Author Archives: novojuris

Income Tax clearance: M &A or secondary transactions

Obtaining a no objection certificate or prior permission under section 281 of Income Tax Act, 1961 (Section 281 Certificate) is a mandatory ‘conditions precedent’ in a merger, acquisition or a secondary transaction. A general disdain is the time it takes to obtain the permission. Without the permission, the transaction could risk being voided by the tax department.

This article analyses the significance of the Section 281 Certificate, when should it be procured and implications if not procured.

tax certificate

Breaking down Section 281

As per Section 281 of the Income Tax Act (“Act”), in the event an assessee creates a charge or parts with the possession (by way of sale, mortgage, gift, exchange or any other mode of transfer whatsoever) of, any of his assets in favour of any other person, during the pendency of any proceeding under the Act or after the completion thereof, but before the service of notice under Rule 2 of the Second Schedule of the Act, such charge or transfer shall be void as against any claim in respect of any tax or any other sum payable by the assessee as a result of the completion of the said proceeding or otherwise. As per the explanation to the section, ‘asset’ includes shares and securities as well.

The section has the following exceptions in which case, such charge or transfer is not void:

  • if it is made for adequate consideration and without notice of the pendency of such proceeding or, as the case may be, without notice of such tax or other sum payable by the assessee; or
  • if it is made with the previous permission of the assessing officer.

It may also be noted that this section applies to cases where the amount of tax or other sum payable or likely to be payable exceeds Rs.5000 and the assets charged or transferred exceed Rs.10,000 in value.

In a nutshell, section 281 of the IT Act requires an assessee to obtain the permission of the assessing officer before creating a charge on certain assets or transfer of certain assets in the event there are ongoing tax proceedings or pending claims/demands against such assessee. The main objective of section 281 is to safeguard the interests of the revenue against assessees who may fraudulently part with their assets to avoid payment of taxes.

Process for obtaining Section 281 Certificate

The Central Board of Direct Taxes through its Circular No. 4/2011 [F. NO. 402/69/2010-ITCC], dated 19-7-2011 (“Section 281 Circular”), has issued certain guidelines for obtaining the Section 281 Certificate. The format of the application (which also mentions the documents and other information to be provided) is also provided in the said Circular. The assessing officer may, at his discretion, ask for additional documents. The application is to be filed at least 30 (Thirty) days prior to the proposed transaction. The Section 281 Circular also contains the circumstances under which Section 281 Certificate could be granted by the assessing officer, the timelines within which the assessing officer has to grant/refuse the permission under section 281 and the validity of the certificate granted. It is interesting to note that the Circular provides for an approval timeline of 10-15 days.

It may also be noted that the assessing officer would require the approval from the Range Head for granting permission if the value of assets being transferred or on which charge is being created, or the amount of charge being created is Rupees Ten crores (Rupees Hundred Million) or more.

Analysis of Section 281

Going by the strict interpretation of section 281, the Certificate is required only when an assessee creates a charge or parts with possession of any asset, under the following circumstances:

  • If the transfer is made during the pendency of any proceeding under the Act, or
  • After the completion of any proceeding under the Act but before the service of notice under rule 2 of the Second Schedule of the Act.

It appears that strict interpretation seems narrow.

In most cases, in a M & A or in a secondary sale of securities, the purchaser insists on Section 281 Certificate to de-risk a possibility of a tax claim which in turn would impact the purchase consideration. As an extension to that, the purchaser also wants to apriori know of the possibility of tax claims, before releasing the purchase consideration. Hence, Section 281 Certificate is almost always a Conditions Precedent to the transaction. In cases where it takes a long time to obtain the Section 281 Certificate, the purchaser reluctantly moves it as a “conditions subsequent” but with a personal guarantee or specific indemnities from the seller/s to de-risk the possibility of the transaction being considered void by the tax authority.

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Cabinet to consider relaxing FDI norms to attract Overseas Investment

Foreign Direct Investment (FDI) is major driver of growth and development of the economy of the country. With this intent, the Government of India has time and again come up with investor friendly reforms under FDI regulations to have more liberalized reforms across various sectors.

To boost up FDI, the Union Cabinet headed by Prime Minister Narendra Modi on 28 August 2019, has approved the proposal for reviewing of the FDI policy on various sectors. They have considered relaxing foreign direct investment (FDI) norms in several sectors, including coal mining, manufacturing, single-brand retail and digital media, to attract overseas players.

