Wednesday, September 30, 2009

Incorporation of an Arbitration Clause by Reference

One of the most controversial and interesting questions in contemporary arbitration law is incorporation by reference. It is a common practice in some industries, particularly shipping and construction, for the contractual relationship between the parties to be composed of several documents. It sometimes happens that a dispute arises with reference to one of these documents, while the arbitration clause is contained in another. Common law rules have evolved to ascertain whether the parties intended to incorporate the arbitration clause in one document into another, and the normal rule is that “general” incorporation to the other document does not suffice.


The Supreme Court has recently considered this issue in a well-reasoned and comprehensive judgment, in M.R. Engineers v. Som Datt Builders, 2009 (9) SCALE 298. In this case, Som Datt Builders Ltd. [“SDBL”] had entered into a contract with the Kerala PWD. Clause 67.3 of this contract contained an arbitration clause which provided that disputes would be referred to a Committee of three arbitrators to be nominated by various Government departments. SDB sub-contracted a part of its obligations to MR Engineers Pvt. Ltd. [“MREPL”]. The work order provided that “This sub- contract shall be carried out on the terms and conditions as applicable to main contract unless otherwise mentioned in this order letter.


Disputes arose between MREPL and SDBL over payments allegedly owed to MREPL, and MREPL eventually filed an application under s. 11 of the Arbitration and Conciliation Act, 1999, seeking the appointment of an arbitrator. MRE argued that Clause 67.3 of the contract between the Kerala PWD and SDBL stood incorporated into the contract between SDBL and MREPL by virtue of the language extracted above. The Kerala High Court dismissed the application, holding that incorporation was insufficient and that there was consequently no arbitration agreement between MREPL and SDBL.


In the Supreme Court, Justice Raveendran referred to the provisions of s. 7(5) of the Arbitration Act, which provides that “[t]he reference in a contract to a document containing an arbitration clause constitutes an arbitration agreement if the contract is in writing and the reference is such as to make that arbitration clause part of the contract.” The Court rightly noticed that the words “such as to make that arbitration part of the contract” meant that mere reference is insufficient. Clearly, s. 7(5) required “conscious acceptance” of the arbitration clause, and the Court held that this question would have to be answered in accordance with the normal rules of document construction, in the absence of statutory guidelines.


The primary indicator of this intention is the language of the incorporating clause. The Court noticed that contracts sometimes incorporate other contracts in their entirety, using language along the lines of “all the terms and conditions…” or “this contract shall be governed by the provisions of…” etc. In such cases, the arbitration clause is also incorporated. Where, however, the incorporating clause refers to a specific aspect of another contract, the presumption is that it was not intended to incorporate the arbitration clause. This proved to be extremely important in the case, because the incorporating clause used the phrase “this sub-contract shall be carried out…” The Court held that the use of words “carried out” indicated the intention of the parties to confine incorporation to matters of performance and execution, and that it could consequently not extend to clauses outside this sphere, such as security deposits and arbitration clauses.


The second important proposition in this case is a distinction that the Court made between “standard form contracts” and other contracts. Relying on observations in Russell on Arbitration, the Court held that general reference may suffice if the reference was to a standard form of terms and conditions of “trade associations or regulatory institutions”. The reasoning is that parties that accept the terms and conditions of such well-known associations and institutions are presumably aware of the existence of the arbitration clause, particularly since these terms and conditions are almost always published. On this basis, the Court distinguished two of its prior decisions where incorporation was accepted in the context of the General Conditions of Contract of the Grain & Food Trade Association and the General Conditions of the Fertilizer Association of India. In this case, the Court observed that the reference was general and not to a standard form of a trade association. It was therefore regarded as insufficient on the facts of the case.


A final reason to reject the incorporation argument is the source for another important legal proposition – the arbitration clause, after incorporation, must remain consistent with the contract into which it is incorporated. In this case, the arbitrators were to be appointed by various Government Departments, which could clearly not apply to a contract to which the Government was not a party.


