Saturday, July 31, 2010

Delhi High Court clarifies Transfer Pricing law

In a fillip to the increasing global ambitions of Indian industries, the Delhi High Court, in Maruti-Suzuki India Ltd. v. ACIT, clarified the application of transfer pricing provisions to the use of foreign trademarks in India. The issue arose out of the Maruti-Suzuki collaboration all of us are well aware of, and was a good example of judicial intervention to stifle the parochial approach of the Income-tax department to international transactions.

In 1992, Suzuki and Maruti entered into a License Agreement with the approval of the Government of India. Under this Agreement, Suzuki agreed to provide technical assistance to Maruti. Also, the Agreement also provided for the use of the logo ‘Maruti-Suzuki’ on all products and parts manufactured, assembled and sold in India pursuant to the agreement, and on the containers, packages and wrappings used in connection with these products and parts. A combined royalty for both, the technical assistance and the use of the trademark was to be paid by Maruti. In addition to these conditions in the Agreement, Maruti also replaced the ‘M’ on its products with ‘S’. Since Suzuki was a majority shareholder in Maruti, the assessing officer referred the transaction to the transfer pricing officer [“TPO”], under section 92(CA)(1).

Based on these facts, the TPO drew some highly far-fetched conclusions. For starters, the showcause notice suggested that by changing its brand name from Maruti to Suzuki, and by using the ‘S’ on its products instead of the ‘M’, Maruti had transferred its brand name to Suzuki. Since no consideration was paid by Suzuki to Maruti, the TPO concluded that the transaction was not conducted at arm’s length. In the actual order however, the TPO dropped this line of reasoning, and observed that by the use of the joint logo of ‘Maruti-Suzuki’, Suzuki was ‘piggybacking’ on Maruti’s reputation in India. In his opinion, since Maruti was a big brand in India, and Suzuki did not have an Indian presence, this transaction benefited Suzuki, for which consideration should flow from Suzuki to Maruti. Further, it asked for a breakup of the consideration paid by Maruti into two parts- for the technical assistance and the use of the trademark, concluding that 50% would have to be attributed to the trademark use. Finally, the order also observed that the advertisement expenditure incurred by Maruti to further the ‘Maruti-Suzuki’ brand name in fact benefited Suzuki, and would hence have to be accompanied by consideration paid by Suzuki to Maruti. On this basis, the TPO concluded that since consideration which would have been paid by an independent entity, had not been paid by Suzuki, the transaction was not conducted at arm’s length.

In a writ petition against this order, Maruti challenged this order contending that the transaction was at arm’s length and that no consideration can be required to flow from Suzuki to Maruti for any part of the transaction (the procedural reasons why a writ petition was maintained as opposed to an appeal are discussed in the first 28 paragraphs of the decision, but are not relevant for the present discussion). The Delhi High Court, in a detailed decision intended to assist Assessing Officers to “appreciate the scope of their powers under Transfer Pricing Provisions of the Act”, substantially upheld Maruti’s claim, and remanded the matter back. Recognising the commercial necessity of collaborating with foreign companies in order to face international competition in the domestic market, the Court pointed out that the order of the TPO, if upheld, would actively discourage foreign companies from Indian collaborations. The TPO order would have lead to the absurd conclusion that any foreign company allowing an Indian company to use its trademark would be required to pay for such use. Dismissing this interpretation as incorrect, the Court observed that even though Maruti was an established brand in India in 1992, the use of Suzuki’s mark was commercially necessary for it to compete with the other international car-makers entering the Indian market. Interestingly, the Court relied on the Government approval of the Agreement to verify this commercial necessity. On this basis, it held that an Indian company using the trademark of a foreign company, could not be expected to receive consideration for such use. However, for this, the use would have to be voluntary. In the License Agreement under consideration, the use of the ‘Maruti-Suzuki’ brand name was mandatory. The Court concluded that such a mandatory use could only serve the purpose of furthering Suzuki’s image in India, for which consideration would have to flow to Maruti. Further, with regard to the advertising expense, it again observed that the expenditure incurred benefitted Maruti’s market in India. Unless it was shown that the expenditure incurred was in excess of that which would have been incurred by an independent party, it could not be brought to tax.

That then gave rise to the important question of how this comparable price for an independent party was to be computed, and whether the different parts of the transaction could be considered separately. The Court rightly held that breaking up such a composite agreement would be erroneous. All the rights and obligations incurred by the parties would have to be considered, and the comparable price for such a composite transaction would have to be determined. However, while this is a welcome clarification, there is one part of the dictum that is left unclear. In ¶ 82 of the decision, the Court observes that in making this determination, the composite agreement itself, and any other arrangement entered between the parties which has a bearing on the respective rights and obligations of the parties, must be considered. However, in clause (vi) of ¶ 84, where the Court summarises its conclusions, the Court only mentions rights and obligations incurred by the parties “under the international transaction in question”. It is submitted that the former of these views seems preferable, but the decision itself is silent on which of the two views it adopts. (But for this disparity, the conclusions of the Court in ¶ 84 serve as a useful summary of the decision).

Thus, this decision in Maruti-Suzuki, together with the AAR’s recent pronouncement in In Re The Timken, provide two instances where Indian tribunals have exhibited an appreciation of the commercial imperatives of international transactions.

Wednesday, July 28, 2010

"Subject to" Contracts and Agreements "Not Completed"

The moral of the story is to agree first and start work later.” So observed Lord Clarke recently, in delivering the unanimous judgment of the United Kingdom Supreme Court in RTS Flexible Systems [“RTS”] v. Molkerei Alois Muller Gmbh [“Muller”]. The judgment considers several questions of law that are of significance to long-term commercial contracts, particularly when there is doubt as to whether the parties have at all concluded a contract in the first place.

One may wonder why parties would choose to proceed with a significant commercial relationship in the absence of a clear and concluded contract. For a variety of commercial reasons, however, the execution of a project sometimes predates the conclusion of the contract. In these circumstances, parties commence work in the expectation that they will reach agreement in the near future on their contractual relationship. When, however, they fail to do so, their contractual relationship can only be derived from conduct, and the legal principles governing this exercise were the subject matter of discussion before the UK Supreme Court in RTS.

