private equity and debt in real estate

Private Equity and Debt in Real Estate

November 2014

© Copyright 2014 Nishith Desai Associates www.nishithdesai.com

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© Nishith Desai Associates 2014


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ContentsABBREVIATIONS 01

1. PREFACE 02

I. Legal and Regulatory changes introduced in 2014 02

2. REGULATORY FRAMEWORK FOR FOREIGN INVESTMENT 04

I. Foreign Direct Investment 04II. FVCI Route 07III. FPI Route 07IV. NRI Route 12

3. LEGAL FRAMEWORK – KEY DEVELOPMENTS 14

I. Shares with Differential Rights 14II. Listed Company 14III. Inter-Corporate Loans and Guarantee 14IV. Deposits 15V. Insider Trading 15VI. Squeeze out Provisions 15VII. Directors 15VIII. Control and Subsidiary and Associate Company 16IX. Merger of an Indian company with offshore company. 16

4. TAXATION FRAMEWORK 17

I. Overview of Indian Taxation System 17II. Specific Tax Considerations for PE Investments 18

5. EXIT OPTIONS / ISSUES 22

I. Put Options 22II. Buy-Back 22III. Redemption 23IV. Initial Public Offering 23V. Third Party Sale 23VI. GP Interest Sale 23VII. Offshore Listing 24VIII. Flips 24IX. Domestic REITs 24

6. DOMESTIC POOLING 28

I. AIF 28II. NBFC 28

7. THE ROAD FORWARD 29

I. REITs 29II. Partner issues 29III. Arbitration / Litigation 29IV. Security Enforcement 29

ANNEXURE I

BUDGET 2014: A GAME CHANGER FOR REITS? 31

ANNEXURE II

REITS: TAX ISSUES AND BEYOND 36



ANNEXURE III

OFFSHORE LISTING REGIME: HOW TO RAISE FUNDS AND MONETIZE INVESTMENTS 38

ANNEXURE IV

REGULATORY REGIME FORCING COS’ ‘EXTERNALISATION’ 40

ANNEXURE V

NBFC STRUCTURE FOR DEBT FUNDING 42

ANNEXURE VI

FOREIGN INVESTORS PERMITTED TO PUT: SOME CHEER, SOME CONFUSION 49

ANNEXURE VII

INDIAN GAAR: RULES NOTIFIED 53

ANNEXURE VIII

FOREIGN INVESTMENT NORMS FOR REAL ESTATE LIBERALIZED 56

ANNEXURE IX

THE CURIOUS CASE OF PRICING GUIDELINES 62

ANNEXURE X

SPECIFIC TAX RISK MITIGATION SAFEGUARDS FOR PRIVATE EQUITY INVESTMENTS 67

ANNEXURE XI

BILATERAL INVESTMENT TREATIES 69

ANNEXURE XII

FLIPS AND OFFSHORE REITS 71

ANNEXURE XIII

BOMBAY HIGH COURT CLARIFIES THE PROSPECTIVE APPLICATION OF BALCO 74

ANNEXURE XIV

CHALLENGES IN INVOCATION OF PLEDGE OF SHARES 77

1© Nishith Desai Associates 2014


Abbreviations

Abbreviation Meaning / Full Form

AAR Authority for Advanced Rulings

AIF Alternate Investment Funds

AIF Regulations SEBI (Alternative Investment Funds) Regulations, 2012

CBDT Central Board of Direct Taxes

CCDs Compulsorily Convertible Debentures

CCPS Compulsorily Convertible Preference Shares

DCF Discounted Cash Flows

DDT Dividend Distribution Tax

DIPP Department of Industrial Policy and Promotion

DTAA Double Taxation Avoidance Agreements

ECB External Commercial Borrowing

FATF Financial Action Task Force

FDI Foreign Direct Investment

FDI Policy Foreign Direct Investment Policy dated April 17, 2014

FEMA Foreign Exchange Management Act

FIPB Foreign Investment Promotion Board

FII Foreign Institutional Investor

FPI Foreign Portfolio Investor

FVCI Foreign Venture Capital Investor

GAAR General Anti-Avoidance Rules

GP General Partner

HNI High Net worth Individuals

InvIT Infrastructure Investment Trust

InvIT Regulations Securities And Exchange Board of India (Infrastructure Investment Trusts) Regulations

IPO Initial Public Offering

ITA Income Tax Act, 1961

LP Limited Partner

LRS Liberalized Remittance Scheme

NBFC Non-Banking Financial Services

NCD Non-Convertible Debenture

NRI Non-Residential Indian

PE Permanent Establishment

PIO Person of Indian Origin

PIS Portfolio Investment Scheme

PN2 Press Note 2 of 2005

QFI Qualified Foreign Investor

RBI Reserve Bank of India

REITs Real Estate Investment Trusts

REIT Regulations Securities And Exchange Board of India (Real Estate Investment Trusts) Regulations

REMF Real Estate Mutual Fund

Rs./INR Rupees

SEZ Act Special Economic Zones Act, 2005

SBT Singapore Business Trust

SEBI Securities and Exchange Board of India

SPV Special Purpose Vehicle

TISPRO Regulations Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000

2 © Nishith Desai Associates 2014


Year 2014 witnessed interesting changes from a regulatory, legal and tax perspective. Following a long dormant phase in the capital markets and drying up of foreign investment into India, the reforms proposed to be brought about by the Budget 2014-15 announced by the newly elected Central Government have attempted to resolve some of the growth and liquidity issues faced by the Indian economy over the past few years. A snapshot of some of those changes, which are detailed later in this paper is provided below:

I. Legal and Regulatory Changes Introduced in 2014

A. Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs) Introduced

One of the most common mechanisms of rollover of assets to a REIT was not existent in India till very recently. Recently, SEBI released the REIT Regulations on September 26, 2014. Along with REIT Regulations, SEBI also introduced the InvIT Regulations.

Please refer to Annexure I1 for a detailed analysis of the tax reforms proposed in respect of REITs and InvITs by the Budget 2014-15. However, the REITs regime has not taken of due to several tax and non-tax issues, please refer to Annexure II2 for our article published in Live Mint discussing some of the key issues.

B. Foreign Portfolio Investor (“FPI”) Introduced, Replaces Existent Portfolio Investment Regimes

SEBI notified the SEBI (FPI) Regulations, 2014, harmonizing the portfolio investment routes of Foreign Institutional Investors (“FIIs”) and Qualified Foreign Investor (“QFIs”) into a new class - the FPI. FPI will be a dis-intermediated platform for trading in securities without SEBI approval. The FPI regime has come into force from June 1, 2014.

C. Offshore listing allowed for Unlisted Indian Companies

Hitherto unlisted companies in India were prohibited from issuing American / Global Depositary Receipts (ADRs / GDRs) and Foreign Currency Convertible Bonds (“FCCB”) without a simultaneous or prior listing on a domestic exchange in India. However, RBI and the Central Government have now removed this requirement of prior or simultaneous listing on a domestic exchange, reverting to the position pre-2005, when the requirement was introduced. Private companies can now list their ADRs / GDRs / FCCB in an overseas stock exchange.

The Central Government has recently prescribed that SEBI shall not mandate any disclosures, unless the company lists in India.

Please refer to Annexure III and Annexure IV for articles analyzing the reasons why Indian companies are being driven to list offshore and raise funds abroad.

D. Companies Act, 2013

The Government of India has recently brought into force most provisions of the Companies Act, 2013 (“CA 2013”), which replaced the erstwhile Companies Act, 1956 (“CA 1956”). The Ministry of Corporate affairs decided to implement CA 2013 in a phased manner. The phased implementation of CA 2013 commenced on September 12, 2013 when 98 sections were notified with immediate effect. This was followed by phase two, when on March 26, 2013, further 183 sections were notified that came into effect on April 01, 2014. CA 2013 marks a seminal shift in India’s corporate law regime by introducing new concepts like ‘one person company’, class action suits, etc. which were hitherto not recognized under CA 1956 and establishes new benchmarks for corporate governance by, inter alia, codifying directors’ duties, prescribing more stringent ‘independence criteria’ for independent directors and expanding the definition of related parties.

Please refer to Chapter 3 for detailed analysis of the CA 2013 provisions.

1. http://www.nishithdesai.com/fileadmin/user_upload/pdfs/Research%20Articles/The_Securities_and_Exchange_Board_of_India.pdf2. http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/article/reits-tax-issues-and-beyond-1.html?no_

cache=1&cHash=a54570354bb5bc1969d720fba3cad33a

1. Preface



E. Control

Definition of control under the FDI Policy has been amended by FIPB to bring it in line with the definition of ‘control’ as provided under CA 20133 and SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011.4 The amendment has enlarged the scope of the control. Existing downstream investments by domestic companies with foreign investment will have to be examined more closely to ascertain if they are affected by the new definition of ‘control’. In addition, the amendment may even apply to existing structures making any further downstream investment subject to scrutiny.

F. Non-Banking Financial Companies (NBFC)

The transfer of shares of a company in the financial sector, including NBFCs, from a resident to a non-resident required a no-objection certificate from the RBI, thereby causing delay in the transfer. The requirement of a no-objection certificate has been dispensed with, thereby facilitating such transfers.

Earlier, for change of control of non-deposit taking NBFC, a separate approval from was not required. Only requirement was to give a 30 thirty days’ written notice prior to effecting a change of ‘control’; and unless the RBI restricted the transfer of shares or the change of control, the change of control became effective from the expiry of thirty days from the date of publication of the public notice. However, RBI has now prescribed requirement of prior written approval for any change in control.

While NBFCs were permitted to issue unsecured debentures earlier, they have now been restricted to issue only fully secured debentures. In addition, the exemption of an issuance to only 49 members by way of private placement has also been withdrawn for NBFCs. Also NBFCs have been given status of financial institution under CA 2013.

Please refer to Chapter 6, point for brief analysis of the analysis of the above changes with respect to NBFCs.

Please refer to Annexure V5 for detailed note on investment through an NBFC.

Also, RBI has by way of its circular dated June 6, 20146, relaxed the provisions relating to pledge of shares held by non-resident shareholders in Indian listed companies in favor of NBFCs, to enable the Indian companies to leverage themselves for bona fide business purposes.

G. Put Options Permitted under the Foreign Direct Investment Regime

RBI has now permitted optionality clauses in agreements for foreign direct investment eligible instruments issued to non-residents, provided the valuation norms prescribed for such optionality clauses are adhered to. The valuation norms prohibit any assured returns to the non-resident.

Please refer to Annexure VI7 for detailed analysis on put options.

H. General Anti-Avoidance Rules (GAAR): Finally here

CBDT notified GAAR provisions which shall come into effect from April 1, 2015, but will apply retrospectively to income arising from structures from August 30, 2010. In the run-up to the Budget 2014-15, there was some hope that GAAR would be further deferred for at least another year. GAAR now continues to be effective starting April 1, 2015 and applies to all investments post August 2010. It provides extensive powers to the tax authorities to disregard tax driven structures that are abusive, non-arm’s length or lack commercial substance. Due to the ambiguity in the GAAR provisions, it was expected that detailed guidelines would be released. Unless the Government provides more certainty on the application of GAAR, it will result in significant litigation and negatively impact investor sentiments.

Please refer Annexure VII8 for detailed analysis on GAAR.

3. Section 2(27), CA 20134. Regulation 2(e) SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 20115. http://www.nishithdesai.com/New_Hotline/Realty/Realty%20Check%20-%20Debt%20Funding%20Realty%20in%20India_Jan2012.pdf6. A.P. (DIR Series) Circular No. 1417. http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/article/cheers-for-offshore-funds-put-options-

permitted.html?no_cache=1&cHash=02e2afb88f85c0c69750945d7ac21f598. http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/article/taxing-times-copyright-or-copyrighted-

article-the-debate-continues.html?no_cache=1&cHash=c751ebe0e7a84969cb48b0d50ffbb1c8



Foreign investments into India are primarily regulated by primarily three regulators, the Reserve Bank of India (“RBI”), the Foreign Investment Promotion Board (“FIPB”) and the Department of Industrial Policy and Promotion (“DIPP”). In addition to these regulators, if the securities are listed or offered to the public, dealings in such securities shall also be regulated by the Indian securities market regulator, Securities and Exchange Board of India (”SEBI”).

Foreign investment into India is regulated under Foreign Exchange Management Act, 1999 (“FEMA”) and the regulations thereunder, primarily Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 (“TISPRO Regulations”). Keeping in view the current requirements, the DIPP (an instrumentality of the Ministry of Commerce & Industry), and the RBI make policy pronouncements on foreign investment through Press Notes / Press Releases / Circulars which are notified by the RBI as amendments to the TISPRO Regulations. These notifications take effect from the date of issue of Press Notes / Press Releases / Circulars, unless specified otherwise therein.

In order to bring clarity and certainty in the policy framework, the DIPP for the first time issued a consolidated policy relating to FDI in India on April 1, 2010, which is now revised annually and represents the current ‘policy framework’ on FDI. The latest policy as of the date of this paper is dated April 17, 2014 (“FDI Policy”).

Foreign investment can be classified into the following investment regimes –

i. Foreign Direct Investment (“FDI”);

ii. Foreign Venture Capital Investment regime, for investments made by SEBI registered Foreign Venture Capital Investors (“FVCI”);

iii. Foreign Portfolio Investor regime, for investments made by SEBI registered Foreign Portfolio investor (“FPI”);

iv. Non Resident Indian regime, for investments made by non-resident Indians and persons of Indian origin (“NRI”).

Separately, Indian entities are not permitted to avail of External Commercial Borrowings (“ECB”), which are essentially borrowings in foreign currency, if the end use of the proceeds of the ECB will be utilized towards investment in real estate. However, recently, the ECB norms were relaxed to allow ECB in low cost housing. This paper does not discuss ECB.

We now discuss each of the investment routes together with their attendant regulatory challenges. Tax issues are dealt with later on under a separate taxation head in this paper.

I. Foreign Direct InvestmentAs per the FDI Policy, no Indian company that has FDI9 can engage in “Real Estate Business”. The term, ‘Real Estate Business’, is not defined in the current FDI Policy. The Ministry of Commerce and Industry issued a press release (“Press Release”) on October 29, 2014, that the Union Cabinet has approved the amendment of the FDI Policy. The Press Release issued by the Ministry of Commerce and Industry proposes to define the term as ‘dealing in land and immoveable property with a view to earning profit or earning income there from and does not include development of townships, construction of residential/ commercial premises, roads or bridges, educational institutions, recreational facilities, city and regional level infrastructure, townships.’ This definition would be included in the FDI Policy only when the same is duly amended, which is yet to happen.

While the prohibition on FDI in real estate business has long been the case, the process of deregulating foreign investments into real estate was initiated in 2001 and the turning point for foreign investments into the real estate sector came in 2005 with the issue of Press Note 2 of 2005 (“PN2”) by the DIPP.

PN2 permitted FDI in townships, housing, built-up infrastructure and construction-development projects (which would include, but not be restricted to, housing, commercial premises, hotels, resorts, hospitals, educational institutions, recreational facilities, city and regional level infrastructure) subject to fulfillment of certain entity level and

2. Regulatory Framework for Foreign Investment

9. FDI policy refers to FDI as “a category of cross border investment made by a resident in one economy (the direct investor) with the objective of establishing a ‘lasting interest’ in an enterprise (the direct investment enterprise) that is resident in an economy other than that of the direct investor. The motivation of the direct investor is a strategic long term relationship with the direct investment enterprise to ensure the significant degree of influence by the direct investor in the management of the direct investment enterprise. Direct investment allows the direct investor to gain access to the direct investment enterprise which it might otherwise be unable to do. The objectives of direct investment are different from those of portfolio investment whereby investors do not generally expect to influence the management of the enterprise.” It further mentions that it is the policy of the Government of India to attract and promote productive FDI from non-residents in activities which significantly contribute to industrialization and socio-economic development. FDI supplements the domestic capital and technology.



project level requirements. PN2 required that real estate companies seek foreign investments only for construction and development of projects, and not for completed projects.

Finance Minister in his Budget 2014-15 speech had announced that the investment conditions prescribed under the FDI Policy will be altered to boost the foreign investment in the real estate sector. Though, the DIPP has not released the press note in this respect yet, but the Press Release lays down the amendments proposed in the FDI Policy. Following are few of the key changes sought to be introduced by the Press Release:

A. Minimum area for the Project Development has been Changed

i. Development of Serviced Plots

Minimum land area requirement has been done away with, while earlier the minimum land area of 10 hectares was prescribed for the development of serviced plots.

ii. Construction-Development Projects

Minimum area has been reduced for the construction development projects. Press release prescribes that the minimum area for a construction development project shall be 20,000 sq. meters of floor area whereas earlier the minimum area prescribed was 50,000 sq. meters of built-up area.

iii. Combination Project

There is no change prescribed in the development of a combination project, like as provided in the FDI Policy, either of the conditions prescribed for the serviced project or construction development project will have to be complied with.

B. Minimum Capitalization

The press release makes no distinction in the minimum capitalization for wholly owned subsidiaries and joint ventures with the Indian partners as provided in the FDI Policy. The minimum capitalization prescribed is US $ 5 million.

C. Affordable Housing

The projects which will allocate atleast 30% of the project cost for the low cost affordable housing will be exempted from the complying with the minimum land area and the minimum capitalization requirements as mentioned above.

D. Complete Assets

Press Release clarifies that 100 percent FDI under the automatic route is permitted in completed projects for operation and management of townships, malls/ shopping complexes and business centres.

It has been long debated whether FDI should be permitted in commercial completed real estate. By their very nature, commercial real estate assets are stable yield generating assets as against residential real estate assets, which are also seen as an investment product on the back of the robust capital appreciation that Indian real estate offers. To that extent, if a company engages in operating and managing completed real estate assets like a shopping mall, the intent of the investment should be seen to generate revenues from the successful operation and management of the asset (just like a hotel or a warehouse) as against holding it as a mere investment product (as is the case in residential real estate). The apprehension of creation of a real estate bubble on the back of speculative land trading is to that naturally accentuated in context of residential real estate. To that extent, operation and management of a completed yield generating asset is investing in the risk of the business and should be in the same light as investment in hotels, hospitals or any asset heavy asset class which is seen as investment in the business and not in the underlying real estate. Even for REITs, the government was favorable to carve out an exception for units of a REIT from the definition of real estate business on the back of such understanding, since REITs would invest in completed yield general real estate assets. The Press Release probably aims to follow the direction and open the door for foreign investment in completed real assets, however the language is not entirely the way it should have been and does seem to indicate that foreign investment is allowed only in entities that are operating an managing completed assets as mere service providers and not necessarily real estate. While it may seem that FDI has now been permitted into completed commercial real estate sector, the Press Release leaves the question unanswered whether these companies operating and managing the assets may own the assets as well.

Please refer to Annexure VIII10 for a detailed analysis of the press release.

Though the DIPP has not released the press note amending the FDI Policy, however, it can be expected that the press note will not be different from the press release.

10. http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/newsid/2638/html/1.html?no_cache=1



i. Instruments for FDI

As per the FDI Policy, FDI can be routed into Indian investee companies by using equity shares, fully, and mandatorily/Compulsorily Convertible Debentures (“CCDs”) and fully and Compulsorily Convertible Preference Shares (“CCPS”).11 Debentures which are not CCDs or optionally convertible instruments are considered to be ECB and therefore, are governed by clause (d) of sub-section 3 of section 6 of FEMA read with Foreign Exchange Management (Borrowing or Lending in Foreign Exchange) Regulations, 2000 as amended from time to time. RBI recently amended the TISPRO Regulation to permit issuance of partly paid shares and warrants to non-residents (under the FDI and the FPI route) subject to compliance with the other provisions of the FDI and FPI schemes.

Please refer to Annexure IX12 for a detailed analysis of the amendment of TISPRO Regulation permitting issuance of partly paid shares and warrants to non-residents.

Since, these CCPS and CCDs are fully and mandatorily convertible into equity, they are regarded at par with equity shares and hence the same are permissible as FDI. Further, for the purpose of minimum capitalization, in case of direct share issuance to non-residents, the entire share premium received by the Indian company is included. However, in case of secondary purchase, only the issue price of the instrument is taken into account while calculating minimum capitalization.

Herein below is a table giving a brief comparative analysis for equity, CCPS and CCDs:

11. Please refer below to paragraph (3)(1) on put options12. http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/article/rbi-issues-reforms-for-fdi-investments.

html?no_ca13. All tax rates mentioned herein are exclusive of surcharge and education cess.14. RBI clarified in its A.P. (DIR Series) Circular No. 36 dated September 26, 2012, that shares can be issued to subscribers (both non-residents and NRIs)

to the memorandum of association at face value of shares subject to their eligibility to invest under the FDI scheme. The DIPP inserted this provision in the FDI Policy, providing that where non-residents (including NRIs) are making investments in an Indian company in compliance with the provi-sions of CA 1956, by way of subscription to its Memorandum of Association, such investments may be made at face value subject to their eligibility to invest under the FDI scheme. This addition in the FDI Policy is a great relief to non-resident investors (including NRIs) in allowing them to set up new entities at face value of the shares and in turn reduce the cost and time involved in obtaining a DCF valuation certificate for such newly set up companies.

Particulars Equity CCPS CCD

Basic Character Participation in governance and risk based returns

Assured Dividend – Convertible into Equity

Assured Coupon – Convertible into Equity

Liability to Pay Dividend can be declared only out of profits

Fixed dividend if profits accrue Fixed Interest payment - not dependent on accrual of profits

Limits to Payment No cap on dividend Dividend on CCPS cannot exceed 300 basis points over and above the prevailing SBI prime lending rate in the financial year in which CCPS is issued. No legal restriction on interest on CCD, however in practice it is benchmarked to CCPS limits.

Tax Efficiency No tax deduction, dividend payable from post-tax income - Dividend taxable @ 15%13 in the hands of the company

Interest expense deductible – Withholding tax as high as 40% but it can be reduced to 5% if investment done from favourable jurisdiction

Liquidation Preference

CCD ranks higher than CCPS in terms of liquidation preference. Equity gets the last preference.

Others Buy-back or capital reduction permissible

CCPS and CCDs need to be converted to equity before they can be bought back or extinguished by the Indian company.

ii. Pricing Requirements

TISPRO Regulations regulate the price at which a foreign direct investor invests into an Indian company. Recently, RBI amended the TISPRO Regulations wherein it rationalized the pricing guidelines from the hitherto Discounted Cash Flows (“DCF”) / Return on Equity (RoE) to ‘internationally accepted pricing methodologies’. Accordingly, shares in an unlisted Indian company may be freely issued or transferred to a foreign direct investor, subject to

the following conditions being satisfied:

i. The price at which foreign direct investor subscribes to / purchases the Indian company’s shares is not lower than the floor price computed on the basis of the internationally accepted pricing method. However, if the foreign investor is subscribing to the memorandum of the company, the internationally accepted pricing methodologies does not apply14;

Regulatory Framework for Foreign Investment



ii. The consideration for the subscription / purchase is brought into India prior to or at the time of the allotment / purchase of shares to / by the foreign direct investor.

If any of the above conditions is not complied with, then the prior approval of the FIPB and / or the RBI would be required. If the foreign investor is an FVCI registered with the SEBI, then the pricing restrictions would not apply. In addition, if the securities are listed, the appropriate SEBI pricing norms become applicable.

Please refer to Annexure IX 15 for a detailed analysis on the rationalization of the pricing guidelines.

II. FVCI RouteSEBI introduced the SEBI (Foreign Venture Capital Investors) Regulations, 2000 (“FVCI Regulations”) to encourage foreign investment into venture capital undertakings.16 The FVCI Regulations make it mandatory for an offshore fund to register itself with SEBI.

FVCIs have the following benefits:

A. Free Pricing

The entry and exit pricing applicable to FDI regime do not apply to FVCIs. To that extent, FVCIs can subscribe, purchase or sell securities at any price.

B. Instruments

Unlike FDI regime where investors can only subscribe to only equity shares, CCDs and CCPS, FVCIs can also invest into Optionally Convertible Redeemable Preference Shares (“OCRPS”), Optionally Convertible Debentures (“OCDs”) and even Non-Convertible Debenture (“NCDs”).

