Sunday, July 31, 2016

The State in Business and the Business of Regulation

[The following post is contributed by Bhargavi Zaveri, who is with the National Institute of Public Finance and Policy, New Delhi. She can be contacted at]

The public shareholders of a listed public sector bank were reportedly denied e-voting facilities at an extra-ordinary general meeting held in January 2016. In 2008, a state assembly passed a law unilaterally amending the terms of bonds issued to the public by a public sector undertaking (PSU). PSUs are exempt from several corporate governance-related requirements under the Companies Act, 2013 and its predecessor law (see here and here on this blog for a list of these exemptions). These are examples of the age-old conflict between the State's role as the lawmaker and as the owner of businesses. The State, by being uniquely placed to influence the outcome of a law, is in a position to unduly favour itself as a business participant at the cost of its competitors and counterparties.

The political economy for amending the law to subject state-owned corporations to
higher regulatory standards is absent in India. What else can be done to mitigate this conflict? In an article in the Economic and Political Weekly, I use the concept of regulatory dualism (or the practice of creating voluntary platforms with higher standards) to overcome the political economy problem of making reforms that are resisted by incumbents. Using examples of other countries where established firms resisted reform to corporate governance, I argue that a platform for voluntary compliance creates a 'race to the top' effect for firms to match higher standards. In practice, this means, that if some PSUs voluntarily opt out of the exemptions granted to them, others will follow suit.

- Bhargavi Zaveri

Tuesday, July 26, 2016

Supreme Court on Applicability of the Regime on Collective Investment Schemes

The Supreme Court of India earlier this month ruled on the applicability of the regulatory regime relating to collective investment schemes (“CIS”). In Securities and Exchange Board of India v. Gaurav Varshney, the legal question was rather straightforward. On 25 January 1995, section 12(1B) was inserted into the Securities and Exchange Board of India Act, 1992 (the “SEBI Act”). It provided that no person shall carry out a CIS unless he or she obtains a certificate of registration from the Securities and Exchange Board of India (“SEBI”) “in accordance with the regulations”. However, the “regulations” referred to in the said provision were enacted by SEBI only with effect from 15 October 1999 in the form of the SEBI (Collective Investment Schemes) Regulations, 1999 (the “CIS Regulations”). In the interim, on 3 July 1995, the respondents in the principal appeal, Gaurav Varshney and Vinod Kumar Varshney, began carrying out CIS operations through a company they incorporated. The legal question therefore was whether by carrying out CIS activity during the period when section 12(1B) (that imposes a bar on such activity without registration) was in force but not the CIS Regulations (that prescribe the mode of obtaining SEBI approval), the Varshneys were in breach of the legal regime so as to be subject to criminal action. The High Court below quashed SEBI’s action under section 482 of the Criminal Procedure Code. It is against this decision that SEBI appealed before the Supreme Court.

The Ruling

In answering the legal question, the Supreme Court interpreted section 12(1B) of the SEBI Act, which reads as follows:

No person shall sponsor or cause to be sponsored or carry on or cause to be carried on any venture capital funds or collective investment scheme including mutual funds, unless he obtains a certificate of registration from the Board in accordance with the regulations:

Provided that any person sponsoring or cause to be sponsored, carrying or causing to be carried on any venture capital funds or collective investment scheme operating in the securities market immediately before the commencement of the Securities Laws (Amendment) Act, 1995 for which no certificate of registration was required prior to such commencement, may continue to operate till such time regulations are made under clause (d) of sub-section (2) of section 30.