In this case, Muller sent a “Letter of Intent” [“LoI”] to RTS in 2005 indicating its intention that RTS execute a certain long-term project for Muller. The LoI indicated the price payable, delivery date, and provided that full contractual terms would be agreed within four weeks from the date of the LoI. The LoI provided that this agreement would be based on a Muller standard form known as MF/1, suitably modified. Both parties envisaged at the time that such an agreement would in fact be reached, and RTS commenced work immediately. A draft contract was then sent to RTS, which, as is common in these transactions, was a lengthy and detailed contract. It contained the essence of the MF/1 clauses, of which one was Limitation of Liability. Another clause, known as the Counterpart Clause, provided that “this contract may be executed in any number of counterparts provided that it shall not become effective until each party has executed a counterpart and exchanged it with the other”.

The parties began negotiating on various terms of this contract, and subsequent correspondence indicated that the parties had more or less reached agreement on the contract, which was to be prepared for signature. Payments were made periodically to RTS, and the parties also agreed a modified delivery schedule to address certain anomalies in one of the components of the Project. Subsequently, however, disputes arose, and RTS brought an action for the contract price and, in the alternative, damages. RTS argued (omitting some detail) that the parties had not agreed any contract, or, in the alternative, had concluded a contract that included the MF/1 terms embodied in the draft exchanged by the parties. In the first alternative, the contract price would only represent what the parties presumably considered a reasonable sum for quantum meruit. The judge at the first instance and the Court of Appeal reached differing conclusions as to the existence of the contract and its terms. The Court of Appeal had held that there was no effective contract between the parties mainly because the counterpart clause had not been satisfied.

The Supreme Court begins with a very useful summary of the general principles to apply in these circumstances. With an “objective” theory of contract formation, whether there is a binding contract between the parties

... depends not upon their subjective state of mind, but upon a consideration of what was communicated between them by words or conduct, and whether that leads objectively to a conclusion that they intended to create legal relations and had agreed upon all the terms which they regarded or the law requires as essential for the formation of legally binding relations. Even if certain terms of economic or other significance to the parties have not been finalised, an objective appraisal of their words and conduct may lead to the conclusion that they did not intend agreement of such terms to be a pre-condition to a concluded and legally binding agreement [emphasis mine].

In this case, therefore, there were two issues the Supreme Court had to consider – whether the parties had agreed upon “all the terms which they regarded or the law requires as essential…” and the effect of not complying with the counterpart clause. As to the first, while a court cannot presume the existence of a contract from the fact that the parties have commenced work ostensibly in furtherance of it, it is a significant factor. One of the most important cases to have considered these principles is Pagnan SPA v. Feed Products, [1987] Lloyd’s Rep 601, which the Supreme Court approved. In that case, the Court of Appeal had observed as follows:

It is sometimes said that the parties must agree on the essential terms and it is only matters of detail which can be left over. This may be misleading, since the word ‘essential’ in that context is ambiguous. If by ‘essential’ one means a term without which the contract cannot be enforced then the statement is true: the law cannot enforce an incomplete contract. If by ‘essential’ one means a term which the parties have agreed to be essential for the formation of a binding contract, then the statement is tautologous. If by ‘essential’ one means only a term which the Court regards as importantas opposed to a term which the Court regards as less important or a matter of detail, the statement is untrue. It is for the parties to decide whether they wish to be bound and if so, by what terms, whether important or unimportant.

Applying these principles, the Court found that the conduct of the parties did indicate the existence of a contract – the fact that payments were made in proportion to an agreed contract price, alterations in delivery schedule, conformity with other parts of the draft contract, and so on. That left the counterpart clause, which the Supreme Court held prevents the formation of a contract unless the “parties have by their exchanges and conduct waived the ‘subject to contract’ condition or understanding”. The Court, applying the standard of a “reasonable, honest businessman” by way of analogy, concluded that neither party intended the counterpart clause to continue as a precondition to contract, as it had “been overtaken by events”.

In conclusion, it was too often thought that the mere fact of work could lead to a presumption of contract (or the converse). The UK Supreme Court’s careful and detailed analysis has done much to clarify that it ultimately depends on an analysis of the intention of the parties. It is interesting to note that in January 2010, the Supreme Court of India – in Trimex International FZE v. Vedanta Aluminum – reached more or less the same conclusion, relying partly on Pagnan.


Tuesday, July 27, 2010

Legal character of an overdraft facility

Earlier this month, a division bench of the Bombay High Court considered an important question regarding the legal character of an overdraft facility offered to a customer. The issue before the Court in Sargam Foods v. State of Maharashtra, was whether the cash credit facility offered by a bank can be attached in recovery proceedings against one of its customers.

The relevant provision was Rule 35 of the Bombay Provincial Municipal Corporation (Cess on entry of goods) Rules, 1996, which reads-

35. Special mode of recovery

(1) Notwithstanding anything contained in any law for the time being in force or contract to the contrary, the Commissioner at any time or, from time to time, by notice in writing, a copy of which shall be forwarded to the dealer or person liable to pay cess at his last address known to the Commissioner, require

(a) any person from whom any amount of money is due, or may become due, to a dealer or person from whom any amount has become due under these rules and has remained unpaid; or (b) any person who holds or may subsequently hold money for or on account of such dealer or person, to pay to the Commissioner, either forthwith upon the money becoming due or being held or at or within the time specified in the notice (but not before the money becomes due or is held as aforesaid), so much of the money as is sufficient to pay the amount due by such dealer or person in respect of the arrears of cess, penalty, interest, sum forfeited, fine or the whole of the money when it is equal to or less than that amount.

Explanation For the purpose of this rule, the amount of money due to a dealer or person from, or money held for or on account of a dealer or person by any person, shall be calculated after deducting therefrom such claims, if any, lawfully subsisting, as may have fallen due for payment by such dealer or person to such person. [emphasis supplied]

Thus, the question before the Court was whether the cash credit facility provided to a customer could be considered as being covered by the amounts against which the income tax officer may initiate recovery proceedings. A very similar provision had been considered by a single judge of the Chennai High Court, in K.M. Adam v. The Income-Tax Officer, which was seized of facts involving an overdraft facility. The Court held that such a provision (for attachment of amounts in recovery proceedings) only apply to amounts held by a person who is a debtor vis-a-vis the assessee. In the case of amounts held in the current account or deposit account, the bank is a debtor of the customer. However, “when a Bank lends money on overdraft and the customer is always in debit there is no stage at which the bank is a debtor to its customer, nor any point of time at which it holds any money of his on his account” (¶ 8).

