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Data Localisation: India’s policy framework

The Personal Data Protection Bill, 2018 (“Bill”) and the Data Protection Committee’s (“Committee”) Report (released on 27 July 2018) contains the framework and the policymakers’ insight on protection of personal data in India. The recent Draft e-commerce policy indicates Government’s thought process on storing data in India. The Reserve Bank of India (RBI) in April this year mandates that all data generated by the payment systems in India, is to be stored in India. The Ministry of Health and Welfare has published the draft legislation called Digital Information Security in Healthcare Act, to safeguard e-health records and patients’ privacy.  Thus, all these new rules/policies/regulations (collectively referred as “the Data Protection Framework”) indicate a very strong direction that the Government wishes to undertake on data localisation, which helps in enforcing data protection, secure nation’s security and protect its citizen’s data, better control on transmission of data outside the country and more.

We believe initial steps were taken when under the Companies Act, 2013, the maintenance of books of account in electronic form, required copies to be kept in servers physically located in India.

Many questions abound that the Government take fast paced measures in enabling the infrastructure to build data-centres, which in-turn requires land clearance, electricity etc., ability to keep the operational costs for SMEs low, jump-starting initiatives on artificial intelligence, delicate balance to be maintained on surveillance and protection.  On a positive note, this provides entrepreneurial opportunities in building data centres, alternative energy/ solar grids etc.

Data Localisation under the Data Protection Committee’s Report and the Bill

Chapter 6 of Committee’s Report provides compelling arguments on ‘Transfer of Personal Data Outside India’, where the Committee notes Laissez Faire economy of data, i.e. where free flow of data is the norm and to restrict as an exception. It also recognizes that an embargo on data crossing borders as curbing personal liberty of people. The Committee recommended that even if the intended destination is across borders, all data to which Indian laws would apply would need to be stored locally as well. The Central Government may decide that certain data may not be permitted to be taken out of the country and requiring its processing to be done locally. To highlight sections 40 and 41:

  • The Central Government shall determine categories of sensitive personal data which are ‘critical’ in nature having regard to strategic interests and enforcement, this personal data can only be processed in India.
  • Transfer of other non-critical personal data will be allowed subject to one serving copy of it being stored in India.
  • Cross border transfers of personal data, other than critical personal data will be through model contract clauses with the data transferor being directly liable to the data principal.

Mandatory Data Localisation being prescribed under different aspects

Localisation of Payment Systems Data mandated by RBI: Even before the release of the Committee’s Report and the Bill, data localisation was touched upon by RBI in its Notification of 9 April 2018, where it directed all payment system providers to ensure that all data relating to the payment systems are to be stored in systems situated only in India. Under the said notification, the RBI includes ‘full end-to-end transaction details’, ‘payment instructions’ and other information collected, processed, carried, etc. to be within the ambit of data which is required to be stored. The maintained are to be annually audited and reported to RBI.

Localisation of Data under the National E-Commerce PolicyThe Draft National Policy Framework (the “National e-commerce Policy”) concerning the ‘Digital Economy’ seeking to regulate the ‘e-commerce’ sector in India, proposes localisation of several categories of data involved in e-commerce. The intent stated is to create a ‘facilitative eco-system’ to promote India’s digital economy through measures such as, data generated by users in India from sources such as e-commerce platforms, social media, search engines, etc., and all community data collected by Internet of Things (IoT) devices in public spaces are to be stored exclusively in India and sharing of such data within the country is proposed to be regulated.

The localisation of data is not absolute and cross-border flow is allowed for a handful of cases, such as for software and cloud-computing services involving technology related data-flow (which are free of any personal or community implications) and other standard exceptions consistent with the views expressed in the Committee’s report.

Localisation under the draft amendment to Drugs and Cosmetics Rules, 1945

The recent draft amendment proposed to the Drugs and Cosmetics Rules, 1945, for regulating e-pharmacies, makes it clear that e-pharmacies web-portals have to be established in India for conducting its business in India and data generated to be stored locally. The draft rules states that under no means the data generated or mirrored through e-pharmacy portal shall be sent or stored by any means outside India.  

Data Centres in India

For the data to be stored locally, data centres need to be established, regulated and function under the law. The demand for companies to host their data in India stemmed from  security perspective. The major issues with data localisation is not only of cyber security but also jurisdiction. Cloud computing softwares have taken advantage of the economies of scale and an infrastructural architecture across the world. Thus when there is a threat presumed in one part of the world, the algorithm would move the data to another location or even in multiple locations. In addition to this the Cyber Security Report, 2017 released by Telstra have reported that businesses in India were most at risk to cyber security attacks. Further the organisation in India have experienced the highest number of weekly security incidents of all Asian countries surveyed.

The Privacy Bill provides that the Central Government to notify categories of personal data for which the data centres have to be established in India and the Authority to be established under the legislation to be responsible for the compliances.  Further for achieving its goal of facilitating India’s ‘Digital Economy’, the National e-Commerce Policy purports to grant “infrastructure status” to data centres and server farms in India. An infrastructure status by getting listed under the Harmonized Master List of Infrastructure Sub-sectors by the Department of Industrial Policy and Promotion (DIPP) entails that it’ll be easier to get credit to enter into these operations. This would be accompanied by tax-benefits, custom duties rebates and also 2-year sunset period before localisation becomes mandatory. However, these incentives are only being considered and not promised as of yet.