After analyzing the provision, the Supreme Court concluded that it has two parts. The first, signified by the main provision, relates to persons who had not commenced CIS activity prior to 25 January 1995, when the provision was brought into force, i.e. those who began the business afresh after that date.[1] The second, signified by the proviso, relates to those who were carrying on CIS activity even prior to that date, i.e. existing activity.[2] After doing so, the Court concluded that the case relating to the Varshneys would fall within the first part of section 12(1B), i.e. new activity. The question therefore was whether the bar against commencement of CIS activity after 25 January 1995 (when section 12(1B) came into force) would operate from that date or only when the regulations prescribed by SEBI thereunder came into force. Here, the court was emphatic in its conclusion that the bar against commencing CIS activity without registration would operate with effect from the date that the statutory provision (i.e. section 12(1B)) came into force and not only when the regulations were notified. The Court observed:

21. … Our inevitable conclusion is, that sponsoring or carrying on any collective investment activity, for the first time, on or after 25.1.1995, was a complete bar, in the absence of a certificate of registration from ‘the Board’. It accordingly follows, that if a person/entity had commenced to sponsor or carry on a collective investment scheme after 25.1.1995, without obtaining a certificate of registration from ‘the Board’, it would tantamount to breaching the express mandate contained in Section 12(1B) of the SEBI Act.

22. In our considered view, there can be no doubt, that the date when the Collective Investment Regulations came into force (-15.10.1999), has no relevance, insofar as the breach of Section 12(1B) of the SEBI Act, with reference to such new entrepreneurs, is concerned. The bar to sponsor or cause to be sponsored, or carry on or cause to be carried on any collective investment activity by a new entrepreneur (-who had not commenced the concerned activities, before 25.1.1995) under Section 12(1B) of the SEBI Act, was not dependent on the framing of the regulations. The above bar was absolute and unconditional, till the new entrepreneur (described above) obtained a certificate of registration, in accordance with the regulations. …

Although on this legal question the Supreme Court held in favour of SEBI, it upheld the decision of the High Court below in quashing the criminal proceedings against the Varshneys. This was on account of procedural issues. The Court placed considerable emphasis on the fact that SEBI’s complaint was made under the proviso category, i.e. where a person was carrying on existing CIS activity when section 12(1B) was brought into force. On the other hand, the complaint ought to have been made under the non-proviso category, i.e. in respect of new businesses that were commenced after the section as brought into force on 25 January 1995. This distinction was found to be rather crucial, and the fact SEBI proceeded under the wrong category was found to be fatal to its prosecution.

Hence, while the substantive legal question was decided in favour of SEBI, the procedural question was answered for the benefit of the Varshneys, due to which SEBI’s complaint against them was quashed. Apart from the case relating to Varshneys, the Supreme Court also dealt with the disposed off certain related appeals on similar and other related questions.


From a broader perspective, the Supreme Court’s decision has implications on restrictions of commercial activity imposed by legislation, especially when such activity is subject to licensing or registration requirements. Since such restrictions are subject to detailed rules or regulations to be promulgated by the regulatory authorities, the decision has implications on how persons may carry out such activities between the time that the legislation has imposed a restriction and before the regulatory authorities promulgate the rules or regulations. The Court’s resounding answer is that the activity cannot be carried out in the interim, and this operates as a total prohibition. That prohibition will be lifted only when the rules or regulations are subsequently promulgated. The issue becomes even more acute when there is a considerable delay between the imposition of the legislative restriction and the subsequent promulgation of the rules or regulations, as was the case with section 12(1B) and the CIS Regulations, which faced a delay of over three years. This puts affected parties at a disadvantage, as no CIS activity could have been carried on in the interim period. The lesson from this decision for the regulatory authorities would be that they ought to institute mechanisms for licensing or registration as soon as any such restrictions are imposed by legislation, without any delays in the interim.

On the other hand, the procedural aspect of the decision has the impact of imposing an onerous burden on the regulators in that they are required to be more specific regarding the offence that has been committed by a party. In circumstances such as in the present case, where section 12(1B) contains two parts, i.e. for existing businesses and new businesses, the regulator will have to specify whether the violation in a given case is under either of the two parts. If the regulator fails to do so, then prosecution for an offence under the SEBI Act could end up being futile as it turned out in the present case.

[1] This the Court referred to as the “non-proviso category”.
[2] This the Court referred to as the “proviso category”.

