Sunday, February 28, 2016

Delhi High Court on Directors’ Duties and Derivative Actions

It is not very often that we witness cases in India relating to intrinsic company law issues such as breaches of directors’ duties and shareholder remedies through derivative actions. However, questions of directors’ duties have been brought to the fore following the Companies Act, 2013 as they have been codified in the legislation. Derivative action, however, still remains within the realm of common law and has not been the subject matter of codification. Some of these issues were brought to light in a case before the Delhi High Court in Rajeev Saumitra v. Neetu Singh, which was decided on 27 January 2016.

This is one of several cases where matrimonial disputes often morph into significant company law issues.[1] Here, the plaintiff Rajeev Saumitra brought a shareholder derivative suit against his wife Neetu Singh and a private limited company Paramount Coaching Centre Pvt. Ltd. (“Paramount”), of which they were shareholders holding 50% shares each. Another defendant is K.D. Campus Pvt. Ltd. (“K.D. Campus”), a company set up by Neetu Singh. The primary dispute relates to the claim by Rajeev Saumitra that while Neetu Singh was a director and shareholder of Paramount, she began engaging in competing activity with that of the company, and set up K.D. Campus in parallel and began luring the students (customers) of Paramount away. It was alleged that she therefore breached her duties as a director of Paramount. There was also a dispute relating to the use of the PARAMOUNT name and mark, which is not germane to the issues at hand.

Without delving into the details of the facts, this post discusses two company law issues that arose in the case. The first relates to the breach of directors’ duties, particularly the duty to avoid conflict of interest. This might very well be one of the first few cases that deal with the issue under the new Companies Act of 2013. The second is the question of whether and shareholder derivative suits can be permitted to be brought by a shareholder on behalf of the company against a director for a breach of duties.

Breach of Directors’ Duties

The Court examined section 166 of the Companies Act, 2013 that codifies directors’ duties. Apart from requiring the director not to be involved in a situation where he or she has a direct or indirect conflict of interest with the company, the statutory provision states that if a director obtains any undue gain or advantage, the same must be paid over to the company.[2] On the facts, the Court found that Neetu Singh had sought to enter into a competing business by establishing K.D. Campus, thereby suggesting a breach of her duty as a director of Paramount under section 166 of the Companies Act. One issue that came up during the arguments of the parties, but did not receive significant attention in the judgment, is whether there could be common law duties of directors in addition to what has been expressly set out in section 166. In other words, is section 166 an exhaustive codification of directors’ duties in India? This has previously exercised our minds as well, as we have noted here and here. While the Court discussed this in passing and implies the continuance of common law duties, it appears that there was no need to rule definitively on the issue, as it found a breach of section 166.

In addition to breaches of directors’ duties, the plaintiff also alleged violations of section 88 of the Indian Trusts Act, which provides that a director who obtains a gain or advantage in any dealing that is adverse to the interest of the company must hold that for the benefit of the company. Under law, directors are strictly not trustees, although their roles may be similar as they are both fiduciaries. Section 88 of the Trusts Act specifies various relationships that are similar to trusts, and includes directorship of a company as one of them. While this is understandable, the plaintiff also alleged a violation of section 16 of the Partnership Act, which deals with account for profits arising out of a partner’s engaging in a competing business from that of the firm. This is somewhat confounding given that a private limited company was involved in this case, which is legally a different vehicle from that of a partnership. Even though a private limited company (especially one that is owned by a husband and a wife) may carry some practical features of the partnership, it is not clear if partnership law can therefore be applied to deal with disputes, especially when it comes to breaches of directors’ duties. The Court did not conclusively rule on these issues.

Derivative Actions

Shareholder derivative actions in India are few and far between. A number of reasons have been proffered for this. However, lately there have been some actions that have come up before the courts.[3] As often happens in the few cases that come up before the Indian courts, the judge is required to decide whether the action is a personal action brought by a shareholder or one that is a derivative action brought on behalf of the company. In case of a derivative action, the benefit of the action and the remedy flow to the company and not the shareholders.

In the present case, the defendants put forward the argument that the action was a personal action and that it was more appropriate to be brought before the Company Law Board as one for oppression and mismanagement under sections 397 and 398 of the Companies Act, 1956.[4] However, the Court rightly found that the breach of directors’ duties would give the plaintiff shareholder the right to initiate a derivative suit against the errant director on behalf of the company. Moreover, the Court found that the provisions relating to actions for oppression and mismanagement do not oust the jurisdiction of the civil court, which is very much entitled to hear cases such as civil suits brought in the form of shareholder derivative actions.

Based on the conclusion arrived at on the question of breach of directors’ duties as earlier and also the admissibility of a derivative law suit, the Court issued appropriate orders on injunctions relating to the defendant’s ability to carry on competing business.