The key highlights of the proposed changes are as follows:

Coal Mining

The present FDI policy allows 100% FDI under automatic route for captive coal mining only. The captive coal mining deals with coal & lignite mining for captive consumption by power projects, iron & steel and cement units and other eligible activities. Along with the captive coal mining, 100% FDI under automatic route is also allowed for setting up coal processing plants like washeries. However, the companies are prohibited to sell washed coal or sized coal from its coal processing plants in the open market and supply the washed or sized coal to those parties who are supplying raw coal to coal processing plants for washing or sizing.

This proposal aims at allowing 100% FDI under automatic route for “Associated Processing Infrastructure”. Associated Processing Infrastructure includes coal washery, crushing, coal handling, and separation (magnetic and non-magnetic). This proposal has opened 100% FDI for selling coal subject to provisions of Coal Mines (Special Provisions) Act, 2015 and the Mines and Minerals (Development and Regulation) Act, 1957.

In crux

  • 100% FDI under automatic route is allowed for Associated Processing Infrastructure.
  • 100% FDI under automatic route is allowed for sale of coals.

Contract Manufacturing

Contract manufacturing in international markets is used in situations when one company arranges for another company in a different country to manufacture its products. This concept is not captured in Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 and therefore there is no clear laws and rules regulating FDI in contract manufacturing in India. Therefore, the Government through this proposal has allowed to include contract manufacturing under the manufacturing sector and has allowed 100% FDI under automatic route. Manufacturing activities may be conducted either by the investee entity or through contract manufacturing in India under a legally tenable contract, whether on Principal to Principal or Principal to Agent basis.

In crux

  • Contract manufacturing included as an activity under the manufacturing sector.
  • 100% FDI under automatic route is allowed for contract manufacturing.

Single Brand Retail Trade (SBRT)

The present FDI policy provides that 30% of the value of goods has to be procured from India if SBRT entity has FDI more than 51% and the same can be met as an average during the first 5 years, and thereafter annually towards its India operations. As regards local sourcing requirement, the Government has decided to count procurements made from India by the SBRT entity for that single brand as local sourcing, irrespective of whether the goods procured are sold in India or exported. Also, the Government would relax the cap of 5 years by removing it. The approvals allow ‘sourcing of goods from India for global operations’ can be done directly by the entity undertaking SBRT or its group companies (resident or non-resident}, or indirectly by them through a third party under a legally tenable agreement.

The present policy limits the global sourcing by stating that only that part of the global sourcing shall be counted towards local sourcing requirement which is over and above the previous year’s value. The Government is trying to relax this restriction by considering sourcing from India for global operations shall be considered towards local sourcing requirement.

The present FDI policy states that if any SBRT wants to trade through e-commerce, they would be required to operate through brick and mortar stores before trading through e-commerce. The Government by approving this proposal is relaxing the said condition by allowing SBRT to operate through e-commerce subject to the opening of brick and mortar stores within 2 years of starting to trade online.

In crux

  • Goods procured are sold in India or exported to be considered as local sourcing.
  • The 5 years cap removed.
  • No incremental value for calculating local sourcing requirement.
  • SBRT can trade through e-commerce prior to having a brick and mortar store.

Digital Media

The present FDI policy is silent on the fast-growing digital media segment. In the print media sector, 26 percent FDI is allowed through government approval route. Similarly, 49 percent FDI is permitted in broadcasting content services through government approval route. With this proposal, it has been decided by the Government to permit 26% FDI under government route for uploading/ streaming of News & Current Affairs through Digital Media, on the lines of print media.

In crux

  • Introduction of the concept of digital media
  • 26% FDI under governmental route is allowed for uploading/ streaming of News & Current Affairs through Digital Media.

The proposed change reflects that the Government is keen on promoting FDI in various sectors. These amendments are meant to liberalize and simplify the FDI policy to provide ease of doing business in the country. These changes will lead to benefits of increased investments, employment and growth.

Source:  https://pib.gov.in/PressReleseDetail.aspx?PRID=1583294

Extension of Order Permitting Telangana Shops & IT/ITES to remain open on all days of the year

Government of Telangana vide Government Order (G.O.) No.24 dated July 25, 2019[1], extended the permissions to all Shops and Establishments to keep open on all days of the year for a period of three (3) years till June 15, 2022 subject to fulfilment of the conditions in the extension G.O.

