INDIAN CORPORATE LAW

Insider Trading: Where Do We Draw the Line?

v.umakanth@gmail.com (Umakanth V.) — Fri, 04 Dec 2009 03:35:00 +0000

In an interesting two-part column series in the Mint (here and here), Govind Sankaranarayanan considers the broad academic debate surrounding insider trading. He makes at least two pertinent observations: (i) the line between insider trading that is considered acceptable and that which is improper is quite often blurred and difficult for regulators to segregate; and (ii) there is a need for regulators to undertake greater investigations and enforcements, which may not only act as greater deterrence but may also help set some boundaries between the permissible and the proscribed.

Consequences of Listing Violations

v.umakanth@gmail.com (Umakanth V.) — Fri, 04 Dec 2009 03:16:00 +0000

One of the usual consequences that befalls a company when it violates conditions of the listing agreement is a delisting of its shares from the stock exchanges. This is perceived to be a disincentive that deters companies from breaching listing conditions. It has recently been put to use in a more mild form by the Bombay Stock Exchange that threaten to suspend 18 companies for non-compliance of the listing agreement unless they show improvement in compliance standards. Such a consequence tends to be a double-edged sword. While it hurts managers and controlling shareholders of these companies, it also curtails liquidity to small and minority shareholders whose primary exit continues to be the stock markets. Although it is not clear whether the companies involved in the BSE notice carry very many public shareholders, the suspension of trading or delisting does not address the conceptual problem of simultaneously affecting public shareholders’ interests.

The more optimal outcome would be the use of Section 23E of the Securities Contracts (Regulation) Act, 1956 that operates as a deterrence against perpetrators of non-compliance without in any way impinging on the rights of the public shareholders (who continue to enjoy the advantages of listing and stock exchange trading). Section 23E reads as follows:

If a company … fails to comply with the listing conditions or delisting conditions or grounds or commits a breach thereof, it or he shall be liable to a penalty not exceeding twenty-five crore rupees.

The imposition of hefty penalties on a few errant companies, if not all, may send strong deterrence signals to the market that may likely improve overall compliance with the listing agreement.

Commencement of Disinvestment Process

v.umakanth@gmail.com (Umakanth V.) — Fri, 04 Dec 2009 02:27:00 +0000

Following the Finance Minister’s announcement in Budget 2009 to undertake disinvestments, the Government has now announced stake sales in 25 public sector companies through public offers. Its zeal to ensure the success of these public floats of shares is evidenced by a proposal to grant significant powers to the Department of Disinvestment. The truth, however, is that disinvestments tend to be a complex exercise, which is borne out by the fact that legal issues emerging from the previous round of disinvestments initiated a few years ago yet remain unresolved (although those pertain to stake sale in favour of strategic partner rather than a public offer of shares - here and here).

Restructuring Companies: Capital Gains and Transfer Pricing

noreply@blogger.com (V. Niranjan) — Thu, 03 Dec 2009 16:25:00 +0000

In a very interesting decision that could have significant implications for restructuring companies, the Authority for Advance Rulings [“AAR”] has discussed several controversies in connection with restructuring schemes. The decision, Re Dana Corporation (decided November 30, 2009), is available here.

The applicant, Dana Corporation, was incorporated in the USA. As part of its extensive worldwide operations, it owned shares in three Indian companies, all of which were its subsidiaries. In 2007, Dana Corporation filed for reorganisation under Chapter 11 of the Bankruptcy Code of the United States. Under American law, a Chapter 11 reorganisation bankruptcy allows the business to continue, and the company’s debt obligations are reorganised under the supervision of the Bankruptcy Court. Under the scheme approved by the Bankruptcy Court, a new holding company was created [Dana Holding Companies, or DHC], to which Dana Corporation was required to transfer the shares it held in the three Indian companies. This transfer was effected indirectly – Dana Corporation transferred its holding in the Indian companies to another group company called Dana World Trade Corporation, which was controlled by DHC. Subsequently Dana Corporation merged with Dana Companies LLC, and ceased to exist as an independent entity.

The question that arose was whether the transfer of shares in the three Indian companies by Dana Corporation to Dana World Trade Corporation was taxable in India. The applicable provision in the Income Tax Act, 1961, is Section 45 – the provision on capital gains. To charge a transaction to capital gains, it is necessary to establish “profits and gains” that “arise from the transfer of a capital asset”. The computation provision is s. 48.

The applicant argued before the AAR that this transfer was not for consideration, since its object was merely to comply with the requirements of the bankruptcy reorganisation scheme. It then relied on the well-known principle that a charging section cannot be invoked when the computation provision fails (CIT v. BC Srinivasa Shetty, 128 ITR 294). The Revenue argued that the expression transfer, defined in s. 2(47) of the Act, includes transfers by operation of law and transfers under the order of a court. It further argued that the consideration for such transactions is the agreement of the holding company to participate in the reorganisation scheme. Consequently, the Revenue contended that consideration could be determined through transfer pricing provisions, and particularly by resorting to the arm’s length price mechanism prescribed in s. 92 of the Act.

The AAR formulated two questions to decide the issue: first, whether any profit or gain arose to Dana Corporation as a result of transferring its holding in the Indian companies to Dana World Trade Corporation, and secondly, whether any “amount” was received by or accrued to Dana Corporation as a result of the transfer. The Authority rejected the Revenue’s contentions on both questions. In doing so, the Authority referred to what is known as the “real income principle”, and observed “the profits or gains under the Income Tax Act must be understood in the sense of real profits or gains, on the basis of ordinary commercial principles on which the actual profits are computed [emphasis mine].” Applying this principle, the Authority held that s. 45 does not apply unless the profit or gain is a “distinctly and clearly identifiable component of the transaction”, and that “there must be a causal nexus between the transfer of capital asset and the profit or gain…”

Analysing these “ordinary commercial principles” of a company reorganisation, the Authority held that the transfer is bereft of “consideration”, because the transfer of shares in furtherance of a reorganisation scheme is not understood commercially as a “bargain” for reciprocal services. The Authority also held that the transferor receives “no profit or gain” because the reorganisation plan is “in the overall interests of its business and that there is a certain business advantage to the applicant has no bearing on the point whether any consideration has in fact been received or accrued on the transfer of shares”.

Finally, in what could potentially have expanded the scope of transfer pricing provisions, the Revenue argued that income has to be computed on arm’s length basis regardless of whether there is consideration. The Authority rightly rejected this contention, noting that s. 92 begins with the words “any income arising from an international transaction shall be computed having regard to arm’s length price”, clearly implying income must arise in the first place. The Authority correctly noted that s. 92 cannot be used to levy capital gains on a transaction that does not satisfy the ingredients of s. 45 in the first place.

I believe that three important conclusions follow from this discussion. First, the Authority’s reference to the “real income” principle is controversial. The real income principle was articulated by Indian courts most prominently in the context of “sticky loans” – banks argued that some loans are so clearly non-performing assets that interest need not be credited as income, although the loans had not been written off either. We have briefly discussed this controversy in a previous post. The real income principle has usually been regarded as subject to the provisions of the Act – in that sense, it is merely a guide to interpretation and does not impose a substantive limitation on the power of the legislature to enact tax laws. In that context, approving the real income principle in the context of capital gains along with express observations that consideration must be “real” and not “notional” is likely to generate some controversy.

Secondly, it was not argued before the Authority that a transfer of shares pursuant to an amalgamation or merger scheme does not constitute a transfer as defined in the Income Tax Act, although there is some support for this proposition in Indian law. Some cases have held that the transfer of shares in accordance with a scheme under ss. 391-6 of the Companies Act does not constitute a transfer for the purposes of the Act (CIT v. Rasiklal Maneklal, 177 ITR 198, CIT v. Amin, 106 ITR 368, CIT v. MCTM Corporation, 22 ITR 524 and CIT v. Master Raghuveer Trust, 151 ITR 368). The basis of these decisions was that a transferor in these circumstances does not receive the asset “by operation of any transaction” but “in satisfaction” of a pre-existing right – in short, that there is no consideration. There is, however, uncertainty as to this position, and the scope of the Supreme Court’s decision in CIT v. Grace Collins ((2001) 3 SCC 430), apparently to the contrary, is not entirely clear. Finally, the Authority appears to have clearly reached the correct conclusion as to the applicability of transfer pricing provisions.

All in all, the controversy over tax implications of amalgamations and mergers, whether under Indian law or otherwise, looks set to continue.

The Debate over Multiple Classes of Shares

v.umakanth@gmail.com (Umakanth V.) — Thu, 03 Dec 2009 03:56:00 +0000

Currently, the issue of shares with differential rights as to voting and dividend is in a state of flux. While the Companies Act, 1956 and the Rules issued pursuant to that allow shares with differential rights, SEBI has proscribed the issue of shares with “superior voting rights” in listed companies, implicitly allowing shares with “inferior” voting rights. Finally, however, the Companies Bill, 2009 seeks to put all this to rest by banning shares with differential rights altogether. It is not clear if that intended result would ensue as there is still demand from industry to allow shares with differential voting rights as they provide tremendous flexibility to issuers and shareholders to structure rights on shares.

