Author Archives: novojuris

Nidhi Provisions Notified under Companies Act, 2013

 Ministry of Corporate Affairs (“MCA”) vide Notification dated July 1, 2019,  appointed that Section 406 of the Companies Act, 2013 shall come into force from August 15, 2019.

Nidhi company is created for borrowing and lending money between members. Some prerequisites for a Nidhi company are incorporation as public limited company with minimum 200 members, net owned funds to deposits ratio not to be more than 1:20, etc.

Further, MCA vide Notification dated July 1, 2019, has notified the Nidhi (Amendment) Rules, 2019 which amends the Nidhi Rules, 2014 effective from August 15, 2019.  The brief changes are as shown below:

Rule No Existing Amendment effective from August 15, 2019
2(d) Applicability of the rules to company incorporated as Nidhi under Section 406 of Companies Act, 2013 or those under Section 620A of Companies Act, 1956 New rule inserted for applicability to every company declared as Nidhi or Mutual Benefit Society under Section 406(1) of Companies Act, 2013
3(da) Not applicable New rule inserted to define a “Nidhi” which involves a company which accepts deposits from its members and lends to only its members for mutual benefit
3A Not applicable New rule inserted prescribing the procedure for the Central Government to notify a public company as a Nidhi, pursuant to any application made inform NDH-4 and also mandating companies to comply with filing of Form NDH-4 within time limits prescribed, failing which, such companies are disallowed from filing any notice of alteration of capital in Form SH-7 or return of allotment in Form PAS-3
4 A public company could be a ‘Nidhi’ only if incorporated as a Nidhi Omission of parts of the rule that required prior incorporation as Nidhi,
5 (1) Minimum requirements for every Nidhi was to be adhered within one year from commence of the Nidhi Rules, 2014 Now the requirements are to be adhered within one (1) year from the date of Nidhi’s incorporation
5(3) Extension of time could be provided by Regional Director in case a Nidhi files an application in Form NDH-2 to comply with the requirements of minimum 200 members and for maintaining ratio of 1:20 for net owned funds to deposits The time period of extension which can be granted by a Regional Director is now limited to up to one year, through insertion of a proviso
5(4) Nidhi which failed to comply with minimum requirements were prohibited to accept deposits beyond second financial year, unless it complied Even if such Nidhi complied with the requirements beyond second financial year, prohibition to accept deposits continues till a fresh declaration is obtained under Section 406(1) of New Act
7(1) Nidhi were to issue either fully paid up or partially paid-up equity shares of the nominal value Nidhi is prohibited from issue of partly paid up equity shares
12 The application form for a deposit should contain a statement that a depositor could approach RoC over non-payment of deposit The statement is changed so that a depositor can approach only a bench of National Company Law Tribunal.

Further new rule is inserted mandating the mention of the date of declaration or notification as Nidhi in the application for deposit.

23 The Regional Director was empowered to enforce compliance Regional Director is replaced with the Central Government to enforce compliance.

Further two new rules 23A and 23B are inserted to mandate existing Nidhi to get fresh declaration as Nidhi after commencement of the Nidhi (Amendment) Rules, 2019

Form NDH-4 Not applicable Insertion of new form for filing application for declaration as Nidhi Company and for updation of status by Nidhis

Source: http://www.mca.gov.in/Ministry/pdf/NidhiRules_01072019.pdf

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New Compliance under POSH for Entities in Telangana

Telangana Government’s Department of Women Development and Child Welfare vide its Notification on its website, has mandated entities with 10 or more employees to register their Internal Complaints Committee (ICC) constituted under Section 4 of the Sexual Harassment of Women at Workplace (Prevention, Prohibition and Redressal) Act, 2013 (“POSH”) on the T-She box web portal on or before July 15, 2019, failing which a penalty of Rs.50,000/- will be imposed on the defaulting entities.

POSH is an act notified in 2013 with an intention to provide protection against sexual harassment of women at workplace and for redressal of complaints of sexual harassment. Section 6 of POSH mandates that every District Officer should constitute a ‘Local Complaints Committee’ to receive complaints of sexual harassment from establishments where ICC has not been constituted due to having less than ten workers. Hence, every employer with 10 or more employees is required to constitute an ICC with a senior level woman presiding officer, a member from a non-governmental organization and at least two members among the employees.

The present notification in Telangana mandates registering of such ICC with the Department of Woman and Child Welfare.  On a similar note, Karnataka Government vide its Notification dated May 25, 2019, made it mandatory for IT/ITES companies to form an ICC under POSH to avail an exemption till May 24, 2024, from the applicability of Industrial Employment (Standing Orders) Act, 1946.

