Ten Legal Traps for Investors in India
By Anand S. Dayal
Ten legal requirements are traps for the unwary for foreigners investing in India. Each is relatively uncomplicated but often holds up and frustrates investors. Knowing what they are and taking them into account at inception will reduce transaction costs and reduce the likelihood of false starts.
The first is share price restrictions. The Reserve Bank of India has rules for how much may be paid or can be charged on exit when foreigners buy shares in Indian companies.
Nonresident purchasers of shares must pay a price that is not less than the “fair value” of the shares. A nonresident seller can receive no more than the “fair value” unless the sale is to another nonresident, in which case there is no restriction on the share price.
The fair value requirement applies both to existing shares acquired through purchase, as well to fresh or new shares issued by an Indian company.
The “fair value” of the shares must be determined using guidelines prescribed by the Controller of Capital Issues, and it must be certified by a chartered accountant in India. If the transaction involves a security listed on a recognized stock exchange in India, then the price must normally be within 5% of the daily average high and low price for the week preceding the transfer. The valuation certificate must be filed with the Reserve Bank of India as part of a regulatory filing that must be made whenever shares in Indian companies are bought or sold.
Transactions entirely outside India may require a public offer in India if the transaction involves an indirect acquisition of more than 15% of a listed Indian company or a change in control of such a company.
A direct or indirect buyer of listed shares must make a public offer if the buyer will end up owning more than 15% of the target should it make the purchase or the purchase will lead to a change in control of the company. The public tender cannot be for less than 20% of the outstanding shares in the target company. The buyer must tender for shares at the price the shares are trading on the stock exchange when the shares are acquired. The obligation to make a public tender applies only to shares in companies that trade on an Indian exchange.
By itself the requirement for a public offer in a domestic transaction is not unusual. What is unusual is such a tender may be required in India for a share purchase that otherwise would take place indirectly and entirely outside India.
In the past, there are several instances where a global acquisition, involving a relatively minor India subsidiary, has triggered the public tender requirement in India, but no public offer was made of shares in the local Indian company due to oversight or incorrect advice. The Securities and Exchange Board of India has required the buyers in such cases to remake the required public tender at the price prevailing at the time of the acquisition and to pay interest and fines. This has spawned substantial litigation, some of which is still ongoing.
Preference shares and convertible debentures held by nonresidents are treated as debt in India, unless they are mandatorily convertible into equity. If they end up being treated as debt, then caps will come into play on the use of funds and the distributions that can be made to holders of the shares or debentures.
There are caps on distributions on preferred shares even when the shares are recognized as equity. Preferred shares can receive a maximum dividend of 300 basis points over the prime lending rate of the State Bank of India prevailing on the date that the board of directors of the Indian company approves the issuance of shares.
If treated as debt, preferred shares and convertible debentures must comply with all of the restrictions imposed on external commercial borrowing, including end-use restrictions and all-in-cost ceilings, that are discussed below. They are treated as such borrowing when the shareholder is a nonresident.
Compared to modern corporate statutes, the companies law in India is unduly restrictive. Features that are commonplace in other countries, such as the issuance of shares other than for cash, share buybacks, differential shareholder rights as to voting and dividends and “put” or “call” options on listed shares, are difficult to implement in practice.
The Companies Act, 1956 is due for a major overhaul. Until that happens, its somewhat rigid approach to the internal functioning of companies tends to create roadblocks in accommodating the commercial aspects of more complex transactions. The following are some of the most troublesome restrictions in practice.
Shares can only be issued for cash or a cash equivalent except in narrow circumstances. This applies to resident as well as nonresident share purchasers.
Share buybacks are permissible, but only using “surplus” funds that are otherwise available to pay dividends and subject to a limit of 25% of the paid-up capital plus surplus and maintaining a post buyback debt-to-equity ratio of 2:1.
Differential shareholder rights as to voting and dividends are permissible, provided the company has been profitable in the previous three financial years and the shares with differential rights do not exceed 25% of the total issued share capital.
The enforceability of put and call options on listed securities is at present unclear, although such options are common. Options are vulnerable on the grounds that the Securities Contracts (Regulation) Act, 1956 prohibits contracts for the sale or purchase of listed securities (other than spot delivery contracts), except for such contracts that are traded on a stock exchange.