Friday, July 22, 2016

Bonus Debentures: A New Perspective on Certain Issues and Concerns

[The following post is contributed by Priya Garg, who is a student at the West Bengal National University of Juridical Sciences (WB-NUJS).

An earlier post on this Blog discussing the features and implications of bonus debentures is available here.]

Bonus debentures are those debentures which a company issues to its shareholders by using its reserves’ balance. Their issue does not require cash inflow from the shareholders, making these debentures free of cost for the shareholders. There is no specific provision under the Indian Companies Act, 2013 dealing with the issue of bonus debentures due to which companies issuing bonus debentures rely upon a scheme of arrangement under Sections 391-394 of the Companies Act, 1956 to establish the validity of such issue.[1] This gives rise to several questions relating to the issue of bonus debentures which remain unanswered. Some of these issues and concerns related to the issue of bonus debentures have been identified here, and the possible answers to some of the issues have also been elaborated upon.

First, due to the lack of a provision dealing specifically with the issue of bonus debentures, on account of an immensely broad scope of Section 391 of the Companies Act, 1956 regarding the arrangements that can be arrived at among the shareholders and the creditors, as well as because of the wide discretionary powers that the Court possesses while arriving at its decision to sanction the resolution passed at the meeting convened upon its order under Section 391, there has been ambiguity with respect to the legal position on different aspects pertaining to the issue of bonus debentures. However, concerns over several such ambiguities have not been raised in Indian scenario. This is because hitherto the bonus debentures issued in India have been the simplest cases of debentures issue as the debentures so issued have been non-convertible debentures and they have been issued out of general reserves and to all the shareholders. Hence, the position of law with respect to the more complicated cases some of which have been stated here remain unclear:

a.   Whether bonus debentures can be issued out of capital redemption reserve (CRR) or securities premium reserve (SPR) besides their issue from the undistributed profits/general reserves/free reserves?

Though it is a settled that bonus debentures can be issued out of the company’s general reserves, Indian courts did not get the opportunity to determine if such debentures, like in case of bonus shares, can also be issued out of Capital Redemption Reserve or Securities Premium Reserve. Under Section 69(1) of the Companies Act, 2013, Capital Redemption Reserve is credited whenever the company reduces its share capital by making payment out of its distributable profits. This is to ensure that the creditors’ interest stay protected despite the reduction of company’s share capital. This explains the reasons behind statutorily restricting the use of Capital Redemption Reserve to the issue of bonus shares, etc. and also for providing that unless explicitly stated otherwise, the balance of the Capital Redemption Reserve can be reduced only in the manner in which share capital can be reduced. Similarly, under Section 52(1) of Indian Companies Act, 2013, Securities Premium Reserve balance can be decreased only in the manner in which share capital can be reduced.

Under, Section 100 of Indian Companies Act, 1956, reduction of share capital has three pre-conditions: first, company’s articles of association should provide for such reduction, second, a special resolution is passed by the shareholders approving the reduction; and third, the Court sanctions the resolution so passed. The Court while sanctioning the resolution is required to ensure that no creditor (creditors being the affected party) opposes the reduction. The same procedure has to be followed for debiting the balance of Capital Redemption Reserve and Securities Premium Reserve. Therefore, ideally, bonus debentures could be issued by debiting the Capital Redemption Reserve and Securities Premium Reserve, provided that for the meeting which the Court orders to convene under Section 391, all the creditors and not merely the shareholders are invited, and in such meeting no creditor opposes the motion and later, the Court’s sanctions of such resolution. Alternatively, the Court can sanction the special resolution passed by the shareholders supporting the reduction of Capital Redemption Reserve/Securities Premium Reserve to issue bonus shares under Section 391, provided no creditor expresses disapproval to the proposal. Similarly, these two reserves can be utilized to issue bonus debentures in cases where the company does not have any creditors. 

Therefore, though this position has not been pronounced by law yet, nevertheless, by application of legal principles, it can be stated that debentures can be issued out of the Capital Redemption Reserve and Securities Premium Account.  Further, business prudence demands that the law is interpreted with the possibility of using Capital Redemption Reserve and Securities Premium Reserve in this manner because that would enable bonus debentures to become a real alternative to issue of bonus shares as a source of finance.

b.   In the areas of ambiguity, can the Court apply the principles related to the issue of bonus shares?