At a more general level, the topic of dual-class shares (with differential rights) has received some attention with Facebook’s proposal for a public offering with dual-class shares. The Economist has a report on the success of dual-class shares in the markets. Note that dual-class shares act as defensive mechanisms favouring holders of shares with superior control (voting) rights. Here is an extract:

Over the past 20 years firms with dual-class share structures have accounted for around 7% of IPOs, such as that of Visa, a credit-card company, last year. Studies by Chad Zutter and Scott Smart, economists at the University of Pittsburgh and Indiana University respectively, have found that dual-class IPOs tend to be priced at lower price-earnings and price-sales ratios than comparable single-class IPOs, suggesting that there is a penalty. But it is surprisingly small.

One likely explanation for this is that most public companies in America used to have powerful poison pills that protected management from hostile takeovers no matter what their share structure, says Jay Ritter of the University of Florida. They also had supine shareholders. Both of these things have changed in the past couple of years, however, as doughtier shareholders have agitated against poison pills. So perhaps Facebook will pay a higher price than it expects for its dual structure.

This seems to suggest that the way forward (even in the Indian context) would be to allow dual-class shares or shares with differential voting rights (along with predetermined checks and balances) and then leave it to the market to price these shares accordingly. That would be a more optimal approach than to ban these instruments altogether.

Task Force on Governance Reforms

v.umakanth@gmail.com (Umakanth V.) — Tue, 01 Dec 2009 12:28:00 +0000

A few days ago, the website of the Ministry of Finance carried a draft report consisting of recommendations by a Task Force appointed by the Confederation of Indian Industry (CII) to reform corporate governance norms in India. This Task Force was appointed in the wake of the Satyam scandal earlier this year, and its recommendations represent one of the most significant pieces of reform following that scandal.

Yesterday, the recommendations were put up for voluntary adoption by Indian listed companies. The reasoning is as follows:

Large, highly visible and publicised corporate scandals often provoke legislative and regulatory actions. CII advocates caution against overregulating. It needs to be recognised that while the super-structure of corporate governance is built on laws and regulations, these cannot be anything more than a basic framework. Much of best-in-class corporate governance is voluntary – of companies taking conscious decisions of going beyond the mere letter of law. The spirit of this Task Force Report is to encourage better practices through voluntary adoption - based on a firm conviction that good corporate governance not only comes from within but also generates significantly greater reputational and stakeholder value when perceived to go beyond the rubric of law.

Therefore, it is only natural that this report should focus on recommendations, which are being placed before corporate India for adopting voluntarily. It is the belief of CII that Indian Industry would respond spontaneously and help set standards, which would define global benchmarks in the medium term.

This is similar to the approach followed by the voluntary code initiated by CII in 1998 that spearheaded the corporate governance process in India.

The current set of recommendations touches upon a number of reforms that were long overdue.

1. Appointment of independent directors

Although the requirement of director independence is now well recognized in India, there is a fundamental flaw in that independent directors continue to be appointed by the majority shareholders (or promoters), and this impinges upon the independence in fact of the individuals so appointed. The requirement of a nomination committee is not mandatory under Clause 49 of the listing agreement. The Task Force recommendations call for the constitution of a nomination committee consisting of a majority of independent directors (including chairman) to evaluate, shortlist and recommend appropriate candidates for the position of independent directors and non-executive directors. Although this is a welcome move, a lot depends on the process followed by the nomination committee and the extent to which the nomination process is transparent.

The following is an example of the exacting standards required to be followed by nomination committees that may provide some guidance:

The [nomination committee requirement] significantly expands the disclosures relating to the director nomination process. A company is … also required to: make the nominating committee's charter publicly available, disclose whether the nominating committee members meet … independence requirements, disclose whether the committee has a policy regarding considering nominees recommended by shareholders, describe the minimum qualifications for nominees recommended by the committee, describe the qualities and skills that the nominating committee believes are necessary or desirable for board members, describe the nominating committee's process for identifying and evaluating candidates and whether fees are paid in connection therewith, disclose who recommended the nominee, and disclose the identity of any candidate nominated by a holder of more than five percent of the voting common stock, regardless of whether the nominating committee chose to nominate that candidate.

Patty M. DeGaetano, “The Shareholder Direct Access Teeter-Totter: Will Increased Shareholder Voice in the Director Nomination Process Protect Investors?” (2005) 41 Cal. W.L. Rev. 361 at 382.

The Task Force recommendations require listed companies to issue formal letters of appointment to non-executive and independent directors that set out their duties, liabilities and remuneration. Missing in this discourse is a detailed analysis of the precise role that independent directors ought to discharge on listed companies, i.e. advisory or monitoring.

2. Remuneration of directors

This issue has acquired great significance lately. The Task Force points to deficiencies in the current practice of linking director remuneration to the profitability of companies and recommends that companies should have the option of choosing between paying a fixed contractual remuneration or continuing with the existing practice of paying a commission on a percentage basis. Appropriate caution is also to be exercised while remunerating directors through stock options, as the options are to be held by the director until one year of exiting the board. This is to prevent short-termism at the board level.

Furthermore, the Task Force recommends a fixed component (not more than 30%) and a variable component (at least 70%) for remuneration of non-executive directors, apart from additional payments for roles such as chairman, membership or a committee, etc.

3. Audit committee

Currently, two-thirds of the audit committee must be independent directors. Recognising the insufficiency of existing safeguards, the Task Force recommends that all member of the audit committee must be independent. Moreover, the role of the audit committee is proposed to be enhanced. As far as related party transactions are concerned, the role of the audit committee as presently envisaged is to ensure appropriate disclosure of the same in the financial statements. The Task Force now recommends that the audit committee (consisting of independent directors) should be given the power to pre-approve material related party transactions. This specific power of approval given to independent directors is a novelty in the Indian scenario, although that exists as a crucial safeguard in other jurisdictions such as the U.S. (Delaware) to prevent loss of shareholder value due to related party transactions, particularly those between the company and a controlling shareholder or group.

4. Other board reforms

The Task Force recommended several matters relating to the board process. These include:

- separation of the offices of the chairman and the chief executive officer;
- conduct of board meetings through tele-conferencing and video-conferencing;
- encouraging executive sessions of independent directors.

5. Audit Reforms

Noting the ambiguities in current regulations governing the auditing industry, the Task Force calls for independence of auditors, including by addressing the provision of non-audit services by auditors, recommending mandatory rotation of auditor partners as a first step, and rotation of auditors as next. Measures have also been proposed to enhance the liability of auditors.

Finally, the Task Force recommends changes to the overall corporate governance set up in India. It calls for greater emphasis on risk management (an issue highlighted by the financial crisis), harmonization in the role of various regulatory agencies governing the financial sector, creating an effective and credible enforcement mechanism and emboldening institutional investors and the press to adopt an activist stance.

While this has begun as a voluntary exercise, at least some of these recommendations can be expected to find their place in Clause 49 of the listing agreement or in the Companies Bill, 2009.

Recent proposals for a Tobin Tax

mihircn@gmail.com (Mihir Naniwadekar) — Tue, 01 Dec 2009 09:42:00 +0000

Recently, the UK government proposed the levying of a ‘Tobin tax’ or a financial transactions tax to recover the cost of bailouts in recession situations. The proposal has not won many supporters; indeed, India is one of the countries which has opposed the tax. Despite initial rejections of the idea, the IMF is said to be considering the implications of such a tax.

Named after the economist James Tobin, the Tobin tax was initially conceived of as a tax on international trade of currency. The idea has gradually expanded to mean a tax on all banking financial transactions. The UK government sees the tax as a way of ensuring that the costs of future bailouts are borne by players in the financial sector, rather than by all taxpayers.A similar idea was proposed by John Maynard Keynes during the Great Depression. James Tobin then picked it up and developed it further in the 1970s. Neither of those efforts actually saw widespread acceptance for the idea. But, has the time for the Tobin Tax finally arrived?

Perhaps the main argument against the imposition of such a tax is that it would be unworkable in practice. As the UK government itself admitted, the tax would achieve its objectives only if it is imposed internationally. Politically, that seems to be unlikely. Nonetheless, economists have argued that the tax needs to be seriously considered. Paul Krugman, for instance, argues:

Why is this a good idea? The Turner-Brown proposal is a modern version of an idea originally floated in 1972 by the late James Tobin, the Nobel-winning Yale economist. Tobin argued that currency speculation — money moving internationally to bet on fluctuations in exchange rates — was having a disruptive effect on the world economy. To reduce these disruptions, he called for a small tax on every exchange of currencies... Such a tax would be a trivial expense for people engaged in foreign trade or long-term investment; but it would be a major disincentive for people trying to make a fast buck (or euro, or yen) by outguessing the markets over the course of a few days or weeks. It would, as Tobin said, “throw some sand in the well-greased wheels” of speculation…

Krugman’s article goes on to address some of the concerns voiced by opponents of the tax. Modified proposals have also been put forward to address concerns with the tax. [One of these is Paul Spahn’s two-tiered version of the tax which contemplates a minimal underlying transaction tax along with an exchange surcharge that is triggered only “in times of exchange-rate turbulence and on the basis of well-established quantitative criteria”.] While economically the tax might appear to have justifications, translating these into political consensus is bound to be problematic.

When are TDS provisions applicable?

mihircn@gmail.com (Mihir Naniwadekar) — Sun, 22 Nov 2009 13:32:00 +0000

In a decision which may lead to grave practical difficulties in international commercial transactions, the Karnataka High Court has recently ruled in effect that ‘tax’ must be deducted at source in respect of all payments made to non-residents, irrespective of whether or not the sums paid are chargeable to tax in India. The case, CIT v. Samsung Electronics, can be accessed here.