C. Lock-in

Under the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (“ICDR Regulations”) the entire pre-issue share capital (other than certain promoter contributions which are locked in for a longer period) of a company conducting an initial public offering (“IPO”) is locked for a period of 1 year from the date of allotment in the public issue. However, an

exemption from this requirement has been granted to registered FVCIs, provided, the shares have been held by them for a period of at least 1 year as on the date of filing the draft prospectus with the SEBI. This exemption permits FVCIs to exit from investments immediately post-listing.

D. Exemption under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 Takeover Code (“Takeover Code”)

SEBI has also exempted promoters of a listed company from the public offer provisions in connection with any transfer of shares of a listed company, from FVCIs to the promoters, under the Takeover Code.

E. QIB Status

FVCIs registered with SEBI have been accorded qualified institutional buyer (“QIB”) status and are eligible to subscribe to securities at an IPO through the book building route.

However, the RBI while granting the permission/certificate mandates that an FVCI can only invest in the following sectors, viz. infrastructure sector, biotechnology, IT related to hardware and software development, nanotechnology, seed research and development, research and development of new chemical entities in pharma sector, dairy industry, poultry industry, production of bio-fuels and hotel-cum-convention centers with seating capacity of more than three thousand.

III. FPI RouteOn January 7, 2014, SEBI introduced the SEBI (Foreign Portfolio Investment) Regulation 2014 (“FPI Regulations”). FPI is the portfolio investment regime. The Foreign Institutional Investor (“FII”) and Qualified Foreign Investor (“QFI”) route have been subsumed into the FPI regime. Exiting FIIs, or sub-account, can continue, till the expiry of the block of three years for which fees have been paid as per the SEBI (Foreign Institutional Investors) Regulations, 1995, to buy, sell or otherwise deal in securities subject to the provisions of these regulations. However, FII or sub-account shall be

15. http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/article/rbi-issues-reforms-for-fdi-investments.html?no_cache=1&cHash=aa112b7416545ec9dccccab2a900687f

16. Venture capital undertaking means a domestic company:- (i) whose shares are not listed in a recognised stock exchange in India; (ii) which is engaged in the business of providing services, production or manufacture of articles or things, but does not include such activities or sectors which are speci-fied in the negative list by the Board, with approval of Central Government, by notification in the Official Gazette in this behalf.



required to pay conversion fee of USD 1,00017on or before the expiry of its registration for conversion in order to buy, sell or otherwise deal in securities under the FPI Regulations. In case of QFIs, they may continue to buy, sell or otherwise deal in securities subject to the provisions of these regulations, for a period of one year from the date of commencement of FPI Regulations, or until he obtains a certificate of registration as FPI, whichever is earlier. Under the new regime SEBI has delegated the power to designated depository participants (“DDP”) who will grant the certificate of registration to FPIs on behalf of SEBI.

A. Categories

Each investor shall register directly as an FPI, wherein the FPIs have been classified into the following three categories on the basis of risk-based approach towards know your customer.

i. Category I FPI

Category I includes Government and government-related investors such as central banks, Governmental agencies, sovereign wealth funds or international and multilateral organizations or agencies.

ii. Category II FPI

Category II includes the following:

i. Appropriately regulated broad based funds;

ii. Appropriately regulated persons;

iii. Broad-based funds that are not appropriately regulated but their managers are regulated;

iv. University funds and pension funds; and

v. University related endowments already registered with SEBI as FIIs or sub-accounts

The FPI Regulations provide for the broad-based criteria. To satisfy the broad-based criteria two

conditions should be satisfied. Firstly, fund should have 20 investors even if there is an institutional investor. Secondly, both direct and underlying investors i.e. investors of entities that are set up for the sole purpose of pooling funds and making investments shall be counted for computing the number of investors in a fund.

iii. Category III FPI

Category III includes all FPIs who are not eligible under Category I and II, such as endowments, charitable societies, charitable trusts, foundations, corporate bodies, trusts, individuals and family offices.

B. Investment Limits

The FPI Regulations states that a single FPI or an investor group shall purchase below ten percent of the total issued capital of a company. The position under the FII Regulations was that such shareholding was not to exceed ten percent of the share capital.

Under the FPI Regulations ultimate beneficial owners investing through the multiple FPI entities shall be treated as part of the same investor group subject to the investment limit applicable to a single FPI.

C. ODIs/P Note

An offshore derivative instrument (“ODIs”) means any instrument, by whatever name called, which is issued overseas by a foreign portfolio investor against securities held by it that are listed or proposed to be listed on any recognized stock exchange in India, as its underlying units. Participatory Notes (“P-Notes”) are a form of ODIs.18

P-notes are, by definition a form of ODI including but not limited to swaps19, contracts for difference20, options21, forwards22, participatory notes23, equity

17. Specified in Part A of the Second Schedule of the FPI Regulations18. Section 2(1)(j) of the FPI Regulations19. A swap consists of the exchange of two securities, interest rates, or currencies for the mutual benefit of the exchangers. In the most common swap

arrangement one party agrees to pay fixed interest payments on designated dates to a counterparty who, in turn, agrees to make return interest pay-ments that float with some reference rate.

20. An arrangement made in a futures contract whereby differences in settlement are made through cash payments, rather than the delivery of physical goods or securities. At the end of the contract, the parties exchange the difference between the opening and closing prices of a specified financial instrument.

21. An option is a financial derivative that represents a contract sold by one party to another party. It offers the buyer the right, but not the obligation, to call or put a security or other financial asset at an agreed-upon price during a certain period of time or on a specific date.

22. A forward contract is a binding agreement under which a commodity or financial instrument is bought or sold at the market price on the date of making the contract, but is delivered on a decided future date. It is a completed contract – as opposed to an options contract where the owner has the choice of completing or not completing.

23. Participatory notes (P-notes) are a type of offshore derivative instruments more commonly issued in the Indian market context which are in the form of swaps and derive their value from the underlying Indian securities.




The position of the holder of an ODI is usually that of an unsecured counterparty to the FPI. Under the ODI (the contractual arrangement with the issuing FPI), the holder of a P-note is entitled only to the returns on the underlying security with no other rights in relation to the securities in respect of which the ODI has been issued. ODIs have certain features that prevent the holder of such instruments from being perceived as the beneficial owner of the securities. These features include the following aspects: (i) whether it is mandatory for the FPI to actually hedge its underlying position (i.e. actually “hold” the position in Indian securities), (ii) whether the ODI holder could direct the voting on the shares held by the FPI as its hedge, (iii) whether the ODI holder could be in a position to instruct the FPI to sell the underlying securities and (iv) whether the ODI holder could, at the time of seeking redemption of that instrument, seek the FPI to settle that instrument by actual delivery of the underlying securities. From an Indian market perspective, such options are absent considering that the ownership of the underlying securities and other attributes of ownership vest with the FPI. Internationally,

however, there has been a precedence of such structures, leading to a perception of the ODI holder as a beneficial owner – albeit only from a reporting perspective under securities laws.26

The FPI Regulations provide that Category I FPIs and Category II FPIs (which are directly regulated by an appropriate foreign regulatory authority) are permitted to issue, subscribe and otherwise deal in ODIs.27 However, those Category II FPIs which are not directly regulated (which are classified as Category-II FPI by virtue of their investment manager being appropriately regulated) and all Category III FPIs are not permitted to issue, subscribe or deal in ODIs.

FPIs shall have to fully disclose to SEBI any information concerning the terms of and parties to ODIs entered into by it relating to any securities listed or proposed to be listed in any stock exchange in India (Fig 1).

Please refer to our research paper ‘Offshore Derivate Instruments: An Investigation into Tax Related Aspects’ 28, for further details on ODIs and their tax treatment.

Eligible FPI’s Counterparty (holder of ODI)

Portfolio of listed securities on any recognized stock exchange in India

Returns on underlying portfolio

Fixed or variables payments. Eg: LIBOR plus a margin on a sum equivalent to a loan on the value of the underlying portfolio of the issued ODI

Distributions including dividends and capital gains

Investment holdings to hedge

exposures under the ODI

as issued

Fig 1: Investment through ODIs.

24. An Equity-linked Note is a debt instrument whose return is determined by the performance of a single equity security, a basket of equity securities, or an equity index providing investors fixed income like principal protection together with equity market upside exposure.

25. A Warrant is a derivative security that gives a holder the right to purchase securities from an issuer at a specific price within a certain time frame.26. CSX Corporation v. Children’s Investment Fund Management (UK) LLP. The case examined the total return swap structure from a securities law

perspective, which requires a disclosure of a beneficial owner from a reporting perspective.27. Reference may be made to Explanation 1 to Regulation 5 of the FPI Regulations where it is provided that an applicant (seeking FPI registration) shall

be considered to be “appropriately regulated” if it is regulated by the securities market regulator or the banking regulator of the concerned jurisdic-tion in the same capacity in which it proposes to make investments in India.

28. Offshore Derivate Instruments: An Investigation into Tax Related Aspects http://www.nishithdesai.com/fileadmin/user_upload/pdfs/Research%20Papers/Offshore_Derivative_Instruments.pdf

linked notes24, warrants25, or any other such instruments by whatever name they are called.

Below is a diagram that illustrates the structure of an ODI.



D. Listed Equity

The RBI has by way of Notification No. FEMA. 297/2014-RB dated March 13, 2014 amended the TISPRO Regulations to provide for investment by FPIs. Under the amended TISPRO Regulations, the RBI has permitted ‘Registered Foreign Portfolio Investors’ (“RFPI”) to invest on the same footing as FIIs.

A new Schedule 2A has been inserted after Schedule 2 of the TISPRO Regulations to provide for the purchase / sale of shares / convertible debentures of an Indian company by an RFPI under the Foreign Portfolio Investment Scheme (“FPI Scheme”). The newly introduced Schedule 2A largely mirrors Schedule 2 of TISPRO which provides for investments in shares / convertible debentures by FIIs under the portfolio investment scheme (“PIS”). Accordingly, an FPI can buy and sell listed securities on the floor of a stock exchange without being subjected to FDI restrictions.

Since, the number of real estate companies that are listed on the stock exchange are not high, direct equity investment under erstwhile FII route was not very popular. FPI investors are also permitted to invest in the real estate sector by way of subscription / purchase of Non-Convertible Debenture (“NCD”), as discussed below.

E. Listed NCDs

Under Schedule V of the amended TISPRO Regulations, read with the provisions of the FPI

Regulations, FPIs are permitted to invest in, inter alia, listed or to be listed NCDs issued by an Indian company. FPIs are permitted to hold securities only in the dematerialized form.

Currently, there is an overall limit of USD 51 Billion on investment by FPIs in corporate debt, of which 90% is available on tap basis. Further, FPIs can also invest up to USD 30 Billion in government securities.

Listing of non-convertible debentures on the wholesale debt market of the Bombay Stock Exchange is a fairly simple and straightforward process which involves the following intermediaries:

i. Debenture trustee, for protecting the interests of the debenture holders and enforcing the security, if any;

ii. Rating agency for rating the non-convertible debentures (there is no minimum rating required for listing of debentures); and

iii. Registrar and transfer agent (“R&T Agent”), and the depositories for dematerialization of the non-convertible debentures.

The entire process of listing, including the appointment of the intermediaries can be completed in about three weeks. The typical cost of intermediaries and listing for an issue size of INR One Billion is approximately INR One Million.

Herein below is a structure chart detailing the steps involved in the NCD route:

FPI

Stock Exchange (WDM)

Issuing Company

Offshore

Step 2

NCDs

Cash

Buy

Listing of NCDs

Step 1: Issuance of NCDs

Fig 2: Investment through NCDs

Step 3: Trading of NCDs on the floor of stock exchange

India

Warehousing Entity




Recently, the RBI and SEBI permitted direct subscription of ‘to be listed’ NCDs by the FII (now FPIs), thus doing away with the requirement of warehousing entity. These ‘to be listed’ NCDs have to listed on a recognized stock exchange within 15 days of issuance, else, the FPI shall be required to dispose-off the NCDs to an Indian entity / person.

Under this route, any private or public company can list its privately placed NCDs on the wholesale debt market segment of any recognized stock exchange. An FPI entity can then purchase these NCDs on the floor of the stock exchange from the warehousing entity. For an exit, these debentures may be sold on the floor of the stock exchange29, but most commonly these NCDs are redeemed by the issuing company. So long as the NCDs are being offered on private placement basis, the process of offering and listing is fairly simple without any onerous eligibility conditions or compliances.

The NCDs are usually redeemed at a premium that is usually based on the sale proceeds received by the company, with at least 1x of the purchase price being assured to the NCD holder.

Whilst creation of security interest30 is not permissible with CCDs under the FDI route, listed

NCDs can be secured (by way of pledge, mortgage of property, hypothecation of receivables etc.) in favor of the debenture trustee that acts for and in the interest of the NCD holders.

Also, since NCDs are subscribed by an FPI entity under the FPI route and not under the FDI route, the restrictions applicable to FDI investors in terms of pricing are not applicable to NCD holders. NCDs, in fact, are also in some situations favored by developers who do not want to share their equity interest in the project. Further, not only are there no interest caps for the NCDs (as in the case of CCDs or CCPS), the redemption premium on the NCDs can also be structured to provide equity upside to the NCD holders, in addition to the returns assured on the coupon on the NCD.

Separately, purchase of NCDs by the FPI from the Indian company on the floor of the stock exchange is excluded from the purview of ECB and hence, the criteria viz. eligible borrowers, eligible lenders, end-use requirements etc. applicable to ECBs, is not applicable in the case of NCDs.

The table below gives a brief comparative analysis for debt investment through FDI (CCDs) and FPI (NCDs) route:

29. There have been examples where offshore private equity funds have exited from such instruments on the bourses.30. Security interest is created in favour of the debenture trustee that acts for and on behalf of the NCD Holders. Security interest cannot be created

directly in favour of non-resident NCD holders.

Particulars CCD – FDI NCD - FPI

Equity Ownership

Initially debt, but equity on conversion Mere lending rights; however, veto rights can ensure certain degree of control.

ECB Qualification

Assured returns on FDI compliant instruments, or put option granted to an investor, may be construed as ECB.

Purchase of NCDs by the FPI from the Indian company on the floor of the stock exchange is expressly permitted and shall not qualify as ECB.

Coupon Payment

Interest pay out may be limited to SBI PLR + 300 basis points. Interest can be required to accrue and paid only out of free cash flows.

Arm's length interest pay out should be permissible resulting in better tax efficiency. Higher interest on NCDs may be disallowed. Interest can be required to accrue only out of free cash flows. Redemption premium may also be treated as business expense.

Pricing Internationally accepted pricing methodologies

DCF Valuation not applicable

Security Interest

Creation of security interest is not permissible either on immoveable or movable property

Listed NCDs can be secured (by way of pledge, mortgage of property, hypothecation of receivables etc.) in favor of the debenture trustee who acts for and in the interest of the NCD holders

Sectoral conditionalities

Only permissible for FDI compliant activities

Sectoral restrictions not applicable.

Equity Upside Investor entitled to equity upside upon conversion.

NCDs are favorable for the borrower to reduce book profits or tax burden. Additionally, redemption premium can be structured to provide equity upside which can be favourable for lender since such premium may be regarded as capital gains which may not be taxed if the investment comes from Singapore.

Administrative expenses

No intermediaries required NCD listing may cost around INR 10-15 lakh including intermediaries cost. In case of FPI, additional cost will be incurred for registration with the DDP and bidding for debt allocation limits, if required.



IV. NRI Route

A. Investment in Listed Securities

Similar to FPIs, the NRIs can also purchase the shares of a real estate developer entity under the PIS. Under Schedule 3 of the TISPRO Regulations, NRIs are permitted to invest in shares and convertible debentures on a stock exchange subject to various conditions prescribed therein. The regulations prescribe the following limits on the investment by NRIs:

i. The total investment in shares by an NRI cannot exceed 5% of the total paid up capital of the company and the investment in convertible debentures cannot exceed 5% of the paid up value of each series of convertible debentures issued by the company concerned; and

ii. The aggregate of the NRI investments in the company cannot exceed 10% of the paid up capital of the company. However, this limit could be increased up to the sectoral cap prescribed under the FDI policy with a special resolution of the company.

B. Direct Investment in Unlisted Securities

i. Investment on repatriation basis

Investment by NRI in unlisted securities on repatriation basis is in a manner similar to any other investment allowed under Schedule 1 of TISPRO Regulations; however, as stated earlier the onerous requirements of minimum area, minimum capitalization, lock-in etc. applicable for FDI in construction development projects are not required to be met by NRIs per paragraph 6.2.11.2.

ii. Investment on Non-repatriation Basis

Under Schedule 4 of TISPRO Regulations, NRIs on a non-repatriation basis are permitted to purchase

shares or convertible debentures of an unlisted Indian company without any limit and permission to purchase. The above permission is not available to NRIs for certain prohibited companies.31

C. Direct Acquisition of Immovable Property

The Foreign Exchange Management (Acquisition and Transfer of Immovable Property in India) Regulations, 2000, deal with direct acquisition of immovable property by ‘a person resident outside India’. Under the regulations a ‘person resident outside India’ has been classified into two sections:

i. A person resident outside India, who is a citizen of India i.e. an NRI.

ii. A person resident outside India, who is of Indian origin i.e. a person of Indian Origin32 (“PIO”)

Both NRI’s and PIO’s have been under the regulations allowed to directly purchase or sell immovable property other than agricultural property, plantation or a farm house in India. However there are certain conditions imposed under the regulations on the payment of the purchase price and on repatriation of the sale consideration received.

i. Purchase Price Conditions

The payment of the purchase price can be made only by the following means:

￭ Funds received in India through normal banking channels by way of inward remittance from any place outside India; or

￭ Funds held in any non-resident account maintained in accordance with the provisions of the FEMA and the regulations framed by RBI from time to time.

ii. Repatriation of Sale Proceeds

NRIs/ PIOs are allowed to freely repatriate the sale proceeds provided:

31. Prohibited companies means - company which is a chit fund or a nidhi company or is engaged in agricultural/plantation activities or real estate busi-ness or construction of farm houses or dealing in transfer of development rights

32. A ‘PIO’ means an individual (not being a citizen of Pakistan or Bangladesh or Sri Lanka or Afghanistan or China or Iran or Nepal or Bhutan) who 1. at any time, held an Indian Passport or 2. who or either of whose father or mother or whose grandfather or grandmother was a citizen of India by virtue of the Constitution of India or the

Citizenship Act, 1955 (57 of 1955).




￭ The immovable property was acquired in accordance with the regulations;

￭ The amount remitted outside India does not exceed the amount paid for the acquisition of the immovable property;

￭ In case of residential property, the repatriation is not for the amount received on sale of more than two residential properties.

However, any upside that is obtained on sale of such property after being subject to applicable capital gains tax and withholding can be remitted outside India through a Non-Resident Ordinary Rupee Account. However, the amount so repatriated cannot exceed USD 1 (One) million a year.



CA 2013 recently replaced CA 1956. CA 2013 introduces several new concepts and modifies several existing ones. Some of the relevant new provisions introduced by CA 2013 are as follows:

i. Shares with Differential Rights

ii. Listed Company

iii. Inter-Corporate loans

iv. Deposits

v. Insider trading

vi. Squeeze out provisions

vii. Directors

viii. Subsidiary and Associate Company

ix. Merger of an Indian company with offshore company.

I. Shares with Differential RightsUnder CA 1956, private companies were allowed to issue shares with differential rights for their contractual agreements because of an exemption available to them.33 However, with the replacement of CA 1956 with CA 2013, this flexibility is no longer available to private companies. Now, private Companies, like public companies, can issue only equity and preference shares and shares with differential rights subject to certain conditions, as discussed below.34 Accordingly, preference shares with voting rights on an as-if-converted basis may not be permitted now.

The Companies (Share Capital and Debentures) Rules, 2014 for issuance of equity share capital35 prescribe several conditions for any company issuing equity shares with differential voting rights to adhere to, such as:

i. Share with differential rights shall not exceed 26% (twenty six per cent) of the total post issue paid up equity share capital, including equity shares with differential rights issued at any point of time;

ii. The company shall have a consistent track record of distributable profits for the last 3 (three) years;

iii. The company should not have defaulted in filing financial statements and annual returns for the

preceding 3 (three) financial years.

With this change, structuring different economic rights for different class of equity shareholders may become difficult given the conditions that companies have to comply with under the Companies (Share Capital and Debentures) Rules, 2014. For instance, investors in real estate expecting a preferred IRR could earlier take their preferred returns by way of dividends on different class of equity, which may be difficult now. Any returns on preference shares will be capped at a dividend of around 13% (SBI prime lending rate + 300 basis points).

II. Listed CompanyCA 2013 defines listed company as a company which has any of its securities listed on any recognized stock exchange.36 Even private companies with their NCDs listed on any recognized stock exchange will be considered as a listed company. CA 2013 places a whole gamut of obligations on listed companies, such as:

i. Returns to be filed with the registrar of companies if the promoter stake changes;

ii. Onerous requirements relating to appointment of auditors;

iii. Formation of audit committee, nomination and remuneration committee and stakeholders relationship committee;

iv. Secretarial audit.

III. Inter-Corporate Loans and Guarantee

Under CA 1956, loans made to or security provided or guarantee given in connection with loan given to the director of the lending company and certain specified parties required previous approval of the Central Government. However, section 185 of CA 2013 which has by far been the most debated section of CA 2013, imposes a total prohibition on companies providing loans, guarantee or security to the director or any other person in whom the director is interested, unless it is in the “ordinary

3. Legal Framework – Key Developments

33. Section 90(2) of CA 1956 exempts applicability of Sections 85 to 89 to a private company unless it is a subsidiary of a public company34. Sections 43 and 47 of CA 201335. Chapter IV, Share Capital and Debentures, Rules under CA 2013 36. Section 2(52), CA 2013



course of business” of the company to do so. Whilst the restriction contained in CA 1956 applied only to public companies, CA 2013 has extended this restriction to even private companies. Such restriction would create significant difficulties for companies which provide loans, or guarantee/ security to their subsidiaries or associate companies for operational purposes.

IV. DepositsUnder CA 2013, acceptance of deposits by an Indian company is governed by stricter rules. Securities application money that is retained for more than 60 days without issuance of securities shall be deemed as a deposit. CA 2013 lays down stringent conditions for issuance of bonds and debentures – unsecured optionally convertible debentures are treated as deposits. CA 2013 also specifies additional compliances for deposits accepted prior to the commencement of CA 2013.

V. Insider TradingCA 2013 now has an express provision for insider trading wherein insider trading of securities of a company by its directors or key managerial personnel is prohibited.37 SEBI had notified the SEBI (Prohibition of Insider Trading) Regulations, 1992 to govern public companies. The provision governs both public and private companies. Hence, nominee director appointed by a private equity investor may also be subjected to insider trading provisions. However, the practical application of section 195 of CA 2013, with respect to a private company remains to be ambiguous.

VI. Squeeze out ProvisionsUnder CA 2013 an acquirer or person acting in concert, holding 90% of the issued equity share capital has a right to offer to buy the shares held by the minority shareholders in the Company at a price determined on the basis of valuation by a registered valuer in accordance with prescribed rules.38 The corresponding provision under the 1956 Act was permissive and not mandatory in nature.39 In this regard, private equity investors may want to exercise some caution while the majority shareholders approach the 90% shareholding threshold in a

company. Interestingly, there is no provision that minority shareholders will be bound to transfer their shares to an acquirer or person acting in concert and the section lacks the teeth required to enforce a classic squeeze up.

VII. DirectorsCA 2013 introduces certain new requirements with respect to directors40 such as:

i. Independent Director: Independent Directors have been formally introduced by CA 2013, earlier the listing agreements41 provided for appointment of independent directors. CA 2013 provides that ‘Every listed public company’ shall have at least one-third director of the total number of directors as independent directors. The term ‘every listed public company’ is ambiguous as it is the only instance in CA 2013 which applies to the ‘listed public company’ and not just ‘listed company’. This is relevant because under CA 2013, a ‘listed company’ also includes a private company which has its NCDs listed on the stock exchange.

ii. Resident Director: Every company to have a director who was resident in India for a total period of not less than 182 days in the previous calendar year.

iii. Women Director: Prescribed class of companies shall have atleast one woman director.