Further, vide G.O. No. 25 dated July 25, 2019[2], the Telangana Government also extended the exemption issued to all Information Technology (IT) and IT-enabled services (ITES) establishments in Telangana with regard to the below provisions for a period of five (5) years till May 29, 2023:

  1. Section 15: Prohibition on keeping open of establishments before/after the fixed hours
  2. Section 16: Daily work of eight (8) hours and weekly work of 48 hours
  3. Section 21: Prohibition on employment of young persons between the age of 14 to 18 years after 7 pm and before 6 am
  4. Section 23: Prohibition on employment of women after 8:30 pm and before 6 am
  5. Section 31: Mandatory five (5) holidays on Republic Day, May Day, Independence Day, Gandhi Jayanthi and Telangana formation day

Earlier the exemption was in effect for five (5) years from May 30, 2013 in the combined State of Andhra Pradesh, while this G.O. 25 is applicable only for the State of Telangana.

[1] https://labour.telangana.gov.in/content/gos/GOMsNo24_Exempt_to_all_Shops365_days.PDF

[2] https://labour.telangana.gov.in/content/gos/GOMsNo25_Exemption_to_IT.PDF

Creche rules notified in Karnataka for establishments with 50 or more employees

Karnataka State Government vide Gazette Notification No.LD 127 LET 2018 dated August 8 2019, notified the Karnataka Maternity Benefit (Amendment) Rules, 2019 (“Karnataka Creche Rules”), wherein new rules relating to crèche facilities is inserted in the Karnataka Maternity Benefit Rules, 1966.

Earlier, the Central Government vide Gazette Notification dated March 28, 2017 had amended the Maternity Benefit Act, 1961 (“Act”) by inserting a new Section 11A mandating every establishment with fifty or more employees to have the facility of crèche and also to intimate in writing and electronically to every woman at the time of her initial appointment regarding every benefit available under the Act.  Further, the Central Government vide Gazette Notification No.S.O. 1026(E) dated March 31 2017, & S.O. 1049 (E) dated April 3 2017, had notified that the crèche related provision will be effective from July 1, 2017.

Further, the Government of India vide its Circular dated November 17 2017, requested that the State Governments being the appropriate Government under the Act, may take immediate action to frame and notify rules for the crèche facilities. The Karnataka State Government had published the draft rules on July 21 2018, inviting comments from the public and the present Karnataka Creche Rules was notified effective from the date of publication in the Official Gazette.

The compliance under the Karnataka Creche Rules is shown in the below table:

Standards Compliance Requirements
Number of Creches
  • One crèche for use of children below 6 years of age for every thirty children
  • Creche facility to be provided to employees of all types of employment like permanent, temporary, regular, daily wage, contract labour etc.
Location
  • To be situated within half a kilometre from the gate of the establishment
  • Easy access to the parents
  • To be away from excessively noisy process or dust/fumes/odours etc.
Building
  • Construction of room height of at least 9 feet with heat resistant material and waterproof with fencing
  • 5 Square Feet floor area for each child in crèche
  • Shady open-air playground well maintained/safe/secure or ensure safety/security in case of use of public playgrounds or parks
  • Artificial lightning to be connected with emergency power back up
  • Kitchen or in its absence, employer to make available hygienic food/beverages
  • Dedicated water purifier & washbasins at 1 for every 15 children
  • Washroom adjoining crèche with a separate facility for drying of soiled clothes and change of dresses
  • Separate ‘Latrine’ for children at 1 for every 20 children and separate ‘Latrine’ for staff/mothers adjoining the bathroom
Facilities
  • To be open 24/7 for employees working in shifts  with not more than eight hours a day per shift
  • Uniforms and clean clothes for staff as well as children
  • Water supply at the rate of 5 gallons per child per day
  • Supply of clean towels, oil and soap
  • Play and teaching materials, display of daily schedule/norms of child safety etc.
  • Medical check-up of children before admission and once in two months
  • Recording of Body-Mass Index once a month and other medical examination to be stored in the crèche
  • 250 ml of milk per child below the age of two years and adequate refreshments for child above two years
Equipments
  • Cradles
  • Cots
  • Beds
  • Mattresses
  • Cotton Sheets
  • Utensils to feed
  • Furniture for child and parents
  • Rubber sheets
  • Blankets
  • Pillow
  • First Aid Kit/ Medicine Kit
  • Toys
Staff
  • One women ‘Teacher cum Warden’ who is Government recognized qualification  holder & training in childcare
  • One woman ‘Creche Attender’ who is qualified or trained in midwifery
  • One woman ‘Ayah’ for every 10/15 children