In the facts of the case, the assessee made some payments to a non-resident for the purchase of shrink-wrapped software. No deduction of tax at source was made in terms of Section 195. The AO held that the payments were chargeable to tax in

India

u/s 9(1)(vi) of the Income Tax Act, 1961 as ‘royalty’, and treated the assessee as an assessee-in-default u/s 201 of the Act for non-deduction of tax at source. The CIT(A) upheld this view. On appeal, the Tribunal held that the payments were for shrink-wrapped software, which is ‘goods’ following the decision of the Supreme Court in Tata Consultancy Services.

The judgment in TCS as also the subsequent decision of the ITAT in Sonata, (2007) 106 T.T.J. (ITAT) 797, make it abundantly clear that payments for shrink-wrapped software would not be chargeable to tax in

India

. V. Niranjan, in a recent article published in the Journal of Business Law describes the decision in Sonata thus:

"The leading case is Sonata Information Technology v Additional Commissioner of Income Tax, International Taxation. The Income Tax Assessing Officer considered that the payment for software import constituted "royalty" under s.9(1)(vi) of the Income Tax Act 1961, on the reasoning that there was no sale of software as there was no transfer of ownership rights and sale, if any, was only restricted to the CDs in which the software is transacted… Royalty is payable only if the copyright itself is transferred, and Sonata correctly observed only a copy of the copyrighted software is licensed to the user. However, Sonata then followed Tata Consultancy Services to hold that it is a sale of goods, which by definition does not attract royalty." [Footnotes omitted]

(See: V. Niranjan, “A Software Transfer Agreement And Its Implications For Contract, Sale Of Goods And Taxation”, [2009] 8 J.B.L. 799)

Thus, it is clear that the AO in the facts of the Karnataka decision got it wrong – the payment was not chargeable to tax in

India

. This would have been sufficient to dispose of the appeal – but the High Court’s view was that this evident non-chargeability was completely irrelevant. The Court held that the moment there is a payment made to a non-resident, the provisions of Section 195 are attracted. Non-chargeability is no excuse to avoid deduction of tax at source. The only situation when tax need not be deducted is if the payee files an application before the AO for the grant of a certificate authorizing him to receive the sum without deduction.

The effect of such a reading is quite incongruous. For example, one might consider this position along with the stance of the Revenue in the Vodafone case that Section 195 applies even to payments where both the payer and the payee are non-residents. If both these propositions are to be accepted (i.e. chargeability is irrelevant and situs of payment/payer is irrelevant) the conclusion is that an English company paying a sum of money to another English company for reasons entirely unconnected with India, would be an assessee-in-default under the Indian Income Tax Act unless it gets a certificate from the Indian AO! For, the question of whether that payment is susceptible to tax in

India

is entirely irrelevant. I had discussed the law on the extraterritoriality of Section 195 here. For the moment leaving aside the issue of extraterritoriality, even assuming that the payment is made by a resident, this position is likely to cause grave commercial hardship. Even assuming that a payment is specifically exempted by the Act or by a treaty, a withholding liability u/s 195 will subsist. The only remedy is for the non-resident to file an application – something that is only likely to increase delays and promote uncertainty in commercial transactions.

Does the plain language of the provision support the Court’s stance? Section 195 says, “Any person responsible for paying to a non-resident, not being a company, or to a foreign company, any interest (not being interest on securities) or any other sum chargeable under the provisions of this Act (not being income chargeable under the head "Salaries" shall, at the time of credit of such income to the account of the payee or at the time of payment thereof in cash or by the issue of a cheque or draft or by any other mode, whichever is earlier, deduct income-tax thereon at the rates in force…”

On its plain reading, the applicability of Section 195 turns on whether the sum is chargeable or not. Perhaps realizing this difficulty, the Karnataka High Court sought to place reliance on the Supreme Court judgment in Transmission. The Court’s reasoning effectively consisted of reproducing a few paragraphs in Transmission, and concluding that the issue was a settled one.

The facts in Transmission, seen from the Supreme Court judgment, were that appeals were filed by the assessee against an order of the AO treating the assessee as an assessee-in-default. These appeals were allowed by the CIT(A), who stated that the words “any other sum chargeable under the provisions of this Act” in Section 195 do not contemplate trade receipts within their ambit, and Section 195 applies only to cases where the sums paid are ‘pure income profits’. The ITAT was of the same view. On further appeal, the High Court stated that two fundamental questions arose for consideration, which were: (a) whether the provisions of Section 195 are applicable to cases where the sum paid to the non-resident does not wholly represent income; and (b) if Section 195 is applicable in such cases, whether the AO could enforce deduction of tax at source on the gross amount of trading receipts or only in respect of that portion of the trading receipts which may be chargeable as income under the Act.

Before the Supreme Court, the same two issues were raised in appeal. The Supreme Court held, “The scheme of Sub-sections (1), (2) and (3) of Section 195 and Section 197 leaves no doubt that the expression “any other sum chargeable under the provisions of this Act” would mean ‘sum’ on which income-tax is leviable. In other words, the said sum is chargeable to tax and could be assessed to tax under the Act.”

Undoubtedly, the Court went on reject the assessee’s first contention; saying, “there is no substance in the contention of the learned Counsel for the Appellant that the expression “any other sum chargeable under the provisions of this Act” would not include cases where any sum payable to the non-resident is a trading receipt which may or may not include ‘pure income’. At the same time, the Court clarified, “the answer given by the High Court that (i) the assessee who made the payments to the three non-residents was under obligation to deduct tax at source under Section 195 of the Act in respect of the sums paid to them under the contracts entered into; and (ii) the obligation of the respondent-assessee to deduct tax under Section 195 is limited only to appropriate proportion of income chargeable under the Act, are correct.”

The portions of the judgment underlined above would clearly indicate that the controversy before the Karnataka High Court was not a settled one – if anything, arguably, the issue was settled in favour of the assessee insofar as chargeability being a precondition for application of TDS provisions. It is perhaps time for the Supreme Court to step in and set the record right.

Dissecting Indian Corporate Governance

v.umakanth@gmail.com (Umakanth V.) — Fri, 20 Nov 2009 10:07:00 +0000

India Knowledge@Wharton carries a discussion (or a mutual interview of sorts) between Wharton professors Jitendra Singh and Harbir Singh and former SEBI Chairman M. Damodaran on several issues pertaining to Indian corporate governance, including the role of independent directors. The discussion is rich in that it dissects several fundamental issues of Indian corporate governance, such as whether it is prudent for Indian corporate governance to follow other models or whether it should develop a model of its own, a matter that we constantly endeavour to focus on this Blog. It examines the position and role of independent directors in an Indian setting, given the existence of controlling shareholders (or promoters). The discussion is also radical and provocative at some level – for example, there is a suggestion that Indian regulations should consider two-tier boards (similar to those present in certain civil law countries such as Germany and China) that is likely to lead to better monitoring and governance of companies. While the emergence of this line of thought in India is noteworthy, its practicality and likelihood of success is far from being guaranteed. Overall, it is an interesting and thought-provoking discussion.

The SEBI-NSDL Controversy

noreply@blogger.com (Shantanu Naravane) — Thu, 19 Nov 2009 14:35:00 +0000

The recent decision of the SEBI to set aside as ultra vires two orders passed by a Special Committee set up by it has led to a huge furore in commercial and legal circles. The origin of the controversy was the appointment of CB Bhave as the Chairperson of the SEBI at a time when SEBI was investigating the propriety of the actions of the National Securities Depositary Limited (“NSDL”), in relation to several past events. The fact that CB Bhave had been the CMD of NSDL prior to his appointment as Chairman of SEBI, lead to an obvious conflict of interest. In order to avoid this conflict, it was decided that the investigation be carried out by an independent Committee. The investigation was completed and an order delivered in December 2008. In a departure from usual practice, the SEBI did not disclose the findings till November this year, when it also declared that the two orders were ultra vires and hence void. The basis of this conclusion was that

a. The Board had delegated its authority to the committee to dispose of three quasi-judicial proceedings pending against NSDL.

b. The committee, however, entered findings that the Board failed as a regulator, while disposing of two matters relating to IPO Irregularities and DSQ Software Ltd.

c. These findings against the Board are outside the confines of delegation and therefore, these are without the authority of law.

d. These findings, which have vitiated these two orders, cannot be severed from the rest of the orders. Hence these orders are null and void and are non est.

e. The third order (in the matter of Rajnarayan Capital Market Services Limited) is in order since it does not have similar findings.

Much has been said about the effect of such a decision on the accountability of the SEBI, and the real suspicion that the decision is in bad faith. However, there are also two important legal issues that arise from this decision of the SEBI, which is what I focus on here. These are:

First, does the SEBI have the power to declare an order of the Special Committee as ultra vires? Secondly, even if it has this power, was the order here in fact ultra vires and liable to be declared void?