Cost-Benefit Analysis on Data Localisation

In Chapter 6 of its report, the Committee takes up a detailed analysis of the benefits and repercussions of adopting mandatory data localisation in India. Benefits as stated in the report include:

  • Reduction in the costs of enforcement of India’s own laws because of easier availability of data within its jurisdiction, the cost and time spent on co-ordinating with foreign agencies for access to requisite data being reduced.
  • Overseas transactions of data involve reliance on fibre optic cable networks spread around the world, which are vulnerable to attacks and perhaps localisation of data may reduce this security risk.
  • Having copies of all data collected in India will be a huge boost to the digital infrastructure as the domestic industry will now be able to harness a lot of data. For instance, the report points out that developments in Artificial Intelligence will see a great boost from this.
  • As a matter of national security, the complete localisation of critical data prevents any foreign surveillance of India’s internal affairs.

The report also states that the localisation of data can have its costs too, however it severely downplays them. The report recognizes that to make storing of data mandatory in India, will result in a burden on the domestic enterprises which use foreign infrastructure like cloud computing for running their businesses. The implications include the increased costs of doing business for small and medium businesses, also there may be the danger of monopolization in the digital infrastructure because only a few firms would have the expertise and capital to invest in creating huge data centres in India. However, the Committee states that they are not persuaded by this argument and are confident that the potential of the Indian market will adequately trump the additional cost of setting up the infrastructure.

 Our observations

Digital India and building a thriving Digital Economy in India, building strong competencies in artificial intelligence, protecting nation’s security and data of its citizens are very critical and is now becoming mandatory for India. Establishing a strong domestic infrastructure is a big commitment for the Government, which includes making available vast tracts of land, uninterrupted power supply to the data centres and such other pre-requisites. It is to be seen how India can harvest the long term benefits.

Important reading material:

https://economictimes.indiatimes.com/news/economy/policy/draft-ecommerce-policy-champions-india-first/articleshow/65206404.cms

https://economictimes.indiatimes.com/news/economy/policy/as-ministries-argue-draft-ecommerce-policy-lands-with-pmo/articleshow/65495585.cms

https://inc42.com/features/draft-indian-ecommerce-bill-favouring-domestic-players-at-the-cost-of-the-ecosystem/

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M & A: Different structures and a comparative

Acquisition of an entity can be undertaken in a number of ways such as an asset transfer, stock purchase, share swap, etc. It is critical to have certainty on the mode or structure of acquisition from the initial stage itself since the definitive agreements and the implementation steps for effectuating the acquisition will largely depend on the mode of acquisition. An acquisition transaction can be structured in different ways depending on the objective of the acquiring entity or the buyer. In this article, we have attempted to provide a brief overview and comparative of some of the different structures of acquisition.

Asset Purchase

  • In an asset purchase transaction, the acquiring entity takes over, either all or certain identified assets of the target entity or the seller. The first step in an asset purchase transaction is to determine what the assets and liabilities being taken over would be. Similarly, the definitive agreements should clearly lay down the assets/ liabilities being taken over and those which are not.
  • One of the major advantages of an asset purchase transaction is that the buyer can pick and choose the assets and liabilities which are to be acquired. The buyer may also choose not to take over any liabilities but purchase only the assets.
  • Another important aspect which has to be taken into consideration is with respect to the employees. In an asset transfer transaction, consent of the employees has to be taken if they are part of the acquisition transaction. Compliance to various labour laws has to be met. If the employees are not part of the transaction, then retrenchment compensation under Industrial Disputes Act, 1947 has to be examined. Please see our previous post on Employee Rights in M&A to know more on this.
  • In an asset purchase transaction, tax is calculated basis depreciable assets and non-depreciable assets. Capital gains tax is applicable basis the difference between the cost of acquisition and sale consideration. Depending on the holding period of the asset, either long term capital gains tax or short-term capital gains tax is applicable. In case of depreciable assets, depreciation is allowed as deduction.
  • Stamp duty is levied, in an asset purchase transaction, on the individual assets being transferred. Stamp duty is usually a percentage of the market value of the assets.
  • Losses or any other tax credits cannot be carried forward in an asset purchase transaction, as the target entity itself is not being acquired in this case. After an asset transfer, the shell entity remains and it is often a commercial consideration of whether the promoters of the acquired entity need to compulsorily shut down the shell entity or if it can be used for other business purposes. If the target entity continues to exist, considerations of ongoing business, usage of any remaining intellectual property, etc. become major discussion points between the parties involved.
  • Slump Sale: Slump sale refers to the sale of the entire business of an entity as a going concern without values being assigned to individual assets. As per section 2(42) of the Income Tax Act, 1961, ‘slump sale’ means the transfer of one or more undertakings as a result of the sale for a lump sum consideration without values being assigned to the individual assets and liabilities in such sales. In case of a slump sale, the seller is liable to pay tax on the profits derived on the transfer at rates based on the period for which the undertaking is held. If the undertaking is held for more than 36 months, the capital gains will be taxed as long-term capital gains and if the undertaking is held for less than 36 months, capital gains will be taxed as short-term capital gains.