Relying on this decision, which was subsequently affirmed by a single judge of the Karnataka High Court, the division bench held that a cash credit facility cannot be attached. Echoing the view of the Chennai High Court, the bench observed, “The unutilised overdraft account does not render the banker the debtor in any sense and the banker is, therefore, not a person from whom money is due to the customer. Nor is the banker in such case, a person from whom money may become due” (¶ 8).

Thus, the uniform position adopted by the High Courts (it is submitted, rightly) is that a cash credit or an overdraft facility cannot be attached in tax recovery proceedings, since the bank is not the debtor of the customer with respect to the unutilised amount of the cash credit/overdraft facility. Another brief discussion of the judgment is available here.

Thursday, July 22, 2010

The United States Supreme Court on the 'Principal Place of Business'

Two earlier posts had discussed the issue and the oral arguments before the United States Supreme Court in Hertz Corp. v. Friend. Earlier this year, the Court delivered a unanimous verdict, holding that the ‘principal place of business’ of a corporation is its ‘nerve centre’, i.e. the headquarters of the corporation.

As discussed earlier, the issue came before the Court as part of a class action suit. Two Californian citizens filed a suit against Hertz Corporation in a California State Court. Hertz removed the claim to the Federal District Court, on the ground that it was not a Californian citizen, since it was incorporated and headquartered in New Jersey. The Respondents urged that the principal place of business had to be determined with reference ‘first to the location of employees, tangible properties and production activities, and then second to income earned, purchases made and where sales take place’. Since a majority of Hertz’s operations were in California, and were ‘significantly larger than any other state in which the corporation conducts business’, it was a Californian citizen and the Californian State Court was the appropriate forum. The Federal District Court accepted this ‘place of operations’ test proffered by the Respondents, and was affirmed in appeal by the Ninth Circuit. However, this test was different from the test adopted by other circuit courts (the Seventh Circuit for instance), and it was relying on this disparity that Hertz filed an appeal with the Supreme Court.

The oral arguments saw Hertz emphasising the superiority of the nerve centre approach, while the Respondents stressed the policy of the class action law under consideration (Class Action Fairness Act of 2005). It was also argued that the term principal place of business owed its origins to bankruptcy laws, and had to be interpreted widely like it was in bankruptcy litigation. However, rejecting these arguments, Justice Breyer speaking for a unanimous Court, upheld Hertz’s contentions, equating the ‘principal place of business’ of a corporation to its ‘nerve centre’ or ‘headquarters’.

In a lucidly written opinion that repays study, Justice Breyer puts forth three reasons for adopting the nerve centre approach. First, on the text of the CAFA, the principal place of business is envisaged as being a single place, within a State. The place of operations test had led some circuit courts to conclude that an entire State was the place of operations. This inconsistency between the result of the ‘place of operations’ test, and the text of the provision was the first blow to its applicability. Secondly, the Court placed a premium on administrative simplicity, observing that the ‘nerve centre’ approach led to much greater predictability and stability than the ‘place of operations’ test, which would aid in conserving judicial resources, and enable corporations to make investment and business decisions. Finally, the Court examined the legislative history of the provision in aid of its interpretation. Interestingly, the legislative history had been relied on by the Respondents (to contend that it was intended to be broader than the place of incorporation). The Court examined the debates that preceded the introduction of the phrase ‘principal place of business’, which apart from emphasising the need for administrative simplicity showed that the ‘place of operations’ test had been implicitly rejected by the drafters. A 1951 Report revealed that one of the phrases which was considered was ‘any State from which it (the corporation) received more than half its gross income’. This is very similar to the ‘place of operations’ test, as argued by the Respondents. However, six months later, in response to criticisms, the proposal for this monetary test was replaced by the phrase ‘principal place of business’. This clearly showed that the principal place of business was something other than the place of operations.

That said, there still remained the concern that applying the nerve centre approach would allow corporations to ‘shop’ for favourable jurisdictions, which would go militate against the efficacy of class action suits. In equating the nerve centre to the headquarters, the Court introduced the caveat that it should be “the actual centre of direction, control and coordination ... and not simply an office where the corporation holds its board meetings” (p. 14). If the record revealed ‘jurisdictional manipulation’, where the headquarters were “a mere mail drop box, a bare office with a computer, or the location of an annual executive retreat”, the nerve centre would be “the place of actual direction, control and coordination, in the absence of such manipulation” (pp. 18-9). The Court also accepted that there would be hard cases where even the nerve centre approach would be difficult to apply, and may, in some cases, “produce results that seem to cut against the basic rationale” of diversity jurisdiction. It also admitted that the test was imperfect, and not always simple to apply. However, it was the test’s superiority (inspite of its imperfection) and relative simplicity that rendered it appropriate to determine the principal place of business of a corporation.

Thus, the Court put to rest the concern voiced earlier that the decision may turn more on the policy underlying the CAFA, and inadequately address the corporate law principles involved in the dispute. Admittedly, even now, the decision has little to offer by way of direct judicial precedent in common law systems like India, especially when dealing with tax planning. However, by basing itself on the appropriate meaning of the principal place of business as opposed to policy concerns, the decision has left open the possibility of a ripple effect being observed in other jurisdictions in coming years.

Tuesday, July 20, 2010

Interpretive Guidance in Rule-Making

While reading the Supreme Court’s judgment in the Daiichi case, which Mihir has discussed here, I was particularly struck by certain observations of the court that appear at the end of the judgment. The case involved an intensive reading and close interpretation of the provisions of the SEBI Takeover Regulations. Here are the relevant observations:

57. Before parting with the records of the case we would like to say that in arriving at the correct meaning of the provisions of the Takeover Code specially regulation 14(4) and 20(12) we were greatly helped by the reports of the two Committees headed by Justice Bhagwati. We mention the fact especially because as per the legislative practice in this country, unlike an Act, a regulation or any amendments introduced in it are not preceded by the "Object and Purpose" clause. The absence of the object and purpose in the regulation or the later amendments introduced in it only adds to the difficulties of the court in properly construing the provisions of regulations dealing with complex issues. The court, so to say, has to work in complete darkness without so much as a glimpse into the mind of the maker of the regulation. In this case, it was quite apparent that the 1997 Takeover Code and the later amendments introduced in it were intended to give effect to the recommendations of the two Committees headed by Justice Bhagwati. We were, thus, in a position to refer to the relevant portions of the two reports that provided us with the raison d’ĂȘtre for the amendment(s) or the introduction of a new provision and thus helped us in understanding the correct import of certain provisions. But this is not the case with many other regulations framed under different Acts. Regulations are brought in and later subjected to amendments without being preceded by any reports of any expert committees. Now that we have more and more of the regulatory regime where highly important and complex and specialised spheres of human activity are governed by regulatory mechanisms framed under delegated legislation it is high time to change the old practice and to add at the beginning the "object and purpose" clause to the delegated legislations as in the case of the primary legislations.
It is even more interesting to find that the Takeover Regulations Advisory Committee (TRAC) has been quick to take the cue, and has observed in its report:

19. The Committee has also taken note of the observation of the Supreme Court of India in a recent judgment where a statement of objects and reasons for provisions of subordinate legislation has been recommended. The Committee has provided an initial draft of explanatory notes on clauses and has suggested that SEBI finalize the same along with the text of the Proposed Takeover Regulations.
Such efforts at instilling a culture that builds detailed and transparent processes for promulgating delegated legislation will not only provide greater clarity to persons subject to such legislation but will also help in judicial interpretation as observed in the Daiichi case.

Report/revision of Takeover Regulations

The Report of the Takeover Regulations Advisory Committee (TRAC) is, as is widely reported, released. SEBI's Press Release summarizes the important recommendations.

Here's my short piece on the subject in today's Mint. Here are Sandeep Parekh's views on his blog.

Would write soon here particularly on issues such as the hike in threshold limit, increase in size of the open offer to 100% of the public shareholding, indirect acquisitions, delisting and the revised pricing formula.

- Jayant Thakur

Monday, July 19, 2010

Regulating Bankers’ Pay

Consistent with international trends to impose greater regulation on executive compensation in banks, the Reserve Bank of India (RBI) has issued draft guidelines on compensation of whole time directors/ chief executive officers / risk takers and control function staff. This applies to private sector and local area banks and all foreign banks operating in India, and is in addition to tight controls that already operate with respect to public sector banks.

The preamble contains the rationale:
Flawed incentive compensation practices in the financial sector were one of the important factors contributing to the recent global financial crisis. Employees were too often rewarded for increasing the short-term profit without adequate recognition of the risks the employees’ activities posed to the organizations. These perverse incentives amplified the excessive risk taking that severely threatened the global financial system. The compensation issue has, therefore, been at the centrestage of the regulatory reforms. To address the issues in a coordinated manner across jurisdictions, the Financial Stability Board (FSB) has brought out a set of principles and implementation standards on sound compensation practices in April and September 2009, respectively. The principles are intended to reduce incentives towards excessive risk taking that may arise from the structure of compensation schemes. The principles call for effective governance of compensation and its alignment with prudent risk taking and effective supervisory oversight and stakeholder engagement. The principles have been endorsed by the G-20 countries and the Basel Committee on Banking Supervision (BCBS) and are under implementation across jurisdictions.
The draft guidelines adopt the FSB Principles for Sound Compensation Practices. They call for determination of compensation on the basis of long-term performance parameters, for the establishment of remuneration committees on banks, and even for a claw-back provision (that is fairly novel in the Indian context). Comments are due on the draft guidelines by July 31, 2010.

For a discussion on the policy among banking experts, please see India Knowledge@Wharton.

Friday, July 16, 2010

Physical Settlement in Derivatives Trading

Over a decade ago, when trading in derivatives was commenced on Indian stock exchanges, it was decided that such instruments must be introduced in a phased manner. This was following the recommendations in the L.C. Gupta Committee report. Consequently, various types of derivatives were introduced at different points in time – index futures, futures in specific securities, options and so on. Similarly, it was decided that all derivatives transactions on stock exchanges would initially be cash-settled. Those were truly “contracts for differences”. Physical settlement of derivatives contracts was not permitted because, if I recall right, the stock exchange mechanisms were then not in a state of preparedness to deal with such settlements.

The Economic Times explains the differences between cash settlement and physical settlement:

In physical settlement, the seller will have to deliver the underlying shares at the time of expiry, if his position has not been squared off till then. Similarly, the buyer will have to take delivery of shares, if his position is open at expiry.

At present, all trades in the equity derivatives segment are settled in cash, based on the difference between opening and closing prices. For instance, if a trader is long 1000 futures of DLF at Rs 300, and the price falls to Rs 280 on the day of expiry, the trader will suffer a loss of Rs 20,000 — the difference between the price at which he bought the futures and the price on settlement day.

Even if he is confident that the price could recover in a few days, he doesn’t have the option of taking delivery of 1000 DLF shares and holding on till the price moves up. Similarly, a trader, who has short-sold futures doesn’t have the option of delivering the underlying shares, even if he owns them.
Recognising the difficulties of a cash-only settlement and perhaps due to the sophistication that leading Indian stock exchange systems have now acquired, SEBI has now issued a circular providing flexibility to stock exchanges to offer physical settlement for derivatives transactions. All physical settlements must initially be completed within six months. This will bring settlement on the Indian exchanges closer to other leading markets.

While this development may be seen as encouraging greater use of derivatives (which have acquired the status of “weapons of mass destruction”), they do have several benefits if properly utilized. Transitioning derivatives transactions from the “over-the-counter” (OTC) market to the stock exchanges has the advantage of bringing about greater transparency to these transactions in addition to infusing liquidity in the markets. Others jurisdictions too are witnessing similar efforts to move derivatives from the OTC markets to regulated exchanges, with the prime example being the reform efforts in the U.S. by way of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Wednesday, July 14, 2010

NALSAR Student Law Review: New Issue

The latest issue of the NALSAR Student Law Review (which is available online) carries a number of articles that may be relevant to readers of this Blog. Here is a list of those:
- Regulation and Responsibility of Credit Rating Agencies vis-a-vis the Current Economic Crisis- A Comparative Analysis

- Rethinking the Linkages Between Foreign Direct Investment and Development: A Third World Perspective

- The Place of Reasonableness in the Restraint of Trade: Just how much does India depart from the Common Law

- Lost in Transit: The Fate of Anti-Assignment Clauses in Patent Licensing Agreements in the Case of Mergers

- Stretching the Limits of Statutory Interpretation: Critical Review of Bhatia International v. Bulk Trading
Hat-tip: Aditya Swarup

Guidance on Due Diligence

M&A Law Prof Blog has a link to JeffreyWeiner’s Due Diligence in M&A Transactions: A Conceptual Framework which provides an overview of the due diligence process and its objectives in an M&A transaction. It will be a particularly useful reading for corporate lawyers who are starting out this season.

