Sunday, February 28, 2010

Public Company shares cannot be fettered at all, says Bombay HC

The Bombay High Court has ruled that any pre-emptive rights over shares in public limited companies are patently illegal in view of the principle of “free transferability” enshrined in Section 111A of the Companies Act, 1956 (“the Act”). This revives the debate on enforceability of shareholder agreements and joint venture agreements governing public limited companies.

In the case of Western Maharashtra Development Corporation Ltd. Vs. Bajaj Auto Ltd. (MANU/MH/0109/2010), in an emphatic decision, the Bombay High Court has said that a pre-emptive right would impose a fetter on transferability of shares – a requirement, in the view of the court, envisaged only for private companies and in fact prohibited for public companies, in the scheme of the Act – and therefore “patently illegal”. Setting aside an arbitral award resolving a dispute over price for transfer of shares under a right of first refusal clause between the litigating parties, the court has said that arbitrator ought to have held that the pre-emptive right was completely contrary to law and therefore unenforceable and consequently, the award deserved to be set aside.

The Court ruled thus:-

“53. The provision contained in the law for the free transferability of shares in a public Company is founded on the principle that members of the public must have the freedom to purchase and, every shareholder, the freedom to transfer. The incorporation of a Company in the public, as distinguished from the private, realm leads to specific consequences and the imposition of obligations envisaged in law. Those who promote and manage public companies assume those obligations. Corresponding to those obligations are rights, which the law recognizes as inhering in the members of the public who subscribe to shares. The principle of free transferability must be given a broad dimension in order to fulfill the object of the law. Imposing restrictions on the principle of free transferability, is a legislative function, simply because the postulate of free transferability was enunciated as a matter of legislative policy when Parliament introduced Section 111A into the Companies' Act, 1956. That is a binding precept which governs the discourse on transferability of shares. The word "transferable" is of the widest possible import and Parliament by using the expression "freely transferable", has reinforced the legislative intent of allowing transfers of shares of public companies in a free and efficient domain.

54. The effect of Clause 7 of the Protocol Agreement is to create a right of pre emption between the Petitioner and the Respondent in the event that either of them seeks to part with or transfer its shareholding in MSL. In that event, the party desirous to transfer its shareholding is obligated to furnish a first option to the other for the purchase of the shares at such rate, as may be agreed to between the parties or decided upon by arbitration. The consequence of Clause 7 of the Protocol Agreement, which has been incorporated in the Articles of Association, is to preclude sale to or purchase by the members of the public of the shares, which are offered for sale if the offer is accepted by the Petitioner, or as the case may be, by the Respondent within thirty days of the receipt of the notice. The effect of a clause of preemption is to impose a restriction on the free transferability of the shares by subjecting the norms of transferability laid down in Section 111A to a preemptive right created by the agreement between the parties. This is impermissible. Section 9 of the Companies' Act, 1956 gives overriding force and effect to the provisions of the Act, notwithstanding anything to the contrary contained in the Memorandum or Articles of a Company or in any agreement executed by it or for that matter in any resolution of the Company in general meeting or of its Board of Directors. A provision contained in the Memorandum, Articles, Agreement or Resolution is to the extent to which it is repugnant to the provisions of the Act, regarded as void.”

The decision can have far-reaching and perhaps unintended consequences, not just for joint venture partners and private equity investors, but also for banks, financial institutions and even for regulators and stock exchanges. If a holder of shares of a public company is prohibited from agreeing not to transfer his shares except subject to certain conditions (indeed, in consideration for a reciprocal promise) no fetter or encumbrance of any nature can be permitted.

A pledge of shares by a shareholder would create a fetter on transfer. So would be a non-disposal undertaking given by shareholders to banks to raise funds either for themselves or for the public companies in which they hold shares. The Securities and Exchange Board of India, by subordinate legislation, imposes a “lock-in” on shares held in public companies in certain situations. So do stock exchanges routinely ask substantial shareholders not to transfer their shares for specified periods of time. These measures would be per se illegal too since subordinate law has to necessarily give way to Parliament-made law and cannot impose restrictions higher than the principles laid down by Parliament.

Indeed, the Delhi High Court has held a similar view, refusing to overturn a decision of the Company Law Board, and the Supreme Court did not grant leave to appeal against the Delhi High Court decision. The Bombay High Court has noted thus:

“55. The Delhi High Court had occasion to consider the issue in its decision in Smt. Pushpa Katoch v. Manu Maharani Hotels Ltd. MANU/DE/0867/2005 : 121 (2005) DLT 333 In the case before the Delhi High Court, in a Petition under Sections 397 and 398 of the Companies' Act, 1956, one of the grievances was that three sisters of the Appellant had transferred their shareholding in a Public Limited Company, in violation of a right of preemption contained in a family settlement. The Company Law Board held that the Articles of Association of the Company, which was a Public Limited Company, did not recognize a right of preemption. Since the Company was a Public Limited Company, no fetter could be imposed on the right of the shareholder to transfer his shares, by virtue of the provisions of Section 111A. The CLB rested its decision both on the basis that the preemptive right was not recognized by the Articles of Association and on the foundation that a Public Company could not have a provision recognizing preemptive rights to its members. The Delhi High Court in an appeal arising out of the judgment of the CLB relied upon the judgment of the Supreme Court in Rangaraj (supra) to hold that a restriction which is not specified in the Articles, would not bind either the Company or its shareholders. The Delhi High Court also held that by virtue of the provisions of Section 111A, the right of a shareholder to transfer his/her shares could not be fettered. Mr. Justice A.K. Sikri held thus:

‘The CLB further rightly mentioned that as per the provisions of Section 111A of the Act, there could not be any fetters on the right of a
shareholder to transfer his/her shares. It may be noted that the Legislature has made different provisions for transfer of shares in case of private limited company and public limited company. Section 111, which deals with "Power to refuse registration and appeal against refusal", relates to the private limited companies. On the other hand, provisions of Section 111A dealing with "Rectification of register on transfer" are attracted in the case of public limited companies. While
restrictions can be stipulated in the Articles of Association so far as transfer of shares of a private limited company is concerned, sub section (2) of Section 111A of the Act specifically provides that the shares or debentures and any interest therein of a company shall be freely transferable. Proviso to this Sub-section further stipulates that if a company without sufficient cause refuses to transfer the shares within two months, the transferee may file an appeal to the Company Law Board and "it shall direct company to register the transfer of shares". Since the respondent No. 1 company is a public limited company, the CLB rightly opined that there could be no fetters on the right of a
shareholder to transfer his/her shares. We have already noted that there is no such provision giving pre emptory right to other promoters in the Articles of Association. Even if there was such a provision in the Articles of Association, it would have been ultra vires the provisions of the Act, as no company can provide in the Articles of Association any matter which offends the specific provision of an act (see Re. Denver Hotel Co., 1893(1) Chancery Division 495). No doubt, the four sisters promoted the company and their intention was to make the family property as a hotel and run the same. No doubt, in the Board meeting
held on 16th March 1994 and the Memorandum of Family Agreement it was recorded that any promoter wanting to sell the shares would first offer the same to other promoters. However, at the same time, while incorporating this company, the promoters decided to have a public company limited by shares rather than a private company. They should have understood the implication and consequences of getting a public company incorporated. If they wanted such an arrangement, as recorded in the minutes of the meeting dated 16th March 1994 and the Memorandum of Family Settlement, they should have been wise enough to incorporate a private company and further to provide such a clause in the Articles of Association. After incorporating a public company, it was too late in the day to think of such an arrangement and recording the same in the Board meeting or the family settlement, which could not have any legal basis.’
A Special Leave Petition against the judgment of the Delhi High Court was dismissed by the Supreme Court on 7th April 2006. I am in respectful agreement with the view of the Delhi High Court which reflects the correct position in law.”

The key question that has emerged is whether a person entitled to free and marketable title to a property (the property being shares held in a public company) is necessarily fettered from dealing with such property freely in any manner other than transfer of shares. The court’s opinion underlines a fetter on the owner of such property. A holder of shares in a public company is therefore fettered from enjoying such property to the fullest – a contract to refrain from disposing of the shares in any manner for receipt of a reciprocal promise, has been held to be illegal and unenforceable.

The issue of whether at all a fetter on share ownership in a public company can be contracted has not been considered in detail by the Supreme Court so far – all debate has been around whether an agreement not enshrined in the Articles of Association would be enforceable. One would have to keenly wait and watch this space.

Friday, February 26, 2010

Taxation and the Budget: An Initial Assessment of the Finance Bill, 2010

From the perspective of taxation (particularly income tax and service tax), the budget proposes changes in several areas. Importantly, the Finance Minister has clarified that the Direct Taxes Code will be introduced from 1st April, 2011. The GST will also be sought to be implemented from that date. In this post, I shall look at a few issues in income tax and service tax that may arise out of the Finance Bill, 2010.

The definition of “Charitable purposes”:

A Proviso added to the explanation to Section 2(15) of the Income Tax Act by the Finance Act, 2008, had resulted in some confusion as to whether an institution which incidentally earned some fees in connection to its charitable activities would be entitled to take advantage of the benefits granted to charitable institutions. In Himachal Pradesh Environment Protection and Pollution Control Board v. CIT, the Income Tax Appellate Tribunal had held that the Proviso only excluded those institutions in which the charitable purpose was a “mask” or a device to hide the true purpose of trade and commerce. Thus, the test under the Proviso in determining whether an institution advanced an object of general public utility and was a charitable institution or not; was whether or not the charitable purpose was a mask to shield commercial activities or not.

The Finance Bill, 2010, adds a further Proviso that “the advancement of any other object of general public utility” shall continue to be a “charitable purpose” if the total receipts from any activity in the nature of trade, commerce or business, or any activity of rendering any service in relation to any trade, commerce or business do not exceed Rs.10 lakhs in the previous year. The interpretation of this may result in some ambiguity. The new Proviso is sought to be inserted with retrospective effect from 1st April, 2009.

The Revenue can perhaps argue that this further Proviso indicates that the test for whether the first Proviso applies or not; is not whether the charitable activity is a “mask” for commercial activities. Instead, the first Proviso would apply in every case where fees are earned by the institution, except (as per the second Proviso) where the fees do not exceed Rs. 10 lakh. It seems a possible construction that in every case where fees received exceed Rs. 10 lakh; the first Proviso would apply – even if the charitable purpose is not a mask for commercial activities. The newly inserted Proviso seems to indicate, in other words, that the test is not just of what the true nature of the activities of the institution is, but is instead a blanket test applicable to all institutions which earn fees from charitable purposes – whether the charitable purpose is a device or not, is immaterial. If the fees received are over Rs. 10 lakhs, the institution would not be carrying out a charitable purpose.

Assessees can, of course, argue that the second Proviso is an additional test to satisfy; over and above the test that the charitable purpose is a mask. That interpretation would mean, however, that those activities which are simply a mask or a device for commercial purposes, would still be entitled to take the benefit of “charitable purposes” if the fees they earn are less than Rs. 10 lakhs. The Memorandum accompanying the Finance Bill seems to indicate that the construction in favour of the Revenue is the true intent behind the Bill. It specifically refers to the “absolute restriction” imposed by the First Proviso. As a matter of policy, however, there may not be a strong reason to say that an organization which carries out genuine charitable activities is not established for a charitable purpose if incidental to its activities it earns some fees. What view the judiciary will take of the effect of the new Proviso is a matter which remains to be seen after the enactment into law of the Bill.