Source: http://tshebox.tgwdcw.in/

New BEN-2 Form for declaration of Beneficial Owners

Ministry of Corporate Affairs (“MCA”) vide Notification dated July 1, 2019, amended the Companies (Significant Beneficial Owners) Rules, 2018 by substitution of the existing Form BEN-2 for declaration of Beneficial Owners through the Companies (Significant Beneficial Owners) Second Amendment Rules, 2019.

The Companies (Significant Beneficial Owners) Rules, 2018 was framed under Section 90 of the Companies Act, 2013 to identify the owners of a company incorporated by way of multilayered intermediate entities.  Such owners hold shares of a company but will not have any beneficial interest in such shares. These owners having an interest in indirect holding of shares, but their names are not entered in the register of members, are termed as ‘Beneficial Owner’. While such beneficial owner is required to file a declaration in Form BEN-1, the company is required to file a return in Form BEN-2.  These rules were earlier amended on February 8, 2019, whereby the definition of a significant beneficial owner was amended, to one who had a right of at least 10% of shares/voting right or has the right to receive 10% or more of distributable dividend. Form BEN-2 is to be filed within 30 days from the date of receipt of declaration in Form BEN-1. No additional fees is payable if Form BEN-2 is filed within 30 days from the date of deployment on MCA-21.

Source: http://egazette.nic.in/WriteReadData/2019/206373.pdf

New Procedure for filing Annual Return on Foreign Liabilities & Assets

Reserve Bank of India (“RBI”) vide its Circular No.37 dated June 28, 2019, discontinued the existing practice of submission of annual returns on Foreign Liabilities and Assets (FLA) through email to RBI by July 15 of every year.  RBI has provided a web-portal interface https://flair.rbi.org.in to the reporting entities to get an RBI provided login-name and password, using which the entities are required to report inward and outward foreign affiliate trade statistics (FATS).

Since 2012, RBI had mandated filing of the annual return FLA for all Indian companies which have received any foreign investment or has made overseas investment. The procedure for submission of the form was by sending an email to the RBI by July 15th every year attaching a duly filled form in soft copy.

The details sought in the revised Foreign Liabilities and Assets Information Reporting (FLAIR) system include, information on first year of receipt of foreign direct investment/overseas direct investment, disinvestment, and other financial details on fiscal year basis.

 

Source: https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT226CBAA4706347E46429D5034B4671A6F60.PDF

Mooting the utility of Representations & Warranties Insurance Policies in exit deals for a PE and VC Investor

M&As and Investment transactions have been growing rapidly in India and there is no doubt that in such transactions allocating the risk of a breach is extremely important. In the recent past, we are witnessing detailed indemnification clauses including the “loss” related clauses covering grossing up of tax and grossing up of shareholding.

In the secondary sale of shares, venture capital investors are reluctant to provide representations beyond their title in the shares that they hold. Traditionally, such investors will be hesitant in providing any indemnity to potential acquirers because the traditional method of indemnification involves the carry forward of payment rule, wherein the VC investor may be required to indemnify the party beyond a certain time frame as well. Moreover, VC investors have a limited fund life and hence prefer not to have indemnity obligations beyond the life of a fund.

The most common way in which a buyer protects itself is by incorporating provisions of indemnity in the contract which requires the seller to indemnify the buyer for any breach of representation or warranty. Traditionally, indemnification is the most common method of safeguarding one’s interest in a transaction but there were many limitations to this approach, like risks for seller wherein he is not able to receive the remainder of the purchase price, risks for buyer wherein the buyer fears that the fund held back would be insufficient to cover all indemnity claims.

Traditionally used methods to secure the promises of indemnification are:

  1. A holdback of purchase price
  2. Escrow account for indemnification
  3. Unconditional bank guarantees
  4. Set-off against future payments

Representations and Warranties Insurance (“RWI”) could be a substitute or augment the traditional indemnification mechanisms.

There are benefits of an RWI policy for both buyers and sellers in a deal/transaction. For sellers, it eliminates any requirement for escrow or holdback that would otherwise reduce the money received by the seller at closing, provide a cleaner exit with fewer contingent liabilities incident to the sale. For the buyers, the bid looks much more attractive as indemnification is protected by a third-party insurer, they can also increase the indemnity amount which otherwise would have been highly-negotiated by the seller. For both parties, the process for negotiation and finalizing of the transaction document is expedited and as the insurance covers all losses, sellers might not be resistant to agreeing to post-closing indemnities in the deal as well.

What are Representations and Warranties?

In case of breach of any representations or warranties in the transaction document, the rise of indemnity claims is almost always provided for. For the uninitiated, a ‘Representation’ is a statement of fact about the current state of the business made by a seller to the buyer or by a buyer to the seller in a purchase agreement[1]. A ‘Warranty’ in simple words, guarantees the accuracy of the representation[2] and ensures compensation in case the representation so made is false. Representations and warranties are negotiated clauses of the transaction and the scope of representations and warranties depends greatly on the nature of transactions.