Tuesday, July 13, 2010

Fees for Technical Services - Ashapura Minechem

We have discussed at length the controversy last year over taxation of fees for technical services. In brief, the Supreme Court had taken the view in Ishikawajma that s. 9(1)(vii) of the Income Tax Act, 1961 applies only when services by a non-resident are both rendered and utilized in India. This appeared inconsistent with the plain text of the provision, and with a subsequent Explanation inserted by the Finance Act, 2008. However, the Explanation was not sufficiently unambiguous to conclude the matter, and High Courts and Tribunals across the country differed on whether it had the effect of nullifying Ishikawajma. The 2010 Finance Act seemed to have finally put the matter to rest, by providing expressly that s. 9(1)(vii) applies even when services are not rendered in India.

Recently, the first opportunity to test the scope of the new Explanation arose before the Mumbai ITAT, in Ashapura Minechem v. ADIT. Ashapura Minechem entered into an agreement with a Chinese company – China Aluminum International Engineering Corp Ltd [“CAIEL”] – whereby it agreed to pay a fee of $1 million in consideration for bauxite testing services performed by CAIEL. Ashapura Minechem contended that it was not liable to deduct tax at source under s. 195, because the principal sum of $1 million was not exigible to tax under s. 9(1)(vii). For this proposition, Ashapura relied principally on the decisions in Ishikawajma and Clifford Chance. Ashapura also argued, in the alternative, that the sum did not qualify for taxation under Art. 12 of the Indo-China Double Taxation Avoidance Agreement [“DTAA”].

The Tribunal correctly rejected the submission that Ishikawajma continues to be good law. Noting that the retrospective amendment inserted by the 2010 Finance Act is free from any ambiguity, the Tribunal held that the law in India is that fees for technical services paid to a non-resident are taxable when those services are utilized in India, regardless of where they are rendered. The Tribunal clearly demonstrated that this is not inconsistent with the principle of “territorial nexus”, observing that there are broadly three models of taxation of non-residents – “territorial tax systems”, such as France, Belgium and the Netherlands, where tax liability is fastened only on income earned within the borders of that country; “source” taxation, where the source of income is located within the country levying tax, and “residence” taxation, where the taxpayer is resident in the country levying tax. Most countries follow a combination of source and residence taxation, and the ensuing conflict is sought to be resolved internationally by a network of bilateral agreements, known as Double Taxation Avoidance Agreements or DTAAs. In the absence of such a treaty, there is nothing to prevent both countries from taxing the same transaction, and no legal principle is available to a taxpayer to challenge such a levy. Thus, as the Tribunal noted:

It is thus fallacious to proceed on the basis that territorial nexus to a tax jurisdiction being sine qua non to taxability in a jurisdiction is a normal international practice in all systems. This school of thought is now specifically supported by the retrospective amendment to section 9.

The second contention that Ashapura Minechem raised was far closer, and raised an interesting question as to whether Indo-Sino treaties treat fees for technical services differently. Art. 12(4) of the Indo-China DTAA defines “fees for technical services” as “any payment for the provision of services of managerial, technical or consultancy nature by a resident of a Contracting State in the other Contracting State…” [emphasis mine] Art. 12(6), the deeming provision, provides that “royalties or fees for technical services shall be deemed to arise in a Contracting State when the payer is … a resident of that Contracting State.” Ashapura argued that Art. 12(4) is a peculiar provision that applies only when services are both rendered and utilized in India, and based this submission on the expression “provision of services… in the other Contracting State”. It contrasted this with other treaties that omit a deeming provision for fees for technical services. The Tribunal rejected this submission by noting that such transactions are in any case taxable under Art. 12(6) and noted that Ashapura’s view of Art. 12(4) would render Art. 12(6) meaningless, for every transaction to which it could conceivably apply would be covered by Art. 12(4).

In sum, the controversy over taxation of non-residents for fees for technical services appears to have been finally settled.


Academic Literature on Independent Directors in India

Events in Indian corporate governance that occurred starting January 2009 have spurred academic research on the role and effect of independent directors on corporate boards. While some findings indicate an important role for such directors on Indian companies, others are not so optimistic and call for greater reform of that institution. The purpose of this post is to point to some of the available literature.

1. The paper Independent Directors and Firm Value: Evidence from an Emerging Market by Rajesh Chakrabarti, Krishnamurthy V. Subramanian and Frederick Tung represents perhaps the first event study pertaining to independent directors in India. Their study finds a positive impact through the presence of independent directors on corporate boards. Here is the extract:
Do independent directors add value to emerging market firms? Using a natural experiment that provides exogenous changes in independent directors together with unique data on all director resignations, we find that the answer to this question is “Yes!” The natural experiment we exploit is provided by the recent Satyam fiasco in India. Following the disclosure of extensive accounting fraud by the promoter family in Satyam, several independent directors resigned from other Indian firms. Since these resignations were motivated by an unexpected shock external to the firm, they were unaffected by firm- and director-specific factors coinciding with the time of the resignation. Using the extraordinarily large number of such resignations in January 2009, we find the four-day cumulative abnormal return surrounding director resignations to be -1.3%. This effect is robust even after controlling for unobserved firm and director characteristics using fixed-effects and is also reflected in ex-post firm performance as measured by Tobin's Q. Consistent with the monitoring role of independent directors, we find that the effect is disproportionately greater for those independent directors that sit on the audit committee and possess business expertise; while the effect of being in the audit committee is greater for smaller firms, the effect of business expertise is felt more in large firms. Finally, the departing independent directors are missed less in family owned firms.
This paper appears to follow the trends displayed in two previous studies that report positive results in firm value due to enhanced corporate governance norms. The first study by Black and Khanna reports a positive market response to the introduction of mandatory corporate governance norms, while the second by Dharmapala and Khanna reports positive response to greater enforcement measures.