CA 2013 has for the first time, laid down specific duties of directors, as follows:

i. To act in accordance with the articles of the company;

ii. To act in good faith in order to promote the objects of the company for the benefit of its members as a whole and in the best interests of the company, its employees, the shareholders, and the community and for the protection of environment;

iii. To exercise his duties with due and reasonable care, skill and diligence and shall exercise independent judgment;

iv. Not to involve himself in a situation in which he may have a direct or indirect interest that conflicts or possibly may conflict, with the interest of the company;

37. Section 195, CA 201338. Section 236, CA 201339. Section 395, CA 195640. Section 149, CA 201341. Listing agreements set out the conditions that a company or issuer of share has to abide. Clause 49



v. Not to achieve or attempt to achieve any undue gain or advantage either to himself or his relatives, partners, or associates and if such director is found guilty of such, he shall be liable to pay an amount equal to that gain to the company;

vi. Not to assign his office and any such assignment shall be void.

Having said the above, the liability of an independent director and non-executive director has been restricted to such acts of omission or commission which had occurred with his knowledge, attributable through board processes, and with his consent or connivance or where he had not acted diligently.

VIII. Control and Subsidiary and Associate Company

CA 2013 defines the term ‘control’ and the definition of subsidiary and associate company has changed:

i. According to CA 2013, control,42 “shall include the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner”. It is for the first time that the control has been defined in the company law.

ii. Subsidiary Company: An entity will be subsidiary of the holding company, if holding company controls the composition of the board of directors of the company or controls (directly or indirectly) more than one half of the total share capital.43

iii. Associate Company: An entity will be an associate of the company, if the company has a significant influence over the entity, but it is not the subsidiary company of the company.44

The concept of control as provided in the definition of subsidiary company is narrower than what is provided in the definition of the control.

IX. Merger of an Indian Company with Offshore Company

Section 234 of CA 2013 permits mergers and amalgamations of Indian companies with foreign companies. However, the provisions of Section 234 go on to say that such mergers and amalgamations are permitted only with companies incorporated in the jurisdictions of such countries notified from time to time by the Central Government. Hitherto, only inbound mergers were permitted, whereby a company incorporated outside India could merge with an Indian company.

42. Section 2(27), CA 201343. Section 2(87), CA 201344. Section 2(6), CA 2013

Legal Framework – Key Developments



I. Overview of Indian Taxation System

Income tax law in India is governed by the Income Tax Act, 1961 (“ITA”). Under the ITA, individuals and entities, whether incorporated or unincorporated, if resident for tax purposes in India, shall be taxed on their worldwide income in India. Companies are held to be resident in India for tax purposes a) if they are incorporated in India; or b) if they are controlled and managed entirely in India. Therefore, it is possible for companies incorporated outside India to be considered to be resident in India if they are wholly controlled in India. Non-residents are taxed only on income arising from sources in India.

India has entered into more than 80 Double Taxation Avoidance Agreements (“DTAAs” or “tax treaties”). A taxpayer may be taxed either under domestic law provisions or the DTAA to the extent that it is more beneficial. In order to avail benefits under the DTAA, a non-resident is required furnish a tax residency certificate (“TRC”) from the government of which it is a resident in addition to satisfying the conditions prescribed under the DTAA for applicability of the DTAA. Further, the non-resident should also file tax returns in India and furnish certain prescribed particulars to the extent they are not contained in the TRC. For the purpose of filing tax returns in India, the non-resident should obtain a tax ID in India (called the permanent account number “PAN”). PAN is also required to be obtained to claim the benefit of lower withholding tax rates, whether under domestic law or under the DTAA. If the non-resident fails to obtain a PAN, payments made to the non-resident may be subject to withholding tax at the rates prescribed under the ITA or 20%, whichever is higher.

A. Corporate Tax

Resident companies are taxed at 30%. A company is said to be resident in India if it is incorporated in India or is wholly controlled and managed in India. A minimum alternate tax (“MAT”) is payable by companies at the rate of around 18.5%. Non-resident companies are taxed at the rate of 40% on income derived from India, including in situations where profits of the non-resident entity are attributable to a permanent establishment in India.

B. Tax on Dividends and Share Buy-back

Dividends distributed by Indian companies are subject to a distribution tax (DDT) at the rate of 15%, payable by the company. However, the domestic law requires the tax payable to be computed on a grossed up basis; therefore, the shareholders are not subject to any further tax on the dividends distributed to them under the ITA. An Indian company would also be taxed at the rate of 20% on gains arising to shareholders from distributions made in the course of buy-back or redemption of shares.

C. Capital Gains

Tax on capital gains depends upon the holding period of a capital asset. Short term capital gains (“STCG”) may arise if the asset has been held for less than three years (or in the case of listed securities, less than one year) before being transferred; and gains arising from the transfer of assets having a longer holding period than the above are characterized as long term capital gains (“LTCG”). The 2014 Finance Budget proposes a minimum holding period of 3 years for LTCG with respect to unlisted securities.

LTCG earned by a non-resident on sale of unlisted securities may be taxed at the rate of 10% or 20% depending on certain considerations. LTCG on sale of listed securities on a stock exchange are exempt and only subject to a securities transaction tax (“STT”). STCG earned by a non-resident on sale of listed securities (subject to STT) are taxable at the rate of 15%, or at ordinary corporate tax rate with respect to other securities. Foreign institutional investors or foreign portfolio investors are also subject to tax at 15% on STCG and are exempt from LTCG (on the sale of listed securities). The 2014 Budget also proposes to treat all income earned by Foreign Institutional Investors or Foreign Portfolio Investors as capital gains income. In the case of earn-outs or deferred consideration, Courts have held that capital gains tax is required to be withheld from the total sale consideration (including earn out) on the date of transfer of the securities / assets.

India has also introduced a rule to tax non-residents on the transfer of foreign securities the value of which may be substantially (directly or indirectly) derived from assets situated in India. Therefore, the shares of a foreign incorporated company can

4. Taxation Framework



be considered to be a “situate in India” and capable of yielding capital gains taxable in India, if the company’s share derive their value “substantially45 from assets located in India”. However, income derived from the transfer of P-notes and ODIs derive their value from the underlying Indian securities is not considered to be income derived from the indirect transfer of shares in India because holding such derivative instruments which are linked to underlying shares in India does not constitute an ‘interest’ in the Indian securities.

Tax is levied on private companies and firms that buy/ receive shares of a private company for less than their fair market value. Therefore, where the consideration paid by a private company or firm is less than the fair market value of the shares, the purchaser would be taxed on the difference under these provisions.

D. Interest

Interest earned by a non-resident may be taxed at a rate between 5% to around 40% depending on the nature of the debt instrument. While a concessional withholding tax rate of 5% for interest on long term foreign currency denominated bonds is available until July 1, 2017, the eligibility of rupee-denominated non-convertible debentures for the same benefit expires on June 1, 2015.

E. Minimum Alternate Tax

Where the tax payable by the investee company is less than 18.5 percent of its book profits, due to certain exemption such company is still required to pay atleast 18.5 percent (excluding surcharge and education cess) as Minimum Alternate Tax.

F. Safe Harbor Rules

‘Safe harbour rules’ have been recently notified with the aim of providing more certainty to taxpayers and to address growing risks of transfer pricing litigation in India. Under this regime, tax authorities will accept the transfer price set by the taxpayer if the taxpayer and transaction meet eligibility criteria specified in the rules. Key features of these rules are:

i. The rules will be applicable for 5 years beginning assessment year 2013-14. A taxpayer can opt for the safe harbor regime for a period of his choice but not exceeding 5 assessment years. Once opted for, the mutual agreement procedure would not be available.

ii. Safe harbor margins have been prescribed for provision of: (i) IT and ITeS services; (ii) Knowledge Process Outsourcing services; (iii) contract R&D services related to generic pharmaceutical drugs and to software development; (iv) specified corporate guarantees; (v) intra-group loan to a non-resident wholly owned subsidiary; (vi) manufacture and export of core and non-core auto components.

iii. For provision of IT and ITeS services, KPO and contract R&D services, the rules would apply where the entity is not performing economically significant functions.

iv. Taxpayers and their transactions must meet the eligibility criteria. Each level of the authority deciding on eligibility (i.e. the Assessing Officer, the Transfer Pricing Officer and the Commissioner) must discharge their obligations within two months. If the authorities do not take action within the time allowed, the option chosen by the taxpayer would be valid.

v. Once an option exercised by the taxpayer has been held valid, it will remain so unless the taxpayer voluntarily opts out.

The option exercised by the assessee can be held invalid in an assessment year following the initial assessment year only if there is change in the facts and circumstances relating to the eligibility of the taxpayer or of the transaction.

G. Wealth Tax

Buildings, residential and commercial premises held by the investee company will be regarded as assets as defined under Section 2(ea) of the Wealth Tax Act, 1957 and thus be eligible to wealth tax in the hands of the investee company at the rate of 1 percent on its net wealth in excess of the base exemption of INR 30,00,000. However, commercial and business assets are exempt from wealth tax.

H. Service Tax

The service tax regime was introduced vide Chapter V to the Finance Act, 1994. Subsequent Finance Acts, (1996 to 2003) have widened the service tax net by way of amendments to Finance Act, 1994. Service tax is levied on specified “taxable services” at the rate of 12.3646 percent on the “gross amount” charged by the service provider for the taxable services rendered by him. The Finance Act, 2004 has introduced “construction services” as a taxable service and thus

45. Although, ‘substantial’ has not been defined under ITA, as per draft DTC 2013, ‘substantial’ is proposed to be 20%46. Excluding currently applicable education cess of 3 percent on service tax

Taxation Framework



such services provided by the investee company would be subject to service tax in India. Further, the Finance Act, 2007, has brought services provided in relation to renting of immovable property, other than residential properties and vacant land, for use in the course or furtherance of business or commerce under the service tax regime.

I. Stamp Duty and Other Taxes

The real estate activities of the venture capital undertaking would be subject to stamp duties and other local/municipal taxes, property taxes, which would differ from State to State, city to city and between municipals jurisdictions. Stamp duties may range between 3 to 14 percent.

II.SpecificTaxConsiderationsforPE Investments

A. Availability of Treaty Relief

Benefits under a DTAA are available to residents of one or both of the contracting states that are liable to tax in the relevant jurisdiction. However, some fiscally transparent entities such as limited liabilities companies, partnerships, limited partnerships, etc. may find it difficult to claim treaty benefits. For instance, Swiss partnerships have been denied treaty benefits under the India-Switzerland DTAA. However, treaty benefits have been allowed to fiscally transparent entities such as partnerships, LLCs and trusts under the US and UK DTAAs, insofar as the entire income of the entity is liable to be taxed in the contracting state; or if all the beneficiaries are present in the contracting state being the jurisdiction of the entity. On the other hand, Swiss partnerships have been denied treaty benefits under the India-Switzerland.

Benefits under the DTAA may also be denied on the ground of substance requirements. For instance, the India-Singapore DTAA denies benefits under the DTAA to resident companies which do not meet the prescribed threshold of total annual expenditure on operations. The limitation on benefits (“LoB”) clause under the India-Luxembourg DTAA permits the benefits under the DTAA to be overridden by domestic anti-avoidance rules. India and Mauritius are currently in the process of re-negotiating their DTAA to introduce similar substance based requirements.

B. Permanent Establishment and Business Connection

Profits of a non-resident entity are typically not subject to tax in India. However, where a permanent establishment is said to have been constituted in India, the profits of the non-resident entity are taxable in India only to the extent that the profits of such enterprise are attributable to the activities carried out through its permanent establishment in India and are not remunerated on an arm’s length basis. A permanent establishment may be constituted where a fixed base such as a place of management, branch, office, factory, etc. is available to a non-resident entity; or where a dependent agent habitually exercises the authority to conclude contracts on behalf of the non-resident entity. Under some DTAAs, employees or personnel of the non-resident entity furnishing services for the non-resident entity in India may also constitute a permanent establishment. The recent Delhi High Court ruling in e-Funds IT Solutions/ e-Funds Corp vs. DIT47 laid down the following principles for determining the existence of a fixed base or a dependent agent permanent establishment:

i. The mere existence of an Indian subsidiary or mere access to an Indian location (including a place of management, branch, office, factory, etc.) does not automatically trigger a permanent establishment risk. A fixed base permanent establishment risk is triggered only when the offshore entity has the right to use a location in India (such as an Indian subsidiary’s facilities); and carries out activities at that location on a regular basis.

ii. Unless the agent is authorized to and has habitually exercised the authority to conclude contracts, a dependent agent permanent establishment risk may not be triggered. Merely assigning or sub-contracting services to the Indian subsidiary does not create a permanent establishment in India.

iii. An otherwise independent agent may, however, become a permanent establishment if the agent’s activities are both wholly or mostly wholly on behalf of foreign enterprise and that the transactions between the two are not made under arm’s length conditions.

Where treaty benefits are not available, the concept of ‘business connection’, which is the Indian domestic tax law equivalent of the concept of permanent establishment, but which is much wider

47. TS-63-HC-2014 (DEL); MANU/DE/0373/2014



and has been defined inclusively under the ITA, would apply to non-resident companies deriving profits from India.

C. Indirect Transfer of shares in India

No explanation has been given under the ITA as to when such securities may be considered to have derived value “substantially from assets located in India”. However, such transfers may be subject to relief available under the relevant DTAA. As discussed, these provisions should not impact p-notes or ODI holders.

As mentioned earlier, ‘substantial’ has not been defined under ITA, based on the recommendation of high level government committee, draft DTC 2013, provides for a threshold of 20% or more assets are situated in India. However, given the ambiguity of the provisions governing indirect transfer of shares in India, the impact of these provisions have to be examined on a case-by-case basis and necessary risk mitigation strategies have to be adopted to address the concerns of buyers or sellers. Please refer to Annexure XII for a detailed analysis.

D. General Anti-Avoidance Rule

India has introduced general anti-avoidance rules (“GAAR”) which provide broad powers to tax authorities to deny a tax benefit in the context of ‘impermissible avoidance agreements’, i.e., structures (set up subsequent to August 30, 2010) which are not considered to be bona fide or lack commercial substance. GAAR will come into effect from April 1, 2015 and would override DTAAs signed by India. Therefore, the transfer of any investment made subsequent to August 30, 2010 shall be subject to the GAAR from April 1, 2015. The applicability of the GAAR is subject to a de minimis threshold of INR 3 crore. GAAR is not attracted in the case of a foreign institutional investor which is not claiming benefits under the DTAA and has invested in in listed or unlisted securities in compliance with the law. The option of obtaining an advance ruling is available even in the context of GAAR structures. Care has to be taken while developing and implementing structures to address GAAR and in this context, it is important to document the business and strategic rationale for each step in a structure.

Please refer to Annexure VII for a detailed analysis.

E. Transfer Pricing Regulations

Under the Indian transfer pricing regulations, any income arising from an “international transaction” is required to be computed having regard to the arm’s length price. There has been litigation in relation to the mark-up charged by the Indian advisory company in relation to services provided to the offshore fund / manager. In recent years, income tax authorities have also initiated transfer pricing proceedings to tax foreign direct investment in India. In some cases, the subscription of shares of a subsidiary company by a parent company was made subject to transfer pricing regulations, and taxed in the hands of the Indian company to the extent of the difference in subscription price and fair market value.

F. Withholding Obligations

Tax would have to be withheld at the applicable rate on all payments made to a non-resident, which are taxable in India. The obligation to withhold tax applies to both residents and non-residents. Withholding tax obligations also arise with respect to specific payments made to residents. Failure to withhold tax could result in tax, interest and penal consequences. Therefore, often in a cross-border the purchasers structure their exits cautiously and rely on different kinds of safeguards such as contractual representations, tax indemnities, tax escrow, nil withholding certificates, advance rulings, tax insurance and legal opinions. Such safeguards have been described in further detail under Annexure X.

G. Structuring Through Intermediate Jurisdictions

Investments into India are often structured through holding companies in various jurisdictions for number of strategic and tax reasons. For instance, US investors directly investing into India may face difficulties in claiming credit of Indian capital gains tax on securities against US taxes, due to the conflict in source rules between the US and India. In such a case, the risk of double taxation may be avoided by investing through an intermediary holding company.

While choosing a holding company jurisdiction it is necessary to consider a range of factors including political and economic stability, investment protection, corporate and legal system, availability of high quality administrative and legal support,

48. Fees for Technical Services

Taxation Framework



banking facilities, tax treaty network, reputation and costs.

India has entered into several BITs and other investment agreements with various jurisdictions, most notably, Mauritius. It is important to take advantage of structuring investment into India, may be the best way to protect a foreign investor’s interest. Indian BITs are very widely worded and are severally seen as investor friendly treaties. Indian BITs have a broad definition of the terms ‘investment’ and ‘investor’. This makes it possible to seek treaty protection easily through corporate structuring. BITs can also be used by the investors to justify the choice of jurisdiction when questioned for GAAR.

Please refer to Annexure XI for detailed note on BITs.

Over the years, a major bulk of investments into India has come from countries such as Mauritius, Singapore and Netherlands, which are developed and established financial centers that have favorable tax treaties with India. Cyprus was also a popular investment holding jurisdiction, but due to a recent ‘blacklisting’ by India due to issues relating to exchange of information, investments from Cyprus could result in additional taxes and disclosure till this position changes. The following table summarizes some of the key advantages of investing from Mauritius, Singapore and Netherlands:

HEAD OF TAXATION MAURITIUS SINGAPORE NETHERLANDS

Capital gains tax on sale of Indian securities

Mauritius residents not taxed. No local tax in Mauritius on capital gains.

Singapore residents not taxed. Exemption subject to satisfaction of certain ‘substance’ criteria and expenditure test by the resident in Singapore. No local tax in Singapore on capital gains (unless characterized as business income).

Dutch residents not taxed if sale made to non-resident. Exemption for sale made to resident only if Dutch shareholder holds lesser than 10% shareholding in Indian company. Local Dutch participation exemption available in certain circumstances.

Tax on dividends Indian company subject to DDT at the rate of 15%.

Indian company subject to DDT at the rate of 15%.

Indian company subject to DDT at the rate of 15%.

Withholding tax on outbound interest

No relief. Taxed as per Indian domestic law.

15% 10%

Withholding tax on outbound royalties and fees for technical services

15% (for royalties). FTS 48 may be potentially exempt in India.

10% 10%

Other comments Mauritius treaty in the process of being renegotiated. Possible addition of ‘substance rules’.

There are specific limitations under Singapore corporate law (e.g. with respect to buyback of securities).

To consider anti-abuse rules introduced in connection with certain passive holding structures.



One of the largest issues faced by private equity investors investing in real estate under the FDI route is exit. Following are some of the commonly used exit options in India, along with attendant issues / challenges:

I. Put OptionsPut options in favour of a non-resident requiring an Indian resident to purchase the shares held by the non-resident under the FDI regime were hitherto considered non-compliant with the FDI Policy by the RBI. RBI has legitimized option arrangements49 through an amendment in the TISPRO Regulations. The TISPRO Regulations now permit equity shares, CCPS and CCDs containing an optionality clause to be issued as eligible instruments to foreign investors. However, the amendment specifies that such an instrument cannot contain an option / right to exit at an assured price.

The amendment, for the first time, provides for a written policy on put options, and in doing that sets out the following conditions for exercise of options by a non-resident:

i. Shares/debentures with an optionality clause can be issued to foreign investors, provided that they do not contain an option/right to exit at an assured price;

ii. Such instruments shall be subject to a minimum lock-in period of one year;

iii. The exit price should be as follows:

a. In case of listed company, at the market price determined on the floor of the recognized stock exchanges;

b. In case of unlisted equity shares, at a price not exceeding that arrived on the basis of internationally accepted pricing methodologies

c. In case of preference shares or debentures, at a price determined by a Chartered Accountant or a SEBI registered merchant banker per any internationally accepted methodology.

II. Buy-BackIn this exit option, shares held by the foreign investor, are bought back by the investee company. Buy-back of securities is subject to certain conditionalities as stipulated under Section 68 of CA 2013. A company can only utilize the following funds for undertaking the buy-back (a) free reserves (b) securities premium account, or (c) proceeds of any shares or other specified securities. However, buy-back of any kind of shares or other specified securities is not allowed to be made out of the proceeds of an earlier issue of the same kind of shares or same kind of other securities.

Further, a buy back normally requires a special resolution50 passed by the shareholders of the company unless the buyback is for 10% or less of the total paid-up equity capital and free reserves of the company. Additionally, a buy back cannot exceed 25% of the total paid up capital and free reserves of the company in one financial year, and post buy-back, the debt equity ratio of the company should not be more than 2:1. Under CA 1956, it was possible to conduct two buy-backs in a calendar year, i.e., one in the financial year ending March 31 and a subsequent offer in the financial year commencing on April 1. However, in order to counter this practice, the CA 2013 now requires a cooling off period of one year between two successive offers for buy-back of securities by a company.

From a tax perspective, traditionally, the income from buyback of shares has been considered as capital gains in the hands of the recipient and accordingly the investor, if from a favourable treaty jurisdiction, could avail the treaty benefits. However, in a calculated move by the Government to undo this current practice of companies resorting to buying back of shares instead of making dividend payments, the government, vide Budget 2013-2014 levied a tax of 20%51 on domestic unlisted companies, when such companies make distributions pursuant to a share repurchase or buy back.

The said tax at the rate of 20% is imposed on a domestic company on consideration paid by it which is above the amount received by the company at the time of issuing of shares. Accordingly, gains that

5. Exit Options / Issues

49. http://www.rbi.org.in/scripts/NotificationUser.aspx?Id=8682&Mode=050. Under CA 2013, a Special Resolution is one where the votes cast in favor of the resolution (by members who, being entitled to do so, vote in person or

by proxy, or by postal ballot) is not less than three times the number of the votes cast against the resolution by members so entitled and voting. (The position was the same under CA 1956).

51. Exclusive of surcharge and cess.



may have arisen as a result of secondary sales that may have occurred prior to the buy-back will also be subject to tax now.

The proposed provisions would have a significant adverse impact on offshore realty funds and foreign investors who have made investments from countries such as Mauritius, Singapore, United States of America and Netherlands etc. where buy-back of shares would not have been taxable in India due to availability of tax treaty benefits. Further, being in the nature of additional income tax payable by the Indian company, foreign investors may not even be entitled to a foreign tax credit of such tax.

Additionally, in the context of the domestic investor, even the benefit of indexation would effectively be denied to such investor and issues relating to proportional disallowance of expenditure under Section 14A of the ITA (Expenditure incurred in relation to income not includible in total income) may also arise. This may therefore result in the buy-back of shares being even less tax efficient than the distribution of dividends.

As an alternative to buy-back, the investor could approach the courts for reduction of capital under the provisions of section 66 of CA 2013; however, the applications for such reduction of capital need to be adequately justified to the court. From a tax perspective, the distributions by the company to its shareholders, for reduction of capital, would be regarded as a dividend to the extent to which the company possesses accumulated profits and will be taxable in the hands of the company at the rate of 15%52 computed on a grossed up basis, distribution over and above the accumulated profits (after reducing the cost of shares) would be taxable as capital gains.53

III. RedemptionIn recent times, NCDs have dominated the market. NCDs can be structured as pure debt or instruments delivering equity upside. The returns on the NCDs can be structured either as redemption premium or as coupon, the tax consequences of the same is set out earlier in this paper. The redemption premium in certain structured equity deals can be pegged to the cash flows or any commercially agreed variable, enabling such debentures to assume the character of payable when able kind of bonds. A large amount of foreign investment into real estate has been structured through this route. However, not much

data is available on how many such bonds have been redeemed and at what IRRs. The instances of default are few and it does seem that in most cases such debentures are indeed providing returns and exits to the investors as contemplated.

IV. Initial Public OfferingAnother form of exit right which an investor may have is in the form of an Initial Public Offering (“IPO”). However, looking at the number of real estate companies which have listed in the previous decade in India, this may not be one of viable exit options. The reason why real estate companies do not wish to go public in India is manifold.

For instance, real estate companies are usually self-liquidating by nature. Thus, unless the flagship or the holding company goes public, there may not be enough public demand for and interest in such project level SPVs. There is also some reluctance in going for an IPO due to the stringent eligibility criteria (for instance 3 year profitability track record etc.) and the level of regulatory supervision that the companies (usually closely held) will be subjected to post listing.