The terms ‘Representation’ and ‘Warranty’ are not defined in the Indian Contract Act, 1972, however the Madras High Court in the case of All India General Insurance Co. Ltd. and Anr. v. S.P. Maheswari[3] made a distinction between the two terms. The High Court said that those representations which are made the basis of the contract are known as warranties, and otherwise a representation simpliciter is rather something collateral which only has a tendency to induce the other party.

Even after an exhaustive due diligence process, it is difficult for a buyer to know everything relevant to the purchase, so these representations and warranties fill in gaps in the buyer’s knowledge of a company.

RWI Policies for transactions, an Introduction

It is important to know that there are no “one size fits all” RWI policies offered by insurance companies. Typically, parties go for tax insurance or a transaction-based insurance policy, we will concern ourselves with the latter for this discussion.

An RWI is thus an insurance policy used in deals to protest losses arising due to the breach of representations made in the transaction documents. Every transaction is a different transaction and thus, every RWI policy is tailored according to the specific transaction. Each RWI policy is negotiated to match up with the terms and language of each transaction.

What are the types of R&W Insurance available for transactions?

Typically, transaction insurance policies cover either the ‘buy-side’ or ‘sell-side’, however in terms of practice a buy-side policy is more prevalent. The distinct features of them both are discussed below:

  1. Buy-side policy: In this the RWI policy is acquired by the buyer in the transaction. The advantage of this type of policy is that a direct claim can be made against the insurer without pursuing the seller for the same. The purchaser is able to recover its losses while at the same time ensuring a clean exit for the seller. It is important the transaction documents require a recourse-based buy-side insurance policy, wherein the seller is liable to indemnify the counterparty in case the insurer does not make a payment under the claim to the buyer. The buyer under this type of RWI policy gets additional time to detect and report problems and gets an effective indemnity in public deals as well where it will otherwise be difficult to recover such losses.
  2. Sell-side policy: These policies are acquired by the seller in order to limit their losses. A sell-side policy will typically cover the capped indemnity under the agreement along with any additional defense cost for related litigation. A sell-side policy also reduces the liabilities associated with post-closing breaches of representations and warranties such as claw-back liabilities wherein the seller is required to make good the losses if any breach with respect to representation and warranties occurs after the closure of the deal. A seller may also opt for RWI policy if he is a minority investor but bound to indemnify a buyer via a joint or several liability. A sell-side policy is typically preferred by PE and VC funds in order to give a ‘clean exit’ to its investors.

How to negotiate and obtain RWI policy during a transaction?

An RWI policy is typically completed in multiple stages, starting from the pre-indication strategy wherein the buyer or seller reach out to RWI broker for discussing the objective of the policy, then the broker submits important documents to RWI insurer specifying the details of the transaction as discussed in the pre-indication stage. Once the insurer is selected and paid an underwriting fee and provided with all the relevant documents, a diligence call is arranged between the insurer, the parties to the deal, and their legal representatives. A first draft of the insurance policy is soon provided by the insurer after the diligence call. It is important that the language of policy should be in line with the language in the transaction agreement. The final policy is generally negotiated in advance of the closing date of the transaction. The insurer then provides a ‘binder’ to the policyholder that legally obligates the insurer to bind coverage at the time of signing or closing. Once the binder is signed, the policy becomes binding.

Structure of an RWI policy should not be ambiguous and it should clearly mention what is covered and who is covered under the policy. As a general rule, a claim under the RWI policy is triggered only when there is a breach of covered representation and warranty. The RWI policy should also mention whether the insurance is provided on ‘first party’ (providing coverage to the policyholder) basis or ‘third party’ (providing coverage to another party based on policyholder’s liability to another party) basis.

Limitations

Though RWI policies are instrumental in limiting the liabilities of the seller and buyer but there are certain limitations to them, we shall list a few of them below:

  1. Unlike a typical promise of indemnity, RWI policies will always be limited to a cap based on the amount consideration in the deal/transaction, in developed jurisdictions, it is typically 10% of the purchase price.
  2. RWI policies only cover breaches of those representations and warranties that are explicitly mentioned in the agreement. It does not cover breaches that are ancillary to the covered representations and warranties.
  3. RWI policies tend to contain numerous exclusions which are common to many types of insurance policies. These exclusions are generally with respect to corruption, environment, and bribery.
  4. RWI policies exclude claims wherein the insured may have had knowledge prior to the effective date of the policy of certain facts which could give rise to the breach of representations or warranties.
  5. Transactional RWI policies will not provide coverage for tax risks that might result from transfer pricing agreements.
  6. RWI policies can totally exclude certain issues identified in the buyer’s due diligence process.
  7. Unlike indemnity payments, proceeds from an RWI policy may be considered as net taxable income in India.