Although the Court’s decision was largely dependent upon the facts of the case, and was not as such called upon to lay down any significant principle of law, it highlights some of the issues that are likely to arise under the Companies Act, 2013, and also under common law to the extent that certain aspects (such as shareholder derivative actions) are not codified under that legislation.

[1] One such significant case is the UK Supreme Court decision in Prest v. Petrodel Resources, [2013] UKSC 34, which dealt with piercing the corporate veil.

[2] Sub-section (4) and (5) of section 166.

[3] For example, see Starlite Real Estate v. Jagrati Trade Services (Calcutta High Court, 14 May 2015); Darius Rutton Kavasmaneck vs Gharda Chemicals Ltd. (Bombay High Court, 7 April 2015). There may be others as well that we are not immediately aware of.

[4] The parallel provision of section 241 of the Companies Act, 2013 is yet to come into force.

Thursday, February 25, 2016

Indian REITs – Story So Far, Challenges and Expectations from Budget 2016

[This guest post is contributed by Yashesh Ashar and Swati Adukia.  They are tax professionals and specialize in mergers and acquisition tax. Please note that the views are personal]

I.          Introduction

The Securities and Exchange Board of India (“SEBI”) notified the SEBI (Real Estate Investment Trusts) Regulations, 2014 (“REIT Regulations”) on September 26, 2014 , governing the real estate investment trusts (“REITs”) in India. REITs would:

(i)        Invest primarily in completed, revenue generating real estate assets;

(ii)       Be professionally managed; and

(iii)      Distribute a major part of their earnings to their investors.

REITs are closed ended funds set up as trusts and registered with SEBI, just like mutual funds, with investment primarily in completed and revenue-generating real estate / infrastructure assets. The units of REITs are required to be mandatorily listed and freely traded on a recognized stock exchange in India. The income earned from properties will be distributed to the investors in the trusts. In long term, REITs are expected to complement the growth and cater to the financing needs of both sectors, drive the development of capital markets, provide retail investors with less risky, fixed income investment avenues and provide exit options for financial investors as well as developers.

Effective April 1, 2015, a new tax regime for REITs (also referred to as “business trusts” or “BTs”) had come into effect to provide tax certainty in the hands of BTs as well as investors and to provide for a single of level taxation. Some of the salient features of this tax regime are discussed below.

II.        Dividends

Dividends distributed by a special purpose vehicle (‘SPV’) being a company, into which a BT invests, will be subject to a dividend distribution tax (“DDT”) at the rate of 15%[1] on gross up basis; such dividends will be exempt from tax in the hands of the BT as well as the investors in the BT.

III.       Interest

Interest received by a BT from an SPV, enjoys a complete tax pass through; such interest will be taxed in the hands of the investors in the BT. However, the BT is required to withhold tax (“WHT”) at the rate of 5% (for non-residents investors) and 10% (for resident investors) on distribution of such interest income to the investors.

IV.       Capital Gains

The BT will be taxed on any capital gains realized on disposal of its assets (including shares held in an SPV) at the applicable tax rates, depending on whether the gains are short term (“STCGs”) (i.e. assets are held for 36 months or less) or long term (“LTCGs”) (i.e. the assets are held for more than 36 months). Further, the capital gains component of the income distributed by the BT to its investors will be exempt from tax in the hands of the investors.

V.        Capital Gains Realized by BT Investors on Transfer of their BT Units

Investors in a BT will be liable to pay securities transaction tax (“STT”) on sale of their units in the BT. LTCGs realized by such investors on sale of their units in the BT will be exempt from tax in their hands, while STCGs realized by such investors on sale of their units in the BT will be taxable at the rate of 15%.

VI.       Tax Implications for a Sponsor[2] on Exchange of its Shares in an SPV for Units in a BT

The exchange of shares of an SPV for units in a BT will be exempt from tax in the hands of a sponsor.
LTCGs realized by such sponsors on sale of their units in the BT will be exempt from tax in their hands, if the aggregate period of holding of the SPV shares and REIT units together exceeds 36 month, subject to payment of STT. STCGs realized by such sponsors on sale of their units in the BT will be taxable at the rate of 15%, subject to payment of STT.

The tax implications discussed above are summarized in the following table:

Streams of Income and its Distribution
Capital Gain
Other income
On transfer of assets by BT
On Transfer of Units of BT
DDT @ 20.36% on gross up basis
SPV exempt from withholding tax on interest paid to BTs

BTs liable to WHT at 5% (for residents) and 10% (for non-residents)
Taxable at 20% and 30% for LTCG and STCG, respectively

No withholding obligation on BTs
Taxable @ 30%

No withholding obligation on BTs
Investors (including sponsors)
Taxable at 30% (subject to credit of tax withheld by BT)

In case of sponsors for exchanged  units: Exempt, subject to payment of STT (as equity shares) and STCG at 15%

In case of other units: LTCG – exempt and STCG at 15%

The above provisions were the first welcome move on the part of the Indian government as it lays down a basic framework for one-level taxation and thereby, provided much needed clarity on the tax implications for BTs and their investors. However, considering the international experience, tax efficiency is critical to the success of BTs. As the law stands today, there are several taxation and regulatory challenges which need critical evaluation and amendment to make the regime of BTs successful in India. Some of the key challenges that need to be addressed in the Budget 2016 at various levels of the BT structure are discussed below.