Share Purchase

  • Share purchase is a type of acquisition in which the buyer takes over the target entity by purchasing all the shares of such target entity. The entire liability of the seller is taken over by the buyer in such an acquisition.
  • An advantage of structuring an acquisition as a share purchase, is that there would not be any major disturbances caused to the business of the seller since there is no requirement of entering into fresh contracts, licenses, etc. Losses and other tax credits could also be carried forward.
  • If the shares being sold are held for more than 24 months, capital gains will be taxed as long-term capital gain tax. If the shares being sold are held for less than 24 months, the capital gains will be taxed as short-term capital gains tax. Indexation benefits will be as applicable.
  • In the event of transfer or issue of shares to a non-resident, the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 and the pricing guidelines have to be complied with.
  • Determination of fair market value pricing is important in such case, due to the applicability of pricing guidelines (in case of non-resident involvement) and also as per Section 50CA and Section 56(2)(x)(c) of the Income Tax Act, 1961, that provide for deeming provisions and taxation (in the hands of both transferor and transferee) basis full value consideration, in case of transaction price being less than FMV/full consideration.
  • Deferred Consideration: Since in a complete share purchase acquisition, the buyer also takes over the liabilities of the target entity, it is common to have deferred consideration models, in order to set off any future liabilities from the total consideration package. However, in case of such share purchase acquisition coming under the ambit of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, the Reserve Bank of India, vide Notification No. FEMA 3682016-RB, has mandated that not more than 25% of the total consideration can be paid by the buyer on a deferred basis within a period not exceeding 18 months from the date of the transfer agreement. As mentioned in the said Notification, for this purpose, if so agreed between the buyer and the seller, an escrow arrangement may be made between the buyer and the seller for an amount not more than 25% of the total consideration for a period not exceeding 18 months from the date of the transfer agreement, or, if the total consideration is paid by the buyer to the seller, the seller may furnish an indemnity for an amount not more than 25% per cent of the total consideration for a period not exceeding 18 months from the date of the payment of the full consideration.

However, this brings in difficulties in transactions where for commercial reasons, the buyer and the seller may mutually agree to tranche based or deferred consideration, which as per the mentioned Notification, can only done within certain specified parameters.

Share-Swap

  • Another method of structuring an acquisition deal is through a share swap arrangement. In a share swap arrangement, if one entity wants to acquire another entity, instead of cash consideration, the shares of the buyer entity may be exchanged for the shares of the seller entity. An acquisition can be structured such that the entire consideration is through share swap or it can also be partly through share swap and partly through cash consideration.
  • If a foreign entity is involved in a share swap deal, the FDI and ODI Regulations become applicable. One of the most important consideration to be mindful of, is that the FDI regulations states that the price of shares offered should not be less than the fair market value of shares valued by SEBI registered Merchant Banker. Please refer to our previous post on M&A through Share Swap/Stock Swap Arrangements for more details in this regard.
  • The taxation in a share swap transaction works such that the shareholders swapping the shares are subject to taxation, basis the difference between the value of the shares being swapped. The concern here is that the shareholders will have to pay taxes when they have not received any actual cash consideration, but only shares of another entity by exchanging the existing shares they held.

Acqui-hire

  • In an acqui-hire transaction, typically, a relatively bigger entity, acquires the talent pool of a relatively smaller entity and this has gained significant prominence in the early stage ecosystem in India over the last couple of years. An acqui-hire may also be combined with an asset purchase transaction. The consideration in an acqui-hire is usually based on the talent of the employees, seniority, etc.
  • One of the main advantages of an acqui-hire transaction, from the perspective of the buyer, is that the employees already have experience, the buyer need not spend time, effort and energy in training them.
  • Another advantage of an acqui-hire is that the employees are usually subject to non-compete clauses with their employer and therefore, lateral hiring of employees may not be always possible especially when the acquirer is in a competing business as that of the target company. In an acqui-hire, the non-compete clauses would typically get waived.
  • Shares held by the existing investors of the target company and the way it is dealt varies on a case to case basis and it is mostly a function of discussion between the promoters, the existing investors and the potential buyer, given the economic condition and sustainability of the target company, if the acquisition does not go through.
  • Since the main objective of an acqui-hire is to acquire the employees, the employment agreement entered into with the acquired employees becomes very important. Adequate precaution needs to be taken to ensure that all important clauses such as earn out, non-compete, stock options granted to employees, etc. are included in the employment agreement.
  • Some of the consideration points of an acqui-hire deal would be conducting interviews of the employees selected to be acquired, and assess suitability. Also, there is always the possibility of the acquired employees leaving upon the expiry of the earn-out period, which then needs to be structured in a very balanced manner. This requires a very evaluated cost benefit analysis of the earn out versus the minimum time period for which an employee would be required to continue in the purchasing entity.

Cross-Border Merger

  • Cross-border mergers are one of the ways adopted by entities to expand their operations to a foreign country and entering into new markets. A cross-border acquisition means acquisition of one entity by a foreign entity.
  • Cross border mergers in India are mainly dealt with under the Companies Act, 2013 and the Foreign Exchange Management (Cross Border Merger) Regulations, 2018 (“Merger Regulations”). As per the Merger Regulations, the separate approval of RBI is no longer required as long as the cross-border merger is undertaken in accordance with the Merger Regulations.
  • Cross-border merger may be either ‘inbound merger’ or ‘outbound merger’. Inbound merger means a cross-border merger, where the resultant company is an Indian company. An outbound merger means a cross-border merger where the resultant company is a foreign company. A resultant company means an Indian company or a foreign company which takes over the assets and liabilities of the companies involved in the cross-border merger. There are separate set of compliances required for inbound merger and outbound merger under the Merger Regulations. For example, in case of an inbound merger, the compliances with respect to pricing guidelines, sectoral caps, reporting requirements, etc. under the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 ought to be adhered to. Also, subject to the foreign exchange management regulations, the Indian entity is allowed to hold assets in the foreign country. Also, the Merger Regulations give both the Indian entities and foreign entities a time period of 2 years to comply with the foreign exchange management compliances. Please refer to our previous post on Cross-Border Mergers-Key Regulatory Aspects to Consider for further details regarding the regulatory aspects to be considered in case of cross border mergers.
  • One of the major concerns regarding cross-border mergers is with respect to taxation. While an inbound merger, where the resulting entity is an Indian company, is exempt from capital gains tax as per Section 47 (vi) of the Income Tax Act, 1961, there is no such exemption given in case of outbound mergers. Also, in case of outbound mergers, the branch office in India may be considered as a branch office of the foreign entity. In such a scenario, the branch office in India may be considered as a permanent establishment of the foreign entity in India and global income of the foreign entity may become be subject to tax in India.

