Thursday, February 28, 2013

Budget 2013: Taxation as a Solution to a Governance Problem

A couple of months ago, we had discussed the corporate governance issues that emerge when Indian subsidiaries of multinational companies pay substantial amounts to their parents in royalty.

While we will have a chance to discuss the taxation issues in the Budget in greater detail, the proposal to increase taxation on such royalty payments stands out. The Finance Minister’s speech notes:

147. Another case is the distribution of profits by a subsidiary to a foreign parent company in the form of royalty. Besides, the rate of tax on royalty in the Income-tax Act is lower than the rates provided in a number of Double Tax Avoidance Agreements. This is an anomaly that must be corrected. Hence, I propose to increase the rate of tax on payments by way of royalty and fees for technical services to non-residents from 10 percent to 25 percent. However, the applicable rate will be the rate of tax stipulated in the DTAA.

While the precise impact of this proposal would depend on the use of appropriate double taxation avoidance treaties, the higher taxation is likely to have a negative effect on the payment of royalty at least in some cases. In those, the unintended consequences of taxation may turn out to be a creative solution to address the corporate governance problem (whereby minority shareholders are unable to share in the returns of the company to the same extent as the controlling shareholder due to excessive payments of royalty).

Budget 2013: Foreign Portfolio Investment

The Finance Minister has sought to streamline the currently complex regime for foreign portfolio investment. The Budget speech notes:

- There are many categories of foreign portfolio investors such as FIIs, sub-accounts, QFIs etc. and there are also different avenues and procedures for them. Designated depository participants, authorised by SEBI, will now be free to register different classes of portfolio investors, subject to compliance with KYC guidelines.

- SEBI will simplify the procedures and prescribe uniform registration and other norms for entry of foreign portfolio investors. SEBI will converge the different KYC norms and adopt a risk-based approach to KYC to make it easier for foreign investors such as central banks, sovereign wealth funds, university funds, pension funds etc. to invest in India.

- In order to remove the ambiguity that prevails on what is Foreign Direct Investment (FDI) and what is Foreign Institutional Investment (FII), I propose to follow the international practice and lay down a broad principle that, where an investor has a stake of 10 percent or less in a company, it will be treated as FII and, where an investor has a stake of more than 10 percent, it will be treated as FDI. A committee will be constituted to examine the application of the principle and to work out the details expeditiously.

This approach is based on the recommendation of the Working Group that issued its report back in 2010. However, at that time it was not implemented in the manner intended. While the objective was to streamline the various available schemes for foreign portfolio investment, an additional category of qualified foreign investors (QFIs) was created which failed to gain momentum and added to the slew of options.

On this occasion, SEBI has already initiated the streamlining process last year, and with the Budget announcement the other regulators such as the RBI would also be expected to bring their procedures in line with the objective. This will hopefully address some of the concerns relating to foreign portfolio investment and at least partially avoid the exportation of capital markets discussed in the post earlier today.

The Exportation of Indian Capital Markets

Reuters has a report indicating that the volume of trading in Indian derivatives in the Singapore market is almost as robust as that in the Indian market. This suggests that the Indian capital markets are being exported overseas. Investors are able to enjoy the investment benefits in Indian underlying assets or investments without actually investing in India.

Usually, this phenomenon occurs for one of two reasons. The first is that the domestic system suffers from inefficiencies that compel investors to migrate to a more suitable system. The second is a case where investors might be seeking to invest in jurisdictions that are less stringently regulated, a classic case of the “race to the bottom”. In this scenario, it is clearly the first reason, particularly due to the uncertainty in the Indian tax regime in the last year or so.

This is not the first time such a phenomenon has occurred in India. The participatory notes structure was devised in the last few years precisely for this reason, as I have discussed in this paper.

It remains to be seen whether the Finance Minister’s announcement in today’s Budget regarding the ease of doing business in India or steps in furtherance of that are likely to change the sentiment in the near future.