On the first issue of the powers of the SEBI, they are comprehensively covered by Chapter IV of the SEBI Act (these powers have also been discussed earlier). The structure of the Act broadly envisages action of two types- taken by the SEBI itself (ss. 11, 11A and 11B), or by an Investigating Authority appointed by the SEBI (s. 11C). The decisions taken by either of these are appealable only to the Securities Appellate Tribunal (ss. 15T, 15Y and 20A). Besides this appeal mechanism, the Central Government can also be appealed to (s. 20), and it can also take other action against the decision of the Board or the Investigating Authority (ss. 16 and 17). This schema suggests that the SEBI has no review power over the actions of the Investigating Authority, which is what has led some to argue that the decision in the NSDL case was also incorrect. However, it is important to appreciate that the nature of the Committee and the Investigating Authority is fundamentally different. The Committee was exercising the powers of the SEBI under ss. 11 and 11B, which were delegated to it under section 19. There is nothing in the Act to suggest how the exercise of this delegated power can be controlled. Admittedly, such a power has arguably never before been exercised by SEBI (there is a dispute over whether it was exercised on 2006). However, given that the Special Committee was the first body of its sort under the SEBI framework, there is limited value that can be garnered from past precedent. This necessitates reliance on general administrative law principles on sub-delegation. Usually, the controversy over sub-delegation is focussed on whether the delegate has the power to sub-delegate. Given section 19, this isn’t in issue here. The other issue is the extent to which the delegate can exercise control over the sub-delegate. While this has been a point of serious contention, the more supported view seems to be that the delegate continues to retain authority over the matter that has been sub-delegated. Though some decisions like the UK Court of Appeals in Blackpool Corporation v. Locker, [1948] 1 KB 349) and the Employment Appeal Tribunal in Department For Environment Food & Rural Affairs v. Robertson, [2004] ICR 1289 (affirmed on a different point in Robertson v. Department For Environment Food & Rural Affairs, [2005] EWCA Civ. 138, para. 41), have departed from this view, they have been criticised as proceeding on a mistaken understanding of ‘sub-delegation’ (Jackson, 66 LQR 363, 376). In any event, these decisions also only restrict the rights of the delegate during the delegation, and do not prevent it from revoking the delegation. Thus, there seems to be nothing to prevent SEBI from reviewing the exercise of the delegated powers by the Special Committee, especially when what it purported to review was not the decision per se, but the scope of the decision.

This is not to say that the exercise of this power was appropriate on the circumstances here. In fact, while I believe that SEBI has the power to revoke the authority granted to the Special Committee or to declare it void, there is no doubt that the power was incorrectly used here, for two reasons-

First, the very reason for the constitution of the Special Committee was to avoid all conflicts of interest resulting from Mr. CB Bhave’s previous position on NSDL. The fact that independent and not existing members were chosen for the Committee clearly shows that the mere recusal by Mr. Bhave was considered insufficient to counter the conflict of interest. Subjecting the decision of this independent body to the review of the very body that may be influenced by a conflict of interest seems incorrect and undesirable. In these special circumstances, I think the review by the SEBI was inappropriate, and could not be remedied only by Mr. Bhave’s recusal.

Secondly, the SEBI declared the orders of the Special Committee ultra vires because they consider the role of the SEBI instead of focussing only on NSDL. Further, these observations on the functioning of the SEBI are considered to be so fundamental as to constitute an integral part of the decision. However, a reading of the orders suggests nothing of the sort. In fact, after a few passing mentions during the text of the order dealing with the IPO scam, in the penultimate paragraph 94, the members specifically state, “It would not be appropriate for us to leave this matter without expressing our concern about the failure of SEBI to carry out its regulatory role adequately”. This shows that the observations were ancillary to the other findings of the members, far from being integral and inseparable from their other findings. Further, of the three orders, only the ones pertaining to the IPO scam and DSQ Software were annulled. The third order regarding Rajnarayan Capital Market Services Ltd. was affirmed on the basis that the Committee had made no such observations outside the scope of its mandate. However, as rightly pointed by one of the several discussions of this issue, this distinction is incorrect. Even the RCMSL order contains a recommendation to the SEBI, in paragraph 35. The only difference is that there are no general observations or strictures against the SEBI. This lends force to the argument that the other orders were held ultra vires not due to the consideration of SEBI’s conduct, but because of what they said about SEBI’s conduct. This conclusion also finds support in the fact that the SEBI refused to disclose the orders for about 11 months.

In sum, SEBI’s decision to declare ultra vires the decisions of the Special Committee appointed to look into the NSDL matter is incorrect. However, the problem with the decision is less the lack of competence of the SEBI to take the decision, but more the propriety of the decision on its merits. Hence, while the apprehension over the decision and its implications is justified, doubting the competence of the SEBI to make such a determination would be directing the disapprobation at the wrong target.

Some Literature on Governance and Social Responsibility

v.umakanth@gmail.com (Umakanth V.) — Mon, 16 Nov 2009 08:59:00 +0000

Professor Balasubramanian of IIM Bangalore has posted two interesting papers.

In the first paper, Addressing Some Inherent Challenges to Good Corporate Governance, he examines certain specific issues arising due to the concentrated ownership in Indian listed companies. Specifically, he notes:

While the objectives of good governance, namely creation, protection and equitable distribution of shareholder value, have long been recognized, their full achievement in practice has been dogged by challenges emanating from various sources like dominant shareholders, autocratic executive managements, inefficient independent auditors, inefficient enforcement mechanisms, and so on. Standing out prominently among these challenges is the potential for controlling shareholder dominance often abetted, unwittingly or otherwise, by inefficient board surveillance over the executive.

He then considers two specific issues, both involving corporate decision-making, one at the board level and the other at the shareholder level.

Although Indian listed companies are mandated to have independent directors, Professor Balasubramanian notes that independent directors have not been conferred significant powers. For instance, independent directors are to vote on the board like any other directors, which means that they can be outvoted (unless, of course, independents constitute a majority on the board, which is almost a rarity). Furthermore, quorum requirements do not require the presence of independent directors. The solution he proffers is that independent directors should be given affirmative votes or veto powers on specific matters, particularly those that involved conflict of interest or self-dealing transactions. While this will certainly empower independent directors, it will also impose significant responsibility and accountability that such individuals have to property discharge.

At the shareholder level, he advocates the concept of interested shareholders, whereby those who are interested in a resolution (e.g. controlling shareholders in a self-dealing transaction) ought not to participate in the voting process. Current law does not impose any duties on shareholders to abstain from voting at a general meeting, except in certain limited circumstances imposed by SEBI, as discussed earlier on this blog.

In sum, Professor Balasubramian’s recommendations are in furtherance of the recognition that corporate governance norms in India ought to be tailored to suit the structures and environment that operate in the Indian business context.

The second paper, Governing the Socially Responsible Corporation - A Gandhian Perspective, explores the linkages between corporate governance and Gandhian philosophy. The paper considers Gandhian traits relating to trusteeship, truth, non-violence, and the like, in the corporate context. For example, the element of trusteeship is inherent in directors’ fiduciary duties (e.g., loyalty) towards a company; truth is the basis for corporate disclosures and securities regulation; non-violence carries with it principles of social responsibility whereby the activities of corporations ought not to cause harm to its larger group of stakeholders. The paper also has a useful set of dos and don’ts in corporate governance viewed in this light.

'Principal place of business' - Oral Arguments in Hertz v. Friend

noreply@blogger.com (Shantanu Naravane) — Sun, 15 Nov 2009 06:43:00 +0000

An earlier post had discussed the issue in Hertz v. Friend, which calls upon the United States Supreme Court to determine what is the ‘principal place of business’ of a corporation having operations in more than one State. The Court heard the matter on 10^th November, and the transcript is available here. Unfortunately, while it makes interesting read, the potential the case seemed to have for a discussion on general corporate law theory remains unrealised. A majority of the arguments focussed only on the policy behind the Class Action Fairness Act, with a very limited discussion of concepts like ‘headquarters’ or ‘gaming the system’.

The idea of ‘headquarters’ formed a substantial portion of the petitioner’s arguments, where he was required to discuss the effect of following a headquarter-rule for determining the principal place of business. The headquarter was defined as the place from which the corporation is ‘directed and controlled’. The ultimate test the petitioners seemed to be advocating is that there is a strong presumption in favour of the headquarters being the principal place of business, which can be rebutted if it is proved to be a sham. As to the defendants contention that ‘principal place of business’ was a term of art borrowed from bankruptcy laws, the petitioner argued that they are two terms referring to the same thing.

The defendants focussed more on the policy behind the CAFA, and suggesting that the Congressional intent clearly sought to depart from the headquarters being considered the principal place of business. It was contended that following the headquarters test would allow corporations to ‘game the system’, and should not be allowed. Justice Scalia responded by suggesting that ‘gaming the system’ should not really be a concern since it wasn’t much of a concern in determining the citizenship of individuals. In conclusion, the respondents submitted that the ‘principal place of business’ has to be determined with reference ‘first to the location of employees, tangible properties and production activities, and then second to income earned, purchases made and where sales take place’.

Thus, the oral arguments failed to churn up the discussions on corporate law that could have been expected, and barring the few issues mentioned above, focussed entirely on the policy behind the CAFA and diversity jurisdiction in the US in general. It now remains to be seen what the Court finally chooses as the primary basis of its decision.

Other discussions of the case are available here and here.