There are several questions related to bonus debentures such as:

(a)        Whether or not the company which has once announced the decision recommending a bonus issue can subsequently withdraw the same?, or

(b)        What happens when an individual shareholder refuses to accept the bonus debentures issued to him?, or

(c)        Whether or not the issuing company is required to make a reservation of bonus debentures in favour of the holders of outstanding [compulsorily] convertible debt instruments, in proportion to the convertible part thereof, etc.

The answers to these questions have not been clearly provided by the law yet. Since, bonus debentures and bonus shares share some similarities; there remains ambiguity whether or not the Courts can apply the general principles applicable to the issue of bonus shares while deciding under Section 391 of the Companies Act, 1956 whether or not to sanction the issue bonus shares, or even while adjudicating upon any matter related the bonus debentures.

Further, another issue is that unlike in case of bonus shares, there is no express pre-condition to the issue of bonus debentures that the latter cannot be issued in lieu of the payment of dividends. On one hand, it may be argued that there is no need for having such provision for the issue of bonus debentures. This is because, unlike in case of bonus shares, with respect to the bonus debentures there is an in-built check for the company against issuing bonus debentures in lieu of dividends due to the prospects of having its obligations to pay Dividend Distribution Tax, regular and compulsory payment of interest and redemption amount upon maturity. However, this argument is flawed. This is because had this been the case, there would have been no need for imposing such restriction upon the issue of bonus shares because in a way such an in-built test also exists w.r.t the bonus shares in the form of the apprehension of lowering of Earning per Share upon the expansion of equity base. Therefore, it is important to impose pre-condition upon the issue of bonus debentures that such debentures cannot be issued in lieu of the payment of dividends. This would protect the interest of those shareholders whose interest lies in being paid by way of dividends instead of waiting for the long term benefits. Furthermore, such a pre-condition regarding the issue of bonus debentures is needed to complement the function of Section 63(3) under the Companies Act, 2013 or to ensure that the reason behind enacting Section 63(3) does not get defeated. Under ­­­Section 63(3), a company cannot issue bonus shares in lieu of its payment of dividends. This has been done to protect the investors’ interest by ensuring that the company does not abstain from paying dividends even in instances of profitability by pacifying the shareholders by issuing the bonus shares instead. In absence of a similar restraining pre-condition to the issue of bonus debentures, the company may end up issuing bonus debentures in lieu of payment of dividends because it is aware that it cannot issue bonus shares by evading the payment of dividends. This would partially defeat the objective that Section 63(3) of the Indian Companies Act, 2013 seeks to fulfill. Therefore, in order to assist Section 63(3) in fulfillment of its purpose, it is crucial that an explicit pre-condition is enacted to the issue of bonus debentures that such debentures cannot be issued in lieu of the payment of dividends.

In conclusion, it is important to address the issues and concerns that are presently in existence and which in certain cases explain the reasons behind the infrequent use of bonus debentures. Two major changes which need to be brought are to simplify the procedure related to the issue of debentures and to incorporate direct provisions under the Companies Act dealing specifically with the issue of bonus debentures so that the ambiguities of law in the matter can be solved substantially, if not fully.

- Priya Garg

[1] In the present post, the provisions of Companies Act, 2013 have been analyzed. However, with respect to the provisions of Companies Act, 1956 whose corresponding provisions under Companies Act, 2013 have not been enforced yet, the former have been cited.

Monday, July 18, 2016

Risk Management and Corporate Governance

The current edition of the NSE Quarterly Briefing is on “Risk Management and the Board of Directors in Indian Firms” and is drafted by Professor Afra Afsharipour. The executive summary is as follows:

- Enterprise Risk Management (“ERM”) is a systematic and holistic approach for firms to address all their risks, whether operational, strategic or financial.