V. Third Party SaleIn this option, the investor sells its stake to a third party. If the sale is to another non-resident, the lock-in of 3 years would start afresh and be applicable to such new investor. Also, since FDI in completed ‘assets’ is not permitted, the sale to a non-resident can only be of an under-construction project.

In a third party sale in real estate sector, it may also be important to negotiate certain contractual rights such as ‘drag along rights’. For instance, if the sale is pursuant to an event of default, and the investor intends to sell the shares to a developer, it is likely that the new developer may insist on full control over the project, than to enter a project with an already existing developer. In such cases, if the investor has the drag along rights, he may be able to force the developer to sell its stake along with the investor’s stake.

VI. GP Interest Sale54

A private equity fund is generally in the form of a limited partnership and comprises two parties, –

52. Exclusive of surcharge and cess53. CIT v G. Narasimhan, (1999)1SCC51054. Reaping the Returns: Decoding Private Equity Real Estate Exits in India, available at http://www.joneslanglasalle.co.in/ResearchLevel1/Reaping_the_

Returns_Decoding_Private_Equity_Real_Estate_Exits_in_India.pdf



the General Partner (“GP”) and the Limited Partner (“LP”). The GP of a fund is generally organized as a limited partnership controlled by the fund manager and makes all investment decisions of the fund. In a GP interest sale, the fund manager sells its interest in the limited partnership (“GP Interest”) to another fund manager or strategic buyer. While technically sale of GP Interest does not provide exits to the LPs as they continue in the fund with a new fund manager, it provides an effective exit to fund managers who wish to monetize their interests in the fund management business.

VII. Offshore ListingThe Ministry of Finance (“MoF”) by a notification55 has permitted Indian unlisted companies to list their ADRs, GDRs or FCCBs abroad on a pilot basis for two years without a listing requirement in India. In pursuance to this, the Central Government amended56 the Foreign Currency Convertible Bonds and Ordinary Shares (Through Depositary Receipt Mechanism) Scheme, 1993 (“FCCB Scheme”). RBI also directed57 the authorized dealers towards the amendment to the FCCB Scheme.

Regulation 3(1)(B) of the FCCB Scheme, prior to the amendment restricted unlisted Indian companies from issuing GDRs/FCCBs abroad as they were required to simultaneously list in Indian stock exchanges.

The notification amended the regulation 3(1)(B) to permit Indian unlisted companies to issue GDRs/FCCBs to raise capital abroad without having to fulfill the requirement of a simultaneous domestic listing.

But it is subject to following conditions:

￭ The companies will be permitted to list on exchanges in IOSCO/FATF compliant jurisdictions or those jurisdictions with which SEBI has signed bilateral agreements (which are yet to be notified).

￭ The raising of capital abroad shall be in accordance with the extant foreign FDI Policy, including the sectoral caps, entry route, minimum capitalization norms and pricing norms;

￭ The number of underlying equity shares offered for issuance of ADRs/GDRs to be kept with the local custodian shall be determined upfront and ratio of ADRs/GDRs to equity shares shall be

decided upfront based on applicable FDI pricing norms of equity shares of unlisted company;

￭ The funds raised may be used for paying off overseas debt or for operations abroad, including for the funding of acquisitions;

￭ In case the money raised in the offshore listing is not utilized overseas as described, it shall be remitted back to India within 15 days for domestic use and parked in AD category banks.

The Central Government has recently prescribed that SEBI shall not mandate any disclosures, unless the company lists in India.

VIII. FlipsAnother mode of exit could be by way of rolling the real estate assets into an offshore REIT by flipping the ownership of the real estate company to an offshore company that could then be listed. Examples of such offshore listings were seen around 2008, when the Hiranandani Group set up its offshore arm ‘Hirco PLC’ building on the legacy of the Hiranandani Group’s mixed use township model. Hirco was listed on the London Stock Exchange’s AIM sub-market. At the time of its admission to trading, Hirco was the largest ever real estate investment company IPO on AIM and the largest AIM IPO in 2006. Another example is Indiabulls Real Estate that flipped some of its stabilized and developing assets into the fold of a Singapore Business Trust (“SBT”) that got listed on the Singapore Exchange (“SGX”). However, both Hirco and Indiabulls have not been particularly inspiring stories and to some extent disappointed investor sentiment. Based on analysis of the listings, it is clear that there may not be a market for developing assets on offshore bourses, but stabilized assets may receive good interest if packaged well and have the brand of a reputed Indian developer. Hence, stabilized assets such as educational institutions, hospitals, hotels, SEZs, industrial parks et al may find a market offshore.

Please refer to Annexure XII for a detailed note on exit by rolling assets to offshore REITs.

IX. Domestic REITsRecently, SEBI introduced the REIT Regulations. REITs would serve as an asset-backed investment mechanism where an Indian trust is set up for the holding of real estate assets as investments, either

55. The Press Release is available on:http://finmin.nic.in/press_room/2013/lisitIndianComp_abroad27092013.pdf56. Notification no. GSR 684(E) [F.NO.4/13/2012-ECB], dated 11-10-201357. RBI A.P. (Dir Series) Circular No. 69 of November 8, 2013

Exit Options / Issues



directly or through an Indian company set up as a Special Purpose Vehicle (“SPV”). However, there was no clarity on the proposed tax regime, which is a key element for enabling a successful REIT regime.

The Finance Act, 2014 has made certain amendments to the Income Tax Act, 1961 (“ITA”) to clarify the income tax treatment of REITs and InvITs. These provisions have been incorporated depending on the stream of income that the REIT would be earning and distributing. The Finance Act, 2014 introduced the definition of “business trust” in the Income Tax Act, 1961 which includes REITs. REITs will have a tax pass through status for income received by way of interest or receivable from the SPV as per s. 10 (23FC), 10 (23FD) and 115UA of the Income Tax Act, 1961. Long term capital gains on sale of units as well as dividends received by REITs and distributed to the investor shall be tax exempt. Interest income

received by the REIT is tax exempt and foreign investors shall be subject to a low withholding tax of 5% on interest payouts. Thanks to clarity in tax treatment, global investors can soon participate in core real estate assets in India. The regime for InvITs would provide a massive boost to infrastructure growth and development in India.

Even though the REITs Regulations have been released, so far the regime has not taken off on account of non-tax and tax issues.

Please refer to Annexure I for the detailed analysis of the tax changes introduced in the Budget 2014 in context of the REITs. Also, please refer to Annexure II for our article published in Live Mint on the tax and non-tax issues that make the Indian REIT unattractive.



Domestic pools of capital may be structured primarily in two ways:

I. AIFIn 2012, SEBI notified the (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”) to regulate the setting up and operations of alternate investment funds in India. As provided in the AIF Regulations, it replaces and succeeds the erstwhile SEBI (Venture Capital Funds) Regulations, 1996. The AIF Regulations further provide that from commencement of such regulations, no entity or Person shall act as an AIF unless it has obtained a certificate of registration from the SEBI. The AIF Regulations define ‘Alternative Investment Funds’ as any fund established or incorporated in India in the form of trust, company, a limited liability partnership or a body corporate which is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing in accordance with a defined investment policy for the benefit of investors, and is not covered under the SEBI regulations to regulate fund management.

The real estate funds shall be registered with SEBI as a Category II Alternate Investment Fund and shall be governed by the provisions of the AIF Regulations. The AIF Regulations prescribe that the raising of commitments should be done strictly on a private placement basis and the minimum investment that can be accepted by a fund from an investor is INR 1,00,00,000 (Rupees One Crore Only). The AIF Regulations also prescribe that a placement memorandum detailing the strategy for investments, fees and expenses proposed to be charged, conditions and limits on redemption, risk management tools and parameters employed, duration of the life cycle of the AIF should also be issued prior to raising commitments and be filed with the SEBI prior to launching of a fund. Further, the AIF Regulations also prescribe that the manager or a sponsor of an AIF shall have a continuing interest in the AIF of not less than 2.5% of the corpus or INR 5,00,00,000 (Rupees Five Crore Only), whichever is lower, in the form of investment in the AIF and such interest shall not be through the waiver of management fees.

The AIF Regulations provide that a close ended AIF may be listed only after the final closing of the fund or scheme on a stock exchange subject to a minimum tradable lot of INR 1,00,00,000 (Rupees One Crore Only). Accordingly, the Fund will not be in a position to list its securities without complying

with the above conditions. The AIF Regulations lay down several investment restrictions on category II AIFs. These restrictions are as follows:

i. A Category II AIF cannot invest more than 25 percent of its corpus in any one investee company.

ii. A Category II AIF may invest in units of Category I and II AIFs but not in the units of fund of funds.

iii. An AIF may not invest in its ‘Associates’ except with the approval of 75% of the investors by value of their investments in the AIF. For this purpose ‘Associates’ means a company or a limited liability partnership or a body corporate in which a director or trustee or partner or sponsor or manager of the AIF or a director or partner of the manager or sponsor holds, either individually or collectively, more than 15% of its paid-up equity share capital or partnership interest, as the case may be.

An investee company has been defined to mean any company, special purpose vehicle or limited liability partnership or body corporate in which an AIF makes an investment. A registered AIF will be subject to investigation/inspection of its affairs by an officer appointed by SEBI, and in certain circumstances the SEBI has the power to direct the AIF to divest its assets, to stop launching any new schemes, to restrain the AIF from disposing any of its assets, to refund monies or assets to Investors and also to stop operating in, accessing the, capital market for a specified period.

However, a Category II AIF is not permitted to receive foreign investment under the extant exchange control regulations without prior approval of the FIPB. Though in a few cases, such approval has been granted in cases where the investment was required for the purposes of making the sponsor commitment, no approval has thus far been granted for LPs willing to invest in the AIF. Based on reports, SEBI is in discussions with the RBI and FIPB to allow foreign investment beyond sponsor commitment in AIFs, but as we understand the RBI and the FIPB are not yet comfortable with such permissions on a policy level.

II. NBFCIn light of the challenges that the FDI and the FPI route are subjected to, there has been a keen interest in offshore realty funds to explore the idea of setting up their own NBFC to lend or invest to real estate.

6. Domestic Pooling



An NBFC is defined in terms of Section 45I(c) of the RBI Act, 1934, as a company engaged in granting loans/advances or in the acquisition of shares/securities, etc. or hire purchase finance or insurance business or chit fund activities or lending in any manner provided the principal business of such a company does not constitute any non-financial activities such as (a) agricultural operations (b) industrial activity (c) trading in goods (other than securities) (d) providing services (e) purchase, construction or sale of immovable property. Every NBFC is required to be registered with the RBI, unless specifically exempted.

Following are some of the latest changes with respect to NBFC:

A. Transfer of Shares from Resident to Non-resident58

Earlier there was only a requirement of giving 30 thirty days’ written notice59 prior to effecting a change of ‘control’ of non-deposit NBFC (the term ‘control’ has the same meaning as defined in the SEBI Takeover Code), and a separate approval was not required; and unless the RBI restricted the transfer of shares or the change of control, the change of control became effective from the expiry of thirty days from the date of publication of the public notice.

However, recently, the RBI vide its circular dated May 26, 201460, has prescribed that in order to ensure that the ‘fit and proper’61 character of the management of NBFCs is continuously maintained for both, ‘deposit accepting’ and ‘non-deposit accepting’ NBFCs, its prior written permission has to be obtained for any takeover or acquisition of control of an NBFC, whether by acquisition of shares or otherwise. This RBI circular requires prior approval in the following situations also:

i. any merger/amalgamation of an NBFC with another entity or any merger/amalgamation of an entity with an NBFC that would give the acquirer / another entity control of the NBFC;

ii. any merger/amalgamation of an NBFC with another entity or any merger/amalgamation of an entity with an NBFC which would result in

acquisition/transfer of shareholding in excess of 10 percent of the paid up capital of the NBFC;

iii. for approaching a court or tribunal under Section 391-394 of CA 1956 or Section 230-233 of CA 2013 seeking order for mergers or amalgamations with other companies or NBFCs.

The abovementioned RBI approval is sought from the DNBS (Department of Non-Banking Supervision) division of the RBI.

Separately, earlier, any transfer of shares of a financial services company from a resident to a non-resident required prior approval of the Foreign Exchange Department of the Reserve Bank of India (“FED”), which took anywhere in the region of 2 – 4 months. In a welcome move, as per a recent RBI circular dated November 11, 2013, the requirement to procure such an approval was removed if:

i. any ‘fit and proper/ due diligence’ requirement as regards the non-resident investor as stipulated by the respective financial sector regulator shall have to be complied with; and

ii. The FDI policy and FEMA regulations in terms of sectoral caps, conditionalities (such as minimum capitalization, etc.), reporting requirements, documentation etc., are complied with.”

B. Only Secured Debenture can be Issued 62

NBFCs can only issue whether by way of private placement of public issue fully secured debentures. The security has to be created within a month from the date of issuance. If the security cover is inadequate, the proceeds have to be placed in an escrow account, till the time such security is created.

C. Private Placement 63

As per Section 67(2) of CA 1956, private placement means invitation to subscribe shares or debenture from any section of public whether selected as members or debenture holders of the company concerned or in any other manner. Section 67(3) prescribes that shares or debenture under such offer can be offered to maximum of fifty persons.

58. http://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=8561&Mode=0 59. The public notice had be published in one English and one vernacular language newspaper, copies of which were required to be submitted to the RBI.60. DNBS (PD) CC.No.376/03.10.001/2013-1461. Under the Master Circular on Corporate Governance dated July 1, 2013, RBI had emphasized the importance of persons in management who fulfil the

‘fit and proper’ criteria. The Master Circular provides as follows:“……it is necessary to ensure that the general character of the management or the proposed management of the non-banking financial company shall not

be prejudicial to the interest of its present and future depositors. In view of the interest evinced by various entities in this segment, it would be desir-able that NBFC-D with deposit size of Rs 20 crore and above and NBFC-ND-SI may form a Nomination Committee to ensure ‘fit and proper’ status of proposed/existing Directors.”

62. RBI/2012-13/560 DNBD(PD) CC No. 330/03.10.001/2012-13 and RBI/2013-14/115 DNBS(PD) CC No.349/03.10.001/2013-1463. Ibid



However, NBFCs where excluded from Section 67(3). But RBI has now restricted private placement to not more than 49 investors, in line of the private companies which are to be identified upfront by the NBFC.

D. Deployment of Funds and Miscellaneous

i. NBFCs can issue debentures only for deployment of the funds on its own balance sheet and

not to facilitate requests of group entities/ parent company/ associates. Core Investment Companies have been carved out from the applicability of this restriction.

ii. NBFCs have been restricted from extending loans against the security of its own debentures, whether issued by way of private placement or public issue.

Please refer to Annexure V64 for detailed investment note on investment through NBFCs.

64. http://www.nishithdesai.com/New_Hotline/Realty/Realty%20Check%20-%20Debt%20Funding%20Realty%20in%20India_Jan2012.pdf

Domestic Pooling



7. The Road Forward

The Indian real estate industry is at a stage where the private equity players have seen a lot of exits, with some making excellent multiples while others burning their fingers deep. However, a larger chunk of exits are expected to be witnessed in the next 2-3 years when the sector completes its first full cycle, which is where the key challenge lies. Some of the challenges that Indian real estate sector faces are as follows:

I. REITsThe Budget 2014-2015 has put REITs back on the fast track by proposing to take steps to bring clarity in tax treatment of REITs, including a partial tax pass-through regime for REITs. This will result in the REIT not being subject to any tax in respect of such interest income, whereas the investors will be subject to tax on the same.

The much awaited framework for REITs has also been announced and thanks to the present clarity in tax treatment, global investors can soon participate in core real estate assets in India. Long term capital gains on sale of units as well as dividends received by the REIT and distributed to the investor shall be tax exempt. Interest income received by the REIT is tax exempt and foreign investors shall be subject to a low withholding tax of 5% on interest payouts.

In spite of the positive proposals brought forward by the government to establish an investment-friendly regime, there still remain certain issues with respect of taxation of REITs. It should be noted that almost all countries provide for a complete pass through regime for REITs if the prescribed regulatory criteria is met and a move towards that will further increase interest in this space. It is hoped that the Finance Ministry would address the above issues going forward and possibly simplify the REIT taxation regime.

Please refer to Annexure I for the detailed analysis of the tax changes introduced in the Budget 2014 in context of the REITs. Also, please refer to Annexure II for our article published in Live Mint on the tax and non-tax issues that make the Indian REIT unattractive.

II. Partner IssuesUncooperative partner has been the largest issue for private equity players. Promoter - investor expectation mismatch are now increasingly seen. Enforceability of tag along rights, drag along rights, put options or even 3rd party exits clearly hinge on the cooperation of the local partner. Besides, with exit price capped at the DCF valuation, cooperation of the investee company typically controlled by the Indian promoters is crucial as projections for DCF can only be provided by the investee company.

III. Arbitration / LitigationIndian courts have been known for their lackadaisical approach to dispute resolution. Hitherto, even international arbitration was not free from the involvement of the Indian courts, which was a concern for offshore investors. Now, with the decision of the Supreme Court in the Balco case, the jury is out that parties in an international arbitration can agree to exclude the jurisdiction of the Indian courts. In India, any dispute may be set to comprise of two stages. The first being the liability crystallization process, and other being the award enforcement process. The liability crystallization that typically took several decades sometimes, can now be shorted to less than a year as well where the process is referred to institutional arbitration under the auspices of LCIA etc. Once an award has been delivered, the enforcement process is rather straightforward.

Please refer to Annexure XIII65 for detailed note on Balco judgement.

IV. Security EnforcementEnforcement of security interest is still a challenge in India. For instance, enforcing a mortgage in India is a court driven process and can take long sometimes even extending beyond couple of years. The situation was better in case of pledge of listed shares which was considered the most liquid security, as it could be enforced without court involvement. However, the court stay on the invocation of pledge of shares of Unitech66, in spite of a breach of the terms, has raised

65. http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/article/bombay-high-court-clarifies-the-pro-spective-application-of-balco.html?no_cache=1&cHash=02aa560249d89d9e5e0b18c12f25eddc

66. Court saves promoter pledge, http://www.moneycontrol.com/news/management/court-saves-promoter-pledge_520897.html, last visited on April 8, 2012



questions on this form of security as well.67

Please see Annexure XIV68 for an article on challenges in invocation of pledge.

67. For the first time, a High Court (highest court of law in a state in India) stayed the invocation of a pledge and that too via an ex-parte (without the defending party being present or heard) injunction handed out on a Sunday.

68. http://www.livemint.com/Companies/l5mzgtPyZRxqtimiq4CsxH/Concerns-among-PE-firms-over-enforcing-realty-share-pledges.html

The Road Forward



Budget 2014-15 (“Budget”) has introduced tax incentives for the real estate investment trusts(“REITs”) regime, and also provided for relaxations in foreign direct investment (“FDI”) regime. With the tax incentives in place, the Securities and Exchange Board of India (“SEBI”) is likely to formally announce the REIT regulations that are currently in draft form. In this hotline, we discuss some of the key changes and its Budget 2014 impact on the real estate sector. For a detailed analysis of the impact of Budget 2014-15 on other aspects as well, please refer to our hotline “India Budget 2014: New Beginnings and New Direction”.

I. Changes in Relation to Reits

A. Background

As a background, the Securities and Exchange Board of India (“SEBI”) had released the draftregulations on REITs (“Draft Regulations”) for comments on October 10, 2013. The Draft Regulations as released are available here.(http://www.sebi.gov.in/cms/sebi_data/attachdocs/1381398382013.pdf) Though the Draft Regulations were received positively, it was imperative that attendant tax and regulatory incentives were also announced. Now, with the tax incentives announced and effective from October 1, 2014, it seems almost certain that the SEBI will put in place an operating framework for REITs by October 2014. Please refer to our article titled “REIT Regime In India: Draft REIT Regulations Introduced” for a detailed analysis of, and our suggestions on, the Draft Regulations.

B. Structure of REIT

Before we move on the tax incentives proposed in the Budget, we set out below a quick snapshot of the REIT structure as contemplated under the Draft

Regulations. REITs in India are required to be set up as private trusts under the purview of the Indian Trusts Act, 1882.

i. Parties

The parties in the REIT include the sponsor, the manager, the trustee, the principal valuer and the investors / unit holders. Sponsor sets up the REIT, which is managed by the manager. The trustee holds the property in its name on behalf of the investors. The roles, responsibilities, minimum eligibility criteria and qualification requirements for each of the abovementioned parties are detailed in the Draft Regulations. Sponsors are required to hold a minimum of 15% (25% for the first 3 years) of the total outstanding units of the REIT at all times to demonstrate skin-in-the-game.

ii. Use of SPV

REITs may hold assets directly or through an SPV. All entities in which REITs control majority interest qualify as an SPV for the purpose of the Draft Regulations.

iii. Investment and Listing

Units of a REIT are compulsorily required to be listed on a recognized stock exchange.

iv. Potential Income Streams

REITs are principally expected to invest in completed assets. Income would consist of rental income, interest income or capital gains arising from sale of real assets / shares of SPV.

v. Distribution

90% of net distributable income after tax of the REIT is required to be distributed to unit holders within 15 days of declaration

The illustration below gives the typical REIT structure:

Annexure IBudget 2014: A Game Changer for Reits?

http://www.sebi.gov.in/cms/sebi_data/attachdocs/1381398382013.pdf

http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/article/reit-regime-in-india-draft-reit-regulations-introduced.html



Investor*

*Mininmum Public Float: >25% of REIT Units

*Mininmum Sponser Investment: >15% of REIT

Units

Trustee

Real Estate Asset(S)

SPV

Sponor*

Manager

Real Estate Asset(S)

REIT

C. Proposed Tax Regime under the Budget

The Finance Bill, 2014 (“Bill”) proposes to amend the Income Tax Act (“ITA”) to provide for the income tax treatment of REITs. These provisions have been incorporated depending on the stream of income that the REIT is earning and distributing:

i. Units of REIT Akin to Listed Shares

The Bill proposes that when a unit holder disposes off units of a REIT, long term capital gains(“LTCG”) (units held for more than 36 months) would be exempt from tax and short term capital gains (“STCG”) would be taxed at 15% since units would be treated as listed securities under the ITA. In addition to the above, the Bill has also proposed that securities transaction tax is to be payable on transfer of units of a REIT.

Analysis

Treatment of listed REITs unit akin to listed shares with respect to rates for LTCG and STCG is a major relaxation for the unit holders, and will give a major impetus to the REIT regime. Though the requirement of holding the units for at least 36 months for characterization as long term capital gains, unlike 12 months in case of listed shares, is understandable since REITs are meant to be akin to holding real estate directly which is any ways subject to 36 months holding period, this may be a disincentive to invest in REITs.

ii. Tax Treatment of the Sponsor

The Bill proposes to make the transfer of shares of the SPV into a REIT in exchange for issue of units of the REIT to the transferor (or the sponsor) exempt from capital gains tax under the ITA. However, although the units of a REIT would be listed on a recognized stock exchange, specific amendments are proposed to exclude units of REITs from the exemption of tax on LTCG / STCG if sold by the sponsor; and the cost of acquisition of the shares of the SPV by the sponsor shall be deemed to be the cost of acquisition of the units of the REIT in his hands.

Analysis

￭ Although the Draft Regulations allow REITs to hold real estate assets either directly or through an SPV, the tax benefit for a sponsor to set up a REIT has been extended only to cases where real estate assets are held by the REIT through an SPV. This can be a substantial dampener for sponsors looking to set up REITs holding direct assets since transfer of real estate assets instead of an SPV to a REIT may involve a tax leakage.

￭ An additional issue that is outstanding is in cases where assets are held in a partnership or a limited liability partnership and on the tax treatment in order to transfer the partnership interest to the REIT.

iii. Income in the nature of interest

The Bill provides for a pass through treatment in

Budget 2014: A Game Changer for Reits?



respect of any interest income that is received by the REIT from an SPV. This will result in the REIT not being subject to any tax in respect of such interest income, whereas the investors will be subject to tax on the same. However, there would be a levy of withholding tax that would be imposed on distribution by the REIT to its unit holder. This withholding tax would be at the rate of 10% if paid to resident unit holders and 5% if paid to non-resident unit holders.1 In case of non-resident unit holders, the 5% tax would be the final tax payable by the non-resident, while in case of residents, they will be subject to tax as per the tax rate applicable to them.