Bits of Interest

v.umakanth@gmail.com (Umakanth V.) — Sat, 14 Nov 2009 03:42:00 +0000

1. Siddharth Shah, et. al., offer suggestions for amendment of the SEBI Takeover Code in light of its review by the Takeover Regulations Advisory Committee (TRAC);

2. Shantanu Surpure and Rashi Saraf compare and contrast the regulations in the US and India regarding insider trading, and point to the difficulties in successful investigation and prosecution of violations;

3. Sandeep Parekh critiques SEBI’s approach in the IPO scam cases;

4. T.T. Ram Mohan views Government disinvestment in public sector undertakings from a governance perspective;

5. The Reserve Bank of India (RBI) announces draft guidelines with a view to liberalising the regime governing derivatives in foreign currency by permitting certain types of put and call options, while prohibiting others;

6. The Economist analyzes the acquittal of two Bear Stearns hedge fund managers who were prosecuted for lying to investors about the state of their funds. They are said to have exchanged e-mails that “showed the two panicking behind the scenes while reassuring investors in public.” The collapse of the two Bear Stearns hedge funds in 2007 exhibited the first signals of the financial crisis. This case has some similarities with that of a stock analyst at Merrill Lynch during the Internet bubble years, but the latter case resulted in a different outcome;

7. Noted economist Dani Rodrik disfavours the removal of capital controls. He notes: “Prudential control on capital flows makes a lot of sense. Short-term flows not only wreak havoc with domestic macro-economic management, but also aggravate adversary exchange-rate movements”. He adds: “You can oppose capital controls because you believe financial markets are on the whole a force for good, and that any interference will therefore generate efficiency losses. Or you can oppose controls because you think that they can be easily evaded and are therefore doomed to remain ineffective. What you can’t do is oppose capital controls because they are both costly and ineffective.” All of this is surely music to RBI’s ears.

8. Finally, the Harvard Law School Forum has some lessons for M&A advisors in drafting their engagement letter to protect themselves from third-party liability, at least as a matter of New York Law.

Yet Another Controversy over Section 14A

noreply@blogger.com (Shantanu Naravane) — Fri, 13 Nov 2009 21:15:00 +0000

Earlier posts here had discussed the decision of a Special Bench of the Bombay ITAT in Daga Capital and the possible inequities that could result from its interpretation of section 14A. The most significant one was that expenditure could be disallowed even if no nexus was established between the expenditure and tax-free investment income. To quote from an earlier post explaining the inequity,

Section 14(A)(2) provides that if the Assessing Officer (AO) ‘is not satisfied’ with the assessee’s claim as to the amount of expenditure relatable to exempt income, he shall determine the amount of expenditure ‘in accordance with such method as may be prescribed’. This prescribed method in provided in Rule 8D of the Income Tax Rules, according to which the amount of expenditure disallowed is proportionate to the amount of tax-free investments made, irrespective of the source of the investment. Thus, the mode of computation uses the proportion of the investment vis-a-vis the total assets of the company, to determine what proportion of the total expenditure should be disallowed. Further, section 14A(3) provides that this mode of computation applies also when the assessee claims that no expenditure has been incurred by him in earning the tax-free income. An archetypical case would be when an enterprise has sufficient reserves of interest-free funds to make a tax-free investment. In such a case, there is no question of there being any expenditure in relation to earning tax-free income, since the funds invested in the earning of the income have been internally provided. In such a case, ideally, there should be no disallowance of deductions for expenditures that may have been incurred in other activities of the business. Prior to the decision in Daga Capital, there were a few decisions, specifically in the context of section 14A, stating that the burden was on the Revenue to show the link between the expenditure incurred and the tax-free income earned. However, after the broad interpretation of the provision and the retrospective application of the computation provisions vide Daga Capital, the position seems to have undergone a change. This means that even if an enterprise has not, in fact, borrowed for the purposes of making tax-free investment, but borrowed for other purposes, it still would be denied deductions to the extent worked out by Rule 8D.

Two decisions of the ITAT had sought to alleviate the inequity of the position, by creating a presumption in favour of the assessee in certain cases or by holding that the extent of disallowance cannot be increased on an application of Rule 8D.

However, the Punjab and Haryana High Court in CIT v. Hero Cycles has finally done that which the Tribunal could not do due to rules of precedent- it has held that notwithstanding the application of Rule 8D, the establishment of a nexus between the expenditure incurred and the tax-free income has to be established by the Revenue. On facts, one of the units of the assessee had incurred interest expenditure, and the assessee as a whole had earned some tax free dividend income. The Revenue sought to connect these two together, and apply Rule 8D to disallow the expenditure. However, the CIT(A) found on facts that the interest expenditure had been set off elsewhere, and the dividend income was earned from the investment of tax free money. Based on this finding of fact, the CIT(A) upheld the assessee’s contention.

This decision was appealed against by the revenue to the High Court. Relying on its August 2009 decision in CIT v. Winsom Textile Industries Ltd., the Court affirmed the order of the CIT(A), opining that “[d]isallowance under Section 14A requires finding of incurring of expenditure where it is found that for earning exempted income no expenditure has been incurred, disallowance under Section 14A cannot stand”. While the decision doesn’t seem remarkable in itself, given the concerns expressed after Daga Capital, it serves as an assurance to assessees incurring expenditure and earning tax-free income through different parts of their business.

However, another twist to the issue is provided by the recent order of a Third Member of the Ahmedabad ITAT in Kanel Oil v. JCIT. Discussing the hierarchy between a Special Bench decision and the decision of a non-jurisdictional High Court, the Third Member held that the High Court would override only if there was no other conflicting High Court decision on the issue, and if the High Court decision was not per incuriam. On facts there, the Third member held that the High Court had ignored certain statutory provisions, rendering it per incuriam. On this basis, he held that the Special Bench decision would override the High Court. The merits of this decision, and the competence of a lower court to determine whether the decision of a higher court is per incuriam can be the subject of much independent debate. However, what is relevant here is to note that if Kanel Oil is to be followed, the position may be unsettled even after Hero Cycles. The computation scheme under Rule 8D(2)(ii) and (iii) specifically provides for disallowance even if there no nexus between the expenditure and the income. On this basis, it may be possible to argue that Hero Cycles ignores the text of Rule 8D, and being the decision of a non-jurisdictional High Court, need not be followed in Bombay, where Daga Capital’s Special Bench order would continue to hold fort.

In sum, Hero Cycles seemed to have provided a certain panacea to assessees concerned about the precise scope of Rule 8D and the decision in Daga Capital. However, the degree of relief afforded has been lessened by the uncertain implications of Kanel Oil.

A Round-up on Recent SEBI Reforms

v.umakanth@gmail.com (Umakanth V.) — Thu, 12 Nov 2009 10:40:00 +0000

Earlier this week, SEBI announced a slew of capital market reforms. This comes in the wake of recovery in the markets as well as the Government’s intention to undertake disinvestments in public sector undertakings (PSU). The principal reforms and their impact are discussed below.

Small and Medium Enterprises (SMEs)

SEBI has established a separate regime for listings by SMEs. Companies listing on the SME segment need not comply with the eligibility norms for initial public offerings (IPOs) and follow-on public offerings (FPOs) that are applicable to other companies. However, in order to ensure that only financially sound investors invest in these markets, a minimum application size of Rs. 100,000 has been prescribed. SMEs are eligible to access capital markets under this category so long as their paid-up capital is no more than Rs. 25 crore (Rs. 250 million). If the paid-up capital exceeds this amount, then such company’s listing would be transferred to the main board. In addition, provision has been made for a market-making mechanism for SMEs, and some relaxations have been made for accounting and financial disclosure requirements

These moves are expected to enable companies in the SME segment to access capital markets without being subject to onerous conditions.

Price Discovery in FPOs

In a significant move, SEBI has introduced an additional method of book building for FPOs. Under this scheme, there would only be a floor price set by the company, and bidders would be free to bid at any price above that. Bidders would be allocated shares on the basis of the price they have quoted. In other words, different bidders will be allocated shares at different prices, a novelty in the Indian scenario. However, there is one exception, and that is retail investors would be allotted shares at the floor price. This not only protects retail investor interest, but also pays some regard to the sophistication of institutional investors who are comparatively financially savvy.

While the motive for the introduction of this method may perhaps be relatable to the government's embarkation on the road to disinvestment and the need to fetch as high a price as possible for its shares in PSUs, its success in broader terms may not be free from doubt. It is not clear why companies may adopt the FPO route (which tends to be quite elaborate) rather than use the qualified institutional placement (QIP) route which has been offered to listed companies in a simplified form (and has indeed gained popularity).

One significant question that has been raised pertains to why this option has been made available only to FPOs and not to IPOs. Curiously enough, the price of shares of listed companies is readily available through the discovery mechanism in the secondary markets, which is itself some indication of the value of the company's shares. On the other hand, unlisted companies that are proposing to undertake an IPO do not have the benefit of such a price set by the markets. The current mechanism for IPOs requires the issuing company to indicate a price band, which the investors are bound by. The IPO mechanism does not call for investors bidding at differential rates, although it is precisely in that case that such a mechanism may be more useful than in the case of an FPO where the market price itself provides some guidance. It is possible though that if this additional mechanism is successful in FPOs, there would be a strong case for its introduction in IPOs as well.

(Update – November 14, 2009: The Financial Express has a column by Rajesh Chakrabarti that examines the new FPO pricing option in detail, which also refers to a research paper by Amit Bubna and Nagpurnanand Prabhala)

Miscellaneous Matters

Several other measures have been introduced to enhance the capital markets. These include:

- streamlining the timing of financial disclosures by listed entities;
- interim disclosures of balance sheet items by listed entities;
- simplification of requirements for fast track issues for listed companies desirous of undertaking FPOs or rights issues; and
- voluntary adoption of IFRS by listed entities having subsidiaries.