In sum, the following important propositions emerge from the judgment:

  1. Mere reference is insufficient for the purposes of s. 7(5), which mandates an inquiry into the intention of the parties on the basis of the normal rules of construction of contracts.
  2. General reference to another contract is normally insufficient, except where the reference is to the standard terms and conditions of a “trade association or regulatory institution”.
  3. The language of the incorporating clause is a crucial factor – if it refers to a specific aspect of another contract, such as supply or execution, the arbitration clause is not arbitrated, whereas incorporation in its entirety is sufficient to incorporate the arbitration clause as well.
  4. Incorporation fails if the arbitration clause on incorporation will be inconsistent with the terms or scheme of the contract into which it is incorporated.


Another analysis of this judgment is available here.

Tuesday, September 29, 2009

Towards evolving Global Corporate Governance Standards

In a recent article, Mr. Umakanth drew a distinction between ‘insider’ and ‘outsider’ models of corporate governance, and argued that "...the current regime on corporate governance has been transplanted from jurisdictions which display diffused shareholding and hence is inappropriate to the Indian regime which is dominated by promoter-controlled companies. What is necessary is a paradigm shift in measures to address governance problems pertaining to controlled companies…"
In this context, a recent paper by Prof. Lucien Bebchuk and Prof. Assaf Hamdani titled “The Elusive Quest for Global Governance Standards” makes for interesting reading. In the paper, the authors recognise that "In the United States and the United Kingdom, most public companies do not have a controlling shareholder. In most other countries, companies with a controller dominate…" They then argue that current models for assessing corporate governance structures fail to take into account these differences in ownership structures.
The paper goes on to propose two different models in cases for evolving global standards for assessing the governance of corporations. The models are based on differences in companies which have a controlling shareholder, and companies which do not have one; but is perhaps relevant even when not an ‘individual’ but a ‘family’ is the effective controlling shareholder.
The abstract of the article is as follows:
"Researchers and shareholder advisers have devoted much attention to developing metrics for assessing the governance of public companies around the world. These important and influential efforts, we argue, suffer from a basic shortcoming. The impact of many key governance arrangements depends considerably on companies’ ownership structure: measures that protect outside investors in a company without a controlling shareholder are often irrelevant or even harmful when it comes to investor protection in companies with a controlling shareholder, and vice versa. Consequently, governance metrics that purport to apply to companies regardless of ownership structure are bound to miss the mark with respect to one or both types of firms. In particular, we show that the influential metrics used extensively by scholars and shareholder advisers to assess governance arrangements around the world—the Corporate Governance Quotient (CGQ), the Anti-Director Rights Index, and the Anti-Self-Dealing Index—are inadequate for this purpose. We argue that, going forward, the quest for global governance standards should be replaced by an effort to develop and implement separate methodologies for assessing governance in companies with and without a controlling shareholder. We also identify the key features that these separate methodologies should include, and discuss how to apply such methodologies in either country-level or firm-level comparisons. Our analysis has wide-ranging implications for corporate-governance research and practice."
The article has been posted on SSRN, and can be downloaded from this link.