Analysis

To avail the tax pass through on interest income, the sponsor would have to trade-off by paying tax on transfer of the SPV / assets. This is so because, (a) the REIT cannot acquire any debt securities without a tax incidence for the sponsor (the exemption is only for shares); and (b) if the monies areraised by REIT from the public, and infused into a newly created SPV by way of debt, which acquires the asset from the sponsor, there is no tax exemption for the sponsor in such case. To that extent, the benefit of this relaxation is highly questionable.

iv. Income in the Nature of Dividend

Where dividends are distributed by the SPV to the REIT, the existing provision dealing with Dividend Distribution Tax (“DDT”) under Section 115-O of the ITA would apply and the SPV would face a 15% tax on distribution with no further liability on the REIT as a shareholder. Further, the Bill proposes that any income distributed by the REIT to its unit holder that is not in the nature of interest or capital gains is exempt from income tax. Therefore, distributions of dividends received from the SPV by the REIT to the unit holders would be exempt from tax in India.

Analysis

Though distribution of monies received by the REIT as dividend to the until holders is exempt from tax in the hands of the unit holders, still the applicability of both, the corporate tax and dividend distribution tax, in the hands of SPV makes this route of distribution tax inefficient. Since, unlike listed developers, REITs are mandatorily required to distribute 90% of net distributable income after tax to investors, the applicability of dividend distribution tax is a major dampner. To ensure real pass through, it would have been better if the government had dispensed with the dividend distribution tax in case of REITs.

v. Income in the Nature of Business Profits/Lease Rentals/Management Fee

Chapter XII-FA is proposed to be added to the ITA by which Section 115UA is to be included for dealing with the taxation of income earned by a REIT that is not in the nature of capital gains, interest income or dividend. All such income is proposed to be taxed in the hands of the REIT at the maximum marginal rate i.e. 30%. Such income, while distributed by the REIT to the unit holders would be exempt in the hands of the unit holders.

Analysis

This would apply in a situation where the REIT is holding the assets directly or in situations where they are charging fees to the SPV. There is no relaxation in such case, as even under the existing tax regime, tax once paid by a trust would have been exempt in the hands of the unit holders. To ensure true pass through to REIT, the gains should have been tax exempt in the hands of REIT and should have rather been taxed in the hands of the unit holders.

vi. Income in the Nature of Capital Gains

Where the REIT earns income by way of capital gains by sale of shares of the SPV, the REIT would be taxed as per regular rates for capital gains i.e. 20% for LTCG and slab rates for STCG. However, further distribution of such gains by the REIT to the unit holder is proposed to be exempt from tax liability.

Analysis

Please refer to our analysis in point (v) above.

II. Relaxation in the FDI RegimeIn line with the commitment of the government to have housing for all by 2022, and also to promote the Prime Minister’s vision of ‘one hundred Smart Cities’, the Finance Minister in the Budget has proposed key reforms for foreign investment in the real estate and development sector.

A. Relaxation in Minimum Area and Minimum Capitalization

The Finance Minister has proposed to reduce the requirement of minimum project size from 50,000 square metres to 20,000 square metres, and the capitalization requirement (for a wholly owned subsidiary) from USD 10 million to USD 5 million respectively.



Analysis

￭ Previously, in order to qualify for FDI, the project size had to be a minimum of 50,000 square metres and at least USD 10 million had to be infused for a wholly owned subsidiary. This was a major challenge since in Tier I cities which formed a bulk of the demand demography, finding such a large project was difficult, whereas in Tier II and III cities where such projects were available, the demand was not sufficient enough to warrant investor interest. This relaxation has partially addressed the long standing demand of the industry, which was expecting a reduction to 10,000 square metres, since even 20,000 square metres could be difficult for some Tier I cities (ex – Mumbai).

￭ The relaxation is a positive step towards providing impetus to development of smart cities providing habitation for the neo-middle class, as contemplated in the Budget.

B. Promoting Affordable Housing

The Budget has proposed introduction of schemes to incentivize the development of low cost housing and has also allocated this year a sum of INR 40 billion for National Housing Bank for this purpose. In addition to the above relaxation, to further encourage this segment, projects which commit at least 30% of the total project cost for low cost affordable housing have been proposed to be exempted from minimum built-up area and capitalisation requirements under FDI. The Finance Minister has also proposed to include slum development in the statutory list of corporate social responsibility (“CSR”) activities.

Analysis

￭ The INR 40 billion allocated for NHB will increase the flow of cheaper credit for affordable housing to the urban poor and lower income segment. Further, the relaxation of 20,000 square metres requirements in case of projects committing at least 30% project cost to low cost affordable housing, would provide a major fillip to affordable housing projects where the size of the project is less than 20,000 square metres.

￭ A critical element however will be the way ‘affordable housing’ is defined. The Budget does not lay down the criteria for classification of affordable housing. Under external commercial borrowing regulations, the criteria for affordable housing includes units having maximum carpet area of 60 square metres, and cost of such individual units not exceeding INR 30 lakh.

￭ The Companies Act, 2013 has introduced CSR provisions which are applicable to companies with an annual turnover of INR 10 billion and more, or a net worth of INR 5 billion and more, or a net profit of INR 0.05 billion or more during any financial year. Companies that trigger any of the aforesaid conditions are required to spend least two per cent (2%) of their average net profits made during the three immediately preceding financial years on CSR activities and/or report the reason for spending or non-expenditure. The proposition of the Finance Minister to include slum development in the statutory list of corporate social responsibility activities is quite encouraging, as it not only provides developers an avenue to meet their CSR requirements, but also at the same time could give a huge impetus to this segment.

III. ConclusionREITs are beneficial not only for the sponsors but also the investors. It provides the sponsor (usually a developer or a private equity fund) an exit opportunity thus giving liquidity and enable them to invest in other projects. At the same time, it provides the investors with an avenue to invest in rental income generating properties in which they would have otherwise not been able to invest, and which is less risky compared to under-construction properties.

For a REIT regime to be effectively implemented, complete tax pass through is essential, as is the case in most countries having effective REIT regimes. Though the tax incentives for REITs introduced in the Budget is definitively a positive move, however, the tax incentives only result in partial tax pass through to REIT, at the maximum. It is hoped that the Finance Minister would address the issues as mentioned in this piece going forward and possibly simplify the REIT taxation regime.

Before REITs actually takes off, few other changes need to be introduced, especially from securities and exchange control laws perspective. Currently, units of a REIT may not even qualify as a ‘security’. Since, units of a REIT have to be mandatorily listed, the first step will be to define units of a REIT as a security under the SCRA. The next step will be to amend exchange control regulations to allow foreign investments in units of a REIT. Capital account transaction rules will also need to be amended to exclude REITs from the definition of ‘real estate business’, as any form of foreign investment is currently not permitted in real estate business. Under current exchange control laws, investment

Budget 2014: A Game Changer for Reits?



in yield generating assets may qualify as ‘real estate business’.

The relaxations proposed in the Budget pertaining to affordable housing is a really positive move as there is a major demand for housing in this segment. All in all, the Budget represents the new government’s positive attitude and willingness to follow through

on its message of growth and development, especially in the real estate sector.

Prasad Subramanyan, Deepak Jodhani and Ruchir Sinha

You can direct your queries or comments to the authors



The Securities and Exchange Board of India (Sebi) recently introduced the final regulations for real estate investment trusts (REITs) and infrastructure investment trusts (InvITs). These regulations come on the back of recent tax initiatives introduced in the budget this year. While the initiative is indeed a positive step, the tax measures governing REITs or business trusts (as they are referred to in the Income-tax Act) do not offer much encouragement, neither to the sponsor nor the unit holders.

From a sponsor’s perspective, capital gains tax benefit has been given only in cases where shares of the special purpose vehicle (SPV) holding the real estate are transferred to a REIT against units of a REIT, and not when real estate is directly transferred to a REIT. By doing so, there is an unnecessary corporate layer imposed between the REIT and the real estate asset, which could result in a tax leakage of about 45% (corporate taxes of 30% at the SPV level and distribution tax of 15% on dividends, exclusive of surcharge and cess). To the sponsor, there is no tax benefit (but mere deferral) because she gets taxed when the REIT units are ultimately sold on the floor at a much more appreciated value, even though the units of a REIT would be listed and exempt from capital gains tax if held by other unit holders for more than three years.

While capital gains tax incidence may still be avoided by relying on principles of trust taxation, there will still be no respite from minimum alternate tax (MAT), which could become applicable on transfer of shares to the REIT. Considering that sponsors would like to transfer the shares at higher than book value to ensure commensurate fund raising for the REIT, the issue of MAT seems to be most critical.

From a REIT taxation perspective, although a pass-through of tax liability to investors for REIT income was promised, since the SPV is required to pay full corporate and dividend distribution taxes, where is the pass-through? What is even worse is that no foreign tax credit may be available for such taxes paid in India.

The only way to achieve tax optimization seems to be by way of infusion of debt into the SPV by a REIT. In such a situation, interest from the SPV to the REIT will be a deductible for the SPV, thus allaying

both distribution taxes and corporate taxes. Interest from the SPV would be tax exempt at the REIT level and only a 5% withholding will be applicable on distributions by the REITs to the foreign unit-holders. This should help neutralize REIT taxation at India level, considering that the 5% withholding tax paid in India should also be creditable offshore.

The critical question that would then come up is how the SPV would use this debt. The debt can either be used to retire existing debt, or be structured to retire promoter equity in the SPV. If the debt is used for retiring equity, the risk of ‘deemed dividend’ characterization would need to be carefully considered. Though other creative structures may be devised to minimize tax exposure for the sponsor, it will be critical to ‘dress up’ the SPV appropriately with the right amount of debt and equity, before the SPV is transferred to the REIT.

Apart from the tax challenges set out above, there are also several non-tax issues that make the Indian REIT story unattractive. The requirement for a sponsor to have a real estate track record is likely to rule out a substantial portion of yield generating assets. This eliminates the possibility of non-real estate players such as hotels, hospitals, banks and others (such as Air India) becoming sponsors of REITs.

Most importantly, the marketability of Indian REITs compared with other fixed-income products remains weak since the expected yield on REITs may not exceed 5-6% compared with an around-8% yield offered by government securities. Though REITs may offer a higher return considering the capital appreciation, offshore investors seem reluctant to buy the ‘cap rate story’ attached to a REIT.

Having said that, REITs are likely to offer monetization opportunities to private equity funds and developers, which have till now been unable to find institutional buyers for completed real estate assets. As the appetite for developmental projects has reduced, REITs will offer opportunities to foreign investors to invest in rent generating assets, an asset class otherwise prohibited for foreign investments. It, however, remains to be seen how the Indian REIT story matches up to the Singapore REIT structure for Indian assets, or the more trending lease-rental-discounting structure, or the even more innovative commercial mortgage-backed security structure,

Annexure IIReits: Tax Issues and Beyond

Apart from the Tax Challenges, There are Non-Tax Issues also that make the Indian Reit Unattractive



which seem to be more appealing to potential sponsors.

This article was published in Live Mint dated October 21, 2014. The same can be accessed from the link.(http://www.livemint.com/Money/TyjZw3k6mcIQLNw8H8nNKL/REITs-Tax-issues-and-beyond.html)

Sriram Govind and Ruchir Sinha




Government’s recent initiative to allow unlisted companies to list on offshore markets through the depository receipt (DR) mechanism without the requirement of simultaneous listing in India is likely to be a major shot in the arm for many sectors, and also offer exits to private equity players looking to monetize their investments. Though offshore listing was permitted later last year by Ministry of Finance, such listings could not happen as SEBI had not prescribed the disclosures for such listings.

Government has only recently prescribed that SEBI shall not mandate any disclosures, unless the company lists in India. Once the air around disclosures to SEBI has been cleared, we can expect offshore listing of DRs to grow on the back of the reasons set out below.

First, offshore listing will offer the opportunity to a slew of young Indian companies to tap the overseas markets, which unlike domestic markets remain quite vibrant. 2012 saw only 3 mainboard listings as against 256 in the US.

Second, offshore listing would allow Indian entrepreneurs the platform to tap investors that have a much better understanding of the value proposition of the business. For instance, innovative tech, biotech, internet services are likely to receive a better valuation on NYSE / NASDAQ as against domestic markets.

Today, markets have become associated with sectors - NYSE / NASDAQ is known for tech, SGX for real estate and infra, LSE/AIM for infra and manufacturing. DR’s would allow the opportunity to list on exchanges that are most conducive to the sector.

Third, foreign investors will find it more amenable to invest in DR’s denominated in foreign currency as against INR, which has depreciated by more than 50% since 2007. Hedging cost is likely to be an important driver for the growth of DRs. Many private equity players suffered the wrath of their LPs due to the steep rupee depreciation, despite the company outperforming the expectations.

Fourth, while the offshore listing regime is meant for fund-raising (it requires that funds must be brought back into India within 15 days unless utilized offshore for operations abroad), with a little bit of

structuring, the proceeds can also be used to provide tax free exits to offshore private equity players.

Since there is no end use prohibition, proceeds of the DR can be structured to retire existing debt or private equity. With a growing number of secondary direct funds looking at India, DRs can be the preferred way to invest in India, retire existing investors and monetize the investment later on the floor of the exchange.

Fifth, from a tax perspective, investors can finally breathe easy. There will be no tax on the sale of DRs on the stock exchange. Hence, investors need not worry about GAAR and substance in the treaty jurisdiction or risk of indirect transfer taxation.

Sixth, listing of DRs is likely to be much cheaper than listing of shares on foreign exchanges and sometimes the compliance costs of ADR / GDR may be lower than the compliance costs of domestic listing.

Seventh, offshore listing would give depth to Indian capital markets as well, and brighten the chances of the company going public in India after having a successful show on the offshore markets.

Eighth, listing on offshore exchanges like NYSE / NASDAQ / SGX has its own snob value and is likely to benefit many of the younger companies in gaining reputation and recognition overseas.

Ninth, an increasing number of acquisitions, especially in the tech space are happening by way of swaps, or in other words, the shareholders of the target company receiving consideration in form of shares of the acquirer company.

This is a common strategy to keep the interests of both the parties aligned post acquisition. With most targets for tech companies being offshore, such swap deals are hard to achieve, as there may be few takers for Indian unlisted shares. To that extent, DRs being dollar denominated can be used as currency for acquisitions.

However, notwithstanding the enormous benefits that the offshore listing regime brings, its success remains circumspect as the scheme has only been allowed for 2 years on a pilot basis. The specter of what will happen after 2 years (6 months of which have already elapsed) and the fear of the government

Annexure IIIOffshore Listing Regime: How to Raise Funds

and Monetize Investments



requiring simultaneous listing in India (as was done in 2004) is likely to keep many issuers away. Having said that, offshore listing regime unveils a huge opportunity for fund raising, particularly for young IT / ITES, biotech companies etc. which do not feature on the list of either private equity or banks. What remains to be seen is the if the Government allows for DRs with underlying debt instrument as against equity.

This article was published in The Economic Times dated June 10, 2014. The same can be accessed from the link. (http://articles.economictimes.indiatimes.com/2014-06-10/news/50478612_1_drs-simultaneous-listing-compliance-costs)

Ruchir Sinha and Nishchal Joshipura




With Indian companies rapidly expanding their presence internationally, there has been an increased keenness in companies operating in high growth sectors to migrate their holding company structures from India to reputed offshore jurisdictions. For lack of a better word, let’s refer this process of structuring/ restructuring as ‘externalisation’ as that term may fit the reference better than ‘globalisation’ or ‘internationalisation’, both of which have much wider imports.

There are several drivers for externalisation. First, it moves the businesses away from Indian tax and regulatory challenges into jurisdictions that may be more conducive from an operational standpoint and also substantially mitigates tax leakage and regulatory uncertainty. Unwritten prohibition on ‘put options’, retroactive taxation of indirect transfers, introduction of general anti-avoidance rules fraught with ambiguities, etc, are a few examples why Indian companies may want to avoid direct India exposure.

Second, from a fund raising perspective, it offers Indian companies to connect with an investor base that understands their business potential and thus values them higher than what they would have otherwise been valued at in domestic markets. Infosys, Wipro, Rediff, Satyam are classic examples of companies which preferred to tap the global capital markets (NYSE and Nasdaq) without going public in India.

Third, with the Indian currency oscillating to extremes, one of the biggest concerns for foreign investors is currency risk. By investing in dollars in the offshore holding company (OHC), foreign investors can be immune from the currency risk and benefit from the value appreciation of the Indian companies. Many foreign investors that invested in 2007 when the rupee was at around 42 to a dollar have suffered substantially with the rupee now being at 62 to a dollar.

Fourth, and this is more of a recent issue, with the coming of the new Companies Act, 2013, which provides for class-action suits, enhanced director liability, statutory minimum pricing norms (beyond

exchange control restrictions), there will be keenness to flip the structure to an OHC and ring-fence potential liabilities under the Companies Act, 2013.

Lastly, such offshore jurisdictions also provide for great infrastructure and governmental policies that are discussed with businesses and are more closely aligned to growth of the businesses as against meeting revenue targets. With most clients offshore, there may be certain amount of snob value that may be associated with establishment in such offshore jurisdictions.

Indian tax and regulatory considerations play a very important role in externalisation. From a tax standpoint, flipping the ownership offshore may entail substantial tax leakage, and to that extent it is advisable if the flip is undertaken at early stages before the value is built up in the Indian asset. Another challenge from a tax perspective is the choice of jurisdiction for the holding company in light of the impending general anti -avoidance rules that may disregard the holding company structure if it is found lacking commercial substance. To protect the tax base from eroding, some of the developed countries like the US have anti-inversion tax rules which deter US companies from externalising outside the US.

From a regulatory standpoint, one of the challenges is to replicate the Indian ownership in the OHC, especially since swap of shares or transfer of shares for consideration other than cash requires regulatory approval, which may not be forthcoming if the regulator believes that the primary purpose of the OHC is to hold shares in the Indian company. Indian companies may be restricted from acquiring shares of the OHC on account of the OHC likely qualifying as a financial services company and Indian individuals may be restricted to acquire shares of the OHC under the new exchange control norms since OHC will not be an operating company. The extent of operations to be evidenced remains ambiguous. OHCs acquisition of Indian shares will also need to be carefully structured as the OHC will not be permitted to acquire Indian shares at below fair market value from an Indian tax and exchange control perspective.

Annexure IVRegulatory Regime Forcing Cos’

‘Externalisation’Doing Business away from Indian Tax Oversight and ease of Fund-Raising Among

Reasons for India Inc’s Tryst with Foreign Shores



India has recently allowed Indian companies to directly list on offshore markets, but the conditions that such listing can only be for 51% shares of the Indian company and that the proceeds of such issuance must be used overseas within 15 days may not allow the true potential of offshore listings to be unleashed. The utilisation of the direct listing regime remains to be seen as the Sebi is yet to come out with a circular setting out disclosures required for such listing.

However, considering the challenges faced by India Inc, the need to move away from India for growth seems inevitable in current times.

This article was published in The Economic Times dated January 15, 2014. The same can be accessed from the link. (http://articles.economictimes.indiatimes.com/2014-01-15/news/46224745_1_indian-companies-indian-currency-new-companies-act)

Ruchir Sinha and Nishchal Joshipura


http://economictimes.indiatimes.com/topic/India-Inc

http://economictimes.indiatimes.com/topic/India-Inc



In light of the challenges that the FDI and the FPI route are subjected to, there has been a keen interest in offshore funds to explore the idea of setting up their own NBFC to lend or invest in Indian companies.

An NBFC is defined in terms of Section 45I(c) of the RBI Act, 1934 (“RBI Act”) as a company engaged in granting loans/advances or in the acquisition of shares/securities, etc. or hire purchase finance or insurance business or chit fund activities or lending in any manner provided the principal business of such a company does not constitute any non-financial activities such as (a) agricultural operations, (b) industrial activity, (c) trading in goods (other than securities), (d) providing services, (e) purchase, construction or sale of immovable property. Every NBFC is required to be registered with the RBI, unless specifically exempted.

The Act has however remained silent on the definition of ‘principal business’ and has thereby conferred on the regulator, the discretion to determine what is the principal business of a company for the purposes of regulation. Accordingly, the test applied by RBI to determine what is the principal business of a company was articulated in the Press Release 99/1269 dated April 8, 1999 issued by RBI. As per the said press release, a company is treated as an NBFC if its financial assets

are more than 50 per cent of its total assets (netted off by intangible assets) and income from these financial assets is more than 50 per cent of its gross income. Both these tests (“50% Tests”) are required to be satisfied in order for the principal business of a company to be determined as being financial for the purpose of RBI regulation.

Recommendation of the Working Group on the Issues and Concerns in the NBFC Sector chaired by Usha Thorat has been issued by RBI in the form of Draft Guidelines (“Draft Guidelines”). Draft Guidelines1 provide that the twin criteria of assets and income for determining the principal business of a company need not be changed. However, the minimum percentage threshold of assets and income should be increased to 75 per cent. Accordingly, the financial assets of an NBFC should be 75 per cent or more (as against more than 50 per cent) of total assets and income from these financial assets should be 75 per cent or more (as against more than 50 percent) of total income.

The NBFC could be structured as follows.

Annexure VNBFC Structure for Debt Funding

Off-shore Fund

Structure diagram

Off-shore

Non-Banking Financial Company

India

Indian Company

1. The Working Group report was published by the RBI in the form of Draft Guidelines on its website 12th December 2012



The Offshore Fund sets up an NBFC as a loan company, which then lends to Indian companies. The NBFC may either lend by way of loan or through structured instruments such as NCDs which have a protected downside, and pegged to the equity upside of the company by way of redemption premium or coupons.

I. Advantages of the NBFC Route

A. Assured Returns

The funding provided through NBFCs is in the form of domestic loans or NCDs, without being subjected to interest rate caps as in the case of CCDs. These NCDs can be structured to provide the requisite distribution waterfall or assured investors’ rate of return (“IRR”) to the offshore fund.

B. Regulatory Uncertainty

The greatest apprehension for funds has been the fluid regulatory approach towards foreign investment, for instance put options. The NBFC being a domestic lending entity is relatively immune from such regulatory uncertainty

C. Security Creation

Creation of security interest in favour of non-residents on shares and immoveable property is not permitted without prior regulatory approval. However, since the NBFC is a domestic entity, security interest could be created in favour of the NBFC. Enforceability of security interests, however, remains a challenge in the Indian context. Enforcement of security interests over immovable property, in the Indian context, is usually a time consuming and court driven process. Unlike banks, NBFCs are not entitled to their security interests under the provisions of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act.

D. Repatriation Comfort

Even though repatriation of returns by the NBFC to its offshore shareholders will still be subject to the restrictions imposed by the FDI Policy (such as the pricing restrictions, limits on interest payments etc.), but since the NBFC will be owned by the foreign investor itself, the foreign investor is no longer dependent on the Indian company as would have been the case if the investment was made directly

into the Indian entity.

E. Tax Benefits to the Investee Company

As against dividend payment in case of shares, any interest paid to the NBFC will reduce the taxable income of the investee company. However, an NBFC may itself be subjected to tax to the extent of interest income so received, subject of course to deductions that the NBFC may be eligible for in respect of interest pay-outs made by the NBFC to its offshore parent.

II. Challenges Involved in the NBFC Route

A. Setting up

The first challenge in opting for the NBFC route is the setting up of the NBFC. Obtaining a certificate of registration from the RBI for an NBFC is a time consuming process. This process used to take anywhere in the region of 12 – 14 months earlier, which wait period has now significantly reduced, but it may still take as much as 6 months, or in some cases, even longer.

Draft Guidelines provide that NBFCs with asset size below Rs. 1000 crore and not accessing any public funds shall be exempted from registration. NBFCs, with asset sizes of Rs.1000 crore and above, need to be registered and regulated, even if they have no access to public funds.

Draft Guidelines also provide that small non-deposit taking NBFCs with asset of Rs. 50 crores or less should be exempt from the requirement of RBI registration. Not being deposit taking NBFCs and being small in size, no serious threat perception is perceived to emanate from them.