2. The article The Role of Independent Directors in Controlled Firms in India: Preliminary Interview Evidence by Vikramaditya Khanna and Shaun J. Mathew published in the National Law School of India Review focuses on the precise role that independent directors can discharge on boards of a vast majority of companies in India which have concentrated shareholdings. The abstract of the article is as follows:
The role of independent directors has come under the scanner following the Satyam debacle, and the en masse resignation of independent directors that followed. Professor Khanna and Mr. Mathew argue, on the basis of extensive interview evidence, that there is no clear understanding of the role that an independent director is expected to play in the boardroom. Further, they demonstrate that doubts over the applicability of civil and criminal liability laws to independent directors are often a cause of concern, and argue that these concerns must be addressed in the proposed reform to India’s company legislation.
3. In this paper Evolution and Effectiveness of Independent Directors in Indian Corporate Governance, I attempt to compare and contrast the position of Indian independent directors with their counterparts in the developed markets of the U.S. and the U.K. Here is the abstract:
The goal of this Article is two-fold: (i) to identify the rationale for the emergence of independent directors by tracing their evolution in the U.S. and the U.K. where they originated; and (ii) to examine the transplantation of that concept into India with a view to evaluating the effectiveness of independent directors in that country. This Article finds that there are significant differences in the corporate ownership structures and legal systems between the countries of origin of independent directors on the one hand and India on the other. Due to the diffused shareholding structures in the U.S. and the U.K., the independent directors were ushered into corporate governance norms in those countries in order to operate as a monitoring mechanism over managers in the interest of shareholders. Each stage in the evolution of board independence bears testimony to this fact. However, a transplantation of the concept to a country such as India without placing emphasis on local corporate structures and associated factors is likely to produce unintended results and outcomes that are less than desirable. This Article finds that due to the concentrated ownership structures in Indian companies, it is the minority shareholders who require the protection of corporate governance norms from actions of the controlling shareholders. Board independence, in the form it originated, does not provide a solution to this problem. While this Article is skeptical about the effectiveness of board independence in India, it suggests reforms to embolden independent directors that may empower them to play a more meaningful role in corporate governance.
4. The paper The Naked Truth About Independent Directors by Prithvi Haldea provides several practical and operational insights to the functioning of independent directors in India. Here is an extract:
Corporate governance is not an execution but an oversight mechanism to ensure honesty in a company. (This presumes that dishonesty exists in most companies). So the oversight structure has to be very strong and competent to be able to detect malpractices. If almost the entire foundation of corporate governance rests on the shoulders of the independent directors (IDs), it is now beyond debate that the foundation indeed is extremely fragile.
Surely, the last word is far from being spoken on this issue. It has been reported that the Government is considering the inclusion of specific provisions regarding the roles, responsibilities and liabilities of independent directors in the Companies Bill, 2009. While that will continue to further the academic debate regarding independent directors, it is hoped that some of the lessons from the research listed above will also aid in defining regulatory policy on the topic.

Thursday, July 8, 2010

Supreme Court on Takeover Regulations: Daiichi appeals allowed

A three-Judge bench of the Supreme Court has delivered its judgment (per Aftab Alam J.) in Daiichi Sankyo v. Chigurupati and Daiichi Sankyo v. Narayanan (Civil Appeal No. 7148/2009 and Civil Appeal No. 7314/2009, judgment dated 8 July, 2010); where the Supreme Court has in a common judgment allowed appeals against orders of the SAT in cases involving interpretation of the Takeover Regulations. While the Supreme Court judgment is likely to be discussed in detail subsequently on this blog; in this post, I will briefly summarise some of the legal principles laid down by the Court. 

The facts of the matter were admitted by all parties; and have been discussed in previous posts on this blog, which had debated the correctness of the orders of the SAT. The Court resolved the controversy between the parties by focussing on the interpretation of the term ‘persons acting in concert’ under the Regulations. The Court held, inter alia:

1. The concept of ‘persons acting in concert’ under Regulation 2(e)(1) is based on a target company on one side, and two or more persons acting together with a common objective or purpose of substantial acquisition of shares etc. on the other. Without there being a target company, the concept of ‘persons acting in concert’ is meaningless – it would be as irrelevant “as a cheat with no one as a victim of his deception”.

2. As long as there is no shared objective of substantial acquisition of shares of a target company, there can be no question of persons acting in concert. Without there being such a common objective, the concept is again meaningless – it would be tantamount to being as meaningless as “criminal conspiracy without any agreement to commit a criminal offence”. ‘Persons acting in concert’ is not something which happens fortuitously or by accident or chance; it happens only be design.

3. Thus, for the concept of ‘persons acting in concert’ to be relevant, there must (a) be a target company, and (b) the persons must be acting with the shared common objective or purpose of substantial acquisition of shares in that target company.

4. The deeming provision of of Regulation 2(e)(2) does not do away with any of these two elements. Regulation 2(e)(2) is not a provision independent of Regulation 2(e)(1); but the two must be read together. The deeming provision will have effect in cases where a company or its holding company “makes or agrees to make a move for substantial acquisition of shares etc. of a certain target company.” In such cases, “it would be presumed that the move is in pursuance of a common objective and purpose jointly shared by the holding company and the subsidiary company.

5. But the mere fact that two companies are in a holding-subsidiary relationship would not mean, without anything more, that the two companies are ‘persons acting in concert’.

6. Furthermore, Regulation 2(e)(2) does not create any stand-alone test; it merely creates a rebuttable presumption. This presumption does not operate retrospectively; it applies only from the date two or more persons come together in one of the relationships specified; and does not date back.

7. For the application of Regulation 20(4)(b), it is not relevant or material that the acquirer and the other person, who had acquired the shares of the target company on an earlier date, should be acting in concert at the time of the public announcement for the target company. The relevant time is the time of purchase of shares of the target company. The interpretation of Regulation 20(4) is not affected by Regulation 20(12).

Wednesday, July 7, 2010

FDI in Multi-brand Retailing

The Government has reopened the debate on allowing foreign investment in the multi-brand retail sector. A discussion paper issued yesterday reviews existing studies conducted by the Government and other entities on this topic and also examines the experience in other emerging markets.