Disclaimer: Structuring an M&A transaction is complex and requires a case to case evaluation of objectives, consideration, taxation at each stakeholder level, etc. The purpose of this article is to disseminate information only and readers are requested to seek profession advice shall for any individual requirement.

 We do not practice in tax matters. Any reference to tax matters herein is indicative and for reference purpose only.

Fund raising and valuation: Company can choose the methodology

The recent ruling by the income tax appellate tribunal (“Appellate Tribunal”) of Jaipur dated 12 July 2018 in the case of Rameshwaram Strong Glass Private Limited v ITO has come as a significant relief for tax payers. In this matter, the Appellate Tribunal has held that the income tax laws in India gives an option to the assessee under rule 11UA of the Income Tax Rules, 1962 (“Rules”) to adopt either the break-up value method or the Discounted Free Cash Flow (“DCF”) method for valuation purposes.

Brief facts of the case: Rameshwaram Strong Glass Private Limited (the “Company”) incorporated on 31 January 2011, is a closely held company manufacturing toughened glass. There was no business conducted by the Company from assessment years 2011-2012 to 2013-2014 except for purchase of land. During the assessment year 2013-2014, the Company issued shares at a premium as per the valuation report prepared by a chartered accountant as per the DCF valuation method. The assessing officer (“AO”) claimed that the break-up value method was to be adopted by the Company instead of the DCF method for the purposes of valuation. As per the AO, since the DCF method was adopted instead of the break-up value method, the Company received additional money through the issue of these shares. Also, the AO claimed that the valuation report was incorrect and not justified and the actual premium of the shares should have been lower than what was mentioned in the valuation report. The Company submitted a revised valuation report to the commissioner of income tax, appeals (“First Appellate Authority”) in which a bona-fide error in the earlier report was corrected. The Company also contended that the amount of share premium is a commercial decision which does not require justification under law and the shareholders has the discretion to subscribe to the same. However, the First Appellate Authority directed the Company to prepare the valuation report based on the actual figures and not on estimates. Based on this revised report, the First Appellate Authority held that the earlier valuation report prepared was incorrect, based on imaginary figures and without any basis.

The Company appealed against the order of the First Appellate Authority to the Appellate Tribunal. One of the contentions of the Company was that the Rules allow the Company to choose between the DCF method or the break-up value method. The valuation method adopted by the Company cannot be challenged by the AO as long as it is a recognized method of valuation. Also, the Company contended that the requirement of the tax authority to give valuation report based on the actual figures and then comparing the same with the valuation report prepared through DCF method is not correct since the valuation under DCF method is based on future estimates based on revenue, expenses, investment, etc. The value is derived from the future profitability or cash flows of the Company. Also, since this is a newly formed company, the DCF valuation method had to be used as the capital base of the Company would be very less.

The Appellate Tribunal agreed with the contention of the Company stating that the assessee has the right to choose the method of valuation.  The Rules clearly provide an option to the assesse to follow either the DCF valuation method or the break-up value method. The only condition cast upon an assessee is that the valuation report has to be given by a merchant banker or a chartered accountant using the DCF method who have expertise in valuation of shares and securities. When a particular method of valuation is provided under law and when the assessee has chosen a particular method, directing the assessee to follow a particular method is beyond the powers of the income tax authority. The AO can scrutinize the valuation report if there are arithmetical errors and make necessary adjustments or alterations. However, if the assumptions made in the report are erroneous or contradictory, the authority may call for independent valuer’s report or invite his comments as the AO is not an expert. Also, the First Appellate Authority’s direction to the Company to give the valuation based on actual figures and then comparing such valuation report with that of the earlier report is contrary to the provisions of law since the DCF valuation method is based on future estimates. Therefore, the Appellate Tribunal held that the valuation report prepared by the chartered accountant using the DCF method was proper and the action of the AO and the First Appellate Authority was invalid.

It remains to be seen whether the judgment of the Appellate Tribunal goes up to the Supreme Court. However, as of now, this comes as a relief, in light of the many nuances that we discussed in our earlier post on Early Stage Valuations: Legislative Context and Continuing Saga of Angel Tax.

Note: The Board of Direct Taxes (CBDT) issued a notification on 24 May 2018, whereby the word “or an accountant” from Rule 11UA was omitted. Therefore, if a company is issuing equity shares to resident individuals, merchant banker valuation would be mandatory.

Author: Paul Albert

Significant Beneficial Ownership: Who is the real owner of the shares?

The recent changes to Section 90 of Companies Act, 2013, is to determine the identity of the person behind the curtain who is having a significant ownership of the company and is essentially controlling the management and daily affairs of the company. The Ministry of Corporate Affairs notified the Companies (Significant Beneficial Owners) Rules, 2018 (“Rules”) on 13 June 2018. These Rules were made in exercise of powers provided under Section 90 of the Companies Act, 2013 (Act) which was notified on 6 June 2018.