Section 9:

The controversy in the taxation of non-residents in interpreting Section 9 of the Income Tax Act has been discussed on several occasions earlier. Essentially, under the judgment of the Supreme Court in Ishikawajima, for Section 9(1)(vii) to be applied in order to say that fees for technical services are deemed to accrue or arise in India, it is essential that the service is both rendered and utilized in India. An Explanation was inserted in 2007 attempting to modify this rule. However, as was held by the Karnataka High Court in Jindal, on a plain reading, the Explanation did not do away with the principle of Ishikawajima. This Explanation is sought to be replaced by a new one, again with retrospective effect from 1976. The new Explanation specifically states that it is not necessary that the services should be rendered in India. On its text, it is now clear that the rule in Ishikawajima is not good law.

There may perhaps be a constitutional challenge open to the new Explanation, as being  in violation of territorial nexus requirements – it is debatable whether that challenge would succeed. It is unclear as to how strongly the nexus doctrine would apply to a Union law; and in any case, the mere existence of a nexus is sufficient (the strength of the nexus not being relevant). The Union can well contend that even now, services must be utilized in India even if not rendered in India, and that constitutes territorial nexus. If the Explanation stands as it presently is post-enactment, one thing would be clear: the income of a non-resident shall be deemed to accrue or arise in India under Sections 9(1) (v), (vi), and (vii) whether or not (i) the non-resident has a residence or place of business or business connection in India; or (ii) the non-resident has rendered services in India.


The Finance Bill proposes to clarify that the transfer of assets on a conversion of a company into a Limited Liability Partnership will not be regarded as a transfer of assets for the purpose of capital gains, if certain conditions are met. These conditions include that the company’s total sales, turnover or gross receipts in the three previous years should not exceed Rs. 60 lakh. Thus, for companies not within that limit, a conversion to a limited liability partnership will result in capital gains liability. Several other conditions are also mentioned. Furthermore, under Section 115JAA as it now stands, certain tax credits are allowed to companies which are covered under Section 115JA and 115JB for MAT purposes. This credit will not be allowed – under the proposed sub-section (7) to Section 115JAA – to successor LLP’s on a company’s conversion to an LLP.


There was a controversy between some High Courts about whether a High Court has the power to condone delays in filing appeals under Section 260A of the Income Tax Act. The weight of authority suggested that there was no such power to condone delays under Section 260A. The Bill gives High Courts the power to condone delays, with retrospective effect from 1st October, 1998. This is likely to lead to a huge flood – literally, thousands – of applications for restoration of appeals which were dismissed on account of delay.

Service tax:

The Delhi High Court had held in Home Retail that the renting of immovable property on its own would not constitute a service. The Finance Bill, 2010 indicates that renting of immovable property itself would be a taxable service under the Finance Act, 1994. This amendment is also retrospective, with effect from 1st June, 2007. Furthermore, as the accompanying Memorandum states, under the existing law in relation to service tax, IT software services are included as taxable services only in those cases where the service is used in furtherance of business or commerce. This limitation is sought to be dropped by amending Section 65(105)(zzzze) of the Finance Act, 1994 – information technology software service will be taxable services irrespective of the use to which the service is put to.


In sum, in both service tax and income tax, the Finance Bill, 2010 continues the trend of the legislature to upset judicial decisions by retrospective amendments. There are some changes sought to be introduced in terms of income tax slabs, higher TDS limits have been made available, and the rate of MAT has been increased. From a legal viewpoint, several proposals merit greater debate and scrutiny.

Wednesday, February 24, 2010

Overseas Acquisitions and the Impact of National Pride

In the context the proposed overseas acquisitions by Reliance Industries (of LyondellBasell Industries) and Bharti Airtel (of Zain), the M&A Law Prof Blawg has a interesting take on the impact of national pride generated through press attention on such deals. The Blog refers to a recent paper The Cost of Pride: Why Do Firms from Developing Countries Bid Higher?, which concludes that “firms from developing countries (versus those from developed countries) bid higher on average to acquire assets in developed countries”. The study finds correlation between the high prices of bids and the presence of “national pride” characteristics displayed by transactions.

Tuesday, February 23, 2010

Event Announcement: 3rd NLSIR Symposium on Corporate Governance

The National Law School of India Review (NLSIR), the flagship journal of the National Law School of India University, Bangalore, will be hosting the 3rd Annual NLSIR Symposium, 'Indian Corporate Law and Corporate Governance: At the Crossroads', in Bangalore, on 10th and 11th April, 2010. Extracts from the concept note for the Symposium may be of interest to our readers.

The 1st NLSIR Symposium, ‘Challenges to India’s Patent Regime’, and the 2nd Symposium, ‘Towards Unification: Perspectives on International and Investment Arbitration’, saw participation from members of the judiciary, leading practitioners, academics and students. Among the participants in the previous Symposia were Justice Ar. Lakshmanan, Justice P. Naolekar, Justice Jayasimha Babu, Justice N. Kumar, Mr. Arvind Datar, and Mr. Gourab Banerjee.

The 3rd NLSIR Symposium seeks to address crucial issues in contemporary corporate law and governance. There is no more appropriate time to consider this area of law. The Satyam episode has provoked widespread concerns regarding Indian corporate governance mechanisms. Even outside the area of corporate governance, it is necessary to ask whether the 1956 Companies Act continues to serve the interest of Indian corporations, their stakeholders and the Indian public. Does the proposed Companies Bill even begin to address these questions? What is the fate of the National Company Law Tribunal (NCLT) and company adjudication generally? These are some of the questions that it is necessary to urgently resolve, to understand the journey Indian company law has had over the past fifty years, and the course it must chart in the future. The four Sessions of the Symposium will seek to analyse these and other related issues.