Thursday, September 24, 2009

TDS and Non-Residents

While the Vodafone decision has been discussed earlier, one aspect which has not been looked at is the application of TDS provisions in the case. In the facts of the case, Hutch had received consideration from Vodafone for the alleged transfer of a capital asset situated in India. The primary liability to pay tax would be that of Hutch (the payee). According to the Revenue, the liability of Vodafone (the payer) would be one to deduct tax at source under Section 195 of the Income Tax Act. With several similar transactions under the scrutiny of the Revenue, and with the Vodafone case itself back before the Assessing Officer to decide on jurisdictional issues, the issue of the applicability of Section 195 has great significance.
The relevant part of Section 195 reads:
Any person responsible for paying to a non-resident, not being a company, or to a foreign company, any interest (not being interest on securities) or any other sum chargeable under the provisions of this Act (not being income chargeable under the head "Salaries" shall, at the time of credit of such income to the account of the payee or at the time of payment thereof in cash or by the issue of a cheque or draft or by any other mode, whichever is earlier, deduct income-tax thereon at the rates in force...
One of the important questions in this regard is whether Section 195 operates extraterritorially to cover payments made by non-residents to non-residents outside India. Are the requirements of territorial nexus satisfied in such a case? The Revenue’s argument is clear. For establishing chargeability u/s 9, undoubtedly, nexus is required. According to the Revenue’s argument, once chargeability is established, no further requirements of nexus need to be satisfied for attracting TDS provisions. As such, there is no ground for not giving the words “any person” in Section 195 their natural and ordinary meaning. The Revenue’s stand can be countered by arguing that “any person” can only refer to residents, and the provision must be given a contextual meaning. The case law on the point is not entirely clear. In Satellite TV v. DCIT, (2006) 99 TTJ (Mum) 1025, the Tribunal held that the words used in section 195 were “any person responsible for paying to a non-resident”. On a plain reading, the words “any person” could not be construed to exclude non-residents; nor could it be said that payments made outside India were outside the scope of the Section.
The assessee in that case had relied on an earlier decision of a co-ordinate Bench of the Tribunal in Shrikumar Poddar v. DCIT, (1997) 59 TTJ (Mum) 304. The Tribunal in Satellite TV refused to follow Shrikumar Poddar, saying that a decision is authority only for what it decides, and not for everything that may logically follow from it. Poddar had been decided on the ground that the charging provision in that case was not applicable in the facts of that case. Given this fact, the question of deduction of tax in terms of Section 195 did not arise for the consideration of the Tribunal. Therefore, the observations in Poddar (that Section 195 was not applicable as the payment was made outside India) were treated as obiter and not conclusive of the issue. Accordingly, the Tribunal in Satellite TV took a view different from that in Poddar.
Thus, while obiter in Poddar would support the assessee, the ratio of the decision in Satellite TV would go in favour of the Revenue’s arguments. Arguably, the Revenue’s stand is also vindicated by the Supreme Court judgment in CIT v. Eli Lilly, Civil Appeal 5114/2007. The Court suggests that chargeability under Section 9 would constitute sufficient nexus for the purposes of TDS provisions too. Yet, the Supreme Court specifically confined its decision to TDS under Section 192 (TDS in case of salaries); and on the facts of that case, the issue of payments by non-residents did not arise. Given this state of the case law, the question of the extraterritorial application of Section 195 cannot be regarded as settled. On principle, it is at least arguable that Section 195 should not be attracted in a Vodafone-type case. No doubt, the Section uses the words “any person”. However, the rationale behind TDS provisions seems to require a contextual interpretation of “persons” to mean only “residents”. TDS provisions are meant to ensure easier collection of taxes. The logic is that certain sums, though taxable in the hands of the payee, might escape tax because of problems in enforcement machinery in the case of non-resident payees. Hence, those sums should be deducted by the payer, from whom they can be recovered more easily. For this logic to hold true, it is essential that the payer must be in a better position than the payee – it must be easier to collect from the payer than from the payee. This will be true only in cases where the payer is a resident and the payee is a non-resident. In case both parties are non-residents, it will be as easy or as difficult to collect the sums due from the payee as the payer. In that case, the rationale behind application of TDS provisions is not attracted. In order to remain faithful to this rationale, the words “any person” must be read to mean “any residents”. Such an approach is also supported by a decision of the House of Lords in Clark v. Oceanic Contractors, [1983] 2 WLR 94, where their Lordships had to directly consider the question of whether chargeability is ipso facto sufficient nexus to attract TDS provisions. A provision quite similar to Section 195 was not given extraterritorial application, based on principles of statutory interpretation. This judgment has been more recently explained by the Court of Appeal in Andre Agassi v. Robinson (see paragraph 25 onwards). Whether this approach will be followed in India is a matter which remains to be seen.

Capital Gains and the Cost of Acquisition

A recent post examined the decision of the Bombay High Court in Techno Shares which adopted a new stance on the law of depreciation. Soon after this decision, the Mumbai Bench of the Income Tax Appellate Tribunal seems to have marked another point of departure in relation to the taxation of capital assets, this time on the issue of capital gains tax.


