, penalty for ‘concealment of income’ is effectively replaced by penalty for ‘underreporting’ and ‘misreporting’ of income.

The Act does not define ‘underreporting’ and ‘misreporting’, but sets out the instances where the income will be treated as such. An assessee shall be considered to have underreported its income if, among others, the income assessed (under section 143(3) or any other provision) is greater than the income determined in the return processed under section 143(1), and the underreported income will be the difference between the amount of income assessed and the amount of income determined under section 143(1)(a). However, subsection (6) states that under reported income shall not include, among others, (a) income in respect of which the assessee offers an explanation, or (b) the accounts are correct and complete to the satisfaction of the AO (if an estimate of income is drawn from them). In both the cases, the AO should be satisfied that the explanation is bona fide and the assessee has disclosed all the material facts to substantiate the explanation offered.

Subsection (9) sets out the instances where the under reporting of income would be treated as ‘misreporting’. Misrepresentation or suppression of facts, failure to record investments in the books of account, claiming expenditure not substantiated by any evidence, recording of any false entry in the books of account, and failure to record any receipt in books of account are instances of underreporting which would be treated as ‘misreporting’.

Burden of Proof

The Supreme Court had held previously in many cases that the burden of proof is on the Department to prove that the assessee had a guilty mind to establish that it concealed income or furnished inaccurate particulars. To overcome this interpretation, an Explanation was introduced in section 271(1)(c) where the burden of proof was imposed on the assessee to establish bona fides and innocence. However, under section 270A, the operative portion of the section (assessed income being more than declared income) is sufficient to levy penalty. However, to establish ‘misreporting’, the burden is cast on the Department to prove the same, as there is no provision similar to Explanation under section 271(1)(c). However, it may be noted that the Supreme Court of India in Union of India v. Dharamendra Textile Processors[2] after considering section 271(1)(c) came to the conclusion that the Explanations added to section 271(1)(c) indicate the element of strict liability on the assessee for concealment or for giving inaccurate particulars while filing returns and that the object behind enactment of section 271(1)(c) read with the Explanations indicates that the section has been enacted to provide for a remedy for loss of revenue.

Going by the above, though mens rea may not be required to be established under law, if the material and evidence with the AO sufficiently points to misreporting on the part of the asseessee that falls within the confines of subsection (9), penalty may be imposed under the Act.

Application of Section 270A to Deposit of Specified Notes

In instances where Specified Notes are deposited by the assessee, the liability to establish that it has been generated from an established and bona fide sources depends on facts of the case. Any liability to offer explanation only arises after a return has been filed for the current period (i.e. before 31 July 2017 or 30 September 2017), and if the return is taken up for scrutiny. Any cash deposited in the bank accounts may even form a part of the income which was subject to tax previously or may form part of the funds in the ordinary course of business and which has been deposited in the account, and subsequently offered to tax in the return of income. Hence, the question that arises is under what circumstances can the penalty be levied on these deposits, besides levy of tax.

For the purpose of illustration, let’s assume a trader who, for exchanging his Specified Notes, deposits the same in his bank account, representing sales in the ordinary course of business. At the end of the financial year, he offers the excess of income over expenditure to tax. During the course of the assessment proceedings it is for the AO to establish that the said deposits represents income from undisclosed sources. If the assessee is unable to offer satisfactory explanation regarding the source of the income, the AO may attempt to treat the same as ‘unexplained investment’ (from undisclosed sources) under section 69 of the Act, and impose tax under section 115BBE at maximum marginal rate of 30%. Besides imposing tax, the AO may attempt to invoke penalty proceedings under section 270A as ‘misreporting’ of income. However, no deduction in respect of any expenditure or allowance or set off of any loss shall be allowed to the assessee in computing his income. In addition, penalty will be imposed treated it the same as ‘misreporting’.