At present, there are two separate definitions for the determination of a significant beneficial owner. The first, as per Section 90 of the Act, an individual who holds at least 25 (twenty-five) percent of beneficial interest in the company would be categorised as a significant beneficial owner. Such individual can hold beneficial interest either alone or together or through one or more persons, with such person or persons including person resident outside India, or a trust, with such trust including a trust outside India.

The second definition of significant beneficial ownership has been provided under the Rule 2(e) of the Rules, which ascribes the categorisation of a significant beneficial owner to an individual. However, a major deviation under the Rules from Section 90(1) is that the threshold provided for an individual being classified as a significant beneficial owner is 10 (ten) percent in contrast to the threshold of 25 (twenty-five) percent prescribed under the Act. Moreover, the definition as per the Rules provide for an additional condition that the name of such individual who is holding beneficial interest should not be entered in the register of members.

Both definitions have deemed a necessary condition that an individual must be holding beneficial interest in the company to be deemed as a significant beneficial owner. The term beneficial interest has been defined under Section 89(10) as the right of entitlement of a person alone or together with any other person, indirectly or directly, through any contract or arrangement, to exercise any or all rights attached to the shares; or to receive or participate in any dividend or any such distribution in respect to shares held.

Despite the contradiction in the threshold for determination of significant beneficial ownership in a company, the threshold specified in the Rules would be considered as the applicable threshold. This is because Section 90 of the Act provides that the beneficial interest should not be less than 25 (twenty-five) percent or any other percentage as may be prescribed. Therefore, the threshold of 10 (ten) percent as prescribed under the Rules would be the final threshold percentage to determine significant beneficial ownership.

The application of the Rules extends to companies which has shareholders apart from individuals and natural persons with such shareholders holding beneficial interest in the company as per prescribed limits. The application of these rules however, does not extend to holding of shares in instances of pooled investment vehicles or investment funds such as AIFs (Alternative Investment Funds), Real Estate Investment Trusts, Mutual Funds, Infrastructure Investment Trusts.

The Rules elucidate that a beneficial interest would include right of entitlement held either alone or jointly with another person, be it directly or indirectly under any contract or arrangement. The right of entitlement would include the right to exercise any or all rights attached to such shares and receive or participate in any dividend or other distribution. Beneficial owners would be such persons holding a beneficial interest.

The rules deem significant beneficial owners to be such individuals, who while acting alone or together or through one or more persons or through a trust, hold beneficial interest of not less than 10% of the shares in the company with the names of such owners not being entered in the register of members of the company as the holder of such shares.

In cases where the beneficial interest is possessed by persons other than individuals or natural persons, the significant beneficial ownership would be determined as follows:

  1. Where the member is a company – the significant beneficial owner would be the natural person who holds 10 (ten) percent of the share capital of the Company or who exercises significant influence or control in the company through other means.
  2. Where the member is a partnership firm – the significant beneficial owner would be the natural person who holds 10 (ten) percent of the share capital or has entitlement of not less than 10 (ten) percent of profits of the partnership.
  3. Where no natural person can be identified – where no natural person is identifiable for a company or a partnership firm, the senior management official of the entity would be deemed as the significant beneficial owner.
  4. Where the member is a trust through a trustee – for the purpose of identifying the significant beneficial owner, the process would include identification of the author of the trust, trustee, the beneficiaries with not less than ten per cent. interest in the trust and any other natural person exercising ultimate effective control over the trust through a chain of control or ownership.

The Rules explicitly exempt the applicability of certain funds and investment vehicles that are registered under the SEBI Act. The Rules however, do not deal with the funds that are foreign based and not registered under the SEBI Act. Therefore, if an Indian company has a foreign fund as an investor and has an ownership qualifying under the definition of a significant beneficial owner, it is not clear whether such foreign fund would be required to make a declaration.

The filing compliance under the rules are as follows:

  1. A declaration is required to be filed to the company in which significant beneficial ownership is held within 90 days of commencement of the rules and in case of any change in the significant beneficial ownership, declaration is to be made to the company within 30 days of such change under Form BEN-1.
  2. The company is required to file Form BEN-2 with respect to such declaration within 30 days of receipt of declaration under Form BEN-1.
  3. A company is required to maintain a register of significant beneficial owners under Form BEN-3.
  4. The company can serve a notice seeking information under Form BEN-4. The person on whom the notice has been served is required to revert to the company within 30 days of receipt of notice. Wherein the company is not satisfied with information provided or person fails to furnish required information, is entitled to apply to the Tribunal within 15 days of expiry of the period mentioned in the notice.

As per the Rules, the companies were required to make a filing of Form BEN-2 on receipt of Form BEN-1 within 30 days. However, the Ministry of Corporate Affairs (MCA) be way of a general circular no. 07/2018 dated 6 September 2018 have clarified that the 30-day time limit for filing Form BEN-2 would commence from the date of the e-form being available on the MCA-21 portal rather than with 30 days of receipt of declaration by the company under Form BEN-1. The MCA further clarified that no additional fee would be applicable subject to the case that the company makes the filing of Form BEN-2 within 30 days of the form being available on the MCA-21 portal.