The issue before the Tribunal in Bomi S. Billimoria v. ACIT was the taxation of cashless ESOPs offered by a non-resident company (Johnson & Johnson, USA) to employees resident in India. The option was to purchase the shares at their fair market value. However, the Reserve Bank of India approved the scheme on the condition that there should not be any payment, in India or abroad, for acquiring the shares. The assessee exercised the options, and sold the shares in the U.S. The Revenue sought to tax the gains made by virtue of this sale. The question before the Tribunal was two-fold:

Whether the said gain is a capital gain; and if so, whether it can be taxed as such.


The assessee contended that it was a capital gain, but could not be taxed. This argument was based on a 1981 decision of the Supreme Court in B.C. Srinivasa Setty, [128 ITR 294] which was cited as authority for the proposition that no capital gains tax can be charged if there is no cost of acquisition for the asset in question. The assessee argued that since there had been no cost of acquisition (due to the Reserve Bank of India directive), the gain could not be taxed. The Revenue contended that the said gain was not a capital gain, and was taxable even if it was considered to be a capital gain.


The ITAT decided the issue in favour of the assessee, relying on B.C. Srinivasa Setty. It held that when there was no cost of acquisition and the gain could not be taxed. It went on to say that even if the market price was to be considered the cost of acquisition, the options were sold on the very same day at the same price, and hence the gain would have to be considered nil. Thus, in either case, no tax was leviable on the assessee.


This decision throws up some interesting issues, and potentially problematic scenarios regarding capital gains tax. Conceptually, there is a distinction between there being no cost of acquisition for a particular type of asset, and the assessee not paying the cost of acquisition for a said asset. For instance, there cannot be a cost of acquisition for an asset like goodwill (though there is now a deemed cost of nil under the Act). However, this is different from an asset like the ESOPs in question here, for which there is a cost of acquisition (the market price), which does not have to be paid by the assessee, or is paid by a third party. While Srinivasa Setty is authority for cases similar to the sale of goodwill, it is the extension of the decision to the second type of capital gains that is suspect. A close reading of the decision indicates that the Supreme Court categorically restricted its decision to cases where the cost of acquisition for a type of asset was incapable of being computed. In the words of the Court, capital gains tax can only be charged when the asset is such that, in its acquisition, “it is possible to envisage a cost. The intent goes to the nature and character of the asset, that it is an asset which possesses the inherent quality of being available on the expenditure of money to a person seeking to acquire it. It is immaterial that although the asset belongs to such a class it may, on the facts of a certain case, be acquired without the payment of money”. The ratio of the case applied only to assets for which “no cost element can be identified or envisaged”.


This clearly shows that Srinivasa Setty did not hold that capital gains tax cannot be charged whenever there is no cost of acquisition; it only held that capital gains tax cannot be charged when the cost of acquisition is incapable of being computed. This is also implicitly affirmed by a recent decision of the Supreme Court in PNB Finance v. CIT [307 ITR 75], where the Court again held that no capital gains was chargeable on the facts of the case because “it was not possible to compute capital gains”. On the facts of Billimoria, there was no impossibility of computing the cost of acquisition. In fact, the cost of acquisition was clearly stated to be the market price, which was not paid by the assessee because of the RBI guideline. In such circumstances, the decision of the tribunal may be at odds with the decisions of the Supreme Court on this issue, and may require to be reconsidered.

FDI from Cayman Islands: Recent Changes

In an article titled “Investing in India: How Recent Developments in the Cayman Islands Facilitate Inbound Investment”, Chetan Nagendra examines two recent events: Cayman Islands’ acceptance as a full member of IOSCO and its recognition in the ‘white list’ of jurisdictions that have substantially implemented the OECD tax standard. He notes that these events are likely to see a further flow of investments from Cayman Islands into India as it enables registration of Cayman funds as foreign institutional investors (FIIs) by SEBI:

[Cayman Islands Monetary Authority’ (CIMA)] admission to IOSCO demonstrates the jursidcition’s willingness to engage other regulators to facilitate cross-border information exchange and assistance. It is believed that the Indian securities regulator, the Securities and Exchange Board of India (SEBI) will treat this development positively and allow for speedier and less cumbersome registration of Cayman domiciled funds as foreign institutional investors (FIIs) in India.