- Although not involved in the everyday management of risk, the board of directors plays an important oversight role in ERM by guiding and reviewing the company’s risk policy and ensuring that an effective risk management system is in place.

- Like elsewhere in the world, India’s regulatory structure provides that the board must play a central role in risk management.

- Corporate India has become much more engaged with ERM, although there is room for improvement.

- Enhancing the board’s risk management role can help address the many complex areas of risk faced by Indian firms.

Wednesday, July 13, 2016

India-Mauritius DTAA Protocol: Analyzing the Impact

[The following guest post is contributed by Aarush Bhatia, who is a 5th year B.A.LL.B (Hons.) student at CNLU, Patna]


The protocol[i] dated 10 May 2016 amending the Double Taxation Avoidance Agreement (DTAA) between India and Mauritius is arguably the most significant changerelating to direct taxes in India in recent years, considering that approximately a third of all foreign investments into India are structured through Mauritius. The shift to source based taxation of capital gains from the hitherto residency based taxation is its most important feature.

To summarize, capital gains arising on sale of shares of an Indian company by a Mauritian resident shall be taxable in India (where the source of income lies) as against the earlier position of taxability in Mauritius (based on the residency of the seller). Since the amended protocol refers to shares, both equity as well as preference should be covered. The government has however, mitigated the immediate impact of the protocol on investorsby grandfathering all investments made through Mauritius in shares of Indian companies until 31 March 2017. The protocol provides for a relaxation in respect of capital gains arising to Mauritius residents for shares acquired on or after 1 April 2017 and sold before 1 April 2019, i.e. the transition period. The tax rate on any such gains shall be limited to 50% of the domestic tax rate in India, subject to a limitation of benefits (LOB) clause. The LOB clause states that the benefit of the reduced tax rate shall only be available to such Mauritius resident who is:

(a) not a shell/conduit company; and

(b) satisfies the main purpose and bonafide business test.

It provides that a Mauritius resident shall be deemed to be a shell/conduit company if its total expenditure on operations in Mauritius is less than INR 2,700,000 (approximately 40,000 US Dollars) in the 12 months immediately preceding the alienation of shares. The capital gains tax shall be levied at its full rate only after 1 April 2019.

Impact Analysis

While the manner in which the protocol is sought to be brought into effect is venerable, a more detailed analysis is required in order to fully understand its ramifications on foreign investors. Some of the protocol’s latent ambiguities and wider impact have been scrutinized in this post.

1.         Taxation of Hybrid Instruments

The press release is silent about hybrid instruments like compulsory convertible debentures and futures and options transactions. For instance, foreign investors invest into Indian companies through convertible instruments, with the most common being compulsorily convertible debentures. If such instruments are converted after 1 April 2017, can it be said that the shares are acquired after 1 April 2017 and accordingly taxed in India? It needs to be seen whether any benefit can be obtained from the recently introduced Rule 8AA of the Income-tax Rules, 1962 (which provides that the period of holding shall include, the period for which debenture is held prior to conversion) for determining the date of acquisition of shares.[ii] This issue needs to be clarified under  the text of the protocol as and when it is released by the Central Board of Direct Taxes (CBDT).

2.         Impact On Other Beneficial DTAAs

The protocol has a contagion effect on other DTAAs as well. The position on capital gains under Article 6 of the India-Singapore DTAA is co-terminus with the benefits available under erstwhile provisions on capital gains contained in the treaty with Mauritius. Consequently, with the amendment in India- Mauritius DTAA, alienation of shares of an Indian Company by a Singapore Resident after 1 April 2017 may not necessarily be entitled to obtain the benefits of the existing provision on capital gains as the beneficial provisions under the India-Mauritius DTAA would have terminated on such date. However, clarity is required with regard to grandfathering and transition period provisions.[iii]Further, India has asked the Netherlands to resume negotiations on amending their bilateral tax treaty as the government extends its efforts to plug loopholes in such accords to curb misuse. The Dutch tax treaty, which allows exemption from capital gains and a lower rate of tax on dividends, has led to the proliferation of holding company structures.[iv] While Cyprus is the only other nation whose treaty presently offers capital gains tax exemption to investors, it had been a notified non-cooperative jurisdiction since 2013 for failure to share adequate data on tax evaders.  The government has now got Cyprus to similarly amend the India-Cyprus DTAA. According to the new agreement, Cyprus investors’ capital gains on investments made in Indian companies after March 31, 2017 can be taxed in India. These provisional agreements are awaiting Cabinet approval.