The rationale for FDI in the retail sector is set out as follows:
6.1 The Agriculture sector needs well-functioning markets to drive growth, employment and economic prosperity in rural areas of the country. Further, in order to provide dynamism and efficiency in the marketing system, large investments are required for the development of post-harvest and cold-chain infrastructure nearer to the farmers' field. FDI in front end retailing is imperative to fund this investment. Allowing FDI in front end retail operations will enable organized retailers to generate sufficient cash to fund this investment. Investment in organized retail by domestic players will be ineffectively deployed if FDI is delayed. International retailers should be mandated to bring with them technology and management know-how which will ensure that investment in organized retail works to India's advantage. In order to provide dynamism and efficiency in the marketing system, large investments are required for organized retailing, linked with the back end of the value chain. FDI in front-end retailing is imperative to derive full advantage of the value chain for the producer and the consumer. International retailers will bring with them technology and management know-how that will finally impact our whole retail sector through the adoption of best practices.


6.4 FDI in retail, may, therefore, be an efficient means of addressing the concerns of farmers and consumers, as referred to above. The private sector, especially organized retail, is best suited to make investments of this magnitude. Permitting foreign investment in food-based retailing is likely to ensure adequate flow of capital into the country & its productive use, in a manner likely to promote the welfare of all sections of society, particularly farmers and consumers. Opening FDI in retail could also assist in bringing in technical knowhow to set up efficient supply chains which can act as models of development. It would also help bring about improvements in farmer income & agricultural growth and assist in lowering consumer prices/inflation.


6.7 Keeping in view the large requirement of funds for back-end infrastructure, there is a case for opening up of the retail sector to foreign investment. At the same time, in the Indian context, there is a view that this may be more appropriately done in a calibrated manner. We must ensure that the FDI does make a real contribution to address the inadequacies of back-end infrastructure. Alongside, we need to address the challenge of integrating the small retailer in the value chain.
Rather than make any specific proposals or recommendations, the Government has set out a list of 12 questions for inviting public views and comments, which are due by July 31, 2010.

Given the tenor of the discussion paper and the questions, it appears that while there is merit in opening up the retail sector to FDI, the liberalization will occur in a progressive manner and will come (at least initially) with a number of conditions.

From the perspective of the ease of doing business, any reform would have to streamline the process of investment. For instance, a comprehensive regime that deals with FDI in trading may be more preferable compared to the existing structure that differentiates between various types of trading such as wholesale trading, cash and carry wholesale, single-brand retailing and multi-brand retailing (that may not only be complex from a regulatory standpoint but also expose the system to the risk of regulatory arbitrage depending on the conditions associated with each route).

Friday, July 2, 2010

Risk Management Systems

1. In this column in the Mint, I attempt to stress the importance of systems for managing risk in the modern corporation.

2. In this post, Professor Jayanth Varma discusses whether systems and controls may have prevented the peculiar case of “a drunken broker (Steven Perkins) who bought $520 million of crude oil futures sitting at home at night with his laptop”!

Thursday, July 1, 2010

The Issue of Limitation in Consumer Complaints

A recent note discusses the decision of the Supreme Court in Kandimalla Raghavaiah v. National Insurance, concluding that it is being misinterpreted, and lays down dangerous precedent for insurance claims. While the concern highlighted by the abovementioned note, that “consumers will continue to find themselves at the receiving end with genuine complaints being thrown out for being time–barred” is completely valid, it appears that the decision has not been misinterpreted, and in fact espouses a view detrimental to valid insurance claims.

The source of the controversy lies in the relationship between the insurance claim and a complaint before the National Consumer Disputes Redressal Commission [“National Commission”], established under section 9(c) of the Consumer Protection Act, 1956 [“Act”]. On the facts of the case, a claim for insurance resulting out of a fire in a godown was not pursued for four years after the fire broke out. The insurance company refused to settle the claim, on the ground that the claim was time-barred (The decision is silent on the issue of which provision the insurance company relied on for the limitation period). Against this decision, the claimant approached the National Commission, which dismissed the petition as time-barred under section 24A of the Act. It was this decision which was appealed against to the Supreme Court.

Section 24A of the Act reads-

(1) The District Forum, the State Commission or the National Commission shall not admit a complaint unless it is filed within two years from the date on which the cause of action has arisen.

(2) Notwithstanding anything contained in sub-section (1), a complaint may be entertained after the period specified in sub-section (1), if the complainant satisfies the District Forum, the State Commission or the National Commission, as the case may be, that he had sufficient cause for not filing the complaint within such period :

Provided that no such complaint shall be entertained unless the National Commission, the State Commission or the District Forum, as the case may be, records its reasons for condoning such delay. [emphasis supplied]

The question to be decided by the Supreme Court was when the cause of action could be said to have arisen. The appellant contended that (for a variety of reasons not necessary to go into here), it could not have filed the complaint earlier. More importantly, it was contended that the refusal to settle the claim was the deficiency in service against which the complaint with the National Commission was filed. Since the cause of action, for the purposes of section 24A, was this deficiency of service, the limitation period would begin only after the refusal to settle and not at the time of the damage to the claimant. The insurance company, significantly, did not contend that the claim was barred by limitation under section 24A. In paragraph 8 of the decision, the respondent are reported as contending only that the requirements for filing a claim were not fulfilled by the claimant, and the claim was rightly rejected. Thus, the insurance company’s defence was there was no deficiency of service, and not that a complaint against a deficiency of service was barred by limitation.

Now, under the Consumer Protection Act, a complaint is filed for a defect in goods, or for deficiency in services. The cause of action for such a complaint is thus the defect or the deficiency, as the case may be. Admittedly, the fire in the godown would be the cause of action for the insurance claim. In determining the period of limitation for the insurance claim, the date of the fire in the godown would be relevant. However, the limitation period for filing an insurance claim would be governed by the terms of the insurance policy, which is not discussed by the Supreme Court. This issue was considered by an earlier decision of the Apex Court in Oriental Insurance v. Prem Printing Press (2009). Here, a specific clause in the policy provided that the claim shall be deemed to have been abandoned and not recoverable three months after its repudiation. This was interpreted by the Supreme Court as meaning that three months after the final and conclusive rejection of the claim by the insurance company. Now, the case note mentioned above, argues that the decision in Kandimalla Raghavaiah conflicts with the earlier decision in Prem Printing Press, since the latter held the limitation period to be commencing from the rejection of the claim. However, that view is erroneous, since the two cases dealt with two different limitation periods. In Kandimalla Raghavaiah, it was to commence with the cause of action, in Prem Printing Press, it was to begin with the repudiation of the claim.