Relevance of the Indemnity clause in transaction documents is still not diluted

Inclusion of RWI in the transaction agreement would still not cover every liability arising from breach of covered representations and warranties, thus there will be certain aspects where indemnity provision under the transaction document would still hold value.

  1. In determining the loss bearing capacity of parties till the payment retention amount for the RWI policy.
  2. In determining who will bear the loss arising from the items excluded from the coverage under the RWI policy.
  3. Provide for de-minimis amount i.e. the minimum loss to borne before making a claim under the indemnity provision.
  4. In cases where parties commercially agree to include a recourse-based insurance policy, an indemnity provision in the transaction document proves helpful to enable the buyer to enforce a claim against the seller.
  5. RWI policies will always have cap on the recoverable amount and typically have a life of 3-6 years post the closing of the deal. An indemnity provision however, can still cover a higher amount of indemnity or provide a longer time frame than what is provided under the RWI policy.

Conclusion

An RWI policy provides an option to parties involved in M&A/Investment transactions to allocate the risk associated with the transaction to a third-party, and thus proceed with the deal themselves spending less time on negotiating the indemnity clause. It has become an important tool in any restructuring process as it offers greater flexibility when compared to traditional methods for addressing the liabilities (such as holdback, escrows, etc.). As the Indian market matures further, it is important for RWI policies to get tailored as per the need of the Indian market. Inclusion of RWI in the transaction agreements proves instrumental in boosting the confidence of investors seeking to make exits in providing indemnities to potential buyers. However, an RWI policy too has certain limitations and a well-drafted indemnity clause in the transaction document is still needed to bring clarity on those aspects on which the RWI policy falls short.

[1] Marialuisa S. Gallozzi; Eric Phillips, Representations and Warranties Insurance, 14 Envtl. Cl. J. 455

(2002)

[2] Id.

[3] A.I.R.1960 Mad. 484

Opportunities and Challenges for AIFs in India’s first IFSC, GIFT City, Gujarat.

We are pleased to share with you an article that our Founder Sharda Balaji along with our Associate Avaneesh Satyang contributed to the 2nd volume, Issue 2 of the KNOWLEDGEex Magazine released by Indian Association of Alternative Investment Funds (IAAIF). 

Introduction to IFSC and GIFT City

India has been witnessing a high growth in the investment funds domain, ranging from fund-raising activity to active investments by funds, and also an adaptive and dynamic regulatory environment conducive to the witnessed growth. The formation of most of these funds however have been concentrated to the well-known financial hubs such as Hong Kong, Mauritius, Singapore, etc. The success of theses financial hubs is generally attributed to the regulatory, tax and other business-conducive financial service centres. The International Financial Service Centre (IFSC), is India’s attempt to create an avenue into financial globalisation.

An IFSC allows overseas financial institutions and overseas branches/subsidiaries of Indian financial institutions to operate within India and cater to customers outside the jurisdictions of India. This is achieved only when the IFSC provide favourable regulatory regimes and business environment to investors and financial institutions.

Provisions for the setting up and regulations of an IFSC were thus introduced in the Special Economic Zone Act, 2005, and in 2015, Gujarat International Finance Tec-City (GIFT City) came into being to facilitate such financial services within the geographical territory of India, which would otherwise have been carried on abroad or through offshore branches/subsidiaries of Indian financial institutions.

As an IFSC, GIFT City is regulated under specific regulations and guidelines by India’s major financial sector regulators, i.e. the Reserve Bank of India (RBI), the Securities Exchange Board of India (SEBI), and the Insurance Regulatory and Development Authority of India (IRDA). This is because of the major identified thrust areas for IFSCs in India, which would need regulation as follows:

  • Banking and Forex: to be regulated by the RBI
  • Capital Markets: to be regulated by SEBI
  • Insurance: to be regulated by IRDA

Why consider AIFs in GIFT City?

GIFT City as a facilitator of international business has already set a firm initial footing in the above identified thrusts areas with more than 150 units licensed by the financial regulators already operating in GIFT City. The banking units at GIFT City are working well with transactions of more than USD 16 Billion having taken place. In the insurance sectors, the IRDA has licensed entities engaged in insurance business. And for the Capital markets, both National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) are operating out of GIFT City, and several SEBI licensed companies are offering IFSC products from GIFT City.

Setting up of Alternative Investment Funds (AIFs) in GIFT City, being the species of private pooled funds recognized in India, becomes another important step in commencing the third stage of proliferation of financial and capital market activities.