Due to the elaborate time period involved in setting up the NBFC, one of the common alternatives adopted, especially in case of non-deposit taking NBFCs was to purchase an existing NBFC. This was because earlier there was only a requirement of giving 30 thirty days’ written notice2 prior to effecting a change of ‘control’ of non-deposit NBFC

2. The public notice had be published in one English and one vernacular language newspaper, copies of which were required to be submitted to the RBI



(the term ‘control’ has the same meaning as defined in the SEBI Takeover Code), and a separate approval was not required; and unless the RBI restricted the transfer of shares or the change of control, the change of control became effective from the expiry of thirty days from the date of publication of the public notice.

However, recently, the RBI vide its circular dated May 26, 20143, has prescribed that in order to ensure that the ‘fit and proper’4 character of the management of NBFCs is continuously maintained for both, ‘deposit accepting’ and ‘non-deposit accepting’ NBFCs, its prior written permission has to be obtained for any takeover or acquisition of control of an NBFC, whether by acquisition of shares or otherwise. This RBI circular requires prior approval in the following situations also

i. any merger/amalgamation of an NBFC with another entity or any merger/amalgamation of an entity with an NBFC that would give the acquirer / another entity control of the NBFC;

ii. any merger/amalgamation of an NBFC with another entity or any merger/amalgamation of an entity with an NBFC which would result in acquisition/transfer of shareholding in excess of 10 percent of the paid up capital of the NBFC;

iii. for approaching a court or tribunal under Section 391-394 of the Companies Act, 1956 or Section 230-233 of Companies Act, 2013 seeking order for mergers or amalgamations with other companies or NBFCs.

The abovementioned RBI approval is sought from the DNBS (Department of Non-Banking Supervision) division of the RBI.

Separately, earlier, any transfer of shares of a financial services company from a resident to a non-resident required prior approval of the Foreign Exchange Department of the Reserve Bank of India (“FED”), which took anywhere in the region of 2 – 4 months. In a welcome move, as per a recent RBI circular dated November 11, 2013, the requirement to procure such an approval was removed if:

i. any ‘fit and proper/ due diligence’ requirement as regards the non-resident investor as stipulated by the respective financial sector regulator shall have to be complied with ; and

ii. The FDI policy and FEMA regulations in terms of sectoral caps, conditionalities (such as minimum capitalization, etc.), reporting requirements, documentation etc., are complied with.”

Since, the requirement of obtaining RBI approval in case of change in control even for non-deposit taking NBFC is relatively very new, only time will tell how forthcoming RBI is in granting such approvals and to that extent, how favourable is this option of purchasing NBFC.

B. Capitalization

The NBFC would be subject to minimum capitalization requirement which is pegged to the extent of foreign shareholding in the NBFC as set out in the FDI Policy.

3. DNBS (PD) CC.No.376/03.10.001/2013-144. Under the Master Circular on Corporate Governance dated July 1, 2013, RBI had emphasized the importance of persons in management who fulfil the

‘fit and proper’ criteria. The Master Circular provides as follows: “……it is necessary to ensure that the general character of the management or the proposed management of the non-banking financial company shall

not be prejudicial to the interest of its present and future depositors. In view of the interest evinced by various entities in this segment, it would be desirable that NBFC-D with deposit size of Rs 20 crore and above and NBFC-ND-SI may form a Nomination Committee to ensure ‘fit and proper’ status of proposed/existing Directors.”

Percentage of Holding in the NBFC Minimum Capitalisation

Up to 51% FDI USD 0.5 million, with entire amount to be brought upfront.

More than 51% FDI USD 5 million with entire amount to be brought upfront.

More than 75% FDI USD 50 million, with USD 7.5 million to be brought upfront and the balance in 24 months.

NBFC Structure for Debt Funding



Considering the need for capitalization, it is not uncommon to see non – residents holding less than 75% stake in the NBFC even though a significant portion of the contribution comes from non-residents. Premium on securities is considered for calculating the minimum capitalization.

In addition to the above, every NBFC is required to have net owned funds5 of INR 20 million (INR 2.5 million provided application for NBFC registration is filed on or before April 20,1999).6

C. The Instrument

Before we discuss the choice of an instrument for the NBFC, let’s discuss the instruments that are usually opted for investment under the FDI route

CCDs essentially offer three important benefits. Firstly, any coupon paid on CCDs is a deductible expense for the purpose of income tax. Secondly, though there is a 40% withholding tax that the non-resident recipient of the coupon may be subject to, the rate of withholding can be brought to as low as 10% if the CCDs are subscribed to by an entity that is resident of a favorable treaty jurisdiction. Thirdly, coupon can be paid by the company, irrespective of whether there are profits or not in the company. Lastly, being a loan stock (until it is converted), CCDs have a liquidation preference over shares. And just for clarity, investment in CCDs is counted towards the minimum capitalization.

CCDs clearly standout against CCPS on at least the following counts. Firstly, while any dividend paid on CCPS is subject to the same dividend entitlement restriction (300 basis points over and above the prevailing State Bank of India Prime Lending Rate at the time of the issue), dividends can only be declared out of profits. Hence, no tax deduction in respect of dividends on CCPS is available. To that extent, the company must pay 30%7 corporate tax before it can even declare dividends. Secondly, any dividends can be paid by the company only after the company has paid 15%8 dividend distribution tax. In addition, unlike conversion of CCDs into equity, which is

not regarded as a ‘transfer’ under the provisions of the Income-tax Act, 1961, conversion of CCPS into equity may be considered as a taxable event and long term or short term capital gains may be applicable. Lastly, CCPS will follow CCDs in terms of liquidation preference.

However, unlike other companies, a combination of nominal equity and a large number of CCDs may not be possible in case of NBFCs. Though all non-deposit accepting NBFCs are subjected to NBFC (Non-Deposit Accepting or Holding) Companies Prudential norms (Reserve Bank) Directions (the “Prudential Norms”), once such NBFC has ‘total assets’ in excess of INR 1 billion (USD 20 million approximately)9, the NBFC is referred to as a ‘systemically important NBFC’. Unlike other NBFCs, a systemically important NBFC is required to comply with Regulation 15 (Auditor’s Certificate), Regulation 16 (Capital Adequacy Ratio) and Regulation 18 (Concentration of Credit / Investment) of the Prudential Norms. The choice of instrument is largely dependent on the capital adequacy ratio required to be maintained by the NBFC for the following reason.

Regulation 16 of the Prudential Norms restricts a systemically important NBFC from having a Tier II Capital larger than its Tier I Capital.

“Tier I Capital” = Owned funds10 + Perpetual debt instruments (upto15% of Tier I Capital of previous accounting year) -Investment in shares of NBFC and share/ debenture/bond/ loans / deposits with subsidiary and Group company (in excess of 10% of Owned Fund)

“Tier II Capital” = Non-convertible Preference shares / OCPS + Subordinated debt + General Provision and loss reserves (subject to conditions) + Perpetual debt instruments (which is in excess of what qualifies for Tier I above) + Hybrid debt capital instruments + revaluation reserves at discounted rate of fifty five percent;

5. Net Owned Funds has been defined in the RBI Act 1934 as (a) the aggregate of paid up equity capital and free reserves as disclosed in the latest balance sheet of the company, after deducting there from (i) accumulated balance of loss, (ii) deferred revenue expenditure and (iii) other intangible asset; and (b) further reduced by the amounts representing (1) investment of such company in shares of (i) its subsidiaries; (ii) companies in the same group; (iii) all other NBFCs and (2) the book value of debentures, bonds, outstanding loans and advances (including hire-purchase and lease finance) made to and deposits with (i) subsidiaries of such company and (ii) companies in the same group, to the extent such amounts exceed ten percent of (a) above

6. Although the requirement of net owned funds presently stands at INR 20 million, companies that were already in existence before April 21, 1999 are allowed to maintain net owned funds of INR 2.5 million and above. With effect from April 1999, the RBI has not been registering any new NBFC with net owned funds below INR 20 million.

7. Exclusive of surcharge and cess.8. Exclusive of surcharge and cess.9. Note that an NBFC becomes a systemically important NBFC from the moment its total assets exceed INR 100 crores. The threshold of INR 1 billion

need not be reckoned from the date of last audited balance sheet as mentioned in the Prudential Norms.10. “Owned Fund” means Equity Capital + CCPS + Free Reserves +Share Premium + Capital Reserves –(Accumulated losses + BV of intangible assets +

Deferred Revenue Expenditure)



Thus, CCDs being hybrid debt instruments which fall in Tier II cannot be more than Tier I Capital. This disability in terms of capitalization is very crucial for the NBFC and its shareholder as it not only impedes the ability of the NBFC to pay out interests to the foreign parent in case of inadequate profits, but is also tax inefficient. There is currently an ambiguity on whether NCDs are to be included in Tier II Capital as they do not qualify in any of the heads as listed above for Tier II Capital.

D. No Ability to Make Investments

Having discussed the funding of the NBFC itself, let’s discuss how the NBFC could fund the investee companies. Under the FDI Policy, an NBFC with foreign investment can only engage in certain permitted activities11 under the automatic route, and engaging in any financial services activity other than such activities will require prior approval of the Foreign Investment Promotion Board (“FIPB”), an instrumentality of the Ministry of Finance of the Government of India.

While lending qualifies as one of the permitted categories (‘leasing and finance’), ‘investment’ is not covered in the list above. Therefore, any FDI in an NBFC that engages in ‘investments’ will require prior approval of the FIPB. Such an approval though discretionary is usually granted within 3 months’ time on a case to case basis. Therefore, an NBFC with FDI can only engage in lending but not in making investments.12

We are given to understand that in a few cases where the redemption premium of the NCDs was linked to the equity upside, RBI qualified such instruments to be in the nature of investments rather than just loan instruments. Once the nature of the instrument changed, then nature of the NBFC automatically changed from lending to investment, and FIPB approval was immediately required in respect of foreign investment in an NBFC engaged in investment activity.

Core Investment Companies

A core investment company (“CIC”) is a company which satisfies the following conditions as on the date of the last audited balance sheet (i) it holds not less than 90% of its net assets in the form of investment in equity shares, preference shares, bonds, debentures, debt or loans in group companies; (ii) its investments in the equity shares (including instruments compulsorily convertible into equity shares within a period not exceeding 10 years from the date of issue) in group companies constitutes not less than 60% of its net assets ; (iii) it does not trade in its investments in shares, bonds, debentures, debt or loans in group companies except through block sale for the purpose of dilution or disinvestment; and (iv) it does not carry on any other financial activity referred to in Section 45 I (c) and 45 I (f) of the Reserve Bank of India Act, 1934 except for granting of loans to group companies, issuing of guarantees on behalf of group companies and investments in bank deposits, money market instruments etc.

A CIC is not required to register with the RBI, unless the CIC accepts ‘public funds’ AND has total financial assets in excess of INR 1 billion.

‘Public funds’ for the purpose of CIC include funds raised either directly or indirectly through public deposits, Commercial Papers, debentures, inter-corporate deposits and bank finance but excludes funds raised by issue of instruments compulsorily convertible into equity shares within a period not exceeding 10 years from the date of issue.

E. Deployment of FundsNBFCs can issue debentures only for deployment of the funds on its own balance sheet and not to facilitate requests of group entities/ parent company/ associates. Core Investment Companies have been carved out from the applicability of this restriction.

11. The activities permitted under the automatic route are: (i) Merchant Banking, (ii) Under Writing, (iii) Portfolio Management Services, (iv)Investment Advisory Services, (v) Financial Consultancy, (vi) Stock Broking, (vii) Asset Management, (viii) Venture Capital, (ix) Custodian Services, (x) Factoring, (xi) Credit Rating Agencies, (xii) Leasing & Finance, (xiii) Housing Finance, (xiv) Forex Broking, (xv) Credit Card Business, (xvi) Money Changing Business, (xvii) Micro Credit, (xviii) Rural Credit and (xix) Micro Finance Institutions

12. The FDI Policy however under paragraph 6.2.24.2 (1) provides that: “(iv) 100% foreign owned NBFCs with a minimum capitalisation of US$ 50 million can set up step down subsidiaries for specific NBFC activities, without any restriction on the number of operating subsidiaries and without bringing in additional capital.

(v) Joint Venture operating NBFCs that have 75% or less than 75% foreign investment can also set up subsidiaries for undertaking other NBFC activities, subject to the subsidiaries also complying with the applicable minimum capitalisation norms.”




F. Credit Concentration Norms

A systemically important NBFC is not permitted to lend or invest in any single company exceeding 15% of its owned fund, or single group13 of companies exceeding 25% of its owned fund. If however the systemically important NBFC is investing and lending, then these thresholds stand revised to 25% and 40% respectively.

Exemption from such concentration norms may be sought and has been given in the past where the NBFC qualified the following two conditions – firstly, the NBFC did not access public funds14, and secondly, the NBFC did not engage in the business of giving guarantees. Interestingly, ‘public funds’ include debentures, and to that extent, if the NBFC has issued any kind of debentures (including CCDs), then such relaxation may not be available to it. In the absence of such exemption, it may be challenging for loan or investment NBFCs to use the leverage available to them for the purpose of making loans or investments.

G. Only Secure Debentures can be Issued

NBFCs can only issue fully secured debentures whether by way of private placement or public issue. The security has to be created within a month from the date of issuance. If the security cover is inadequate, the proceeds have to be placed in an escrow account, till the time such security is created.

H. Enforcing Security Interests

NBFCs, unlike banks, are not entitled to protection under the SARFAESI Act. This is a major handicap for NBFCs as they have to undergo through the elaborate court process to enforce their security interests, unlike banks which can claim their security interests under the provisions of SARFAESI Act without the intervention of the courts. Representations were made by industry associations seeking inclusion of NBFCs within the ambit of SARFAESI Act, especially in the current times when NBFCs are fairly regulated.

We understand that the then RBI Governor D. Subbarao responded to the exclusion of NBFCs on the ground that their inclusion under the SARFAESI Act would distort the environment for which Securitisation Companies (SCs)/ Reconstruction Companies (RCs) were set up by allowing more players to seek enforcement of security rather than attempting reconstruction of assets.

Subbarao mentioned that SARFAESI Act was enacted to enable banks and financial institutions to realise long-term assets, manage problem of liquidity, asset liability mis-matches and improve recovery by exercising powers to take possession of securities, sell them and reduce nonperforming assets by adopting measures for recovery or reconstruction, through the specialised SCs/RCs, which would be registered with the RBI and purchase the NPAs of the banks and FIs. According to him, two methodologies were envisaged - first, the strategy for resolution of the assets by reconstructing the NPAs and converting them into performing assets, and second, to enforce the security by selling the assets and recovering the loan amounts

Subbarao further mentioned that SARFAESI Act is not merely a facilitator of security enforcement without the intervention of Court. It is a comprehensive approach for restructuring the assets and make it work and only when it does not work, the recovery mode was envisaged.

He was apprehensive that since NBFCs have followed the leasing and hire purchase models generally for extending credit and they enjoy the right of repossession, the only benefit SARFAESI Act would extend to the NBFCs will be for enforcement of security interest without the intervention of the court, which may distort the very purpose for which SCs/RCs were created, namely, reconstruction and the inclusion would simply add a tool for forceful recovery through the Act.

Draft Guidelines provide that NBFCs should be given the benefit under SARFAESI Act, 2002, since there is an anomaly that unlike banks and public financial institutions (“PFIs”), most NBFCs (except those registered as PFIs under Section 4A of the Companies Act) do not enjoy the benefits deriving from the SARFAESI Act even though their clients and/or borrowers may be the same.

I. ExitExit for the foreign investor in an NBFC is the most crucial aspect of any structuring and needs to be planned upfront. The exits could either be by way of liquidation of the NBFC, or buy-back of the shares of the foreign investor by the NBFC, or a scheme

13. The term “group” has not been defined in the Prudential Norms14. “Public funds” includes funds raised either directly or indirectly through public deposits, Commercial Papers, debentures, inter-corporate deposits

and bank finance.



of capital reduction (where the foreign investor is selectively bought-back), or the sale of its shares in the NBFC to another resident or non-resident, or lastly, by way of listing of the NBFC.15

Unlike most countries, liquidation in the Indian context is a time consuming and elaborate process in India, sometimes taking in excess of 10 years.

Buyback of securities is another alternative, however, CCDs cannot be bought back. CCDs must be converted into the underlying equity shares to be bought back. Buy-back of securities is subjected to certain conditionalities as stipulated under Section 68 of the Companies Act, 2013. A buyback of equity shares can happen only out of free reserves, or proceeds of an earlier issue or out of share premium.16 In addition to the limited sources that can be used for buy-back, there are certain other restrictions as well that restrict the ability to draw out the capital from the company. For instance, only up to a maximum of 25% of the total paid up capital and free reserves of the company can be bought in one financial year, the debt equity ratio post buy-back should not be more than 2:1 etc. Buy-back being a transfer of securities from a non-resident to a resident cannot be effected at a price higher than the price of the shares as determined by the discounted cash flows method. Although, buy back from the existing shareholders is supposed to be on a proportionate basis, there have been certain cases such as Century Enka where the court approved a scheme for selective buy-back of 30% of its shareholding from its non-resident shareholders.

From a tax perspective, traditionally, the income from buyback of shares has been considered as capital gains in the hands of the recipient and accordingly the investor, if from a favourable treaty jurisdiction, could avail the treaty benefits. However, in a calculated move by the Government to undo this practice of companies resorting to buying back of shares instead of making dividend payments the Budget 2013- 2014 has now levied a tax of 20%17 on domestic unlisted companies, when such companies make distributions pursuant to a share repurchase or buy back.

The said tax at the rate of 20% is imposed on a domestic company on consideration paid by it which is above the amount received by the company at the time of issuing of shares. Accordingly, gains that

may have arisen as a result of secondary sales that may have occurred prior to the buy-back will also be subject to tax now.

The proposed provisions would have a significant adverse impact on offshore realty funds and foreign investors who have made investments from countries such as Mauritius, Singapore, United States of America and Netherlands etc. where buy-back of shares would not have been taxable in India due to availability of tax treaty benefits. Further, being in the nature of additional income tax payable by the Indian company, foreign investors may not even be entitled to a foreign tax credit of such tax.

Additionally, in the context of the domestic investor, even the benefit of indexation would effectively be denied to such investor and issues relating to proportional disallowance of expenditure under Section 14A of the ITA (Expenditure incurred in relation to income not includible in total income) may also arise. This may therefore result in the buy-back of shares being even less tax efficient than the distribution of dividends.

As an alternative to buy-back, the investor could approach the courts for reduction of capital under the provisions of section 68 of the Companies Act, 2013; however, the applications for such reduction of capital need to be adequately justified to the court. From a tax perspective, the distributions by the company to its shareholders, for reduction of capital, would be regarded as a dividend to the extent to which the company possesses accumulated profits and will be taxable in the hands of the company at the rate of 15%.18 Any, distribution over and above the accumulated profits (after reducing the cost of shares) would be taxable as capital gains.

Sale of shares of an NBFC or listing of the NBFC could be another way of allowing an exit to the foreign investor; however, sale of shares cannot be effected at a price higher than the price of the shares determined by the discounted cash flow method. Listing of NBFCs will be subject to the fulfillment of the listing criterion and hinges on the market conditions at that point in time.

15. The forms of exit discussed here are in addition to the ability of the foreign investor to draw out interest / dividends from the NBFC up to 300 basis points over and above the State Bank of India prime lending rate.

16. As a structuring consideration, the CCDs are converted into a nominal number of equity shares at a very heavy premium so that the share premium can then be used for buy-back of the shares.

17. Exclusive of surcharge and cess.18. Exclusive of surcharge and cess




￭ Amendment recognizes shares/debentures with a built-in option/right as eligible instruments which may be issued to foreign investors;

￭ Such securities cannot have an assured exit price, although the Amendment specifies methodologies to determine the exit price;

￭ The prescribed price determination measures may make it more beneficial to invest in compulsorily convertible securities rather than equity shares;

￭ A minimum lock-in period of one year has been prescribed before the option can be exercised.

‘Put Options’ in favour of a non-resident requiring an Indian resident to purchase the shares held by the non-resident under the foreign direct investment (“FDI”) regime were hitherto considered as violative of the FDI Policy by the Reserve Bank of India (“RBI”). The RBI has now legitimized option arrangements through its recent amendment (“Amendment”) to the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (“TISPRO”), notified through its circular1 dated January 09, 2013 (the “Circular”). TISPRO now recognizes that equity shares, fully and mandatorily convertible preference shares and debentures (“FDI Instruments”) containing an optionality clause can be issued as eligible instruments to foreign investors. However, the Circular specifies that such an option / right when exercised should not entitle the non-resident investor to exit at an assured return.

I. BackgroundThe validity and enforceability of put options has always been a bone of contention from an Indian securities law and exchange control perspective.

In the past, Securities and Exchange Board of India (“SEBI”) had taken a stand, in context of public companies, that option arrangements are akin to forward contracts, hence restricted. SEBI relaxed its position through a notification2 in October, 2013.

The SEBI notification granted validity to contracts containing clauses related to preemptive rights, right of first offer, tag-along right, drag-along right, and call and put options.

From an RBI perspective, the issue was more from an external commercial borrowings (“ECB”) perspective. RBI had issued a notification on June 8, 2007 vide Circular 73, setting out that non-residents could only subscribe to FDI Instruments, and any instrument that may be redeemable or optionally redeemable will qualify as ECB. Interpreting that Circular, the RBI regarded put options in favour of non-residents as redeemable instruments, not permitted under the FDI regime. That interpretation was even extended to situations where the put option was not on the company, but the promoters of the company.

On a separate count, taking a cue from SEBI, the RBI also took a view that a put option provision in an investment agreement would qualify as a ‘option’ or an over the counter derivative, which is not permitted under the FDI route. That view was taken despite the fact that no separate price was paid for the optionality, and the optionality could not be traded independent of the FDI Instrument.

Having said that, there was no clear written policy that restricted put options, and RBI’s approach was seen to be on a case-to-case basis, typically in cases where the promoters (not willing to honor the put) approached the RBI themselves. However, the aggressiveness with which the RBI implements such an unwritten policy was remarkable. The risk of having a put was not just limited to it being not enforceable, RBI in fact regarded the mere existence of put in a contract as a violation of the FDI Policy and initiated proceedings against the parties for having provided for such options in their investment contracts.

In fact, the Department of Industrial Policy and Promotion (DIPP) had brought in a written prohibition on options in the Consolidated FDI Policy dated October 01, 2011, but deleted that provision within 30 days of it in light of industry

Annexure VIForeign Investors Permitted to Put: Some

Cheer, Some Confusion

1. RBI Circular No. RBI/2013-2014/436 A.P. (DIR Series) Circular No. 86 (January 09 2013) available at: http://rbidocs.rbi.org.in/rdocs/Notification/PDFs/APDIR0901201486EN.pdf

2. SEBI Notification No. LAD-NRO/GN/2013-14/26/6667 (October 03, 2013) available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1380791858733.pdf



wide criticism. However, notwithstanding the deletion of prohibition of options, RBI continued with its approach that put options in favour of non-residents were violative of the FDI policy. Please refer to our hotline discussing the change in regulatory policy here (http://tmp.nishithdesai.com/old/New_Hotline/CorpSec/CORPSEC%20HOTLINE_Oct0311.htm) and here (http://tmp.nishithdesai.com/old/New_Hotline/CorpSec/CORPSEC%20HOTLINE_Nov0111.htm).

II. AmendmentThe Amendment, for the first time, provides for a written policy on put options, and in doing that sets out the following conditions for exercise of options by a non-resident:

i. Shares/debentures with an optionality clause can be issued to foreign investors, provided that they do not contain an option/right to exit at an assured price;

ii. Such instruments shall be subject to a minimum lock-in period of one year;

iii. The exit price should be as follows:

￭ In case of listed company, at the market price determined on the floor of the recognized stock exchanges;

￭ In case of unlisted equity shares, at a price not exceeding that arrived on the basis of Return on Equity (“RoE”) as per latest audited balance sheet. RoE is defined as the Profit after Tax divided by the net worth (defined to include all free reserves and paid up capital)

￭ In case of preference shares or debentures, at a price determined by a Chartered Accountant or a SEBI registered Merchant Banker per any internationally accepted methodology.

III. AnalysisIn a market where IPOs are almost non-existent, put options give tremendous comfort to offshore private equity funds, should a trade sale not materialize within their exit horizons. Put options become even more important for certain asset classes like real estate or other stabilized yield generating assets where secondary sales and IPOs are not very common in the Indian context. The Amendment is a positive development for such players as commercial justifications behind inclusion of options into investment agreements have been recognized, and Indian companies and their founders can no longer treat such rights/options as mere paper rights.