Monday, February 25, 2013

Takeover Regulations: Computing Creeping Acquisition Limits

SEBI has published its informal guidance on a matter that delves into the mechanics of computing the creeping acquisition limit of 5% per year in a company whose share capital may have undergone changes during the same period.

Aksh Optifibre Limited made an application on August 17, 2012 to SEBI to seek its informal guidance on the specifics of its case. The company’s promoters had made a series of acquisitions of shares and global depository receipts (GDRs) of the company during the period between April 1, 2012 and July 31, 2012. During that period, the share capital of the company underwent dilution due to certain conversion of foreign currency convertible bonds (FCCBs) into equity shares. While the promoters acquired shares/GDRs at three different points in time during the period, there were two occasions where the share capital was diluted.

The company’s question to SEBI was whether the 5% creeping acquisition limit under Reg. 3(2) of the SEBI Takeover Regulations of 2011 must be calculated with reference to the total number of shares outstanding at the beginning of the financial year (i.e. April, 2012) or those outstanding at the time of computation of the limit (i.e. post dilution due to conversion).

After considering the provisions of the Takeover Regulations, SEBI arrived at an altogether distinctive interpretation which is different from either of the situations suggested in the company’s query to SEBI. SEBI’s approach requires the company to consider each acquisition separately. Its reasoning is as follows:

5. It is clarified that the quantum of acquisition of voting rights for the purpose of regulation 3(2) of the Takeover Regulations, 2011, shall be computed separately for every acquisition of voting rights based on the paid-up share capital of the target company at the time of acquisition and aggregated for the financial year. …

SEBI’s letter contains an explanation through the workings of the acquisitions and dilutions during the period that occurred with respect to the company.

SEBI’s interpretation is consistent with the explanation (i) to reg. 3(2) which provides that “gross acquisitions alone shall be taken into account regardless of any intermittent fall in shareholding or voting rights … owing to … dilution of voting rights owing to fresh issue of shares by the target company”. Therefore, it would be necessary to add up the percentages of each acquisition separately without giving effect to each dilution so as to determine the aggregate acquisitions during the financial year.

Reasons for informal guidance: While on the question of informal guidance, the Securities Appellate Tribunal (SAT) has passed an order on an appeal by Gillette India Ltd., which requires SEBI to provide reasons while rejecting an application seeking an informal guidance regarding an interpretation of the provisions of the Securities Contracts (Regulation) Rules, 1957. Although this order has been passed by SAT at the admission stage and not on merits, SAT’s approach imposes an onus on SEBI to provide reasoning while issuing informal guidance. This might be particularly so if the informal guidance is contrary to the position sought by the company.

Sunday, February 24, 2013

RBI Guidelines for Licensing of New Private Sector Banks

The Reserve Bank of India (RBI) has issued a final set of guidelines for licensing of new banks in the private sector. These guidelines will becomes operational with effect from July 1, 2013 and applications under them for establishing new banks must be submitted to the RBI before that date.

These guidelines are based on the draft issued by the RBI in August 2011. Since then, the RBI has received and considered comments on the draft. Moreover, the Banking Regulation Act, 1949 underwent amendments in December 2012, which were a precondition to the effectiveness of the new regime.

The new guidelines lay down an enabling but strict regime for the private sector to apply for the establishment of banks. The broad structure and conditions of the new regime remain broadly similar to those indicated in the draft, and hence the analysis contained in our post of August 2011 largely holds good.

A principal change from the draft is that real estate and stock broking companies are no longer prevented at the outset from making applications to set up banks. The risks arising from these types of entities will be determined by the RBI subjectively while exercising its discretion in approving licenses for new banks. Moreover, by requiring promoter groups to set up banks through a non-operative financial holding company (NOFHC), the intention is to ring-fence the banking and financial activities of the group from other activities.

Other conditions, including those relating to minimum capitalization, foreign investment, priority sector lending and corporate governance are detailed in the guidelines, which are summarized here.