The judgments of the Supreme Court on the subject matter during previous demonetization drives can be referred to. A three-judge bench of the Supreme Court in Srilekha Banerjee and Ors. v.  Commissioner of Income Tax, Bihar and Orissa,[3] following the earlier judgment in Mehta Parikh & Co. v. Commissioner of Income Tax, Bombay,[4] held that if there is an entry in the account books of the assessee which shows the receipt of a sum, it is necessary for the assessee to establish, if asked, what the source of that money is. It stated that the Department cannot act unreasonably and reject that explanation of the assessee to hold it otherwise. It stated that if, however, the explanation is unconvincing and one which deserves to be rejected, the Department can reject it and draw the inference that the amount represents income either from the sources already disclosed by the assessee or from some undisclosed source. It stated that before the Department rejects any evidence, it must either show an inherent weakness in the explanation or rebut it by putting to the assessee some information or evidence which it has in its possession, and the Department cannot by merely rejecting unreasonably a good explanation, convert good proof into no proof.

Waiver of Penalty

Section 273A(1) empowers the Principal Commissioner or Commissioner to grant waiver or reduction from penalty imposed or imposable under section 270A. The waiver or reduction under section 273A(1) can be granted by the Principal Commissioner or Commissioner either on his own motion or otherwise, i.e., on an application made by the taxpayer. The assessee should have, prior to the detection by the AO of the concealment of particulars of income, voluntarily and in good faith, made full and true disclosure of such particulars. He should have also co-operated in any enquiry relating to the assessment of his income and has either paid or made satisfactory arrangements for the payment of any tax or interest payable in consequence of an order passed under the Act. An order accepting or rejecting the application shall be passed within a period of twelve months from the receipt of the application after giving the assessee an opportunity of being heard.

Other Issues

In addition to discharging liability under the Act, the assessee has to duly consider obligations under indirect tax legislations, given the information exchange channels between various arms of the Revenue. Depending on the nature of business, the assessee may be called upon to correlate the deposits under State VAT laws, excise laws or under the Finance Act, 1994, towards service tax also. Further, assessee should be cautious while making claims of sources as loans or advances towards property transactions as sections 269SS and 269T prohibits cash transactions in excess of Rs. 20,000 for accepting or advancing loans and deposits or in relation to transfer of an immovable property, whether or not the transfer takes place. Provisions with regard to collection of tax at source under section 206C and quoting of PAN of the buyers have to be borne in mind by bullion traders who make cash sales above specified limits (bullion exceeding Rs. 2,00,000 and jewellery exceeding Rs. 5,00,000) and by sellers who receive sale consideration in cash exceeding Rs. 2,00,000 for sale of any goods.

More importantly, attention maybe drawn to section 276C which contains provisions for launching prosecution for wilful attempt to evade tax. The section has been further amended to provide for rigorous imprisonment (between six months to seven years) where the amount sought to be evaded, or tax on under-reported income exceeds Rs. 25,00,000.

Conclusion

The primary point to be noted here is that all cash that is deposited is not definitely income, or for that matter, undisclosed income. However, the onus is largely on the assessee to prove that he has not misreported or suppressed any facts while making deposits of the Specified Notes. At the same time, the Department cannot summarily, and without any cogent reasons, reject the explanations offered by the assessees. It is not an exaggeration to say that this drive is likely to result in prolonged litigation and some degree of inconvenience to the assessees. With reports coming in that notices are already being issued seeking explanation for the sources of cash deposits, we can only hope that the ‘ease of doing business principles’ are emulated even with the Indian residents and assessees. It may however be borne in mind that this window may not be taken as an opportunity to deposit any cash and pay tax at regular rates on undisclosed income, as there is likely to be detailed scrutiny after the Income Declaration Scheme, 2016, having ended quite recently.

- Kailash Nath P S S






[1] MANU/SC/0182/2010.

[2] (2008) 306 ITR 277.

[3] MANU/SC/0101/1963.

[4] MANU/SC/0053/1957.