Source: http://www.mca.gov.in/Ministry/pdf/CompaniesSignificantBeneficial1306_14062018.pdf

http://www.mca.gov.in/Ministry/pdf/GCCircularBen_10092018.pdf

Jurisprudence of Corporate Criminal Liability of Directors

Gone are the times when the world viewed Indian Companies as ‘family businesses’. With time, the structures adopted in Indian companies have grown increasingly specialized and complex, with specific directors being nominated to take charge of specified activities of the Company. As we will see, the provisions for making the direction and management of a company liable are mostly deeming provisions. However, there can be an opinion amongst stakeholders while dividing duties amongst the board members that in case criminal liability arises against the company then the director nominated for overlooking that aspect of its business shall also be held criminally liable. The legal approach, though, is a little more complex than that.

This article is a disambiguation in this regard, and through the following paragraphs an understanding of the theoretical framework, the legislative intent and the judicial interpretations in developing the standards to impose criminal liability on directors will be discussed. As companies have grown with time, so have statutory provisions and the understanding with respect to corporate actions which amount to criminal offences, and who is deemed liable for it.

Laying the Theoretical Framework: Corporate Criminal Liability

The recognition of the company as a separate legal entity is the basic cornerstone of laws relating to corporate liability around the world. However, courts struggled in attempting to fasten liability over companies for acts which were considered criminal offences. The courts had historically struggled on two main fronts in this regard (1) to assign mens rea, i.e. a criminal intent factor to fictional entities such as companies, and (2) to punish corporates where statutory punishments were mostly corporal in nature, i.e. requiring punishment via imprisonment.

On the face of this need, emerged the doctrine of corporate criminal liability, which basically enables the courts to single out individuals responsible for criminal acts committed in the name of companies. For offences which did not require the proof of mens rea, the simple answer that courts came up with was to introduce a modified version of the Doctrine of Vicarious Liability through which the controlling persons of the company would be made liable[i]. But soon company directors were also brought to answer for the criminal acts for which criminal intent was also necessary to be proven[ii]. This was called the theory of ‘Identification’ or ‘Attribution’, a modified form of vicarious liability, where for the purpose of the criminal act, the person in control of the affairs of the company (that is to say its directors and managers) and the company were considered one and the same.

Earlier, the courts in India only recognized that companies can act through their managers and directors, but the law as it stands now however, consolidates the position that companies are as culpable as any living person and can be prosecuted and punished for the same, this is governed by two major decisions in this regard. First is the case of Standard Chartered Bank v. Directorate of Enforcement[iii] wherein the constitution bench of the Supreme Court held that a company can be prosecuted and convicted for an offence requiring minimum imprisonment. And secondly, in Iridium India Telecom Ltd. v. Motorola Inc[iv], wherein the issue was whether a company could be held liable under Section 420 of the Indian Penal Code, 1860, the Apex Court answered in the affirmative and clarified further, that even if the offence would require the proof of mens rea, a company can be made liable to the act as the guilty mind of the person in control of the company’s affairs is ‘attributed’ to the company as well.

Director’s Liability under India’s Legislative Framework

The Companies Act, 1956 employed the concept of “officer who is in default”, to impose the liability for defaults by a company over officers responsible for its management. However, penalties under the Companies Act, 1956 were seen as largely ineffective against cases of serious internal frauds committed by the promoters and senior management of companies. But, with the enactment of the Companies Act, 2013 ( the “Act”), came also the statutory recognition of the duties of a director, such as exercise of due and reasonable care, skill, diligence, and independent judgement.  Earlier, by virtue of their positions, only the MD, whole-time directors, and company secretaries used to fall within the scope of “officer who is in default”, but the Act has significantly expanded this scope to include any person who would, in the given scenario, have had superintendence/ control/ direction/ management over the affairs of the company. Under the Act, independent directors can also be made answerable for lapses in performing their duties. The Act also includes the elements of knowledge and intent in determining who is an officer who is in default. Moreover, section 447 of the Act, which deals with fraud, makes persons liable who act or abuse their position with intent to deceive, to gain undue advantage, or to injure the legitimate interests of others (company/ shareholders/ creditor/ persons) whether or not there is wrongful gain or loss. Nevertheless, it is necessary to prove intent and knowledge in most cases.

Apart from the Companies Act, 2013, offences by companies are also stipulated under various other legislations. These provisions extend the liability for contravening the provisions under the relevant statute to companies, and the persons in charge of and responsible for the conduct of the business of the company. Further, these provisions typically provide for a non-obstante clause which stipulates that if it is proved that the director, manager, secretary or other officer of the company connived, consented to the offence or can be attributed to the negligence, then such director, manager, secretary or other officer shall also be deemed guilty and proceeded and punished accordingly.

Some of the legislations that contain the above-mentioned provision would be as follows:-

  • the Air (Prevention and Control of Pollution) Act, 1981;
  • the Water (Prevention & Control of Pollution) Act, 1974;
  • the Prevention of Money Laundering Act, 2002;
  • the Securities Contracts (Regulation) Act, 1956;
  • the Securities Exchange Board of India Act, 1992;
  • the Competition Act, 2002; and
  • the Income Tax Act, 1961.

The question that arises basis the above discussion, then, is whether any person simply designated as an officer in default by the Company, can be held criminally liable.

In Sunil Bharti Mittal v. Central Bureau of Intelligence[v] the Supreme Court gave recognition to the theory of attribution/ identification in determining whether a director or person in charge of the company can be prosecuted for an offence by the company. The court stated that the person upon whom the acts of the company must be attributed must be the ‘alter-ego’ of the company, that is the degree of identity between the acts of the company and the ‘directing mind and will’ of the responsible persons must be high enough for the courts to infer them as one and the same. Moreover, just because a person is at the helm of the affairs, that would not make him/her liable for crimes requiring intent. In this case, the Supreme Court held that the special court was right to not accept charge sheet against the managing director just because he was the head of the company.