A detailed analysis of the Amendment, its ambiguities and practical challenges are set out herein below.

A. Lock in

While a minimum lock in period of one year has been specified, it is unclear as to which date it should apply from. For example, if the date of optionality agreement and issuance of securities are different, which would be the relevant date? On a conservative basis, it may be appropriate to reckon the lock-in conditions from the later of the two dates.

There are also issues about whether the lock-in restricts only the exercise of securities or also the secondary transfer of securities, as well as whether a secondary transfer would reset the clock in the hands of the new investor. It appears that the one year lock would be required only if the option is being exercised (and not in case of all secondary transfers), and would apply afresh in the hands of each subsequent transferee.

B. Will DCF Pricing cap still Apply, if the Exit Price for Options is Higher than DCF

Under the current regulations, non-residents are not entitled to sell the FDI Instruments to an Indian resident at a price exceeding the price computed per the discounted free cash flows (“DCF”) methodology.

However, the DCF cap applicable to FDI Instruments will not be applicable to sale of FDI Instruments with a put option. This is because the exit pricing applicable in case of exercise of the option by the non-resident has been introduced by amendment to Regulation 9 of the TISPRO regulations, whereas the DCF price cap is applicable to securities transferred under Regulation 10 B(2) (by virtue of the RBI circular dated May 4, 2010). Regulation 10B only applies to transfers by non-residents, which are not covered under Regulation 9. Therefore, the DCF cap will not be applicable when determining the exit price pursuant to exercise of put option.

The question remains on whether the option pricing norms set out in the Amendment will only apply if the option is exercised, or even if shares with options are transferred to the grantor of the option without the exercise of an option.

C. Exit price for Equity Shares

The Amendment provides that the exit price in respect of equity shares of unlisted company should not exceed the price arrived at on the basis of Return

Foreign Investors Permitted to Put: Some Cheer, Some Confusion



on Equity (“RoE”) as per the last audited balance sheet.

The formula is divorced from the traditional form of calculating RoE (where the denominator is average shareholder equity and not networth) and brings in several impractical situations set out below.

Plain reading of the provision suggests that the exit price would be capped at the RoE. Whilst it is not clear, it appears that the RoE formula should be interpreted to mean principal plus the RoE. That is to say, if the invested amount was INR 100, and the company generated profits of INR 20 each year for five years, leading to a hypothetical net worth of 200, the RoE would be equal to the profits of the sixth year divided by 200. If the profit after tax in the sixth year were INR 20, the RoE would be 20/200 or 10%. Accordingly, the exit price for the foreign investor would be capped at INR 110, which clearly may not be reflective of the FMV of the instrument.

The formula for determining the exit price seems to be at complete odds with the pricing suggested for convertibles (any internationally accepted valuation methodology), listed equity shares (ruling market price), or even shares and convertibles without optionality attached (discounted cash flow valuation), which are likely to be much closer to FMV than the RoE methodology.

For instance, if the formula is applied, accumulated profits only decrease the RoE. The formula also leaves the exit price contingent on the last audited balance sheet, which may have unintended and distortionary consequences. For example, if the put option is to be triggered after a fixed period of time (being five years, in the above example), and the company incurs a loss in the sixth year, on a conservative basis, the exit price may be capped at a price lower than the investment amount.

If the put option is tied to an event of default, the valuation mechanism may have unintended consequences as the default may have an impact on the profitability of the company in the year of exit.

Requiring an exit at RoE is clearly ambiguous. Ideally the RoE can only be the basis to compute the exit price. To that extent, it remains to be seen if the RBI will permit the exit price on equity shares with optionality attached to be a variable of the RoE that brings the exit price closer to FMV, just as in case of convertibles and listed shares

D. Determination of Price of Convertibles Securities

The Amendment provides the exit price for convertibles upon exercise of put option should be

a price determined based on international accepted pricing methodology, as determined by a SEBI registered merchant banker or chartered accountant.

This valuation mechanism is likely to provide more flexibility to investors at the point of exit, and hence going forward we may see investors preferring more of convertible securities as compared to equity shares for their investments in Indian companies. Having said this, it is unclear why different valuation mechanisms were believed to be required for equity shares and compulsorily convertible securities, which are in any case treated on the same footing and subject to DCF cap on an as if converted basis under the current regulatory regime.

E. Status of Existing Option Arrangements

The Circular clearly sets out that all existing contracts must comply with the conditions set out in the Amendment to qualify as being FDI compliant.

In light of this, a position could be taken that all existing contracts that are not compliant with the conditions set out in the Amendment become FDI non-compliant, especially if they provide for options with assured returns.

The terms of such put options contained in existing contracts may need to be revisited to bring them in compliance with the Amendment. However, if the existing terms of issuance already provide that the exit price should be subject to applicable law, then the terms of the security may be considered to have been amended by the law and should thus be considered valid notwithstanding the Amendment.

F. Impact on Joint Ventures and M&A deals

Options are not just contained in private equity transactions. Even joint venture transactions and sometimes M&A transactions contain put options in favour of non-residents. These options are usually pegged to fair market value (determined per commercial negotiations) or at discount or premium to the fair market value.

There may be a need to look at such joint venture agreements, as the commercially negotiated price will now be subjected to the pricing for options as set out in the Amendment.

IV. ConclusionThe Amendment is a welcome development as it gives predictability and commercial flexibility



to foreign investors, in relation to contractual provisions, which are fairly standard in the international investment context. However, pegging the exit price for equity to RoE (and not a multiple of RoE that brings the exit price closer to FMV) is likely to be a cause of major concern for investors. While preference shares may be preferred from an exit pricing perspective, Companies Act 2013, which denies the flexibility of voting on as-if-converted basis may galvanize the investors to invest in common equity. The need to amend existing contracts to bring them in line with the Amendment may be a challenging task, especially for most offshore private equity players that would

be hesitant to revisit investment agreements if they are close to their exit horizons. What will also be interesting is to see how the term ‘exercise’ is interpreted and whether RBI will require exit pricing as set out for options to be applicable even when the shares are transferred to the Indian resident granting the option voluntarily, and not in exercise of the option/right.

Aditya Shukla, Shreya Rao and Ruchir Sinha


Foreign Investors Permitted to Put: Some Cheer, Some Confusion



The Central Board of Direct Taxes has recently notified Rules that would govern India’s new General Anti-Avoidance Provisions (“GAAR”). Although the Rules introduce some safeguards, the real concerns surrounding GAAR remain unaddressed. Ambiguities continue to remain with respect to concepts such as lack of commercial substance, substantial commercial purpose, bona fide objects, abuse and misuse of law. One remains clueless about the interplay between GAAR and other anti-avoidance and anti-treaty abuse provisions, as well as the fate of Mauritius and other popular investment routes. The limited grandfathering of specific investments (prior to August 30, 2010) makes GAAR more retroactive than prospective.

India like every other country is justified in defending its tax base, and is in sync with the global move to curb money laundering and abusive tax schemes. However, these concerns have to be balanced with the need for greater taxpayer certainty, eliminating double taxation on a global basis and enhanced accountability on behalf of tax administrations.

The primary concern with GAAR may be summarized as thus: Is there a real guarantee that GAAR shall not end up as another “weapon to intimidate taxpayers” (borrowing the UK GAAR Committee’s words of caution)? This concern has special relevance in an environment conventionally known for protracted litigation, retroactive law making, high pitched tax assessments and corruption.

The GAAR Rules have been notified as a follow-up to the Government’s announcement in January this year accepting specific recommendations of the Shome Committee constituted in 2012 to critically analyze the GAAR provisions. Earlier, the provisions were also reviewed by the Parliamentary Standing Committee on Finance which had also made some important recommendations. Apart from the limited grandfathering, the Rules introduce a few procedural safeguards and some relief for P-note holders. However, several key recommendations by the Shome Committee and the Standing Committee including certain safe harbours, and clarity on the Mauritius route have been left out.

I. Background to GAARGAAR was introduced into India’s tax statute in 2012 and has been criticized widely on account of the ambiguities in its scope and application, lack of safeguards and possibility of misuse by the tax authorities. GAAR empowers the Revenue with considerable discretion in taxing ‘impermissible avoidance arrangements’, disregarding entities and recharacterising income and even denying tax treaty benefits.

The introduction of GAAR led to immense hue and cry among investors, which prompted the Government to appoint an Expert Committee under the renowned economist Dr. Parthasarthy Shome to consult with stakeholders and review GAAR. (Click here for our hotline with insights and analysis of the Shome Committee’s report.) In its detailed report, the Expert Committee had recommended a substantial narrowing down of the scope of GAAR and other protections in the interest of fairness and certainty.

Following the recommendations of the Shome Committee, various amendments were introduced through the Finance Act, 2013 including the following:

￭ GAAR shall be effective from April 1, 2015;

￭ GAAR would apply only if the main purpose of an arrangement is to obtain a tax benefit;

￭ Factors such as the holding period of the investment, availability of an exit route and whether taxes have been paid in connection with the arrangement may be relevant but not sufficient for determining commercial substance;

￭ GAAR cases shall be scrutinized by an Approving Panel chaired by a retired High Court Judge, a senior member of the tax office (of the rank of Chief Commissioner of Income Tax) and a reputed academician or scholar with expertise in taxation or international trade and business.

The recently notified Rules seek to provide a few exclusions and address certain procedural and other matters not covered by the Finance Act, 2013.

Annexure VIIIndianGaar:RulesNotified

Some Relief, But Ambiguities Remain



II.ApplicationofGAAR:SpecificClarifications

The Rules provide the following clarifications with respect to the application of GAAR in India:

A. De Minimis Rule

GAAR shall not be applicable to any arrangement where the tax benefit arising to all parties to the arrangement does not exceed a sum of INR 30 million in the relevant financial year.

B. Limited Grandfathering and Retroactivity

Investments made prior to August 30, 2010 have been grandfathered and GAAR shall not apply to exits from such investment. This was date when the Government introduced the Direct Taxes Code Bill (still pending before Parliament) which initially proposed GAAR. The grandfathering is very limited since GAAR may still apply to a range of transactions, structures and arrangements set up prior to August 30, 2010. Further, investments made subsequent to August 30, 2010 will be subject to GAAR. One could therefore say that GAAR is retroactive in most contexts. For GAAR to be truly prospective, it should only apply to arrangements initiated subsequent to implementation of GAAR.

C. Relief for FIIs?

The Rules also provide that GAAR shall not apply to a Foreign Institutional Investor (“FII”) that does not claim benefits of a tax treaty and subjects itself to taxation under domestic law. The Rules do not provide any real relief for FIIs, and difficulties with respect to treaty relief in the face of GAAR would continue to cause concern. FIIs (especially tax exempt investors such as foreign pension funds, endowments and mutual funds) also have to be cautious about availability of credit in the home country against any taxes paid in India on account of GAAR.

D. Relief for P-note Holders

GAAR would not be applicable to any investment made by a non-resident that directly or indirectly invests in offshore derivative instruments or otherwise through an FII. Even though some relief has been provided to P-Note holders, difficulties may arise if the FII passes on the tax costs to the P-Note holders.

E. Timelines & Procedure

The Rules lay down the procedure for invocation of GAAR. If the tax officer is of the view that an arrangement is an ‘impermissible avoidance arrangement’, he is required to issue a notice to the taxpayer asking him to state reasons for the non-applicability of GAAR. The notice to the taxpayer has to contain details of the arrangement, the tax benefit, basis and reason for considering that (i) the main purpose is to obtain tax benefit; and that (ii) the arrangement is an impermissible avoidance agreement; along with a list of supporting documents and evidence. The tax officer is also required to make a reference to the Commissioner of Income Tax (“CIT”) in Form 3CEG.

If relying upon the reference of the tax officer, the CIT is of the view that GAAR need not be invoked; the CIT is required to issue directions to the tax officer in the Form 3 CEH within a period of 1 month from the end of month in which the reference was received by him. If the CIT reaches this conclusion on the basis of taxpayer’s response to the notice, the CIT shall issue directions to the tax officer within a period of 2 months from the end of month in which the taxpayer furnishes objections to the notice received by him.

If the CIT does not accept the taxpayer’s objections, he can make a reference to the Approving Panel after declaring the arrangement as an impermissible avoidance arrangement in Form 3CEI within 2 months from the end of the month in which the final submission of the taxpayer was received.

III. Concluding CommentsThe following suggestions should be considered before GAAR is finally implemented:

A. Need for Safe Harbours

It would be helpful to provide statutory safe harbours identifying specific scenarios where GAAR will not apply. For instance, it may be clarified that GAAR should not apply to question commercial substance of a listed entity (domestic or foreign), certain commercially driven structured finance arrangements, court sanctioned merger or demerger schemes, choice of funding through debt or equity, or arrangements where foreign tax has been paid. Not-for-profit organizations can also be outside the purview of GAAR. The Government has recently introduced specific safe harbours for transfer pricing which, though limited in scope, was welcomed by the industry.The Government may consider introducing something similar for GAAR as well.

Indian Gaar: Rules Notified



B. More Clarity on Commercial Substance

A number of terms have been used in the GAAR provisions which still remain ambiguous. It is hoped that the Government will also release detailed explanations, along with illustrations, on the meaning of expressions such as ‘commercial substance’, ‘substantial object’, ‘bonafide’, ‘misuse or abuse’ and other ambiguous terms that are used in the provisions. The guidance provided by countries such as Australia, UK and South Africa are far superior to what is presently available in India.

C. Mauritius et al- GAAR and tax Treaty Relief

In the tax treaty context it would be preferable to include bilaterally negotiated anti-abuse provisions rather than a unilaterally enforced GAAR. The Shome Committee rightly recommended that GAAR should not be invoked if the treaty has a Limitation of Benefit (“LoB”) provision limiting treaty entitlement in specific cases. For instance, the tax treaty with Singapore has an LoB clause because of which the capital gains tax exemption on share transfers may not be available to a Singapore entity that lacks commercial substance or is a shell or conduit company. Certain expenditure or listing requirements may be fulfilled so that the entity is not treated as conduit or a shell company. To the extent the entity satisfies the LoB criteria in the treaty, GAAR should not apply to it.

It is reported that the India-Mauritius tax treaty is currently being renegotiated and it is possible that certain substance requirements may be introduced. Interestingly, Mauritius has recently identified certain additional criteria for companies (having Global Business 1 licenses) to be considered as being ‘managed and controlled’ in Mauritius.1 The additional considerations include having an office premise in Mauritius, fulltime employment of administrative/technical personnel one of whom shall be a resident in Mauritius, settlement of

disputes by arbitration in Mauritius, holding of assets worth at least USD 100,000 in Mauritius, relevant qualifications and involvement by resident directors, and reasonable expenditure in Mauritius which is expected from any similar corporation which is controlled and managed from Mauritius. Companies are expected to comply with these changes from January 1, 2015.

D. GAAR and Specific Anti-avoidance Rules

Several countries including UK, Canada and Australia consider that GAAR should be used sparingly and as a last resort. GAAR should not be invoked in situations where specific anti avoidance rules (like transfer pricing) are applicable.

E. Change in Mindset and Increase in Accountability

Ambiguous legal provisions such as GAAR create further tension in the existing adversarial environment in India characterized by the large backlog of cases. It is estimated that over a trillion rupees is stranded in various stages of tax litigation. It is therefore not surprising that the Parliamentary Standing Committee had recommended disciplinary action for officials who made irrational and unreasonable tax assessments that are eventually set aside by the Courts.

To introduce GAAR and obtain a buy-in from stake holders it is essential to eliminate adversarial approach towards taxpayers, reduce compliance costs, remove ambiguous legal standards and introduce a charter of taxpayer rights which guarantees enforcement of tax laws in a fair, equitable and non-arbitrary manner.

Ashish Sodhani and Mahesh Kumar


1. The Financial Service Act, 2007 provides certain conditions that the FCS shall consider to determine whether a GBC1 is ‘managed and controlled’ in Mauritius



￭ Minimum area threshold reduced from 50,000 sq ft. to 20,000 sq ft.

￭ No minimum area threshold, if 30% project cost is contributed towards development of affordable housing.

￭ Are investments in completed yield generating real estate assets allowed?

In a recent press release issued in relation to its meeting dated October 29, 2014 (“Press Release”),

the Union Cabinet has cleared the further liberalization of Foreign Direct Investment (“FDI”) in ‘construction-development sector’, in line with the announcements in the Finance Minister’s budget speech for 2014.

I. ChangesThe changes sought to be made by the Press Release are set out below.1

Annexure VIIIForeign Investment Norms for Real Estate

Liberalized

Provisions Revised Policy Pursuant to Press Release Existing Policy

Minimum Land Requirements

Minimum area to be developed under each project would be:

i. Development of serviced plots: No minimum land requirement;

ii. Construction-development projects: Minimum floor area of 20,000 sq. meters;

iii. Combination project: Any of the above two conditions need to be complied with.

Minimum area to be developed under each project would be as under:

i. Development of serviced housing plots: Minimum land area of 10 hectares;

ii. Construction-development projects: Minimum built-up area of 50,000 sq. meters;


Minimum Capitalization Requirements

Minimum capitalization of USD 5 million. For wholly owned subsidiary: minimum capitalization of USD 10 million;

For joint ventures with Indian partners: minimum capitalization of USD 5 million.

Timing of investment

The funds would have to be brought in within 6 months of commencement of the project.

‘Commencement of the project’ has been explained to mean ‘date of approval of the building plan/ lay out plan by the relevant statutory authority’.

Subsequent tranches can be brought in till the earlier of:

i. Period of 10 years from the commencement of the project; or

ii. The completion of the project.

The funds would have to be brought in within 6 months of ‘commencement of business of the Company’.

No such concept of 10 years from commencement of business earlier.

Lock-in The investor is permitted to exit from the investment at (i) 3 years from the date of final installment, subject to development of trunk infrastructure, or (ii) on the completion of the project.

The investor is permitted to exit from the investment at expiry of 3 years from the date of completion of minimum capitalization.

1. The changes brought in by the Amendment are expected to be formalized in the form of a Press Note or by way of inclusion in the FDI Policy, and till such time the changes do not have the binding force of law.



‘Trunk infrastructure’ has not been defined, but is explained to include roads, water supply, street lighting, drainage and sewerage.

Repatriation of FDI or transfer of stake by a non-resident investor to another non-resident investor would require prior FIPB approval.

For investment in tranches: The investor is permitted to exit from the investment at the later of (a) 3 years from the date of receipt of each tranche/ installment of FDI, or (b) at expiry of 3 years from the date of completion of minimum capitalization.

Prior exit of the investor only with the prior approval of FIPB.

Sale of developed plots only

Only developed plots are permitted to be sold. Developed plots would mean plots where trunk infrastructure is developed, including roads, water supply, street lighting, drainage and sewerage.

The requirement of completion certificate has been done away with.

Sale of undeveloped plots prohibited. Undeveloped plots would mean plots where roads, water supply, street lighting, drainage and sewerage, and other conveniences, as applicable under prescribed regulations, have not been made available.

The investor was required to provide the completion certificate from the concerned regulatory authority before disposal of serviced housing plots.

Minimum development

No requirement of any such minimum development.

At least 50% of the project must be developed within a period of 5 years from date of obtaining all statutory clearances.

Exemption They are no longer exempt from the sale of undeveloped plots.

Certain investments were exempt from complying with the following requirements: (i) minimum land area; (ii) minimum capitalization, (iii) lock-in, (iv) 50% development within 5 year requirements and (v) sale of undeveloped plots.

Affordable Housing

Projects which allocate 30% of the project cost for low cost affordable housing are exempt from the minimum land area, and minimum capitalization requirements.

No such exemption.

Certificate from architect

The investee company required to procure an architect empanelled by any authority authorized to sanction building plan to certify that the minimum floor area has been complied.

No such requirement.

Completed projects

It has been clarified that 100% FDI permitted in completed projects for operation and management of townships, malls/ shopping complexes and business centers.

No such provision/ clarification

Responsibility for obtaining all necessary approvals

Investee Company. Investor/ Investee company.

II. Analysis

Particulars Revised policy pursuant to Press Release Existing Policy

Minimum Land Requirements

Minimum area to be developed under each project would be:

i. Development of serviced plots: No minimum land requirement;

ii. Construction-development projects: Minimum floor area of 20,000 sq. meters;


Minimum area to be developed under each project would be as under:

i. Development of serviced housing plots: Minimum land area of 10 hectares;

ii. Construction-development projects: Minimum built-up area of 50,000 sq. meters;




A. Serviced Plots and Combination Projects

Removal of minimum land requirements for serviced plots is a substantial relaxation. It appears that in case of combination projects as well, there shall be no minimum land requirement. Such relaxation could attract creative structuring for foreign investments in smaller areas.

B. Construction-development Projects

In case of construction-development projects, the minimum land requirement has been reduced from

50,000 sq. meters of built-up area to 20,000 sq. meters of floor area. The introduction of floor area concept, as against the earlier benchmark of built-up area may need to be examined. ‘Floor area’ has been stated to be defined ‘as per the local laws/ regulations of the respective state governments / union territories’. Definitions of ‘floor area’ vary from state to state. While floor area is defined for some areas, other areas do not have any definition of the term, such as the regulations for Greater Mumbai. It is to be seen whether floor area in these regions would be equivalent to built-up area or floor space index (FSI), though in some cases, floor area is close to built-up area.

Particulars Revised Policy Pursuant to Press Release

Existing Policy

Minimum Capitalization Requirements

Minimum capitalization of USD 5 million.

For wholly owned subsidiary: minimum capitalization of USD 10 million;

For joint ventures with Indian partners: minimum capitalization of USD 5 million.

In a market largely driven by debt such as listed non-convertible debentures, a lower minimum capitalization would be helpful considering minimum capitalization can only consist of equity

and compulsorily convertible instruments. This will also be helpful in tax structuring and optimization of returns for investors.

Particulars Revised Policy Pursuant to Press Release Existing Policy

Timing of investment

The funds would have to be brought in within 6 months of commencement of the project.

‘Commencement of the project’ has been explained to mean ‘date of approval of the building plan/ lay out plan by the relevant statutory authority’.

Subsequent tranches can be brought in till the earlier of:

iii. Period of 10 years from the commencement of the project; or

iv. The completion of the project.

The funds would have to be brought in within 6 months of ‘commencement of business of the company’.

No such concept of 10 years from commencement of business earlier.

C. Commencement of Business of Company to Commencement of Project

‘Commencement of business of the company’ had not been defined in the FDI Policy. It was seen practically that the regulator’s view was that the period of 6 months was to be calculated from the earlier of the date on which the investment agreement was signed by the investor, or the date the funds for the first tranche are credited into the account of the company. However, the criterion has now been changed to 6 months from the commencement of the project of the company, which has been explained to mean the date of the approval of the building plan/ lay out plan by

the relevant authority. This is a welcome move since this brings clarity as against dependence on interpretation of ‘commencement of business’.

D. Period for Subsequent Tranches

The FDI Policy did not have any restriction on the maximum period till which the investor could infuse funds. However, the Amendment states that subsequent tranches of investment can only by brought in till a period of 10 years from the commencement of the project, which seems to imply that the regulator is reluctant towards real estate projects which have extremely long gestation periods.

Foreign Investment Norms for Real Estate Liberalized



E. Exit on Completion

A welcome change is permitting investors to exit on the completion of the project. Hitherto, each tranche of investments were locked-in for a period of 3 years, even if the project was completed. This posed a major challenge for last-mile funding for projects, since the investment was stuck even on the completion of the project.

F. Lock-in of 3 years from Final Instalment

The lock-in for ongoing or non-completed projects for 3 years from the final tranche may need to be examined. The earlier regulations required any tranche to be locked in for a period of 3 years from the date of receipt of such tranche only.

G. 50% in 5 years

Another positive move is the removal of the minimum development of 50% in 5 years from the date of obtaining all statutory clearances. Earlier, there some ambiguity in relation to when the 50% development requirement would trigger, since it was unclear what all statutory approvals meant. To remove this ambiguity, the requirement for the minimum development of 50% in 5 years has been removed. However, in spirit, the same has been introduced by requiring ‘trunk infrastructure’ to be developed before any exit.