VII.   Tax Challenges

A.        Transfer of Assets to BTs by Sponsors

Though SEBI has permitted BTs to hold assets directly, the benefit as regards exchange of the shares of the SPV by the sponsors have not been extended to exchange of assets by sponsors in lieu of units of BTs. Accordingly, such an exchange of assets for units of BTs would be treated as a taxable transfer liable to tax. Further, direct transfer of assets to BTs would have stamp duty implications for the purchasing BT in the range of 5% to 11% on the market value of the assets as determined under stamp duty laws. This would make any direct transfer of assets commercially unviable for sponsors as well as BTs. Jurisdictions such as Singapore provides specific remission of stamp duties to REITs. Similar remission/exemption may also be provided to BTs to contain the transaction costs on direct purchase of assets by BTs.

B.        Partial Pass-Through only for Interest Income

The REIT Regulations (or “BT Regulations”) permit foreign investors to make investments in BTs. However, in the absence of pass through for the capital gains and incomes other than interest income earned by BTs, the foreign investors would not be eligible to claim the benefits of exemption or concessional rates provided under the tax treaties entered into by India with the relevant jurisdiction.

As regards domestic investors, non-pass through for capital gains and other incomes (other than interest) would result in investors not eligible to set-off losses from other activities against income earned from units in BTs.

C.        Expense Deductibility for BTs as well as Investors

As per the Indian tax laws, expenditure attributable to earning exempt income is not allowed as deduction. This would lead to BTs not able to claim expenditure incurred in the form of management fees, interest on monies borrowed against interest income. Also, the investors would not be able to claim deduction for any interest paid on borrowings against capital gains and other income (other than interest) received from BTs. Moreover, generally, under Indian tax laws, management fees would not be allowed as a deduction to BTs from capital gains income. Thus, a complete pass-through for the BTs may allow the investors to claim the deduction, to the extent permissible, for the expenditure incurred in making investments in BTs against capital gains and other income (other than interest income) as well.

D.        Use of a Limited Liability Partnership (“LLPs”) as SPV

LLPs, a globally popular business entity structure, are gaining popularity even in India since their introduction in 2008. LLPs enjoy a tax advantage over companies, as LLPs are not subject to DDT on any income distributed to its partners. Such income is exempt in the hands of BTs as partners to the LLPs. Unfortunately, unlike interest income from companies as SPVs, interest income from LLPs as SPVs have not been given pass through status and therefore, would be taxable at BT level at 30%. Thus, in order to allow a widespread use of the more flexible LLP vehicle, the pass through status for BTs should be extended to income from LLPs as well.

VIII.    Regulatory Challenges

Recently, the Reserve Bank of India had allowed foreign investments in BTs subject to certain conditions. Further, BTs are also added as eligible borrowers for the purpose of raising external commercial borrowings.

However, compared with the regulations covering REITs in other jurisdictions, BT Regulations are more stringent with regard to form of entity, initial offer size, minimum number of investors, minimum distribution norms, disclosure and governance requirements, sponsor commitment and lock-in requirements etc., to achieve the dual objective of permitting only serious players to BT and protection of investors. However, BT Regulations miss out on providing the flexibility to listed entities to transition to BT model, investments in overseas assets and flexibility for BTs to launch open ended schemes which are available to REITs in other comparable jurisdictions.

IX.       Conclusion

The Indian regulators have decided to adopt a cautious approach towards the BT Regulations and therefore, the BT Regulations and the associated tax regimes are at best in ALPHA mode. The successful implementation, operation and development of the BT market in India will depend heavily on the key challenges identified above. The structural reform process in India is usually a lengthy process.  However, considering the heavy reliance being placed by the regulators as well as investors on BTs to further develop the capital markets for the real estate and infrastructure sectors in India, hopefully, the regulators will act swiftly to remove the inflexibilities in regulations and inefficiencies in tax laws in the upcoming Budget 2016.

- Yashesh Ashar & Swati Adukia

[1] All the tax rates mentioned in this post will be required to be increased by applicable surcharge and education cess under Indian tax laws.
[2] Sponsor is a person/persons who set up the REIT and satisfies conditions relating to minimum net worth and minimum experience and sound track record. The sponsors are also required to meet certain minimum commitment and lock-in requirements.