The discerning criteria thus is whether the proof of intent is required to prove an offence. An officer who is in default for contraventions which do not require proof of intent, may, thus, be prosecuted by virtue of his/her position, but the same is simply not tenable in offences where proof of intent is required.

An example of a statute which allows the nomination of person-in-charge for the obligations under a legislation is under section 66 of the Food Safety and Standards Act, 2006,. The provision in this enactment state that a director or manager can be nominated to be responsible for any contraventions of the provisions of the respective enactments.

It is to be noted, that only when the legislation permits the nomination of the responsible director, and such nomination is made before the commission of the offence, only then a director specifically nominated for offences under an act can be prosecuted, even if there is no direct intent[vi].

Hence,

The thumb rule is thus that unless it is specifically provided in a statute, a director may be made criminally liable only if there is existing proof of intent against the director. The directors must ensure that they diligently avoid the commission of such offences in the name of the Company, the onus shall nevertheless remain upon them to prove that the offence was committed without their knowledge or consent[vii].

The laws are changing in their focus from structural to functional aspects of the companies in determining criminal liability, for example, the 2018 amendment to the Prevention of Corruption Act, 1988 brings forth a stricter provision for liability of any director/manager/other officer who “acted in consent or connivance” with the commercial organization (which includes a company) in the commission of an offense under the legislation. The position of the officer in the company would thus be less important to fasten the liability, and whether the company had standards/code of conducts in place to demand the level of diligence and care from its officers in preventing the offence from being committed will also be a factor under the Prevention of Corruption Act, 1988.

It is now more important than ever that companies must actively develop standards of accountability from each level of key people responsible within the organisation and adopt procedures which prevent such conduct in the first place.

[i] Queen v. Great North of England Railways Co., [1846] 9 QB 315; State v. Morris & Essex Rail Co., 23 N.J.L. 360 (1852); Commonwealth v. Proprietors of New Bedford Bridge, 68 Mass (2 Gray) 339 (1854)

[ii] New York Central and Hudson River Rail Road Co. v. United States, 212 US 431 (1909); Moussell Brothers Ltd. v. London & North West Railway Co Ltd, [1917] 2 KB 836; Lennard’s Carrying Co Ltd v. Asiatic Petroleum Co Ltd, [1915] AC 705

[iii] AIR 2005 SC 2622

[iv] (2011) 1 SCC 74

[v] AIR 2015 SC 923

[vi] R. Banerjee v. H.D. Dubey, MANU/SC/0731/1992

[vii] Ministry of Agriculture v. Mayhco Monsanto Biotech (India) Limited, (2016) 137 SCL 373 [CCI]

Author: Avaneesh Satyang

 

Fund Formation: On-Shore and Off-Shore Structures

Global interest in the LP (Limited Partner) ecosystem, for investments in India focused businesses, is at an all-time high. According to recent surveys, about 108 India focused private equity firms are in the market looking to raise funds. The first half of the year 2018 has been characterized by large value deals as pension funds, sovereign funds and global buyout funds have increased their India exposure (Source: Economic Times).

The positive regulatory changes have influenced the investor preference for pooling of funds both on-shore and off-shore for investing in India focused businesses. Some of the significant statutory/legislative revisions/clarifications, brought in over the last couple of years, are as follows:-

  • Liberalization of foreign direct investment (FDI) in the home-grown alternative investment funds (AIFs) sector in 2015, which now allows 100% investment in AIFs through the automatic route, as opposed to the prior FIPB approval requirement.
  • Down-stream investments by AIFs with FDI is now deemed as foreign investment, only if neither the sponsor nor the manager nor the investment manager is Indian ‘owned and controlled’. This has led to an opening up of choices for many FDI taking AIFs and have also taken away the mandatory obligation of complying with the pricing guidelines for any downstream investment.
  • Clarification issued by the Central Board of Direct Taxes (CBDT) that dividend distribution by off-shore companies with respect to underlying Indian assets would not result in a tax liability since it does not result in indirect transfer of shares.
  • Clarification brought in through the Finance Act, 2017, that indirect transfer tax provisions would not be applicable for capital assets held directly or indirectly by way of investment in Category I or Category II FPIs.
  • Opening up of FDI in limited liability partnerships LLPs and taking away minimum capitalization requirements for investment advisory businesses in March 2017.

[Source: RBI Notifications, CBDT Circular No. 4/2015 and the Paragraph 4 of the Finance Act, 2017]

These changes have led us to consider and advise on various unified as well as co-investment fund structures. Each such structure requires evaluation from compliance and taxation perspective. A very high level overview of some of these structures are given below:-

Direct Investment by an Off-Shore Fund. Also known as a pure off-shore structure, this where an off-shore investment pooling vehicle can pool and directly invest into India portfolio companies, as FDI, FPI or FVCI investment. Few things to be kept in mind for this structure would be:-

  • Spread of LP appetite for India/non-India focused investment;
  • Permanent establishment connotation if the off-shore investment manager is being advised by an Indian investment advisor;
  • Advantage of not having to mirror every investment decision of Indian investment manager.