It is to be noted that the authorities at GIFT City and the SEBI are fully aware that India has a big market for India-focused offshore feeder funds which are set-up outside India. Keeping in mind the premise offered by IFSC as fully capital account convertible, i.e. providing full exemption from FEMA norms for transactions from and to the IFSC, emerges as an important alternative to offshore feeder funds. For all transactional and regulatory aspects, an AIF operating from GIFT City, is an offshore AIF.

Thus, to assess the viability of setting up AIFs in GIFT City as opposed to an offshore fund will require an analysis on Regulatory (fund formation, registration, tax considerations, etc.) as well as Operational (ease of conducting business, etc.).

Regulatory Regime for AIFs in GIFT City

Soon after the introduction of GIFT City, SEBI promulgated its SEBI (International Financial Services Centres) Guidelines, 2015 (SEBI Guidelines) on March 27, 2015. The SEBI Guidelines permits only ‘recognized entities’ registered with SEBI or registered/recognized with foreign regulators, to set-up units in IFSC, in this regards AIFs operating in IFSCs are treated as recognized financial institutions.

Further operational and regulatory clarifications for stakeholders waiting to set up AIFs in GIFT City, the circular titled ‘Operating Guidelines for Alternative Investment Funds in International Financial Services Centres’ dated 26 November, 2018 (AIFs in IFSC Guidelines) by SEBI, provided much needed clarity on several aspects with respects to setting up and operation of AIFs in GIFT City.

  1. Continued applicability of the SEBI (AIF) Regulations, 2012 – the AIFs in IFSC Guidelines work under the broad ambit of the SEBI (AIF) Regulations, 2012 (the AIF Regulations). Thus, all provisions of the AIF Regulations and the circulars issued thereunder, will also apply to AIFs set-up in GIFT City, and also to the investment managers, sponsors, and investors. This would include periodic reporting, event-based reporting, adherence to disclosure norms to SEBI.
  2. AIFs in IFSC are considered offshore entities – RBI, in its Foreign Exchange Management (International Financial Services Centres) Regulations, 2015 dated 02 March, 2015 has stated that any financial institution or branch of a financial institution set up in the IFSC and permitted/recognised as such by a regulatory authority shall be treated as a person resident outside India. Therefore, under FEMA, the transactions with Indian residents or making investments in Indian securities would require compliance with FEMA norms.
  3. No separate registration process – The conditions as applicable to domestic AIFs for registration with SEBI, will continue to apply to AIFs in GIFT City as well.
  4. Operating Currency – AIFs operating in IFSCs can accept money only in foreign currency.
  5. Eligible Investors – A person resident outside India, NRIs, Indian institutional investor permitted under FEMA invest funds offshore, Indian resident having net worth of at-least USD 1 Million during the preceding financial year (subject to limits under Limited Remittance Scheme of RBI). It would be beneficial if the guidelines clarify, whether investment by Indian residents into the AIF set up in GIFT City, which further invests into Indian companies, is considered as round-tripping.
  6. Investible Securities – AIFs in GIFT City can only invest in securities that are; listed in IFSC; issued by companies incorporated in IFSCs; or issued by companies incorporated in India or companies belonging to a foreign jurisdiction.
  7. Investment Route – Earlier, such AIFs in IFSCs could only invest in India through the FPI route. Now, such AIFs may invest in India through the FDI or Foreign Venture Capital Investor (FVCI) route as well.

Following is an encapsulation of other conditions applicable to AIFs operating in IFSCs:

Minimum Corpus of AIF at least USD 3 Million.
Minimum investment value by any one investor at least USD 150,000 [for employees/directors of AIFs, minimum value of investment is USD 40,000].
Continuing interest of the Manager/Sponsor at least 2.5% of the corpus or USD 750,000, whichever is lower (such interest cannot be through waiver of management fees). For Cat-III AIFs, the continuing interest shall be at-least 5% of the corpus or USD 1.5 Million, whichever is lower.
Sponsor/Manager of an existing AIF in India may act as Sponsor/Manager of AIF operating in IFSC only by setting up a branch in the IFSC or incorporating a company or LLP in the IFSC.
Appointment of Custodian for Securities Sponsor/Manager of Cat-I and II AIFs are required to appoint a custodian registered with SEBI for safekeeping of securities, if the corpus of the AIF is more than USD 70 Million.

Appointment of custodian is mandatory for all Cat-III AIFs operating in IFSCs.

Application and Registration fees
Application Fee : USD 1,500
Registration fee for Cat-I AIF (other than Angel Funds) : USD 7,500
Registration fee for Cat-II AIF : USD 15,000
Registration fee for Cat-III AIF : USD 22,500
Registration fee for Angel Funds : USD 3,000
Scheme Fee for AIFs : USD 1,500

Following are the special conditions as applicable to Angel Funds operating in IFSCs:

Minimum Corpus USD 750,000
Criteria for becoming an ‘angel investor’ (a) Individual investor to have net tangible assets of at least USD 300,000 (excluding value of principle residence).