Source: Kindly click here to access the notification

RBI on Processing of e-mandate on cards for recurring transactions

Reserve Bank of India (“RBI”) vide its notification on August 21 2019 has permitted the processing of e-mandate on cards for recurring transactions (“Notification”). RBI has put in place various safety measures for card payments including the requirement of additional factor of authentication (AFA), especially for ‘card-not-present’ transactions. With this view in mind RBI earlier in 2011 notified that recurring transactions based on the standing instruction given to the merchant was to be brought within the ambit of AFA.

Keeping abreast with the changing payment needs RBI has permitted e-mandate on cards for recurring transactions with AFA during e-mandate registration, modification and revocation, and also for the first transaction and subsequent successive transactions.

APPLICABILITY:

This Notification shall become effective from 1st September 2019, and shall be applicable to all types of cards i.e. debit, credit, pre-paid instruments (PPI) including wallets. Further, the e-mandate arrangement shall be only for recurring transactions and not for a one-time payment. Kindly note that the maximum limit for a transaction under this arrangement is INR2000/- and no charges are levied on the cardholder for availing the e-mandate facility.

CONDITIONS TO BE FULFILLED FOR PROCESSING E-MANDATE ON CARDS FOR RECURRING TRANSACTIONS:

  1. Registration of card details for e-mandate– The cardholder who wishes to opt for the e-mandating facility shall undertake a one-time registration with AFA validation by the issuer. Further, the registration shall only be complete after all the requisite information is obtained by the issuer. Kindly note that the cardholder at the time of registration is given an option to provide the e-mandate for either a pre-specified value of recurring transactions or a variable value; in case of the latter, the cardholder shall clearly specify the maximum value of the recurring transaction (currently INR2000/- per transaction).
  2. Processing of the first transaction and subsequent recurring transactions- AFA validation shall be performed for processing the first transaction in the e-mandate based recurring transaction. Kindly note the AFA validation may be combined if the first transaction is being performed along with the registration of e-mandate. Further, any subsequent recurring transaction shall be only performed for those cards which have been successfully registered and for which the first transaction has been authenticated and authorised. Kindly note that the subsequent transitions may be performed without AFA.
  3. Pre-transaction notification- To mitigate the risk the issuer shall send a pre-transaction notification at least 24 hours to the cardholder. It is at the time of registering for the e-mandate on the card, the cardholder shall be given the option for receiving the notification through SMS, email, etc. In addition, the cardholder is also given a facility to change the mode of receiving the notification. Kindly note that the pre-transaction notification shall inform the cardholder about the name of the merchant, transaction amount, date/time of debit, reference number, and reason for debit. The same information shall be notified for a post-transaction notification. Finally, at the time of a receipt of a pre-transaction notification, the cardholder shall be provided with an option to opt-out of that particular transaction or the e-mandate. Any such opt-out shall require an AFA validation by the issuer.
  4. Withdrawal of e-mandate- The cardholder shall be given an online facility to withdraw any e-mandate at any point of time by the issuer. However, the exception to this will be a pipeline transaction for which a pre-transaction notification has been communicated to the cardholder and the debit has not been communicated to the cardholder. After an e-mandate is withdrawn the acquirer shall ensure that the merchants on-boarded by them delete all the details including the payment instrument information.
  5. Dispute resolution and grievance redressal- The issuer shall put in place an appropriate redress system with a clear turnaround time for lodging and resolving the grievances put forward by the cardholder. Further, the card network shall make arrangements to separately identify chargebacks and disputes in respect of e-mandates based recurring payments. Also, it is the responsibility of the acquired to ensure that the merchants fulfil the compliance as laid down in this Notification.