It is speculated that Cyprus has agreed to give India the right to tax capital gains similar to the provision in the revised India-Mauritius tax treaty subject to being removed from the blacklist.

3.         Indirect Transfers

While the direct transfer of Indian company shares by a Mauritius resident after 1April 2017 shall be taxable in India, indirect transfers may still remain out of the Indian domestic tax net. To illustrate, in a structure where there are two Mauritius companies say M Co 1 and M Co 2 wherein M Co 1 holds shares of M Co 2 which in turn holds Indian company shares and derives substantial value from India. In such a situation transfer of shares of M Co 2 by M Co 1 leading to an indirect transfer of Indian company shares may still not be taxable in India.[v]

4.         Group Reorganizations

A clarification would also be required regarding application of grandfathering in case of shares allotted to a Mauritius resident pursuant to a merger or demerger in lieu of shares held in the merging or the demerged entity which were acquired before 1 April 2017.[vi]

5.         Most Favoured Nation (MFN) Clause

The lowering of withholding tax (WHT) on interest to 7.5% under the new protocol has provided succour in favour of debt securities like CCDs. While the WHT of 7.5% is lower than the one provided in other DTAAs like Netherlands (10%), Singapore (15%), UAE (12.5%), etc., most DTAAs entered into by India contain MFN clauses, pursuant to which if India enters into a Convention, Agreement or Protocol with another country which reduces the tax rate of items of income like interest income, then such reduced tax rate shall apply in case of their DTAA as well. It remains to be seen whether the rate of WHT under other DTAAs will automatically reduce as a consequence of the protocol.

6.         Impact on Investment Through Participatory Notes (P-Notes)

P-Notes are derivatives issued by FIIs to investors for the underlying securities invested by the FIIs on the Indian stock markets. Mauritius was the most suitable jurisdiction to invest through P-Notes as several FIIs were setup in Mauritius to avail of the India-Mauritius tax treaty benefits. The P-Notes enjoyed the same capital gains benefit as the FIIs enjoyed at the time of transfer of shares by the FIIs on the Indian securities.This benefit would now cease to be available. While it can be argued that GAAR would have checked treaty abuse anyhow without amending the treaty, it is speculated that the real reason behind this amendment seems to be to restrict investments through P-Notes to prevent round-tripping of money. Withdrawal of the treaty benefits would make this route unattractive for such investors.


The protocol seems to be the final chapter in along drawn tussle between investorsand the revenue. The phased manner of withdrawal of benefits by the government is laudable, especially after its retrospective taxation misadventure post the Vodafone case. While the press release clears the air regarding treaty benefits in no uncertain terms, its collateral impact as analyzed would be clear only after the text of the protocol is releaased. The details of the ‘main purpose’ test and the ‘bona fide purpose’ test stated in the press release too are unclear. There is a possibility that these tests may be subjective and lead to some uncertainty regarding the taxability of investments made during the Interim Period.

-Aarush Bhatia

[i]Protocol for amendment of the Convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital gains between India and Mauritius available at
[ii]Sahil Aggarwal, Protocol to India-Mauritius DTAA: A move towards avoidance of double non-taxation, available at
[iii] Ibid
[iv]DeepshikhaSikarwar, After Mauritius, now government wants to amend Dutch tax treaty; asks Netherlands to resume talks, (Economic Times, May 30th 2016) available at
[v] Amit Bahl, Harsh Biyani and SurbhiBagga, Protocol amending India-Mauritius DTAA: Key changes and their impact, available at