The Sessions:
The First Session looks at the role of the corporate vehicle in tax planning. This is among the crucial issues facing Indian tax law today; as exemplified through the Vodafone tax controversy. When does the use of the corporate form cross the line between permissible tax planning and impermissible evasion? The Second Session looks at issues pertaining to the role of the independent director and the statutory auditor. In the backdrop of the Satyam scandal, questions have arisen as to the appropriate role of independent directors and auditors in maintaining and evolving corporate governance norms. These questions will form the focus of the Second Session. The Third Session looks at company adjudication and the ‘tribunalisation’ of justice. With the NCLT case still pending before the Supreme Court, it is time to ask what form of adjudicatory mechanism will best serve the needs of India today. Further, are typical remedies of oppression/mismanagement sufficient to protect shareholders? It is time to evolve new forms of remedies; as done recently in Hong Kong in the form of multiple derivative actions? What is the role and extent to which Courts should interfere in commercial arrangements in order to protect minority shareholder interests? The Fourth Session of the Symposium seeks to undertake a holistic analysis of the Companies Act, 1956. Does the new Bill actually show promising signs? What more can be done – if anything at all needs to be done – to refashion company law and corporate governance to meet the challenges posed in today’s commercial scenario?

The Panelists:
Panelists at the Symposium include Mr. Sandip Bhagat (partner, S&R Associates), Mr. V. Umakanth (former partner Amarchand Mangaldas and Ph.D. scholar, National University of Singapore), Mr. Somashekhar Sundaresan (partner, Jyoti Sagar Associates), Mr. Siddharth Raja (partner, Narasappa, Doraswamy and Raja) and Ms. Kristin van Zwieten (D. Phil. scholar, University of Oxford). Leading members from the judiciary and the Bar are also expected to attend.

Submissions and Participation as Delegates:
The NLSIR invites contributions of up to 10000 words on any of the themes to be discussed in the Symposium. Selected papers will be presented by the authors at the Symposium and will be published in the Symposium issue of the NLSIR. Contributions, and requests for any further information, may be mailed to mail(dot)nlsir(at)gmail(dot)com.

Practitioners, academicians, corporate houses and students are invited to register as delegates. Further details will be available on request. Interested readers can contact the Organising Committee of the Symposium at the above email.

Monday, February 22, 2010

Pricing Adjustments for FCCBs

On November 27, 2008, the Ministry of Finance introduced changes to the pricing norms for FCCBs. As we had discussed then, two changes were proposed:

(i) the minimum price will be the average weekly high and low prices for the 2 weeks prior to the relevant date, instead of the previous price determined as the higher of the average for 6 months and 2 weeks;

(ii) the relevant date for price determination will the date on which the board decides to issue to securities, and not 30 days prior to the shareholders’ resolution as it earlier stood.
These changes were introduced to overcome the difficulties faced by issuers in appropriately pricing FCCBs in declining market conditions. However, since the altered requirements were applicable prospectively, it did not provide any benefits in relation to FCCBs issued prior to the date of relaxation, being November 27, 2008. In view of representations received from companies and after consultation with RBI and SEBI, the Ministry of Finance last week issued a press release whereby “it has now been decided by the Government to provide a window of 6 months under the scheme to interested companies to revise their conversion price as per new pricing norms. This will be effective from the date of the issue of this Press Note”. In other words, companies that had issued FCCBs prior to the price relaxation effected on November 27, 2008 would also be entitled to the liberalised norms.

The adjustment of conversion price is subject to certain conditions: (i) the issue of shares at revised pricing should not breach FDI limits; (ii) the issuer company should obtain the approval of the board as well as its shareholders for repricing; (iii) the issuer company should enter into a fresh agreement with FCCB holders with the renegotiated conversion price; and (iv) the revision in conversion price should be approved by the RBI.

There are, however, some ambiguities in the new pricing guidelines. While it is clear that a 2-week average will be applied in computing the minimum price, the guidelines appear to be silent as to the date from which the 2-week period will be calculated while repricing the FCCB conversion. As a Business Standard report notes:

The point of confusion is the two-week period preceding the launch of an FCCB issue, which is used to calculate the minimum conversion price based on an average of closing share prices. Bankers are not sure whether to consider the 14 days preceding the original issue or the 14 days before the reset of the conversion price, which companies have now been allowed to undertake. The latter would be much more useful, since it would more closely reflect current market prices and facilitate conversion to equity.

However, if the original date at which the FCCBs were launched is considered, the new guidelines will bring little benefit to Indian companies, since most instruments were issued during the 2007 bull run in the stock markets.

“During a bull run, the two-week average price would be higher than the six-month average price, whereas in a bear phase it would be opposite,” said an investment banker with a foreign bank.

Corporate law firms contacted by Business Standard are of the opinion that FCCBs can be re-priced according to current market prices.
While companies and advisors will have to work with the regulators to achieve a resolution of this ambiguity, it seems that repricing the FCCB conversion as per current market prices will present its own unintended consequences.

From a legal perspective, the question is whether the regulatory intent can be derived from the guideline itself. The press note states that interested companies can “revise their conversion price as per new pricing norms”. The reference to “new pricing norms” is to those introduced on November 27, 2008. These norms include not only the pricing determination but also the “relevant date”, which is the “date of the meeting in which the Board of the company or the Committee of Directors duly authorized by the Board of the company decides to open the proposed issue.” To that extent, the relevant date applies with reference to the date of board meeting for authorizing the issue of the FCCBs and not to a current date when the possible repricing decision is being made.

From a policy perspective, if companies are allowed to reprice their FCCB conversion with reference to the current market price, then companies who are the beneficiaries of the new guidelines (i.e. those who issued FCCBs prior to November 27, 2008) would obtain an additional advantage over companies who issued them thereafter. This would result in a mismatch, and it is not clear if the guidelines were designed with a view to achieve such a result.