Source: https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11668&Mode=0

“APPOINTED DATE” IN CASE OF MERGER AND AMALGAMATION

The Ministry of Corporate Affairs (the MCA) vide its notification dated 21 August 2019, has provided a clarification with respect to interpretation of section 232(6) of the Companies Act (Act). Section 232(6) of the Act states that the scheme under section 232 of the Act shall clearly indicate an appointed date from which it shall be effective and the scheme shall be deemed to be effective from such date and not at a date subsequent to the appointed date. The circular has been brought in furtherance of several queries which have been received by MCA. The two important clarification sought are:

  1. Whether it is mandatory to indicate a specific calendar date as ‘appointed date’ in the scheme? and
  2. Whether the ‘acquisition date’ for the purpose of Ind-AS 103 (Business combinations) would be the ‘appointed date’ referred to in section 232(6)?

Prior to issuance of the aforementioned clarification for the first query, the MCA has referred to decision of Supreme Court in the case of  Marshall Sons & Co. India Ltd. v. lTO [223 lTR 809] where the court held that the date on which the amalgamation shall take place can be a date prior the filing of the sanctioning of the scheme by the Court, the date of filing of certified copies of the orders of the Court before the Registrar of Companies (the ROC) (i.e. Appointed Date). However, the scheme would be effective from the Appointed Date only after the order of the Court is filed with the RoC. The MCA also referred to the judgement held in Equitas Housing Finance Limited and Equitas Micro Finance Limited in C.P.Nos.l 19 to 121 of 2016 where the court was the of opinion that appointed date need not necessarily be a calendar date but can be a date tied to the occurrence of a relevant event.

Section 232(6) provides the companies a choice to decide and state a date from which the scheme shall be enforceable. The two options available while deciding the date are:

(i) a specific calendar date, or

(ii) date tied to the occurrence of an event such as of license by a competent authority or fulfilment of any preconditions agreed upon by the parties or meeting any other requirement as agreed upon between the parties, etc., which are relevant to the scheme.

In case the parties to the scheme of merger/amalgamation choose the ‘appointed date’ to be a calendar date, such date can be a date preceding the date of filing the scheme with National Company Law Tribunal. If the ‘appointed date’ is significantly dated beyond a year from the date of filing the scheme, a reason for the same has to be specifically captured in the scheme and such reason shall not be against public interest. Where the ‘appointed date’ is date tied to the occurrence of a relevant event to the scheme, such an event shall be specifically indicated in the scheme on the occurrence of which the scheme would be effective. However, in a situation where ‘appointed date’ is a date subsequent to the date of filing the order with the ROC under section 232(5) of the Act, the company has an obligation to file an intimation of the same with ROC within 30 days of such scheme coming into force and being effective.

With regard to the second query, the MCA states that the ‘acquisition date’ shall be same as ‘appointed date’ mentioned under the scheme and shall also be deemed to be the date of transfer of control for the purpose of conforming to accounting standards (including Ind-AS 103 Business Combinations).

Source: http://www.mca.gov.in/Ministry/pdf/GeneralCircular_21082019.pdf

Differential Voting Rights: Helping Tech Companies to an easy climb up the mountain of entrepreneurship

There is a common and a convenient rule of one vote – one share practised by most of the companies. This rule is generally referred to as voting rights on ordinary shares. However, when there is a requirement to deviate from this rule, the concept of differential voting rights comes into play. This differential voting rights are known as DVRs in India and dual-class shares or DCS in the international perspective. These DVRs are rights which are disproportionate to their economic ownership. When a promoter or shareholder wants to retain decision making powers and rights, they can do so by retaining shares with superior voting rights or by issuing of shares with lower or fractional voting rights to other investors.

The concept of DVR has been captured in the Companies Act, 2013 under Section 43 (a)(ii) which says, that a company limited by shares may have equity share capital with differential rights on voting, or dividends, or otherwise. Rule 4 of the Companies (Share Capital and Debentures) Rules, 2014, provides certain conditions which are required to be complied with, for issuance of shares with differential rights. SEBI (Listing Obligations and Disclosure Requirement) Regulations, 2015, (“SEBI (LODR) Regulations, 2015”) also dealt with DVRs, but, it prohibited the listed companies from issuing shares with superior voting rights.

The need for DVR

In the current era, India is going through vast developments and advancement in many sectors especially the technology and information technology sector. These developments and advancements require huge capital. For raising capital, the companies seek investments, but these frequent and vast investments may lead to dilution of founder/ promoter stake. In order to cope with this, issuance of DVRs are helpful.