However, this distinction does not mean that Kandimalla Raghavaiah was correctly decided. Although the limitation period in Kandimalla Raghavaiah was to begin with the cause of action (as provided by section 24A), the decision still proceeds on a dubious interpretation of the term ‘cause of action’. Cause of action in section 24A must refer to the cause of action of the consumer complaint, and not the cause of action of the insurance claim. In stressing on the significance of section 24A, the Supreme Court cites another prior decision in State Bank of India v. BS Agricultural Industries, where the Court had observed,

It would be seen from the aforesaid provision that it is peremptory in nature and requires consumer forum to see before it admits the complaint that it has been filed within two years from the date of accrual of cause of action. The consumer forum, however, for the reasons to be recorded in writing may condone the delay in filing the complaint if sufficient cause is shown. The expression, `shall not admit a complaint' occurring in Section 24A is sort of a legislative command to the consumer forum to examine on its own whether the complaint has been filed within limitation period prescribed thereunder. As a matter of law, the consumer forum must deal with the complaint on merits only if the complaint has been filed within two years from the date of accrual of cause of action and if beyond the said period, the sufficient cause has been shown and delay condoned for the reasons recorded in writing. In other words, it is the duty of the consumer forum to take notice of Section 24A and give effect to it. If the complaint is barred by time and yet, the consumer forum decides the complaint on merits, the forum would be committing an illegality and, therefore, the aggrieved party would be entitled to have such order set aside.

However, all this paragraph shows is that section 24A cannot be circumvented, and does not suggest that ‘cause of action’ should be interpreted as being different from a deficiency in service or defect in goods, as the case may be. In fact, the facts in BS Agricultural Industries dealt with a deficiency of banking services, and the limitation period was held to have begun from the date when the deficiency occurred. Hence, if at all, the decision is authority for the proposition contrary to that proffered by the Court in Kandimalla Raghavaiah.

The result of this decision now is that in all other complaints, the limitation period under section 24A will commence from the date of the deficiency in service, while in insurance claims, it will commence from the date of the damage. Especially given the long delays that often accompany the settlement of insurance claims, this position defeats the purpose of allowing redress against insurance companies under the Consumer Protection Act. Thus, with due respect, it seems apparent that the decision in Kandimalla Raghavaiah merits urgent reconsideration.

"Professional Services"

It is often said that the importance of careful analysis of statutory language cannot be overstated, especially in fiscal matters. One will not be surprised to find, therefore, that the term “professional services” has recently engendered an interesting controversy as to its true scope. It arose before the Bombay High Court in Dedicated Health Care Services TPA v. ACIT, where it was argued that “professional services” can be rendered only by an individual, and not by a corporation or by any other organised vehicle of business.

The context for this case is the now-widely prevalent service provided in the insurance industry by an entity known as a “Third Party Administrator” [“TPA”]. TPAs enter into service agreements with policyholders to provide hospitalization services, cashless access, billing etc., and are regulated by the IRDA. It is common, therefore, for a TPA to make payments to hospitals on behalf of their clients under the terms of the policy, and the question that arose before the Bombay High Court was whether the TPA is required to deduct tax at source under the provisions of s. 194J of the Income Tax Act, 1961.

Section 194J, which deals with TDS for professional and technical services, and which we have considered in another context here, provides that “any person, not being an individual or a Hindu undivided family, who is responsible for paying to a resident any sum by way of fees for professional services…” shall deduct TDS at a specified percentage of the sum paid. “Professional services” is defined by the Explanation as “services rendered by a person in the course of carrying on legal, medical profession…

From the plain language of the provision above, there are two possible avenues to contend that a payment by a TPA to a hospital does not qualify as “fees for professional services”. The first is to suggest that the “hospital” is not a payee for the purposes of s. 194-J, because it is, as a corporate entity, incapable of rendering “professional services”. The second contention is that even if services are rendered by a hospital, the “payer” (the TPA) is not the beneficiary of the service. The second contention will face the obvious objection that there are elements of agency in the relationship between a TPA and its client, and it is perhaps for this reason that the assessees in Dedicated Health Services chose to focus entirely on the first.

The Court began its analysis by noting that Parliament has used three distinct terms in s. 194-J – “person, not including an individual…”, to describe the character of the payer, “resident”, to describe the character of the payee, and “services rendered by a person in the course of carrying on the medical profession” to indicate the meaning of professional services. “Person” is defined in s. 2(31) of the Act as including inter alia an “individual”. “Resident” is defined in s. 2(42) as a person (and therefore an individual) who satisfies the residency requirements set out in s. 6. The Court, proceeding on the reasonable premise that Parliament employed three different expressions consciously, held that the use of the word “person” in the definition of professional services, in preference to the term “individual” used earlier indicates that s. 194-J applies to corporations as well. The following observations are pertinent:

Firstly, in defining the character of the person who is to make the payment and whose obligation it is to deduct tax at source, Parliament has excluded from the ambit of the expression “any person” an individual and a Hindu Undivided Family. Secondly, in defining the character of the payee under the substantive part of Section 194­J Parliament has used the wider expression “resident”. Thirdly, in terms of Explanation (a), the words “services rendered by a person in the course of carrying on” have to be given a meaning. These words include service rendered which is incidental to the carrying on of a profession…

While one cannot fault this analysis, there is some support in case law for the position that a professional, in general, is an individual and not a corporation. The Supreme Court, for example, held in Surti v. State of Gujarat (AIR 1969 SC 63) that “a professional activity must be an activity carried on by an individual by his personal skill and intelligence.” Other decisions followed this principle in various contexts.

The Bombay High Court recognised this, and held that a hospital “by itself, being an artificial entity, or a corporate enterprise which conducts the hospital is not a medical professional”. However, the Court held that Parliament, which is presumed in law to have been aware of this position, intended to nevertheless impose the withholding tax obligation on payments made to non-individual payees. For this proposition, the Court relied on the fact that the definition of “professional services” is confined to s. 194-J by virtue of the expression “for the purposes of this section…” Secondly, it relied on the difference between “person”, “resident” and “individual” adverted to above. Finally, the Court held that it is anomalous to hold that a doctor who runs a nursing home qualifies as a “payee” under this provision, while a corporation that runs a hospital and provides exactly the same service does not.

Thus, there appears to be a distinction between the terms “profession”, “professional” “professional activity” and “professional services”. In sum, although only an individual can be a “professional” under existing law, it does not follow that only individuals are capable of rendering “services in the course of carrying on the medical profession”.