Sunday, February 21, 2010

TDS u/s 195: Samsung Electronics appeal in the Supreme Court

We have discussed the issue of TDS u/s 195 of the Income Tax Act, 1961 a few times earlier; and have also discussed a recent judgment of the Karnataka High Court in Samsung Electronics. The decision holds that deduction must be made u/s 195 on all sums paid to a non-resident, irrespective of the chargeability of the sum.s As was argued in the earlier posts, this view merits reconsideration. In a development which will give some hope to taxpayers, the Supreme Court has issued notice to the Department on the SLP filed by Samsung Electronics. However, the Bench of Justice Kapadia and Justice Swatanter Kumar has not stayed the judgment of the High Court at this juncture. Final hearings in the matter are scheduled in August 2010. The latest order of the Supreme Court can be downloaded from this link.

Saturday, February 20, 2010

The Court of Appeal Reaffirms the Sanctity of the Corporate Form

Few issues have proved to be more controversial than the strength of the principle that the company is a separate legal entity. The exceptions to the principle – commonly referred to as “lifting” or “piercing” the corporate veil – are both statutory and judge-made. The statutory exceptions are, in the main, not controversial. However, while there is agreement that courts are entitled to lift the corporate veil under “certain circumstances”, it has proved difficult to define what these circumstances are. The modern economy makes this task even more onerous, with the rise of “group entities”, the ubiquitous “investment” company and so on.

In DHN Food Distributors v. Tower Hamlet, [1976] 1 WLR 852, Lord Denning MR preferred to “ignore the separate legal entities of various companies within a group, and to look instead at the economic entity of the whole group.” These observations were doubted in Woolfson v. Strathclyde, 1978 S.C. (H.L.) 90. In the famous judgment in Adams v. Cape Industries, the Court of Appeal effectively rejected the approach in DHN, and reiterated the importance of the corporate form. In particular, the Court regarded only “agency” and “fraud” as proper exceptions to the corporate veil, and held that there is no presumption that the existence of a “single economic unit” is a reason to ignore the corporate form. This was reiterated by the Court of Appeal in 2008, and this blog has discussed these controversies on several occasions.

Over the years, this issue arose in a variety of contexts, of which one of the most prominent was whether a controlling shareholder of a company can also be an “employee” of that company. To some extent, the question had been answered by the Privy Council in the leading case of Lee v. Lee Air Farming, [1961] AC 2, where the issue was whether Mr. Lee, the controlling shareholder, was also “employed” as a pilot by the company that he controlled. Since it is settled law that the “power to control” is an essential ingredient of an employer-employee relationship, it was thus argued that a controlling shareholder, whose contract cannot be terminated without his consent, or duties altered without his consent, is not an employee of the company. The Privy Council nevertheless held that he was an employee, since the principle that a company is a separate legal personality cannot be disregarded.

In this connection, a recent judgment of the Court of Appeal in Secretary of State v. Neufeld, [2009] BCC 687 is of enormous significance. The immediate context was employment legislation in the United Kingdom, which provides, under certain circumstances, that an “employee” of an insolvent company is entitled to recover his unpaid dues from the Government. Quite obviously, the purpose of this legislation was to extend support for employees whose means of livelihood is terminated by the unforeseen insolvency of a company, and not to compensate the shareholders of the company. In this context, the question of whether a controlling shareholder who also had a contract of employment with the company was covered became important. Relying on this reasoning, an Employment Tribunal held that Lee’s case (above) is not relevant to an employment protection context, and some courts accepted this view, while others differed.

In Neufeld, the Court of Appeal has rejected this reasoning and held that a controlling shareholder is entitled to take advantage of the employment legislation and claim compensation from the Government in his capacity as an employee. In a comprehensive and well-reasoned opinion, the Court has reviewed all the authorities on the corporate veil, and extracted the principles applicable to such questions. In brief, the Court held that the “economic interest” that the controlling shareholder has in the company is irrelevant. The following observations are apposite:

There is no reason in principle why someone who is a shareholder and director of a company cannot also be an employee of the company under a contract of employment. There is also no reason in principle why someone whose shareholding in the company gives him control of it—even total control (as in Lee's case)—cannot be an employee. In short, a person whose economic interest in a company and its business means that he is in practice properly to be regarded as their “owner” can also be an employee of the company. It will, in particular, be no answer to his claim to be such an employee to argue that: (i) the extent of his control of the company means that the control condition of a contract of employment cannot be satisfied; or (ii) that the practical control he has over his own destiny—including that he cannot be dismissed from his employment except with his consent—has the effect in law that he cannot be an employee at all.

The Court recognised that an exception to this principle is an instance where the so-called employment contract is a “sham” contract or not a “genuine” employment relationship. However, “sham” is a legal, not economic concept and only requires the Court to determine whether the legal substance of the relationship between the parties is what it purports to be. For example, if A and B enter into an agreement that is called a “Licence Agreement”, a Court is bound to examine whether the terms of the agreement are characteristic of a licence. However, the Court cannot look to whether in “economic reality” the party acquires something other than the rights of a licensee. In this instance, if the court finds that the contract is neither a sham and is a valid or true contract of employment, the employment legislation will apply.

This confirms that recent developments in English law are receding from any dilution of the sanctity of the corporate form, which is significant not just in employment law, but in taxation as well, as the ongoing Vodafone dispute illustrates.

Wednesday, February 17, 2010

Service Tax and Works Contracts

A recent decision of the Punjab and Haryana High Court Commissioner of Central Excise v. Vahoo Colour Lab clarifies the scope of service tax in the context of works contracts. Issues around works contracts have been controversial in relation to income tax as well as sales tax. The controversy in income tax law (in relation to TDS under Section 194C) has been discussed here; and the issue of sales and service tax on software has been discussed here. Insofar as sales tax is concerned, the controversy has been over legislative competence. Certain contracts – works contracts being one such example – have elements of transfer of property as well as service. Are they to be taxed, then, as a sale of goods or as a rendering of services? The difficulty arises because the States have the competence to tax sales of goods; while the Union has the competence to tax services.