(b) body corporate to have net worth of at least USD 1.5 Million.

Minimum investment value for ‘angel investor’ Investment from an angel investor should not be less than USD 40,000 (up to a maximum period of 5 years)
Investible entities Angel funds to invest in Venture Capital Undertakings (VCUs) as defined in Reg. 19(F)(1)(a) of the SEBI (AIF) Regulations, 2012. Also;

– Turnover of venture capital undertaking (VCU, is the company which receives the investment by the AIF) must be less than USD 3.75 Million

– VCU must not be promoted/sponsored/related to industrial group with group turnover more than USD 45 Million

Investment caps on Angel Funds Minimum investment by Angel fund in VCU – USD 40,000. Maximum investment – USD 1.5 Million

 

Continuing interest of Manager/Sponsor 2.5% of the corpus of fund or USD 80,000 whichever is lower (such interest cannot be through waiver of management fees)

Key Takeaways from the Regulatory Perspective

Key Opportunities:

  • The regulatory provisions applicable to AIFs in IFSCs do offer a viable alternative to offshore feeder funds, and can act as a feeder fund for an Indian AIF.
  • Other offshore funds investing in India which traditionally operate out of other countries like Mauritius, Singapore, etc. may deliberate on the option.
  • Indian overseas fund managers looking to set up funds for investing outside India, may find it easier to raise capital from overseas investors and Indian investors simultaneously. Indian offshore fund managers can also use AIFs in GIFT City as feeder fund to invest funds offshore.
  • Costs for setting up the fund appear to be much lower in comparison to setting up an offshore fund.
  • As a deemed overseas fund, conditions on overseas investments by AIF prescribed by SEBI in October 2015 such as overall investment limit (USD 750 million), specific SEBI approvals, and other conditions shall not apply.

Key Challenges:

  • There is lack of clarity with respect to AIFs in IFSCs being able to invest in securities listed on overseas stock exchange.
  • Although, investment under FDI, FVCI or FPI route is allowed for AIFs in IFSCs, it has not been specified whether such AIFs would require separate licenses to invest as FPIs or FVCIs. Ideally, as a recognised AIF, they must be granted FPI/FVCI status as well.
  • New Investment managers of AIF in IFSCs must necessarily be incorporated in the IFSC, this might add to the cost of setting up the fund. Ideally, if the IFSC truly aims to attract global funds, management by offshore managers should also be allowed.
  • With respect to Angel Funds, it appears that angel funds in IFSCs can only invest in Indian entities.

Key Development: Proposed Unified Authority for regulating all financial services in IFSCs in India

Cognizant that the dynamic nature of the business conducted in IFSC requires immense inter-regulatory co-ordination, the Central Government has acted on the need for having a unified financial regulator for IFSCs in India to provide world class regulatory environment to financial market participants. Thus, the International Financial Services Centres Authority Bill, 2019 (the Bill) was introduced in the Rajya Sabha on 12 February 2019 by the Finance Minister providing for the establishment of an authority to develop and regulate the financial services market in the IFSCs. This is an important development, as the presence of a unified and dedicated International Financial Services Centres Authority (the Authority) is proposed to play a significant role towards the IFSCs ultimate goal of ease of doing business.

Under the Bill, all powers relating to regulation of financial products, services, and institutions in IFSCs, which were previously exercised by the respective regulators will be exercised by the Authority. As per the Government’s rationale, the Authority will be responsible for providing world-class regulatory environment to market participants from an ease of doing business perspective.

Tax and Operational Considerations for AIFs in GIFT City

Under Sections 10(23FBA) and 115UB of the Income Tax Act, 1961 (the IT Act), Category I and II AIFs are accorded tax pass-through status with respect to AIF’s income other than business income, thereby tax being chargeable in the hands of the investors. These provisions are extended to AIFs in IFSCs as well, as they continue to be tax residents in India despite being non-residents under FEMA.