Registration is mandatory for foreign institutional investors in India. Cayman Islands domiciled investment funds have historically faced challenges when seeking to invest in Indian listed securities. SEBI has previously required extensive due-diligence on funds domiciled in the Cayman Islands, citing CIMA’s lack of IOSCO membership. It is expected that with IOSCO membership, Cayman domiciled funds that invest in India can now directly register as a FII with SEBI rather than investing through intermediary funds based in another jurisdiction or through participatory notes.

The article however notes that since Cayman Islands does not have a double taxation avoidance treaty with India, funds from Cayman will still have to be routed through jurisdictions that have advantageous tax treaties with India (such as Mauritius and Cyprus).

The article is on page 68 of the World Commerce Review (Sep ’09), which can be accessed here.

Wednesday, September 23, 2009

True and Fair Accounting

Recent events like Satyam and the economic recession have thrown up several issues about appropriate accounting and auditing practices, discussed here and here. In this context, it is interesting to note a decision of the United Kingdom Queen’s Bench in Macquarie Internationale Investments Ltd. v. Glencore UK Ltd., [2009] EWHC 2267 (Comm). Macquarie Internationale Investments had acquired an interest in Corona Energy Holdings Ltd. from Glencore. However, it contended that incorrect accounting had resulted in some of the charges on Corona’s subsidiaries not being recognised in the accounts, and had breached the warranties contained in the Share-Purchase agreements. A large part of the decision focuses on the precise warranty in question, and the precise nature of the charges in question. However, the three issues that are relevant for discussion here are: the meaning of ‘true and fair accounts’; the relationship between ‘true and fair accounts’ and the Financial Reporting Standards [“FSR”]; and the relevance of the purpose for which the accounts are created.


First, considering the extent of investigation required, the Court categorically held that “it does not seem ... that extravagant and disproportionate investigations are demanded, or that there is sufficient evidence of an item if its existence might be established only by investigations which the entity or those preparing its financial statements could not be expected to conduct if exercising reasonable diligence and making sensible enquiries”. Coming to the meaning of ‘true and fair’ accounts, the Court held that while the two terms meant different things, the phrase could not be read disjunctively. In the words of the Court, “it would be an arid and unhelpful exercise to decide whether financial statements are (i) true and (ii) fair as if they were separate questions”. Further, the relevance of general accounting practices to the idea of ‘true and fair’ and the role of cost-effectiveness was also stressed by the Court.


Secondly, on the issue of the relationship between the FSR and the ideal of ‘true and fair’ accounts, the Court accepted that accounts created in accordance with the FSR need not necessarily be ‘true and fair’. However, the concept “must be understood and given effect in light of generally accepted accounting practices”. Only in exceptional circumstances would the Court conclude that FSR-compliant accounts do not give a ‘true and fair’ picture of the accounts of an entity. The issue of inconsistencies in accounting standards has also been discussed here.


Thirdly, MII had argued that the accounts had been used for the purpose of the purchase, and should be considered in that light. However, the Court rejected this contention, holding that “[i]t is one thing for them to be so used, or even to be prepared in the knowledge that they would be so used; the purpose (or a purpose) for which they were prepared is another. As a rule, management accounts are prepared for the purpose of managing a business, and the information in them depends upon the requirements of the business”. In the absence of specific evidence suggesting that the accounts were created for the purpose of the purchase, their mere use for that purpose would not be relevant in determining whether they gave a true and fair picture of the financial state of the group.


While much of the case seems to be decided on the specific facts, the tenor of the decision certainly seems tilted towards the pro-auditor stance adopted by common law courts since Caparo v. Dickman. However, it is this very reaffirmation which assumes great relevance, given the suggestions in other quarters for more stringent accounting standards and practices.


Another discussion on this decision is available here.