Other Reforms

Prior to this, SEBI also announced certain secondary market reforms. These are based on the recommendations of the Secondary Market Advisory Committee:

1. A discussion paper outlines the guidelines for incorporating conditions or clauses in powers of attorney issued by clients to the stock brokers or depository participants; and

2. A circular allows SEBI registered stock brokers to provide access to clients through authorised persons. The detailed eligibility conditions for authorised persons as well as the roles and responsibilities of the relevant parties are set out in detail.

Auxiliary Activities and Permanent Establishments

noreply@blogger.com (V. Niranjan) — Sat, 07 Nov 2009 20:32:00 +0000

We have discussed on several occasions the extent to which a liaison office of an MNC is taxed, and more generally, the concept of a “permanent establishment”. A series of decisions in 2009 has introduced some clarity in the analysis of what constitutes a permanent establishment and what does not. To briefly recapitulate, although s. 9(1) of the Income Tax Act, 1961, enumerates circumstances where income is “deemed to accrue or arise” in India, primarily through a business connection test, several DTAAs provide that income earned in one Contracting State may be taxed in the other Contracting State only if it is attributable to a permanent establishment in that State. Permanent establishment is invariably defined in these treaties, but often excludes entities that only perform “auxiliary activities” in the taxable State. It is thus important to determine what legal principle distinguishes an “auxiliary activity” from other activities, and this question arose most prominently in the context of the taxation of liaison offices.

In February 2009, the Delhi High Court held in UAE Exchange Centre v. Union of India (313 ITR 94) that the exclusionary clause of auxiliary activities must be construed broadly. In that case, the parent company, incorporated in UAE, performed remittance services for NRIs in UAE, where it transferred funds to the NRI’s family in India, on the payment of a fee. The contract was concluded in UAE and payment was received by the company in UAE, denominated in local currency. However, the company also used liaison offices in India to effect the transfer, and the liaison offices consequently had access to the company’s server in the UAE. The liaison office would then download the particulars of the remittance, make the necessary demand draft and despatch it in accordance with the instructions of the remitter. The Revenue argued that the contract was in effect performed by the liaison office – for the essence of the contract was the remittance of money – and that this could consequently not be regarded as “auxiliary”. The AAR had accepted this contention. The Delhi High Court quashed this order, and observed that “but-for” test is inappropriate in construing the exclusionary clause – in other words, the fact that the contract could not have been performed without the aid of the liaison office’s activities is not determinative of its status as an “auxiliary” activity or otherwise. The Court held that the test is broader, and that it was auxiliary because it was in “support” of the main activity entered into in the UAE, for payment in the UAE. In what is likely to be of some importance in subsequent cases, the court also observed that “[o]rganisations and companies operate transnationally. There is an eagerness to bring to tax by States income, by employing deeming fictions so that incomes which ordinarily do not accrue or arise within the taxing State are brought within the States' tax net. It is in this context that the expression "permanent establishment" appearing in the DTAA has to be viewed.” The case is also important for the proposition that the AAR constitutes a “Tribunal” for the purposes of Art. 227 of the Constitution.

This view has been followed. In Cable and Wireless Networks (315 ITR 72), decided in July, a branch office of a UK corporation performed network designing, network management services and other support activities. The AAR held that it did not constitute a permanent establishment since the activity is auxiliary. Similarly, in KT Corporation (181 Taxman 94), a Korean corporation opened a liaison office in New Delhi for the purpose of communicating with Indian banks and other commercial entities. The AAR referred to the OECD Model Commentary’s analysis that the activity must form an “essential and significant part of the enterprise as a whole” and held that the LO did not constitute a PE, relying on Morgan Stanley as well as UAE Exchange. In Hyosung Corporation (314 ITR 343), the AAR reached a tentative conclusion to the same effect.

These decisions are of some importance in enumerating the circumstances under which the head office may be liable to tax exposure on account of the activities of the liaison office. Moreover, the line that the cases have taken – of construing the exclusionary clause of auxiliary activities – appears to be correct and in consonance with the intention of the parties to the DTAA.

Law Firms and Joint Ventures

v.umakanth@gmail.com (Umakanth V.) — Thu, 05 Nov 2009 12:21:00 +0000

A few months ago, we had posted about a paper by Professor Jayanth Krishnan on issues that revolve around the opening up of the Indian legal sector to foreign law firms. He has now released the results of another interesting piece of research titled The Joint Law Venture: A Pilot Study that examines the rate of success or failure of joint ventures between law firms by looking closely at the “joint law venture” model followed over the last decade in Singapore. Here is the abstract:

This pilot study evaluates the effectiveness of law firms entering into joint ventures, an increasingly eyed business model particularly by American and British lawyers seeking to expand into promising financial markets. One country at the center of the joint venture experiment has been Singapore. With the strong encouragement of the Singaporean government (which has long embraced foreign investment), various elite law firms from the United States and Britain have been partnering with domestic Singaporean law firms for over the past decade. Because these foreign firms were traditionally barred from practicing Singaporean law on their own, the ‘joint law venture,’ or JLV as it came to be called, was initiated to provide the Americans and British with an opportunity to access the highly-desired, lucrative local market – through the use of their Singaporean joint venture colleagues. In return, the Singaporean firms were to benefit by gaining international legal contacts, learning ‘best practices’ from their foreign counterparts, and enhancing their reputations by being tied to prestigious law firm powerhouses.

Until now, no work has fully investigated whether these JLVs have actually fared as well as their advocates had hoped. Therefore, based on fieldwork conducted in Singapore, including in-depth interviews of the relevant parties, this project fills this gap – uncovering how due to economic misalignment, cultural misunderstandings, and a sheer breakdown of necessary human relationships, in more cases than not the JLV has been a failed business model. For these reasons, I argue that American and British law firms may wish to think seriously before pursuing the JLV route – not just in Singapore but perhaps even in other markets in which they are already present or are contemplating entering.

E-Voting in Indian Companies

v.umakanth@gmail.com (Umakanth V.) — Wed, 04 Nov 2009 09:52:00 +0000

Public (or retail) shareholders in a company usually exhibit traits that result in “collective action problems”. This refers to the difficulties that arise in achieving consensus among a diffused set of shareholders who do not play an active role in the company. These problems are exacerbated by the heterogeneity of interests and differing levels of information available with these shareholders. For these reasons, public shareholders seldom participate actively in general meetings of the company. In most cases, decisions of general meetings are a foregone conclusion as resolutions proposed by the board and management (with the tacit approval of the majority shareholders) are only put through the formal motion at the meetings. Public or minority shareholders make their appearance in small numbers, and their votes cast are not sufficient to cause any dent to the majority decision. Such problems are compounded because general meetings (which are often held in locations that are not prominent or easily accessible) require shareholders to be present in person or by proxy.

A solution to this problem was devised about a decade ago, which was voting through postal ballot. Section 192A of the Companies Act, 1956 provides that listed companies are required mandatorily to obtain resolution of shareholders through postal ballots on certain matters, and optionally on other matters. However, this has failed to achieve the intended result.

It has now been proposed, as reports (here and here) suggest, that online voting be introduced. There would be no legal or regulatory hurdle to begin with as the explanation to Section 192A states: “For the purposes of this section, "postal ballot" includes voting by electronic mode.” Hence, it is a question of prescribing the appropriate mechanism for electronic voting, which is an exercise reportedly being undertaken by the depositories.

Although it would be difficult to estimate the true extent of change that this proposal would usher in, it is certainly a move in the right direction. Electronic voting may motivate more shareholders (including individuals) to exercise their corporate democratic right with greater convenience, and this may signal greater acceptance of shareholder activism in the Indian context by addressing the collective action problems (at least partially).

Legal Risks and Financial Sector; Capital Controls

v.umakanth@gmail.com (Umakanth V.) — Tue, 03 Nov 2009 10:06:00 +0000

Recent developments in the financial sector have witnessed a sea-change in the nature of legal risks faced by banks and financial institutions. Regulators, banks and financial institutions, as well as their legal advisors (both in-house and external) are required to constantly keep pace with the change. In that context, a recent speech by Shyamala Gopinath, Deputy Governor of the Reserve Bank of India (RBI), contains an interesting account of the legal risks in the present environment, and the steps taken by the RBI to address those risks. The issues highlighted range from those relating to OTC derivatives, enforcement of security arrangements, and the effectiveness of bankruptcy laws (including from a cross-border perspective). While some of the issues carry international implications and have been highlighted due to the financial crisis, others are specific to India.

On a separate note, the Economist has a column that deals with capital controls in emerging economies. Commenting on RBI’s policy, it observes that it is difficult to argue against capital controls, especially given the Indian economy’s resilience in the wake of the global financial crisis: “Having avoided the Asian financial crisis in the 1990s and escaped the worst effects of the most recent meltdown, India’s cautious liberalisers feel they have won the argument this time around. It is hard to disagree.”

The column also describes the undue complexity of India’s capital control regime:

For starters, they are needlessly complex, because India’s policymakers like to retain as much room for manoeuvre as possible. They police capital flows by banning some trades, imposing quotas on others, lifting a price control here or tightening a registration requirement there. This makes life needlessly difficult for foreign investors. The rules are hard to interpret and changes are impossible to predict. One private-equity fund and its investors reckon this confusion and ambiguity cost them $8m in lawyers’ fees. This accomplishes the policymakers’ aim of deterring foreign capital, but not quite in the way they intended. By raising the cost of doing business, the regulatory thicket acts as an implicit tax on investing in India. Its policymakers could achieve the same effect through simple rules and explicit taxes. The $8m that is now spent on lawyers could be given to the Indian government instead.