Indirect Investment through a Unified or Master-Feeder Structure.  The on-shore fund pools investments from Indian investors and the off-shore fund pools investments from global investors and the off-shore fund becomes one of the investors of the on-shore fund, by executing a contribution agreement. Advantages could be as follows:-

  • Indian investors can overcome liberalized remittance scheme (LRS) or overseas direct investment (ODI) or round tripping related restrictions;
  • For global investors, it is easy to invest through an off-shore structure as that helps in operational ease of not having to obtain PAN registration for each investor, not having to report each individual investment with RBI;
  • Global investors still get to benefit from the various Direct Tax Avoidance Agreements (DTAA). For example, continued tax benefits for sale of debentures, lower withholding tax rate of 7.5% for interest income, as available to Mauritius investors under the India-Mauritius DTAA.
  • The investment manager gets to pay on the management fee and carry allocation on the entire fund at the on-shore level.

Co-Investment Structure. This is where, typically, the investment management of the on-shore and the off-shore funds are handled by different entities, in the respective jurisdictions. Advantages would be as follows:-

  • The off-shore fund need not necessarily participate in every investment made by the on-shore AIF.
  • The investment spread between the 2 entities could be decided on a case to case basis, depending on availability of funds.

Taxation from an ‘Association of Persons’ perspective, in India, needs to be carefully thought through while adopting this structure and it is suggested to have completely separated investment committees and managements from this aspect.

Disclaimer: Fund structuring is complex matter that requires a case to case evaluation of investor-base, investor jurisdiction spread, taxation at each investor level, demonstration of level of substance and permanent establishment. The purpose of this article is to disseminate information only and readers are requested to seek profession advice shall for any individual requirement.

M&A through Share Swap/Stock Swap Arrangements

Introduction

A share swap arrangement signifies issuance of a share in exchange for a share rather than remittance of cash consideration. Share Swap arrangements occur when shareholders’ ownership of the target company’s shares is exchanged for shares of the acquiring company as part of any restructuring.

For instance, two companies, A and B, come together to form company C. If the two companies enter into a Share Swap Arrangement, the shareholders of company A can be given shares of company C for every share of company A that they owned. A similar arrangement can be made for company B as well. Now, if such an arrangement occurs between companies wherein the Indian parties are shareholders of the Indian company and the other company is a foreign company, the arrangement would attract both regulations prescribed under the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004 (the ODI Regulations) and the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2017 (the FDI Regulations).

Share Swap arrangements can be useful mechanisms to raise investment in the case of an externalisation plan. Externalisation plans involve promoters of Indian entities moving their holding entities outside India (in case more information about externalisation is required, refer to our article on externalisation schemes, which can be accessed at https://novojuris.com/2018/06/24/ externalisation-many-Indian-startups-are-choosing-to-have-their-holding-entity-outside-india/).

In such scenarios, both FDI Regulation and ODI Regulations become applicable owing to the fact that there is a transfer of shares of an Indian company to a person resident outside India and there is an acquisition of shares of a Foreign Company by a resident Indian in the manner. Therefore, an adherence with the applicable FDI Regulation and ODI Regulation is required for the share swap arrangements.

Implications under FDI Regulations

The FDI Regulations would be applicable in the case of a share swap arrangement where any one company to the transaction is non-resident and the transaction becomes eligible to be governed by the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 and Foreign Direct Investment policy (“FDI Policy”) issued by the Department of Industry Policy and Promotion every year. A key thing that has to be kept in mind is that as per the FDI Regulation, the price of shares offered should not be less than the fair market value of shares valued by SEBI registered Merchant Banker.

Reporting Requirements

The FDI policy provides primarily for two types of reporting mechanisms:

  1. one through the filing of an FC-TRS (Foreign Currency- Transfer of Shares) Form by the Indian company which becomes applicable in the case of transfer of shares, where one party is a non-resident and another one being a resident Indian; and
  2. second being through the filing of an FC-GPR (Foreign Collaboration- General Permission Route) Form by the Indian company which becomes applic`able in the case of allotment of-of shares by an Indian Company to a person resident outside India.

General permission has been granted to non- residents to acquire shares from Indian shareholders under swap arrangement, provided that the price of shares offered is not less than the fair market value of shares valued by SEBI registered Merchant Banker. However, in the case of share swap arrangement between the entities whose sector is under Government approval route, prior approval would be required.

Implications under ODI Regulations

As mentioned above, the ODI Regulations would be applicable in the case of a share swap arrangement where any one company to the transaction is non-resident. In case of share swap arrangement under externalization, the shareholders of Indian company who are resident Indians would acquire shares of the foreign company in exchange for their shares of the Indian company. The share swap arrangement under the ODI Regulations would fall under the automatic route unless otherwise prescribed under FDI Regulation. The arrangement would also be subject to the sectoral caps and entry mechanisms as applicable under the FDI Regulation and approvals from the relevant ministries.

Reporting Requirements

The resident Indian shareholders of an Indian company would be required to file Form ODI with the Authorised Dealer Bank for reporting the share swap arrangement. The Form is required to be submitted to the RBI within 30 (thirty) days of making the share swap.

Conclusion

From a regulatory standpoint, the key question which is not clear is whether the share swap arrangement would fall under general permission category of ODI Regulation & FDI Regulation or under the Government approval. While the respective regulations are clear that prior approval is needed only in case if the sector is under approval route as per FDI Policy and FDI Regulation. However, practically it has been seen that the Reserve Bank of India on case to case basis, has insisted upon such prior approval requirement. There is a need for better clarification or notification from the Reserve Bank of India.

Additionally, it is pertinent to note that the ODI Regulation mandates for prior approval of the Foreign Investment Promotion Board (FIPB) which has been abolished in 2017. Now, in case any such approvals are required, the proposals will be scrutinized and cleared by sector-specific departments concerned.

Authors: Mr Spandan Saxena and Mr Ashwin Bhat