The journey of the framework

Earlier in 2000, the concept of DVR came to India through the Companies Act, 1956, whereby Indian companies were allowed to issue DVRs. However, in 2009, the Securities and Exchange Board of India (SEBI) had disallowed the issue of shares with superior rights to voting or dividend by listed companies, but they were permitted to issue shares with fractional voting rights. In order to bring the new framework, SEBI had invited comments from public on a Consultation Paper named ‘Issuance of shares with Differential Voting Rights (DVRs)’ (Consultation Paper[1]). It dealt with both the shares with superior rights (Superior Rights Shares or SR Shares) and inferior rights (Fractional Rights Shares or FR Shares). The framework got approved by SEBI in its board meeting on June 27, 2019 , permitting issuance of SR share by listed company and disallowing issuance of FR shares.

A walk through in to the new framework

Eligibility conditions: 

A company to be eligible to issue DVRs in form of SR shares, shall adhere to the following conditions:

  1. The company issuing SR share shall be technology company. SEBI defines a technology company as one that is “intensive in the use of technology, information technology, intellectual property, data analytics, bio-technology or nano-technology to provide products, services or business platforms with substantial value addition”.
  2. The SR shareholder should be a part of a promoter group and whose collective net worth does not exceed INR 500 crore. The investment made by SR shareholders in the shares of the issuer company will not be considered while determining the collective net worth.
  3. The SR shall be issued only to promoters/founders who hold an executive position in the company.
  4. The issuance of the SR shares should be authorized by passing a special resolution in the general meeting.
  5. SR shares have been held for at least 6 months prior to filing the Red Herring Prospectus (RHP).
  6. SR shares should have voting rights in the ratio of minimum 2:1 and maximum 10:1 compared to ordinary shares.

Listing and lock-in period: Post the IPO, the issuer company can list the SR shares on Stock Exchanges. However, SR shares are subject to lock-in after the IPO, until they are converted into ordinary shares. Transferring, pledging or lien of SR shares among promoters is prohibited under the framework.

Rights of SR shares: Except for voting on resolutions, the SR shares will be treated at par with ordinary shares in all other aspects. The total voting rights of SR shareholders (including ordinary shares), post listing should not exceed 74%.

Additional rules for companies with SR shareholders pertaining to enhanced corporate governance: The listed  companies issuing SR shares shall comply with the following rules for “enhanced corporate governance” such as:

  1. i) As prescribed under the SEBI (LODR) Regulations, 2015, Independent directors should comprise at least 1/2 of the board and 2/3 of committees (excluding the audit committee) and
  2. ii) The audit committee should only have Independent Directors.

Coat-tail provisions: After the IPO, the SR shares will be given same treatments as ordinary equity shares in terms of voting rights with respect to the following matters:

  1. Appointment or removal of Independent Directors and/or Auditors
  2. Cases where promoter is willingly transferring control to another entity
  3. Related Party Transactions involving SR Shareholder as per SEBI (LODR) Regulations, 2015
  4. Voluntary winding up of the Company
  5. Alteration of the Articles of Association or Memorandum of Association, except any such changes affecting the SR shares
  6. Voluntary Resolution Plan initiated under Insolvency & Bankruptcy Code, 2016
  7. Funds utilized for purposes other than business
  8. Substantial value transaction based on materiality threshold as prescribed under SEBI (LODR) Regulations, 2015
  9. Passing of special resolution for buy-back or delisting of shares
  10. Any other provisions as notified by SEBI from time to time

Sunset clauses: SR shares can be converted under two circumstances:

  1. Time based: After 5 years of listing, the SR Shares shall be converted to Ordinary Shares. By passing a resolution, the validity can be extended only once by 5 years. However, the SR shareholders shall not be allowed to vote on such resolution.
  2. Event based: In the event of demise, resignation of SR shareholders, merger or acquisition where the control would be no longer with SR shareholder, etc., the SR shares shall be compulsorily get converted into Ordinary Shares.

Changes to be incorporated in various laws pursuant to DVR framework:

The Companies Act, 2013: As stated earlier, under Section 43(a)(ii) of the Companies Act, 2013, and Rule 4 of the Companies (Share Capital & Debentures) Rules, 2014 framed under the Companies Act, 2013 prescribes that shares with DVRs in a company, shall not exceed 26% of the total post-issue capital. However, the new framework extends the limit to 74%. Therefore, corresponding changes are required to be brought in the Companies Act, 2013.  Another limiting factor in the Companies Act, 2013 is that “the company must have a consistent track record of distributable profits for the last 3 years”, but criteria for 3 years is silent on IPOs.  Such a criteria may not be helpful and rather impossible for all start-ups. Therefore, this matter should also be taken into consideration.