There is certainly a case for simplification of various rules relating to capital flows. More importantly, the rules ought to be clear with very little left for interpretation.

See also a related report in the Economist.

United States Supreme Court considers a corporation's 'principal place of business'

noreply@blogger.com (Shantanu Naravane) — Fri, 30 Oct 2009 06:04:00 +0000

An important question, with significant implications for contemporary corporate law theory will be heard by the United States Supreme Court on November 10. The matter in question is Hertz Corp. V. Friend (08-1107), which poses the question of which State can be considered to be a corporation’s ‘principal place of business’.

The issue has arisen against the backdrop of a class action against the company, for the violation of state wage and labour laws. The suit was filed in a California State Court, in response to which Hertz Corp. removed the action to Federal district court. Before the Federal district Court, the respondents argued that Hertz’s principal place of business was California, hence it was a Californian citizen, and not different from any other plaintiff. On this basis, it was contended that the matter be remanded back to the State Court. The district court, relying on the ‘place of operations’ test, considered several factors like ‘the location of employees, tangible property, production activities, sources of income, and where the sales take place’, and concluded that since Hertz Corp.’s business in California was ‘significantly larger than any other state in which the corporation conducts business’, California was its ‘principal place of business’ in the United States. This decision was affirmed on appeal by the Ninth Circuit, whose decision is available here.

In its petition for certiorari before the Ninth Circuit Court of Appeal, and now before the United States Supreme Court, Hertz contends that the different circuits in the country are applying four different tests to determine the ‘principal place of business’, necessitating some clarity from the Supreme Court about the appropriate test to be used. The Seventh Circuit uses a ‘nerve center’ test focussed on the location of the ‘corporate brain’ or the corporate headquarters; the third circuit looks at the corporation’s center of activity, while some other circuits rely on the totality of the corporation’s activities (the Fifth, Sixth, Eighth, Tenth, and Eleventh Circuits). Of these, for a wide range of reasons, Hertz advocates the use of the ‘nerve center’ approach, according to which, its principal place of business would be New Jersey and not California. It is also supported in this view by the United States Chamber of Commerce. The respondents contend that though the tests being used are different in nomenclature, they result in very similar conclusions. Further, the Congress has specifically preferred the use of ‘principal place of business’ over ‘place of incorporation’ in §1332 of the Class Action Fairness Act of 2005 (“CAFA”). The ‘principal place of business’ being a term of art borrowed from bankruptcy law, it must be decided the way it is in bankruptcy law, i.e., by considering a wide range of factors, and not only the place of incorporation.

This has given rise to issues of whether corporations having a presence in more than one State should be allowed to chose which jurisdiction they can be sued in, and to what extent the theoretical headquarters of a corporation can be given precedence over the practical headquarters of its operations. Thus, the issue is of great significance, not only in the specific context of the CAFA, but also in corporate law theory in general. Particularly, given the similar controversy that has arisen around tax avoidance and multi-national corporations, the hearing on November 10, and the subsequent decision is of great interest. A more detailed discussion of the issues involved is available here, and copies of the briefs in the matter are available here.

Changing Advertising Practices in India - The End of "Puffery"?

noreply@blogger.com (V. Niranjan) — Thu, 29 Oct 2009 14:47:00 +0000

The Government's proposed “Advertising Code” for food and health products is an interesting development , particularly in light of developments in India over the past three years or so on the subject. This blog has discussed emerging trends in India on the norms governing advertising practices.

To briefly recapitulate, the law does not proscribe comparative advertising, which is a near-ubiquitous practice in today’s commercial world. It does not even require that the advertisement be true and accurate in every respect. English law for a long time was that an advertisement that was mere “puffery” could not form the basis for any action in law. This was based on the belief that an advertisement that is so exaggerated as to be clearly untrue is unlikely to cause any reliance on the part of the consumer who sees it, and consequently does not have to be regulated as strictly as advertisements that purport to be factual but are not. For example, an advertisement claiming that drinking a particular soft drink is the route to becoming a millionaire is clearly “puff”, and is less misleading than claiming that the soft drink is superior on account of the fact that competing drinks contain pesticides. This principle was accepted in India as well, until 2008, when the Madras High Court held that the peculiar circumstances of the Indian consumer make the doctrine inappropriate in Indian law. The Supreme Court and the majority of the High Courts had held otherwise, and the only real restriction on comparative advertising was that it could not "disparage" the goods of a competitor.

In this context, it is interesting to note that the Government’s proposal to introduce an Advertising Code appears to primarily tackle misleading and “puffed” advertisements in food and health products. The proposal has emerged under the framework of the Food Safety & Standards Act, 2006 [“the FSSA Act”], under which the Food Safety and Standards Authority of India has been set up [FSSAI]. The FSSA Act prohibits unfair trade practices and “misleading and deceiving advertisements”. The FSSAI notes although commercial advertising is a protected activity Art. 19(1)(a) of the Constitution of India, no law governs it, except guidelines drafted by the Advertising Standards Council of India [“ASCI”]. Those guidelines, however, have no binding force and are intended to function as self-regulation guidelines.

The Code proposes radical changes to existing commercial practices. The restrictions are that advertisements cannot disparage “good dietary practice”, encourage “excessive consumption”, suggest “portion sizes” that may be appropriately consumed and so on. The Code practically makes puffery illegal by prescribing that “advertisements should not mislead consumers…to believe that the consumption of the product advertised will result directly in personal changes in intelligence, physical ability or exceptional recognition, unless supported with adequate scientific evidence”. It also requires that “celebrities or prominent” people not promote food in such a way as to “undermine a healthy diet”. A copy of the entire Code is available here.

The merits of the regulation apart, it is important to consider a few serious questions of enforcement. For one, since the Code, as will inevitably be the case, is phrased in broad terms, it seems more appropriate that this be part of a self-regulation model. If, on the other hand, the FSSAI decides to enforce it, it may have to evolve suitable institutional support to be able to assess not only what advertisements offend the Code, but also whether there is parity in treatment. For example, s. 5(a)(1) of the Federal Trade Commission Act in the United States empowers the FTC to prevent advertisements that are inconsistent with the Act, in addition to the normal remedy of seeking an injunction from a civil court. Similarly, the United Kingdom in 1962 set up the Advertising Standards Authority to regulate advertising. When the ASA finds a particular advertisement to be inconsistent with the guidelines in the UK, the normal practice is for the owner of the advertisement to remove it, thus establishing a model of self-regulation.

Thus, the Madras High Court’s opinion of 2008 appears to have anticipated these developments. After noticing the law in England and the USA, the Court had observed then that “…it is doubtful if false claims by traders, about the superiority of their products, either simplicitor or in comparison with the products of their rivals, is permissible in law. In other words, the law as it stands today, does not appear to tolerate puffery anymore. I do not know if "Puffing" which is only a twin sister of "bluffing", permitted by English courts in the past, still has the sanction of law even in England, after the advent of 'legacy regulators' such as CAP, Oftel, Ofcom, Clearcast etc…”

If the Code becomes law, the interesting question for Indian law will be whether its principles ought to be extended to other areas of commerce as well. Comments on the Code are available here and here.

Powers of SEBI and SEC Compared

v.umakanth@gmail.com (Umakanth V.) — Thu, 29 Oct 2009 02:54:00 +0000

In his column in the Business Standard this week, our guest contributor Somasekhar Sundaresan argues that, if one were to go by the rule book, SEBI has greater powers than the SEC. He lists out several significant powers of SEBI that can be exercised without intervention of the court. Here are some excerpts:

Take the Raj Rajaratnam case itself. The SEC has had to file a complaint before a court (see http://www.sec.gov/ litigation/complaints/2009/comp21255.pdf) asking the court to pass orders to disgorge the alleged gains earned by way of insider trading, to restrain the accused from acting as officers or directors of any issuer of securities, and to pay civil monetary penalties under the US securities laws.In India, SEBI itself is armed with powers to take each of the aforesaid actions in absolute terms — not just as interim measures.

On an almost daily basis, SEBI issues directions under Sections 11 and 11B of the SEBI Act asking people not to deal in securities or to access capital markets or to be associated with capital markets. SEBI has wide powers to issue “such directions as it deems fit” with the only touchstone of rationale being the “interests of the securities market”.
…

Chapter VIA of the SEBI Act, 1992 empowers SEBI to inflict monetary penalties directly without the intervention of any court. Adjudicat-ing Officers, who are employees of SEBI, acting as quasi-judicial officers have the power to impose civil monetary penalties. These penalties can be as high as Rs 25 crore or three times the benefit gained due to the violation.

SEBI has also written subordinate legislation in the form of regulations governing market intermediaries registered with it to impose disciplinary penalties ranging from censure to cancellation of registration.

The only area where SEBI does not have powers for direct action without an intervention of a court is the ability to send people to jail. Section 24 of the SEBI Act requires SEBI to file a complaint before a criminal court to get an accused convicted and jailed for contravention of any provision of the SEBI Act, or rules or regulations made under it.

'Business connection', 'Attribution' and the withdrawal of Circular 23 of 1969

mihircn@gmail.com (Mihir Naniwadekar) — Wed, 28 Oct 2009 21:23:00 +0000

Through Circular No. 7 of 2009, the CBDT has withdrawn Circular No. 23 of 1969 (“Circular 23”). Circular 23 explained the position relating to ‘business connection’ under Section 9 of the Income Tax Act, 1961.