There are several beneficial provisions available for IFSC units, however, since they are not AIF specific, which leads to ambiguities regarding the availability of such incentives to AIFs in IFSCs. Nevertheless, the beneficial provisions for IFSC units under the IT Act are as follows:

  1. Tax holiday under Section 80LA – Any unit set-up in an IFSC shall not be taxed in relation to income from business as follows in two blocks. First block of 5 years in which 100% of the income beginning with the year in which the permission or registration was obtained is exempt from income tax, and; Second block of 5 years in which 50% of income is exempt for the next 5 consecutive years.
  2. Lower rates of Minimum Alternate Tax (MAT) and Alternate Minimum Tax (AMT) – MAT and AMT in case of a unit located in an IFSC and deriving its income solely in convertible foreign exchange shall be charged at a lower rate of 9% as opposed to the general 18.5%.
  3. Exemption from Dividend Distribution Tax (DDT) – A unit located in an IFSC and deriving its income solely in convertible foreign exchange, being a company, is exempted from paying DDT at the time of distributing dividend.
  4. Gains from certain securities transferred by non-residents not considered as capital gains – Any transfer of derivatives, global depository receipts, or rupee denominated bonds of Indian companies by a non-resident on a stock-exchange in an IFSC is exempt from tax on capital gains.
  5. Exemption from Securities Transaction Tax (STT) – A transaction undertaken on recognised stock exchange in an IFSC shall be exempt from STT.
  6. Exemption from Goods and Services Tax (GST) – All supplies made to and made by units in SEZs are exempt from GST applicability.

Apart from the tax considerations, units in IFSCs also being subject to the Special Economic Zones Act, 2005 as SEZ Units might face other problems. This argument stems from the fact that the SEZs were originally conceived as special designated zones for manufacture and export-oriented industries, and thus SEZ Units are subject to certain conditions which might prove difficult for non-export-oriented business to satisfy. For example, in the recent Special Economic Zones (2nd Amendment) Rules, 2019 dated 07 March, 2019, Rule 53 of the Special Economic Zones Rules, 2006 was substituted to mandate a positive net foreign exchange earning by SEZ Units calculated cumulatively for a period of five years from the commencement of production. IFSC units specialize in financial services and products, might find it very difficult to meet the net foreign exchange earning criteria set by the government.

Key Opportunities

  • The tax holiday is a big benefit for investment managers established in the IFSC, management fee and other income will be exempt.
  • Other exemptions with respect to MAT and AMT for non-market players, and DDT and STT exemptions make GIFT City an attractive destination.

Key Challenges

  • There is dearth of clarity in taxation of income of AIFs in IFSCs on many fronts, such as will the tax holiday be available to AIFs in IFSCs with no business income, whether investors in AIFs will be required to obtain PAN and file tax returns in India in case of tax pass-through being available, etc.
  • There is a need to harmonize the provisions as applicable to SEZ Units with respect to IFSC Units requiring necessary carve outs and exemptions to be created.
  • Unless a unified regulator is in place, the problem of multiplicity and overlapping of authority will continue to diminish the growth of AIFs in IFSCs as viable alternatives to offshore funds.

Observations:

There certainly are numerous benefits for setting up an AIF in GIFT City. With the proposed unified regulator, ease of doing business, it holds many promises.

However, it is to be noted that many grey areas especially with respect to taxation of AIFs in IFSCs need to be clarified and resolved to understand the true effects of such provisions on AIFs as mentioned above. The determining criteria would be clarity to the tax incentives available for AIFs in IFSCs. How well does GIFT City perform, will determine the success of AIFs in IFSCs, too.

Advisors in Start-ups and Early Stage Companies

India is witnessing a high growth in the number of start-ups in the country and is also amongst the top start-up ecosystems in the world. The government has provided a few benefits to startups as well, through the Startup India Action Plan.

However, only a few of these start-ups actually succeed. It is a treacherous path with a lot of unknowns. An advisor or an advisory board in a start-up might help the early stage companies to atleast know some of those unknowns. Financial investors certainly add value, sometimes domain expertise even. The comfort of speaking with an advisor where they bring in the expert views, advice and sheer experience onto the table is very valuable. As the saying goes, ‘Experience is the best teacher’.

Who are these Advisors and what role do they play?

An advisor is a person who brings in his unique skill sets and expert opinion on the business of the company, operational or otherwise. They are the people ‘who have been there and done that’. They can play a major role, especially if the founders and the team are new to the industry and do not have much experience. There are celebrity advisors even, who by being called as an advisor adds value to the startup.

Advisors can play different roles, for example, advisors who bring in their expertise in a particular domain or area; help with their networks and can introduce potential clients, employees or investors; or scaling up teams; expansion to new geo. It is not just having the advisors but also heeding to their advice. Therefore, advisors need to be chosen very wisely, so that their advice can be relied and executed upon.

How to choose the right Advisor?

Hiring an advisor who does not add much value or provides incorrect advice to the company may turn out to be counter-productive or disastrous. The advisors bringing in complementary skills or “deeper” skills which the founding team has a gap would be great. Identify the areas where the founders lack expertise or sufficient industry knowledge, where they face difficulties or have faced difficulties in the past or any area where they would require expert advice. Once there is clarity on where and why advisors are required, do some research and talk to people who can introduce you to some advisors. Discussing the same with the existing investors (if any) might also be a good idea as they might be able to connect the founders with the relevant people. And since the investors have invested in the company, they would ensure that the advisor will be someone who can add value to the company.