The issue was discussed by the Supreme Court elaborately in the context of building contracts, in State of Madras v. Gannon Dunkerley, AIR 1958 SC 560. The Court held that the concept of ‘sale’ must be given its legal understanding for the purposes of ascertaining legislative competence; and involved three elements – (a) the objective existence of goods; (b) the intention of the parties to transfer title in those goods; (c) actual transfer of title in furtherance of that intention, supported by consideration. It was held that a tax on an alleged sale of goods in building contracts would be outside the legislative competence of states. In an elaborate judgment, Justice Venkatrama Aiyar said, “We are… of opinion that on the true interpretation of the expression "sale of goods" there must be an agreement between the parties for the sale of the very goods in which eventually property passes. In a building contract, the agreement between the parties is that the contractor should construct a building according to the specifications contained in the agreement, and in consideration therefore receive payment as provided therein… there is in such an agreement neither a contract to sell the materials used in the construction, nor does property pass therein as movables. It is therefore impossible to maintain that there is implicit in a building contract a sale of materials as understood in law…” Applying this logic, a typical works contract would not involve a sale of goods.

Subsequent to the decision, Article 366(29A) was inserted into the Constitution of India, which laid down several categories of ‘deemed’ sales. It was provided that a “tax on the sale or purchase of goods” would include inter alia a “tax on the transfer of property in goods (whether as goods or in some other form) involved in the execution of a works contract.” To this extent, then, the decision in Gannon Dunkerley was overridden. It must be stressed, however, that the principle of Gannon Dunkerley would continue to apply outside of the specific categories mentioned in Article 366(29A). As Justice Ruma Pal stated in BSNL v. Union of India, “Gannon Dunkerley survived the 46th Constitutional Amendment in two respects. First with regard to the definition of 'sale' for the purposes of the Constitution in general and for the purposes of Entry 54 of List II in particular except to the extent that the clauses in Article 366(29A) operate. By introducing separate categories of 'deemed sales', the meaning of the word 'goods' was not altered. Thus the definitions of the composite elements of a sale such as intention of the parties, goods, delivery etc. would continue to be defined according to known legal connotations” The only change is where the amendment specifically includes the concept of deemed sales. Works contracts are one such element; and states do have the competence to levy sales tax on works contracts. The extent of taxability was again discussed by the Supreme Court in Imagic Creative, (2008) 2 SCC 614.

Imagic dealt with whether the charges collected towards the services for evolution of a certain design, on which service tax had been paid under the relevant provisions of the Finance Act, 1994 were also liable to tax under the Karnataka Value Added Tax Act, 2003. The Court held, “Payments of service tax as also the VAT are mutually exclusive. Therefore, they should be held to be applicable having regard to the respective parameters of service tax and the sales tax as envisaged in a composite contract as contradistinguished from an indivisible contract. It may consist of different elements providing for attracting different nature of levy. It is, therefore, difficult to hold that in a case of this nature, sales tax would be payable on the value of the entire contract; irrespective of the element of service provided.” Thus, the Court held that sales tax would not be payable on the entire value of the contract – the service element must be calculated; and sales tax would be payable on the remainder.

Before the Punjab and Haryana High Court, the question was similar – except that here, the Court had to determine the extent to which service tax would be payable (as opposed to the extent of sales tax as in Imagic). The case involved the question of “whether the assessee is liable to pay the service tax on the value of goods/material consumed, during the course of processing of photography or not…” The Court began by noting that the photography contract was to be treated as a works contract [this is settled law now, but earlier there was a controversy – see Rainbow Colour Labs, 118 STC 9 (SC) and Associated Cement v. Commissioner of Customs, 2001 JT (2) SC 141]. Next, it interpreted BSNL as having laid down the principle that “if the nature of transaction involved is composite contract, of service and sale and if the components of sale element are discernible, then both the components cannot be re-mixed for the purpose of relevant tax.” Consequently, a result analogous to Imagic was reached; and the Court held that service tax and sales tax operate in two different spheres; and service tax would be payable only on the service component and not the whole amount of the consideration.

The decision illustrates that as a matter of law, the confusion in this area is on its way to being cleared. Nonetheless, there might still be several difficulties in ascertaining what part of the consideration is to be attributed to the service element and what part is to be attributed to the sale element. Hopefully, these difficulties will be cleared by the comprehensive Goods and Services Tax.

Saturday, February 13, 2010

Easing the FDI Approval Process

The Government has introduced a recent change to the approval process for FDI that may ease the process, at least for some large transactions. The threshold for obtaining the approval of the Cabinet Committee on Economic Affairs has been increased from Rs. 600 crore (Rs. 6 billion) to Rs. 1200 crore (Rs. 12 billion). The press release sums up the change:

Presently, the recommendations of the Foreign Investment Promotion Board (FIPB) on proposals with total project cost up to Rs.600 crore are approved by the Finance Minister and proposals involving total project cost more than Rs.600 crore are put up to the Cabinet Committee on Economic Affairs. Further, presently the total project cost, including the foreign equity inflow, is taken into consideration in deciding whether the proposal is to be put up for consideration of CCEA. With today’s approval, only proposals involving total foreign equity inflow of more than Rs.1200 crore would be placed for consideration of CCEA. The recommendations of FIPB on proposals with total foreign equity inflow of and below Rs.1200 crore will be considered by the Finance Minister for approval.

This will certainly minimize any delays in investment proposals that are between Rs. 600 crores and Rs. 1200 crores.

Wednesday, February 10, 2010

Do Auctions in Public Offerings Work?

The SEBI (Issue of Capital and Disclosure) Regulations, 2009 were recently amended to provide for “French” auction as one of the methods of price discovery in follow-on public offerings. This was supposedly brought about with a view to encourage the use of such auction mechanism in Government disinvestments.