Securities Contracts (Regulation) Rules, 1957 (‘SCRR’): A company with multiple classes of equity shares at the time of undertaking an IPO, is required to make an offer of each such class of equity shares to the public in an IPO. Further, Rule 19(2)(b) of SCRR provides that minimum dilution and minimum subscription requirements as prescribed have to be complied with, separately for each class of the equity shares. It is a mandatory requirement under the rule that all kinds of shares shall be listed. There is no provision for listing one kind of share and not listing another. As the new framework demands for listing of SR shares without offering to public, it leads to a doubt for a company with different classes of shares whether it should proceed with listing all kinds of share or keep few of such equity shares unlisted. Therefore, a clarification is required in this regard.

SEBI (LODR) Regulations, 2015: Under regulation 41(3) of SEBI (LODR) Regulations, 2015, it has been stated that listed entity shall not issue shares which may confer to a person SR right on equity shares which are already listed. Therefore, an amendment is required which permits the grant of SR shares to equity shareholders.

SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“SEBI Takeover Code”): Regulation 3 and 4 of SEBI Takeover Code provides that when an acquirer is holding 25% or more of the shares or voting rights in a target company, it has an obligation to make a public announcement of an open offer. Based on the stated Regulation of SEBI Takeover Code and the new DVRs framework, Regulation 10 is required to be amended in such a manner that Regulation 3 would not get triggered for making an open offer if the stated threshold is crossed by reason of SR shares getting lapse or converted into ordinary equity shares, provided that there is no attendant change in control in favor of the person crossing such threshold.

Further, Regulation 29 of SEBI Takeover Code requires disclosure for acquisition of additional voting right by holder of ordinary equity share. Since the change in voting rights brought after the conversation of SR shares to ordinary shares, which is an involuntary act on behalf of holder of ordinary equity share, there is a requirement of bringing change in format of disclosure under Regulation 30 of SEBI Takeover Code.

The pros and cons of DVRs:

Advantages from the perspective of issuer:

  • It solves the biggest issue of raising fund without diluting the voting right or the control of the founders/promoters over the company.
  • when there is ordinary equity shares issued to outside investors, there is a possibility that such shareholders acquire majority of the shares of the company and gain control over the management of the company, where as in the case of SR shares, this possibility is minimised.

Disadvantages from the perspective of issuer:

  • It is a challenge for the issuer to find such investors who are not interested in control and management of the company even after investing huge amount of money.
  • Issuing of SR shares is not considered a good corporate governance.

Advantages from the perspective of investor:

  • It is beneficial for those investors who are getting a higher rate of dividend over the ordinary shareholders.
  • The DVRs with FR shares are generally offered at a discount for equal number of shares.

Disadvantages from the perspective of investor:

  • DVRs with SR shares with the founders or large proportion of DVRs with FR shares with public investors, make management excessively powerful and can raise issues of corporate governance.
  • As a result of separating voting right from economic interests, there might be possibilities externalities like management entrenchment, excessive compensation of management, reduced dividend pay-out etc.

Conclusion

When we know that India is still considered to be a developing country and it has a lot of              competition with various other developed and developing states. India should have such corporate and commercial laws which are at par with the corporate and commercial laws of other countries. While India is giving majority of its space for incorporation and functioning of technology companies, it should have DVRs related laws like in US, Canada, Hong Kong etc. Such laws will help in raising the capital of tech companies. The applicability of DVRs law in India will not just help in growth and development of the tech companies in India, but it will also lead Indian tech companies to be good competitors for the tech companies incorporated in other nations.  It would help the promoters/founders of the company to grow their business fast. The only thing to be kept in mind by the companies while adopting such laws  is that, they shall also maintain a good corporate governance in their company.

Authors: Srisha Choudhary and Alivia Das

References:

[1] https://www.sebi.gov.in/web/?file=https://www.sebi.gov.in/sebi_data/attachdocs/apr-2019/1554115093453.pdf#page=1&zoom=auto,-16,800