Ensure that they are people with the relevant expertise and knowledge, proven track record, good communication skills, networking skills, etc. Advisors should be individuals who would invest their time for the growth of the company and who can provide support to the founders where there is lack of expertise or knowledge.

Engaging with the advisor

An advisor may be compensated in cash, equity etc. Many a time, the advisor is interested in just giving back to the eco-system. One should evaluate if the advisor has time to provide support to the startup, whether the advisor is associated with other companies which the startup may have conflict / competition.  Maintaining a good rapport, having regular discussions and candid conversations, updating the advisor on a regular basis about the business and other relevant aspects of the business can go a long way. The most important factor is to ensure that there is trust between the parties.

Some startups look for a small investment by the advisors into the company, as a test to ensure that the advisor believes in the idea, startup, founders etc.

Compensation for Advisors

Let us now evaluate some of the ways to compensate advisors for the value-add they bring to the company.

Start-ups, more often than not, compensate advisors by giving a percentage of equity in the company since they may not have the finances to give cash compensation (unless well-funded). New shares can be issued to the advisors or shares can be transferred from the founders. Such issuance or transfer should ideally happen at the face value of the shares since it is a compensation for the services rendered by the advisors and the advisors would not want to pay the full price of the shares. As the same is being issued/transferred at face value instead of the fair market value, tax implications need to be evaluated since any issuance/transfer of shares below the fair market value will fall under the ambit of the Income Tax Act, 1961. Also, the percentage holding of the founders needs to be taken into account so that their shareholding percentage does not get diluted to a large extent considering that there will be future investments, where the shareholding will get diluted further. Another aspect to be considered is that, an issuance of shares will dilute the shareholding of all shareholders (including investors if any) whereas the transfer of shares from founders will dilute only the founders’ shareholding.

Another way of compensating the advisors is by issuing shares to them by way of consideration other than cash under section 62 (1) (c) of the Companies Act, 2013 (“Act”) read with rule 13 of Companies (Shares Capital and Debenture) Rules, 2014. The private placement process under section 42 of the Act will have to be followed for this purpose. The advisors have to raise invoice for the services rendered which will be commensurate with the fair market value of the advisory shares. Company will be responsible for TDS which will be a cash out on the Company. Further, the entire amount shall be taxed in the hands of the Investor as income from other sources, at the applicable tax slab.

Yet another option could be granting phantom stock options (“PSOs”) to the advisors. These are options which are settled by way of cash settlement. It a performance-based incentive plan through which the advisors will be entitled to receive cash payments after a specific period of time or upon reaching a specific target. A separate agreement can be entered into for capturing the details. This is directly linked to the value of the company’s share price. For example, the advisors could have promise of ‘x’ number of shares at ‘y’ price at grant. At exercise, the appreciation in the value of the share price, is handed out as cash incentive. Tax will be applicable at the time of payout. However, unlike employee stock options, which is recognized under the Act, PSOs by private limited companies does not fall under the ambit of the Act and therefore, will be in the nature of contractual right. Please see our previous post on  Phantom Stock Options to know more about this.

It has to be noted that advisors are not eligible for employee stock options (ESOPs) as ESOPs can be given only to employees and directors subject to the restrictions under the Act and relevant Rules.

Advisory shares to Non-Residents:

It becomes a little more complex when the advisor is a non-resident since the shares issued/transferred to a non-resident needs to be in compliance with the pricing guidelines as provided in Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (“FDI Regulations“). As per the pricing guidelines, capital instruments which are issued or transferred to a non-resident has to be priced as per any internationally accepted pricing methodology for valuation on an arm’s length basis duly certified by a chartered accountant or a SEBI registered merchant banker, in case of an unlisted company. Considering these rules, granting of advisory shares to a non-resident can be a very tricky situation. PSOs may be a better option in this case.

Formal Agreement with Advisors

The engagement with the advisors should be fruitful for the company and help in its growth. It is advisable to enter into a formal agreement with the advisors which captures all important terms regarding the engagement which will be beneficial for both the company and the advisors. This will help in keeping track of the contribution of the advisors and also if in future, any differences arise between the company/founders and the advisors, it will always help to have a formal agreement. The exact role of the advisor and deliverables, vesting schedule, time commitments, compensation, non-compete, confidentiality, exit related provisions, etc. should be captured in such agreements. Specific milestones may also be included in these agreements. Once the milestones are satisfactorily completed, compensation as agreed can be given.

Once the advisors become shareholders in the company, depending on the shareholders’ agreement (if any), the advisor might need to enter into a deed of adherence, so that the rights of the shares are captured.

Author: Paul Albert