However, the results emanating from the first offering where the auction mechanism was deployed are not all that encouraging. It has been reported that due to the lack of adequate response in the NTPC offering, the Government may reconsider the use of auctions and revert to the tried-and-tested bookbuilding method. As a column in the Financial Express notes:

And the government may want to give the French auction method a miss. Perhaps the method does facilitate better price discovery when the market sentiment is good because institutions do tend to put in a higher bid if they believe they will get a bigger allotment. But this time it didn’t work. The price of Rs 209 can hardly be called a discovered price and the signalling by the government may have kept other institutional investors away. In the normal book building process an investor can put in an application even on the last day and hope to get shares, and many investors may have done so had it not been for the large bids at Rs 209. Also, even if the government got itself a few rupees more, a fairly big chunk of the shares is now concentrated in the hands of two big investors, which cannot be good for the stock. That need not have been the case.
Intriguingly, the auction mechanism is used more as an exception in pricing public offerings as compared to the bookbuilding route which is more popular. One recent honourable exception has been the IPO of Google in 2004, which used the Dutch auction route, and not the French auction route that has been adopted in India. For a general discussion of the two methods, see the following:

… French auctions where the bidders who have bid at less than or equal to the cut-off yield get allotments at their bids – the bids at cut-off get pro-rata. Unlike this, in a Dutch auction, …, all the bidders who have bid at less than or equal to the cut-off get pro-rata allotment at the cut-off. The French auction imposes a bidding risk on the investors by imposing a penalty on successful bidders for being off the cutoff. Generally the standard deviation of bids in a French auction will be much lower than the Dutch auction. It has been seen that the Dutch auction brings down the cut-off in a bullish market.
Moreover, academic research has shown that auctions are less likely to succeed in a public offering of securities. The two reasons proffered in studies conducted by Ravi Jagannathan and Ann Sherman are ‘winner’s curse’ and the ‘free rider’ problem:

The winner’s curse, as its name suggests, is the tendency for the winner of an auction to overbid. Theory predicts that this will occur when the extent to which a bidder values the auction item depends on other bidders’ valuation. The winner’s curse applies to the case of tradable shares, since one’s valuation of the share depends on everybody else’s valuation.

In principle, the winner’s curse can be easily overcome: a bidder could simply revise her bid downwards to make allowance for her optimism. In reality, however, bidders often find it difficult to adequately adjust for the winner’s curse, especially when the number of bidders is uncertain and difficult to anticipate. Jagannathan and Sherman provide a simple, stylized example to illustrate what happens when the actual number of bidders turns out to be far bigger than what each bidder had assumed when they computed their bids. The winner’s curse will be severe, and opting out of the auction may make more sense.

The free rider problem, on the other hand, arises because some investors have the incentive to rely on others to collect information on the IPO stock. These uninformed investors will bid high, hoping that the auction clearing price will be set by those who have done their homework. However, high bidding by uninformed bidders reduces the incentives of sophisticated investors to devote time and resources to correctly value the shares—since they are less likely to win due to the aggressiveness of the uninformed investors. Hence the standard, uniform-price auction mechanism becomes unstable.
These may explain (at least partly) the lukewarm response received in the NTPC auction. For further detailed analysis, please see the two papers by Jagannathan and Sherman (here and here).

Enhanced Corporate Governance Practices

Although the Satyam episode invited close scrutiny of the corporate governance norms and practices that were prevalent in India, there is some evidence that it has acted as a wakeup call in enhancing board practices. As Arun Duggal observes in a recent Wall Street Journal column:

The first reaction of corporate boards when Satyam blew in January 2009 was to have an independent verification that the cash, bank deposits and financial investments recorded in the company's books were accurate. The board of directors, particularly independent directors, met with the external and internal auditors to assure themselves that the reported financial statements were true and accurate and that the auditors were independent and diligent. Over 100 independent directors resigned from various boards as they realized that with directorship come certain responsibilities and obligations.

Over the last year, there has been a steady improvement in the functioning of boards. The audit committee function has become more thorough and meetings have become more substantial and longer. Some audit committees meet for half a day or longer rather than a superficial one hour meeting in the past. They also meet with the auditors without management being present. Related party transactions are scrutinized in greater depth and promoters have to disclose if they have pledged their shares to raise financing.
Duggal favours the approach followed by the Indian regulators through adoption of voluntary guidelines for corporate governance rather than acting through a knee-jerk reaction (a reference to Sarbanes-Oxley), although he highlights some shortcomings of the voluntary guidelines and provides suggestions for improvement.

Monday, February 8, 2010

Legal Issues in Stock Lending

We had earlier noted the recent relaxations introduced by SEBI in order to provide a thrust to the securities lending and borrowing (SLB) mechanism and thereby short selling of securities. Some doubts were expressed regarding the sustainability of even the reformed process.

In a column in today’s Mint, Jayant Thakur highlights several legal issues that are bound to arise when the SLB mechanism acquires widespread practice. These include issues pertaining to taxation (particularly capital gains), the use of stock lending by promoters and the applicability of insider trading regulations and the takeover code. While the column seeks a comprehensive identification of the issues, it points towards the need for a fuller appreciation of the issues involved (all of which understandably cannot be accomplished within the constraints of a column’s word limit). It does provide ample fodder that justifies a thorough legal analysis of the issues involved.

Saturday, February 6, 2010

New Blog for Indian Legal Research

I would like to highlight the Legal Research India blog recently started by Arjun Sheoran, student at the National Law School of India University. Essentially, the blog allows readers/users to search the web for relevant legal materials. The search is a Google custom search; with the advantage that it is restricted to some selected websites, listed here – so the results are likely to be more relevant for those engaged in Indian legal research than a general Google search. According to the homepage of the blog, “Legal Research India provides customized search engines for legal research for Indian and foreign law as it searches relevant websites only. It can be used searching for judgments, legislations, articles, journals, reports or any other legal information/material from India, UK, USA or any other jurisdiction…” I have not used it too much yet; but in the couple of instances when I did use it, I found it extremely helpful. I hope the readers of this blog find it useful too.