The Circular was relied upon in the arguments in the Morgan Stanley case before the Supreme Court; as also by the Bombay High Court in SET Satellite. These decisions had laid down the broad proposition that in an international transaction, if the non-resident compensates its permanent establishment (“PE”) at arms-length price, no further profits of the non-resident would be attributable to the PE in India.

With the SET Satellite decision set to come up before the Supreme Court, concerns have been raised as to the implications of the withdrawal of this circular. In particular, does the view in Morgan Stanley or SET Satellite need to be reconsidered in light of the withdrawal of the Circulars? Furthermore, what is the extent to which income from a business connection is taxable in India, after the withdrawal of the Circular?

The principle of Morgan Stanley:

The principle enunciated by the Supreme Court in Morgan Stanley on the question of attribution of income to India is as follows:

“The impugned ruling (of the AAR) is correct in principle insofar as an associated enterprise, that also constitutes a PE, has been remunerated on an arms-length basis taking into account all the risk-taking functions of the enterprise. In such cases, nothing further would be left to be attributed to the PE…”

This was followed by the Bombay High Court in SET Satellite:

“In our opinion considering the judgment, if the correct arm’s length price is applied and paid then nothing further would be left to be taxed in the hands of the foreign enterprise…”

In both these cases, Circular 23 was cited before the Court; yet it did not for part of the Court’s reasoning. In SET Satellite, on this issue, the Bombay High Court directly followed Morgan Stanley (the decision has been previously discussed here). In Morgan Stanley itself, Circular 23 is mentioned in the Supreme Court judgment only when the Supreme Court notes that the AAR placed reliance on the Circular. No reliance is placed on the Circular in the reasoning/conclusion of the Supreme Court itself. The reasoning of the Court is premised on the conceptual relation (and not a relation introduced solely by Circular 23) between a correct transfer pricing analysis and attribution of profits. This relation has been discussed in the previous post on SET Satellite.

Now, if Circular 23 played no part in the actual reasoning of the Court, then the withdrawal of that Circular cannot in any manner require that the principle laid down by the Court be reconsidered. Accordingly, while fears have been expressed that the withdrawal of the Circular will strengthen the Department’s case against SET Satellite in the Supreme Court, it is arguable that those fears are misplaced.

The extent to which income from a business connection can be taxed in India:

Circular 23 stated that “Section 9 does not seek to bring into the tax net the profits of a non-resident which cannot reasonably be attributed to operations carried out in India.” Concerns might be raised as to whether the withdrawal of the Circular changes this basic position.

Circular 23 discussed issues related to extent of taxable income under Section 9. The relevant part of Section 9 provides that all income accruing or arising “directly or indirectly, through or from a business connection in India” is deemed to accrue or arise in India. According to the relevant Explanation 1 to the Section:

“in the case of a business of which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India…”

Thus, the position that only that income which is reasonably attributed to India is covered under Section 9, is clarified in the Section itself. This position is thus due to the Explanation to the Section and not due to Circular 23. Circular 23 only clarified how this would apply in practice – it did not, indeed it could not have, deviated from the principle of attribution which is mandated by the Section itself.

Circular 23, in paragraph 1, itself states that it is a consolidation and restatement of previous clarifications (or the scope of the corresponding Section in the 1922 Act). Paragraph 3 of the Circular again clarifies that “The following clarifications would be found useful in deciding questions regarding the applicability of the provisions of section 9 in certain specific situations…” From this, it is evident that the Circular does not even purport to lay down any specific legal principle; it only discusses the application of the principle in Section 9 to various fact situations.

Conclusion:

There is at least an arguable case that the withdrawal of the Circular makes no difference to the legal position – either on attribution to PEs or on extent of income taxable under Section 9. What, then, was the need to ‘withdraw’ the Circular? The CBDT claimed that there was misuse of the Circular which resulted in assessees claiming relief not in accordance with the provisions of Section 9. Perhaps, the CBDT wanted to give the Revenue wider scope for ingenuity in argument; however, in my view, the legal position would remain unchanged.

A Reiteration of Separate Legal Entity

noreply@blogger.com (Shantanu Naravane) — Wed, 28 Oct 2009 06:57:00 +0000

A recent decision of the Punjab and Haryana High Court in CIT v. Panchratan Hotels has re-emphasised the notion of separate legal entity, albeit in the context of the law of taxation.

Here, the assessee was Panchratan Hotels, and had declared losses for the said assessment year. On 31.7.1992, the shareholders of the company had changed, through a transfer of 100% shareholding from the original shareholder to the new shareholders. On this basis, the CIT contended that there had been a succession of business for the purposes of section 170 of the Income Tax Act. Under section 170, in cases of succession, the predecessor is assessed in respect of the income of the previous year in which the succession occurs, up to the date of succession. On this basis, the CIT contended that the assessment for the year 1.4.1992 to 30.7.1992 was required to be made in the hands of the old company and subsequent assessment from the period 31.7.1992 to 31.3.1993 in the hands of the new company.

For deciding this issue, the Court was required to answer two questions-

(a) Whether the transfer of shares amounted to a succession of business under section 170?

(b) Even if it did, whether section 170 applied to the company whose shares had been transferred?

The Court did not answer the first question conclusively, only noting the argument that a transfer of shares may also amount to a succession under section 170. It based its decision more on the second question, since it was of the opinion that section 170 cannot apply to the facts in issue. The Court observed that the transfer of shareholding would only change the identity of the shareholders and not the identity of the company, which is a separate legal entity. Thus, while the concept of succession would apply to the transferor and transferee of the shareholding, it would not apply to the company whose shares are transferred. In the words of the Court-

Even if for the sake of arguments, we accept that the transfer of shares amounts to transfer of capital assets in terms of Section 2(47), then also in our considered view, Section 170 will not apply. A bare reading of Section 170 shows that the transfer of the business should be from one assessee to another. Person under Section 2(31)(iii) of the Income Tax Act includes a company. Under Company Law, a company is a juristic person. The share holders are not the owners of the company. It is the company itself which is its own owner having its own seal and succession. Where shares are transferred, at best this would be a transfer vis-à-vis, the person who was the holder of the shares to the person to whom the shares are transferred. Therefore, individually when Mr. Kapoor has sold his share to M/s.General Sales Limited then it may amount to a transfer when considering the incomes of Mr. Kapoor or M/s.General Sales Limited. Section 170 may be attracted to both the previous and subsequent owner of the shares but cannot apply to the company itself. This is no transfer as far as the assessee, i.e., M/s. Panchratan Hotel is concerned.

...

The company is a juristic person having its distinct legal entity separate from that of the shareholders. The change in the share-holders of the company does not change the legal identity of the company.

On this basis, the Court reversed the finding of the CIT, and held that the transfer of shares did not result in the change of identity of the company, but only resulted in a change of the owners of the company. While this seems a reiteration of an accepted principle of corporate law, it assumes greater significance in light of the ongoing Hutch-Vodafone tax dispute, where the central question is whether the transfer of the shareholding of a company having assets in India amounts to transfer of those assets situated in India. In that context, this decision affirming the concept of a separate corporate entity, especially in a tax context assumes is of considerable interest. A copy of the judgment is available here.

Supreme Court Reaffirms Dharmendra Textiles

noreply@blogger.com (Shantanu Naravane) — Mon, 26 Oct 2009 04:50:00 +0000

Earlier posts here have considered the issue of whether the penalty under section 271(1)(c) of the Income Tax Act, 1961 is a criminal, quasi-criminal or civil liability, which in turn has implications on whether mens rea is needed for awarding penalty under the section. The Supreme Court had held in Dilip Shroff that mens rea is needed for the non-disclosure of penalty to result in penalty, but this was subsequently overruled by the Court in Dharmendra Textiles. This was followed by decisions of some High Courts and Tax Tribunals narrowing the applicability of Dharmendra Textile to facts, making it possible that a subsequent consideration of the issue by the Supreme Court may reverse the position again.

However, having been presented with the opportunity in CIT v. Atul Mohan Bindal, the Supreme Court has specifically reaffirmed Dharmendra, holding that the penalty is a civil liability, and hence no mens rea is required under the provision. The Court held-

A close look at Section 271(1) (c) and Explanation (1) appended thereto would show that in the course of any proceedings under the Act, inter alia, if the Assessing Officer is satisfied that a person has concealed the particulars of his income for furnished inaccurate particulars of such income, such person may be directed to pay penalty. The quantum of penalty is prescribed in Clause (iii). Explanation 1, appended tosection 271(1) provides that if that person fails to offer an explanation or the explanation offered by such person is found to be false or the explanation offered by him is not substantiated and he fails to prove that such explanation is bona fide and that all the facts relating the same and material to the computation of his total income has been disclosed by him, for the purposes ofSection 271(1)(c), the amount added or disallowed in computing the total income is deemed to represent the concealed income. The penalty spoken of in Section 271(1)(c) is neither criminal nor quasi criminal but a civil liability; albeit a strict liability. Such liability being civil in nature, mens rea is not essential.

It had been discussed earlier that the issue before the Court in Dharmendra Textiles was section 11AC, Central Excise Act, and not section 271(1)(c), Income Tax Act. On this basis, there was scope for the argument that the finding on section 271(1)(c) was obiter and could be departed from. However, after the decision in Bindal, this line of argument has been unquestionably foreclosed, and the nature of penalty under section 271(1)(c) is now a strict civil liability, with no requirement of mens rea. A summary of the decision is available here.