This is certainly likely to create a significant amount of interest among the business groups in India to foray into the banking sector, which might trigger a flood of applications. However, it is likely that only a few licences will in fact be granted in the near future, which may not necessarily cause a radical change in the industry, but would lead to some gradual progression in greater access to banking services and competition.

Thursday, February 21, 2013

Foreign Investment in Corporate Debt

[Vinita Sithapathy, who is a lawyer and a company secretary, has contributed the following post. Vinita graduated from Government Law College, Mumbai in 2008. She has advised clients on banking and finance and corporate M&A transactions since 2008. She can be contacted at]

Last month, the Reserve Bank of India (RBI) introduced some amendments to its existing regime of corporate and infrastructure debt available for investment by foreign institutional investors (FIIs). Under the existing regime, FIIs could invest within an overall limit of USD 45 billion in non-convertible debentures in the corporate and long-term infrastructure debt category. This was split into USD 25 billion for investment into infrastructure debt and USD 20 billion for investment into corporate non-infrastructure debt. The infrastructure category was further sub-divided into a USD 22 billion limit for investment by FIIs and a separate limit of USD 3 billion for investment by entities that fell within the meaning of ‘qualified foreign investors’ (QFIs). Investment by FIIs into infrastructure debt was also subject to the following conditions:

(i)        Original Maturity

The original maturity period of the non-convertible debentures (NCDs) was required to be at least 5 years. Original maturity is understood as the original term of the NCDs at the time of issuance.

(ii)       Residual Maturity

The residual maturity of the NCDs at the time of first purchase by an FII is required to be at least 15 months. Residual maturity is the term of the NCDs that is remaining when an FII purchases the NCDs. This condition applies only the first time a purchase is made by an FII. For any subsequent purchases by an FII, this requirement will not apply.

Investments by QFIs were to be made in mutual funds that invested in the infrastructure debt sector in investments with a residual maturity of 5 years. Subsequently QFIs were permitted to invest in mutual funds that held 25% of their assets in the infrastructure sector (whether debt or equity). It wasn’t clarified whether the residual maturity requirement continued to apply to the debt investments of such mutual funds, but it was assumed that it would.

(iii)      Lock in period

Investments in the NCDs were required to be locked in for a period of 1 year although trading between FIIs was permitted during the lock in period.

RBI’s recent circular has amended the position as follows:

- Limits for investment in the corporate non-infrastructure debt category have been enhanced from USD 20 billion to USD 25 billion. In addition to FIIs, the additional USD 5 billion limit is also available for investment to other categories of investors like sovereign wealth funds, pension funds, multilateral agencies and foreign central banks registered with the Securities and Exchange Board of India (SEBI) as investors. This category of investors was earlier entitled to invest only in infrastructure debt funds (IDFs).

- RBI has also removed the requirement of original maturity and lock in period under the infrastructure debt category (i.e. within the USD 22 billion limit). The residual maturity requirement of 15 months at the time of first purchase by an FII remains as is.  

- The residual maturity requirement for mutual fund investments of QFIs has been done away with and replaced by an original maturity requirement of 3 years.

For investments in infrastructure debt that contain embedded put/call options, SEBI has specified that the date of the put/call option will determine the residual maturity i.e. FIIs could make upfront investments into NCDs with put/call options only if the date of the put/call option was at least 15 months after the date of the investment. Most FII investments in infrastructure sector NCDs (with original maturity of 5 years) were made with embedded put/call options that allowed the FII to exit at the end of 15 months. RBI’s amendment now provides an early exit to investors without having to structure a put/call in the NCDs and a pseudo-original maturity period to comply with the regulations. While investors are most likely to welcome these amendments, this category is probably no more the “long-term” infrastructure debt category.

The recent circular of RBI amending the regime is available at here and the SEBI circular following that and summarising RBI’s amendments is available at here