Wednesday, February 3, 2010

Corporate Restructuring and the Business Purpose Rule

In 1935, the House of Lords famously observed that “every man is entitled to order his affairs” in order to minimise his liability to tax (IRC v. Duke of Westminster, [1936] AC 1). This is the dictum that is often cited as the source of the rule that while tax avoidance is legal, tax evasion is not. The distinction between the two, while not always clear, is regarded by some as especially thin after the growth of the corporation as the preferred vehicle of investment, and defining the use of the corporation as a tax planning device is one of the greatest challenges that corporate and taxation law face today.

India has seen its fair share of controversy in this area. Traditionally, it followed the Westminister rule that tax avoidance is legal, and that a citizen is entitled to the benefit of the letter of the law, even if the result is manifestly contrary to its spirit. This seem rather well-established, until Justice Chinnappa Reddy’s “concurring” opinion in McDowell v. CTO, where he observed that the “ghost” of the Duke of Westminster must be “exorcised” and that any device intended to avoid tax liability is illegal. It is difficult to conclude that the majority endorsed this reasoning, although some dicta in the case suggest that it did. In 2003, however the Supreme Court rejected Justice Reddy’s view in Azadi Bachao Andolan, and the law continues to be the position expressed in Andolan.

In this connection, the recent decision by the Authority for Advance Rulings in Star TV v. Director of International Taxation, Mumbai is a welcome one. A copy of the decision is available on the AAR website. In this case, three Star TV companies incorporated in the British Virgin Islands decided to amalgamate with the Star TV Indian entity, known as Star India Pvt. Ltd. [“STPL”]. The reason offered was that it was to the commercial advantage of Star TV to consolidate its holdings in one company. Before the AAR, the Revenue argued that approving this merger would have adverse consequences on the Revenue, and more importantly that the AAR should itself decline to answer the question since the transaction was designed to avoid tax. The power of the AAR to answer a reference is circumscribed by s. 245R of the ITA, which provides that the “Authority shall not allow the application” where the question raised in the application relates to a “transaction which is designed prima facie for the avoidance of income tax”. Consequently, the AAR considered tax avoidance not in the context of chargeability, but as a jurisdictional question. Indeed, even if the AAR had concluded that the transaction in question was designed primarily to avoid tax, it would not have followed that it is chargeable to income tax merely for that reason.

In any case, an analysis of the opinion reveals support for the Westminster principle. The Revenue argued that the object of the arrangement was to avoid the payment of existing tax dues. This, it is clear, could not have been the case, since, as the AAR held, an amalgamating company transfers its liabilities to the entity into which it amalgamates. As to the argument that this reduces the capital gains tax payable in the future, the AAR noted the developments in India leading upto to Andolan, and that the Westminster principle continues to be applicable. Consequently, the AAR construed “designed for the avoidance of tax narrowly”. The following observations are apposite:

A design to avoid the tax within the meaning of clause (iii) of the proviso to Section 245 R(2) apparently covers such of the transactions which are sham or nominal or which would lead to the inescapable inference of a contrived device solely with a view to avoid the tax. The corollary thereto is that there is no real and genuine business purpose other than tax avoidance behind such transaction.”

The “business purpose” test, according to the AAR, only requires that the arrangement afford some commercial benefit. In this case, the test was satisfied by the business purpose of consolidating various entities into one entity, which achieves “synergies of operation and enhanced operational flexibility.”

In sum, this decision is another indication that India’s tax avoidance jurisprudence is continuing to recede from Justice Reddy’s observations in McDowell, and accepts any device short of a sham. There continues to be some doubt, however, over whether a transfer arising out of an amalgamation is a "transfer" in the first place, for the purposes of s. 2(47) of the ITA. This has interesting implications for the taxability of share transfers in a scheme of amalgamation.

Tuesday, February 2, 2010

Buyback and Takeover Regulations - Yet another development

See my earlier post on a recent decision of SEBI on whether increase in percentage holding consequent to buyback of shares would amount to "acquisition" under the Takeover Regulations. If that and earlier posts are reviewed, one would note that SEBI has taken a fairly consistent stand that such increase does amount to acquisition.

Now, in a recent order granting exemption under the Takeover Regulations, SEBI has taken the matter even further and made its stand even more consistent.

Let's quickly review the background first.

SEBI, with the help of the Takeover Panel, considers applications for exemption from the relevant provisions of the Takeover Regulations. SEBI has granted in several earlier cases such exemption when the percentage holding of the Promoters increases on account of buyback of shares. However, till now, at least in the cases I have read and recollect, the exemption was total. For example, if the holding of the Promoters increased because of this from, say, 60% to 68%, SEBI would exempt the whole of such increase. Thus, the acquisition of shares upto 5% under the creeping acquisition limits (where available - see further comments later) was additionally available.

Now, SEBI, in a recent exemption order, has tightened this further and has stated that only the increase beyond the 5% creeping acquisition would be granted and thus, effectively, the creeping acquisition limit would not be additionally available. Thus, where, in this case, the holding of the Promoters was to increase from 66.82% to 73.92, i.e., an increase of 7.10%, the exemption was granted to the increase of 2.10% only.

SEBI has observed that an increase upto 5% on account of buyback (amongst other ways) was available and hence such limit should be exhausted first and exemption be granted to the 2.10% beyond such 5%. The Promoters thus would not be entitled to use that creeping acquisition.

Such exemption orders are of course granted on a case to case basis and one does not know whether this order reflects a change in policy and whether in all future cases, the creeping acquisition limits would be allowed to be used up first. Nonetheless, this order makes the stand of SEBI even more consistent with its views on the matter.

Let us watch this issue for further developments which may be possible. As discussed earlier, while there are some difficulties in law, considering that SEBI has taken such a consistent stand, no person - Promoters in particular - may want to take SEBI head-on on this issue and risk such an increase without exemption and hence the issue may be deemed to be closed for practical purposes for future buybacks.

- Jayant Thakur