External Commercial Borrowing
Indian companies may engage in external commercial borrowing only for certain permitted end uses. The interest rate and other costs must not exceed an all-in-cost limit that is updated from time to time.
External commercial borrowings are loans taken by an Indian borrower from a nonresident lender, including borrowing from a foreign joint venture partner or investor. At the present time, such borrowings are permitted only to meet the foreign currency requirements of an Indian borrower. However, with prior approval from the Reserve Bank of India, external borrowings of up to US$ 20 million per financial year can be used to meet domestic rupee expenditures. Furthermore, the proceeds of all external borrowings must be disbursed and held outside India. To meet domestic spending in rupees, the borrowed funds can be brought into India only to make actual expenditures. This policy could change.
There are also end-use restrictions on deployment of the borrowed funds. Broadly speaking, external borrowing can only be used to pay the cost of imported capital goods, new industrial projects and for modernization and expansion of existing industrial facilities. It cannot be used for on-lending, investment in capital markets, real estate, working capital, general corporate expenses or repayment of existing rupee loans.
Further, the all-in-cost of an external borrowing is subject to a cap. The all-in-cost is comprised of interest, fees and expenses paid in foreign currency other than any commitment fee. Fees payable in rupees and withholding tax paid in rupees are excluded. For rupee loans, the interest rate must include the swap cost. The all-in-cost ceilings are modified from time to time and vary depending on the average maturity period of the loan.
Except in very narrow circumstances, a nonresident buying shares or other securities in an Indian company must pay cash.
The cash-only requirement precludes other forms of consideration, such as a share swap, promissory note or other valuable consideration, including services and intangibles such as technology, know how and trademarks. Furthermore, regulations require that the cash be brought into India through normal banking channels and be received by the Indian company or seller of securities in cash.
In an asset deal involving two Indian companies, the asset purchase price must be routed through the company in India that is buying the assets. Payments made overseas at the holding or parent company level will not be recognized in India.
This has the potential to affect the overall structure of some transactions outside India, because of the requirement that actual cash be paid in India as consideration for the asset transfer. Usually in an asset deal, both the seller and the buyer are Indian entities. The local entities — both the buyer and the seller — are often surrogates for the actual party in interest outside India. An example is where a multinational company is buying a group of companies, and the group has an Indian subsidiary. The buyer may want to structure the purchase so that the Indian leg of the transaction is an asset purchase as this may have more favorable tax consequences. (Buyers usually like to have the purchase price reflected in basis in assets so that it can be recovered through depreciation.) Since the assets can only be transferred for cash, it may be necessary for the Indian component of the transaction to be funded separately.
The liquidation or winding up of an Indian company is a cumbersome and drawn-out process, even when it is voluntary and the company has no creditors.
It is far easier to register or incorporate a company in India than to wind up a company. India has no modern bankruptcy law, relying instead on general insolvency law. In the case of a company, the Companies Act, 1956 provides for the liquidation of a company and the distribution of its assets to creditors and other claimants. However, even the simplest of cases, a voluntary winding up with no creditors, requires approval from the high court of the state in which the registered office of the company is located.
Many payments made in a transaction require that the person making the payment withhold taxes on it. This applies to interest, dividends, rent, royalties, payments to contractors and fees for professional or technical services, among other payments.
The need for an Indian company making the payment to deduct taxes is often overlooked in structuring transactions. As a result, transactions that are often thought of as being economic equivalents — such as an equipment lease versus a financing arrangement, or a price discount versus liquidated damages — could have different withholding tax consequences. The Income Tax Act, 1961 requires the payor to deduct and deposit taxes at specified rates from a broad variety of payments. There are exceptions in favor of tax-exempt entities, such as the International Finance Corporation, but these are not broadly applicable. The withholding rates may be reduced on Indian tax treaties with other countries.
Inter-company transactions between affiliated companies must be at arm’s length if one of the entities is located outside India. Significant recordkeeping and filing requirements apply.
All transactions between a nonresident entity and its Indian affiliate that have a bearing on the profits, income, losses or assets of either entity must be at an arm’s-length price. The transactions expressly included are the purchase, sale or lease of tangible or intangible property, the provision of services and the lending or borrowing of money. For example, the requirements come into play where a foreign parent makes a loan to its Indian subsidiary.
This could limit the cost savings from outsourcing work to an Indian affiliate, and it creates uncertainty in forecasting the economics of an Indian operation that supplies affiliated entities outside India.