H. Trunk Infrastructure

To be eligible to exit at the end of 3 years from the

last tranche, trunk infrastructure (explained to include roads, water supply, street lighting and drainage and sewerage) must be developed. This requirement did not exist previously, and has been a recent introduction. This has also removed all ambiguities in relation to the 50% development requirement, since this is no longer linked to the obtaining of statutory clearances.

I. Grandfathering

It is unclear whether existing investment, on the anvil of exit currently would be required to satisfy the trunk infrastructure requirements. This may be a major barrier for investors who have completed the 3 year period from their investment, and are seeking exit, although trunk infrastructure has not been developed. It is also unclear whether existing tranches of investment would be locked in till the end of 3 period from any future tranches, if any.

Grandfathering of the existing investments from the requirements to comply with trunk infrastructure and the lock-in period would be important for existing investments.

J. Sale of stake From Non-resident to Non-resident

While the exit of a foreign investor earlier required FIPB approval, transfer of a non-resident investor’s stake to another non-resident investor was not expressly included. The Press Release now confirms this.


Existing Policy

Requirement of commencement certificate for serviced plots

The requirement of commencement certificate has been done away with.

The investor was required to provide the completion certificate from the concerned regulatory authority before disposal of serviced housing plots.


Lock-in The investor is permitted to exit from the investment at (i) 3 years from the date of final installment, subject to development of trunk infrastructure, or (ii) on the completion of the project.

‘Trunk infrastructure’ has not been defined, but is explained to include roads, water supply, street lighting, drainage and sewerage.

Repatriation of FDI or transfer of stake by a non-resident investor to another non-resident investor would require prior FIPB approval.

The investor is permitted to exit from the investment at expiry of 3 years from the date of completion of minimum capitalization.

For investment in tranches: The investor is permitted to exit from the investment at the later of (a) 3 years from the date of receipt of each tranche/ installment of FDI, or (b) at expiry of 3 years from the date of completion of minimum capitalization.

Prior exit of the investor only with the prior approval of FIPB.



A major relaxation which has now been introduced is the removal of the completion certificate requirement. Since these were service plots, a

completion certificate was not forthcoming. Addressing this concern, this is no longer required as long as trunk infrastructure is developed.


Existing Policy

Minimum development

No requirement of any minimum development.

At least 50% of the project must be developed within a period of 5 years from date of obtaining all statutory clearances.

Earlier, there some ambiguity in relation to when the 50% development requirement would trigger, since it was unclear what all statutory approvals meant. To remove this ambiguity, the requirement

for the minimum development of 50% in 5 years has been removed. However, in spirit, the same has been introduced by requiring ‘trunk infrastructure’ to be developed before any exit.


Affordable Housing

Projects which allocate 30% of the project cost for low cost affordable housing are exempt from the minimum land area, and minimum capitalization requirements.

No such exemption.

Affordable housing projects have been defined to mean projects which allot at least 60% of the FAR/ FSI for dwelling units of carpet area not being more than 60 sq. meters. Out of the total dwelling units, at least 35% should be of carpet area 21-27 sq. meters for economically weaker section category.

This would encourage creative structuring of investments into affordable housing. While the intent clearly is to encourage investment into affordable housing and housing for the economically weaker section, the equilibrium between luxury housing and affordable housing remains to be seen.


Completed projects

It has been clarified that 100% FDI permitted in completed projects for operation and management of townships, malls/ shopping complexes and business centers.

No such provision/ clarification

It has been long debated whether FDI should be permitted in commercial completed real estate. By their very nature, commercial real estate assets are stable yield generating assets as against residential real estate assets, which are also seen as an investment product on the back of the robust capital appreciation that Indian real estate offers. To that extent, if a company engages in operating and managing completed real estate assets like a shopping mall, the intent of the investment should be seen to generate revenues from the successful operation and management of the asset (just like a hotel or a warehouse) as against holding it as a mere investment product (as is the case in residential real estate). The apprehension of creation of a real estate bubble on the back of speculative land trading is to that naturally accentuated in context of residential real estate. To that extent, operation and management of a completed yield generating asset is investing in the risk of the business and should be

in the same light as investment in hotels, hospitals or any asset heavy asset class which is seen as investment in the business and not in the underlying real estate. Even for REITs, the government was favorable to carve out an exception for units of a REI from the definition of real estate business on the back of such understanding, since REITs would invest in completed yield general real estate assets. The Press Release probably aims to follow the direction and open the door for foreign investment in completed real assets, however the language is not entirely the way it should have been and does seem to indicate that foreign investment is allowed only in entities that are operating an managing completed assets as mere service providers and not necessarily real estate. While it may seem that FDI has now been permitted into completed commercial real estate sector, the Press Release leaves the question unanswered whether these companies operating and managing the assets may own the assets as well.

Foreign Investment Norms for Real Estate Liberalized



Analysis: The obligation to obtain all necessary approvals, including the business plans has now been clarified to be that of the investee company in India, doing away with the unnecessary hassles around this for investor.

III. ConclusionThe changes introduced by way of the Press Release are along expected lines after the Budget Speech earlier this year. The minimum land requirement was an impediment for foreign investment, since it was difficult to find large tracts of land for development to satisfy the minimum land requirements in

Tier-I cities. Further, the demand was inadequate for such investment to be made in Tier-II cities, where minimum land requirements could be met. Reducing or removal of minimum land requirements, along with removal of the requirement to obtain a completion certificate for sale of such plots would encourage foreign investment into this space.

While the final press note is still awaited to clarify certain aspects, this seems to be a positive move by the government to attract further investment.

Abhinav Harlalka and Ruchir Sinha



Responsibility for obtaining all necessary approvals

Investee Company. Investor/ Investee company.



￭ All pricing guidelines rationalized from DCF / RoE to “internationally accepted pricing methodologies”; and

￭ Partly paid shares and warrants can now be issued under automatic route subject to certain terms and conditions.

The Reserve Bank of India (“RBI”) this week introduced specific reforms with regard to foreign direct investments (“FDI”) in India. Specifically, these reforms are:

￭ Revision of pricing guidelines in respect of transfer / issue of shares (with and without options) to provide for greater freedom and flexibility for investors; and

￭ Recognition of partly paid equity shares and warrants as “eligible instruments” for the purpose of FDI and foreign portfolio investment (“FPII”) under the automatic route.

The reforms have been introduced through relevant amendments to the Foreign Exchange Management (Transfer or Issue of Securities to Persons Resident Outside India) Regulations, 2000 (“TISPRO Regulations”) and the issuance of various circulars.1 The amendment to TISPRO Regulations for the revision of pricing guidelines can be found here (http://rbi.org.in/Scripts/NotificationUser.aspx?Id=9105&Mode=0) and relevant RBI Circular No. 4 can be found here(http://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=9106&Mode=0). The amendment to TISPRO Regulations with regards to partly paid shares and warrants can be found here (http://rbi.org.in/scripts/NotificationUser.aspx?Id=9094&Mode=0) and the relevant RBI Circular No. 3 can be found here (http://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=9095&Mode=0).

I. BackgroundReflecting the evolution of pricing guidelines in line with the change in the business environment, the RBI Governor first indicated the RBI’s intention

to revise the pricing guidelines with respect to FDI in his First Bi-Monthly Monetary Policy Statement where he stated that it had been decided to withdraw “all existing guidelines relating to valuation in case of any acquisition/sale of shares and accordingly, such transactions will henceforth be based on acceptable market practices.” 2

The reforms relating to partly paid equity shares and warrants (under review since 2011) come as a pleasant surprise to the market, and once again will provide greater flexibility for facilitating and structuring investments in Indian companies.

II. Policy Evolution

A. Partly Paid Shares and Warrants

Until October 1, 2010, partly paid shares and warrants under the FDI policy were not considered to be “capital” for the purpose of foreign investment. However, Consolidated FDI Circular No. 2 of 2010 (effective from October 1, 2010) stated that partly paid shares and warrants could be issued subsequent to approval by the Foreign Investment Promotion Board (“FIPB”). This policy underwent further change through the Consolidated FDI Circular No. 1 of 2011 (effective from April 1, 2011), which noted that the policy relating to partly paid shares and warrants was under review. This position has been maintained in consequent FDI policies as well.

B. Pricing Guidelines

The pricing guidelines in case of listed shares have always been based on the price of the share as on the stock exchange3 and this continues under this present set of regulations. However, the policy on pricing guidelines with respect to unlisted shares has been amended over a period of time.

The erstwhile pricing guidelines were first introduced on May 4, 2010 via A. P. (DIR Series) Circular No.49 (“2010 Circular”) when the RBI

Annexure IXThe Curious Case of Pricing Guidelines

RBI Introduces a new Standards for Pricing Guidelines Amongst other Reforms

1. Specifically, relevant circulars are A.P.(DIR Series) Circular No.3 dated July 14, 2014 (“Circular No. 3”) and A. P. (DIR Series) Circular No. 4 dated July 15, 2014 (“Circular No. 4”).

2. Para 24, Reserve Bank of India, Dr. Raghuram G. Rajan, Governor, First Bi-monthly Monetary Policy Statement, 2014-15, April 1, 2014 available at http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=30911 (last visited on July 17, 2014)

3. Pricing guidelines are as prescribed by the Securities and Exchange Board of India (“SEBI”) (Issue of Capital and Disclosure Requirements) Regulations, 2009 (“ICDR Regulations”) in case of preferential allotment



did away with valuation requirements as per the Controller of Capital Issues (“CCI”) based guidelines and instead introduced valuation requirements based on the “Discounted Free Cash Flow” (“DCF”) method of valuation.

Further, earlier this year, a separate set of pricing restrictions was introduced only with regards to “FDI instruments having optionality clauses”.4 The main clarification issued under the Options Circular stated that shares issued to non-residents with options attached thereto would be allowed to be transferred if there were no assured returns.

C. Specifically

￭ Unlisted equity shares could not be sold at a price greater than the price arrived at on the basis of Return on Equity (“RoE”) as per the latest audited balance sheet;

￭ Unlisted compulsorily convertible debentures (“CCD”) or compulsorily convertible preference shares (“CCPS”) could be sold at a price worked out as per “any internationally accepted pricing methodology at the time of exit”.

It is not entirely clear why equity shares and convertible securities (with optionality clauses) were provided different treatment, but general market sentiment leaned towards issuance of convertible securities given the greater freedom provided to such instruments. Please see our hotline on the Options Circular and its impact, titled “Foreign Investors Permitted to Put: Some Cheer, Some Confusion” here (http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/article/cheers-for-offshore-funds-put-options-permitted.html?no_cache=1&cHash=02e2afb88f85c0c69750945d7ac21f59).

Since, the Options Circular, the RBI has clarified that it would rationalize all pricing guidelines, more formally reflected in the Bi-Monthly Monetary Policy referred to above. The current set of reforms is in furtherance of this intention.

III. Further Reforms

A. Partly paid shares and warrants noted as eligible instruments

Post review by the government and the RBI, and via Circular No. 3 as well as amendments to the TISPRO Regulations, partly paid shares and warrants can now be issued to non-residents (under the FDI and

the FPI route) subject to compliance with the other provisions of the FDI and FPI schemes.

With regard to partly paid shares, certain conditions need to be specifically complied with:

￭ Pricing of partly paid shares must be determined up front and at least 25% of the total consideration amount is required to be paid up front; and

￭ The remaining amount is required to be brought in within a period of 12 months of issuance.

Note: This 12 months period is not required where the issue size exceeds INR 5 billion. Further, a monitoring agency is required to be appointed (in the manner envisaged under applicable SEBI Guidelines) irrespective of whether the company is listed or unlisted, who will monitor the repatriation of monies into India within stipulated time.

For warrants, in line with the requirements of the ICDR Regulations, following are the conditions that need to be specifically complied with:

￭ Pricing and conversion formula / price is required to be determined up front and 25% of the total consideration is required to be paid up front; and

￭ The remaining amount is required to be brought in within a period of 18 months.

The price at the time of conversion should not be less than the fair value of the shares as calculated at the time of issuance of such warrants. It must further be noted that only companies in which investment can be made under the automatic route, can issue partly paid shares or warrants under this circular. For companies under the approval route, prior FIPB approval will be required to issue partly paid shares or warrants.

All partly paid shares and warrants issued under Circular No. 3 are required to be in full compliance with the Companies Act, 2013 and the Income Tax Act, 1961.

Circular No. 3 also clarifies that non-resident Indians will also be eligible to invest on a non-repatriation basis in partly paid shares and warrants in accordance with the Companies Act, 2013, applicable SEBI Guidelines, the Income Tax Act, 1961 and Schedule 4 to the TISPRO Regulations (which deals with investment by NRIs on a non-repatriation basis).

Circular No. 3 does not specify the consequence of not bringing in the remaining monies (with regard to partly paid shares / warrants) within the above mentioned period. However, as specified under the

4. Reserve Bank of India, Foreign Direct Investment- Pricing Guidelines for FDI instruments with optionality clauses, A.P. (DIR Series) Circular No. 86 dated January 9, 2014 (“Options Circular”). Please note that TISPRO Regulations were also amended in furtherance of the Options Circular.



SEBI regulations, it would likely result in “forfeiture” of the partly paid shares or warrants, although operational details in this regard will need to be specified.

B. Revised Pricing Guidelines

The DCF based pricing guidelines till date were set out in the 2010 Circular. The pricing guidelines

with respect to securities having options, based on RoE, were set out in Regulation 9 of the TISPRO Regulations read with the Options Circular.

Circular No. 3 and Circular No. 4 and the amendments to the TISPRO Regulations have revised the pricing guidelines to be as follows:

Description Previous Pricing Guidelines Current Pricing Guidelines

Issue of shares For listed securities:

Price worked out in accordance with the ICDR Regulations issued by the Securities and Exchange Board of India (“SEBI Guidelines”)

No amendment to this provision.

For unlisted securities:

Issue price to be not less than the fair value of shares determined as per DCF method.


Issue price to be not less than fair value of shares as per any internationally accepted pricing methodology for valuation of shares on arm’s length basis.

Transfer of shares from resident to non-resident

(R to NR)

For listed securities:

Transfer price to be not less than price at which a preferential allotment of shares can be made under the SEBI Guidelines;




Transfer price to be not less than fair value of shares determined as per DCF method.


Transfer price to be not less than fair value worked out as per any internationally accepted pricing methodology for valuation of shares on arm’s length basis.

Transfer of shares from non-resident to resident

(NR to R)


Transfer price to be not more than price at which a preferential allotment of shares can be made under the SEBI Guidelines;




Transfer price to be not more than fair value of shares determined as per DCF method.


Transfer price to be not more than fair value worked out as per any internationally accepted pricing methodology for valuation of shares on arm’s length basis.

Transfer of equity shares having optionality clause*

*Kindly refer to our analysis on scope of optionality clauses below.


Transfer price to be the market price prevailing at recognized stock exchange where shares are listed.




Transfer price to not exceed price arrived at on the basis of RoE as per latest audited balance sheet.


Transfer price to not exceed price arrived at as per any internationally accepted pricing methodology on arm’s length basis.

Transfer of convertible securities having optionality clause*

*Kindly refer to our analysis on scope of optionality clauses below.

Transfer price to be price as worked out as per any internationally accepted pricing methodology on arm’s length basis at the time of exit.

Transfer price to not exceed price arrived at as per any internationally accepted pricing methodology on arm’s length basis.

The Curious Case of Pricing Guidelines



As we have noted above, the pricing guidelines for listed securities have been mostly left unchanged. Although a case could be made for a more liberal pricing regime when listed securities are traded off the floor / or through off market transactions where value may be a product of negotiation. It is however, equally arguable that off market transactions also have an impact on the market and therefore should be subject to the same pricing regime.

IV. Guiding PrinciplesAs required before, all pricing must be duly certified by a chartered accountant or a SEBI registered merchant banker, and should be adequately disclosed in the financial statements of the company.

The fundamental principle to the newly issued pricing guidelines is that a non-resident investor should not be guaranteed any assured exit price at the time of making of such investment or entering into the investment agreement.

It must further be noted that for optionality based instruments the conditions relating to lock-in for one year or minimum lock-in period relating to the activity (if applicable) shall continue to apply.

V. What Does “Optionality Clause” Mean?

Although the above mentioned reforms go a long way in rationalizing the pricing guidelines applicable to FDI investments / disinvestments, there is still some ambiguity with regard to certain transfer permutations.

First, it is not clear if this “optionality” reference applies only to ‘put options’ or if it also applies to other forms of exits as well. Second, a plain reading suggests that even holding securities which have an option / right to exit at an assured return irrespective of the counter party for such rights, is not allowed under exchange control law since such instruments have been classified as “ineligible instruments”.

Given that quite a few foreign investors in India currently hold multiple avenues for exit, this clarity will help provide certainty to not just investors but also to investee entities and promoters.

VI. Doing away with DCFIn a move that will only boost foreign investor sentiments, the revised pricing guidelines will definitely provide investors (and Indian companies) more freedom and flexibility to negotiate investment

/ disinvestment transactions based on commercials agreed between parties.

One of the issues with the DCF based pricing guidelines was the dependency on the company for arriving at an accurate valuation. Inputs relating to cash flow projections, current and potential working capital amounts, capital expenditure and other items to determine an appropriate discount factor to cash flows needed extensive company inputs. This left a shareholder in a company relying on the company cooperation to arrive at an accurate amount which was not always available. Under the revised pricing guidelines, fair value can be arrived at without necessarily having to rely on extensive company inputs. This allows investors to determine the fair value and exit even where the company is not cooperating.

Another disadvantage of the DCF based pricing guidelines, (highlighted in our then hotline titled “RBI revises pricing norms for foreign investments” which can be found here (http://tmp.nishithdesai.com/old/New_Hotline/M&A/M&A%20Hotline_May1010.htm) was that the DCF based methodology for fair valuation restricted the valuer from basing his valuations on the assets approach or the market comparables approach. This was particularly problematic in industries with long gestation periods, or for distressed companies which had huge assets in their books but did not anticipate any future cash flows. This is no longer an issue.

VII. Understanding “Internationally Accepted Pricing Methodology At Arm’s Length”

An important item for consideration is potential disputes regarding pricing methodologies for agreements which refer to exits, purchase or sale at “fair market value”. If an agreement does not specifically state which methodology is to be considered, under the revised pricing guidelines it would be possible for parties with conflicting interests to obtain valuations under different pricing methodologies and arrive at completely different (and yet completely justifiable) “fair market values” for the same asset.

A view can, however, be taken that for existing agreements entered into till May 2010 (the date of the 2010 Circular) that CCI based pricing methodology would be applicable, and for agreements entered into after 2010 but before July 15, 2014 (i.e. the date of Circular No. 4) that DCF



based pricing methodology would be applicable. But going forward, it would be advisable to ensure that both parties agree to a pricing methodology up front in order to avoid potential disputes at the time of exit.

IFRS 13 “Fair Value Measurement” which sets out the IFRS standards for measuring fair value identifies two broad approaches to fair valuation: (a) market based approach; and (b) income based approach.

Under market based approach, IFRS outlines two techniques, identical / similar instrument technique and comparable company valuation multiples technique. Whereas under income based approach, the DCF technique figures along-side dividend discount model, constant-growth dividend discount model and capitalization model.

In all cases, both IFRS and generally, it must be noted that the choice of a valuation technique is a decision based on the peculiar facts and circumstances of a given transaction, sector and nature of the investee entity. It is likely that now onwards, most investment documents will clearly lay out the methodology which the parties agree to be the “internationally accepted pricing method” for arriving at fair valuation instead of leaving it ambiguous given the potential connotations under the new pricing regime.

Previously, in transactions between related parties, since transfer pricing guidelines (under tax law) were also applicable, share transfers/subscriptions between related parties resulted in the requirement for pricing studies to determine ‘arm’s length price’ that were different from the DCF valuation which was undertaken for exchange control purposes. The liberalization may also mean that a singular study analyzing and concluding the fair valuation at arm’s length could be used for both tax and exchange control purposes.

VIII. ConclusionThe biggest uncertainty for partly paid shares and warrants has always been as to when the balance amount will need to be brought in. By requiring that the full pricing for the partly paid shares and warrants be fixed up front and brought in within 12 and18 months, respectively, the RBI has ensured some comfort is afforded to both the company issuing the securities and the subscriber. This flexibility also enables structuring of earn-outs, post buy-out incentive payments to management and in structuring re-ups.

This full scale revision of pricing guidelines continues the RBI’s evolution with regards to how it seeks to regulate transfer / issuance of securities of Indian companies by / to FDI investors. Where previously, cross border transactions were heavily regulated and monitored by the RBI, we are looking at a shift which provides greater freedom and respects party autonomy.

By entrusting valuation intermediaries like chartered accountant and merchant bankers with the right to guide parties to fair valuation based on facts and circumstances of each transfer, the RBI also follows through on the general trend in modern Indian commercial laws where regulatory bodies’ are looking to delegate more and more operational regulation to intermediaries.

Prasad Subramanyan and Kishore Joshi


The Curious Case of Pricing Guidelines



In order to mitigate tax risks associated with provisions such as those taxing an indirect transfer of securities in India, buy-back of shares, etc., parties to M&A transactions may consider or more of the following safeguards. These safeguards assume increasing importance, especially with the GAAR coming into force from April 1, 2015 which could potentially override treaty relief with respect to tax structures put in place post August 30, 2010, which may be considered to be ‘impermissible avoidance arrangements’ or lacking in commercial substance.

I. NilWithholdingCertificateParties could approach the income tax authorities for a nil withholding certificate. There is no statutory time period prescribed with respect to disposal of applications thereof, which could remain pending for long without any clarity on the time period for disposal. In the last few years, there have not been many instances of such applications that have been responded to by the tax authorities. However, recently, in January 2014, an internal departmental instruction was issued requiring such applications to be decided upon within one month. The extent to which the instruction is adhered to remains yet to be seen.

II. Advance RulingAdvance rulings obtained from the Authority for Advance Rulings (“AAR”) are binding on the taxpayer and the Government. An advance ruling may be obtained even in GAAR cases. The AAR is statutorily mandated to issue a ruling within six months of the filing of the application, however due to backlog of matters, it is taking about 8-10 months to obtain the same. However, it must be noted that an advance ruling may be potentially challenged in the High Court and finally at the Supreme Court. There have been proposals in the 2014-15 Budget to strengthen the number of benches of the AAR to relieve this burden.

III. Contractual RepresentationsParties may include clear representations with

respect to various facts which may be relevant to any potential claim raised by the tax authorities in the share purchase agreement or such other agreement as may be entered into between the parties.

IV. EscrowParties may withhold the disputed amount of tax and potential interest and penalties and credit such amount to an escrow instead of depositing the same with the tax authorities. However, while considering this approach, parties should be mindful of the opportunity costs that may arise because of the funds getting blocked in the escrow account.

V. Tax InsuranceA number of insurers offer coverage against tax liabilities arising from private equity investments. The premium charged by such investors may vary depending on the insurer’s comfort regarding the degree of risk of potential tax liability. The tax insurance obtained can also address solvency issues. It is a superior alternative to the use of an escrow account.

VI. Legal OpinionParties may be required to obtain a clear and comprehensive opinion from their counsel confirming the tax liability of the parties to the transaction. Relying on a legal opinion may be useful to the extent that it helps in establishing the bona fides of the parties to the transaction and may even be a useful protection against penalties associated with the potential tax claim if they do arise.

VII. Tax IndemnityTax indemnity is a standard safeguard used in most M&A transactions. The purchasers typically seek a comprehensive indemnity from the sellers for any tax claim or notice that may be raised against the purchaser whether in relation to recovery of withholding tax or as a representative assessee. The following key issues may be considered by parties while structuring tax indemnities:

Annexure XSpecificTaxRiskMitigationSafeguardsfor

Private Equity Investments



A. Scope

The indemnity clause typically covers potential capital gains tax on the transaction, interest and penalty costs as well as costs of legal advice and representation for addressing any future tax claim.

B. Period

Indemnity clauses may be applicable for very long periods. Although a limitation period of seven years has been prescribed for reopening earlier tax cases, the ITA does not expressly impose any limitation period on proceedings relating to withholding tax liability. An indemnity may also be linked to an advance ruling.

C. Ability to Indemnify

The continued ability and existence of the party providing the indemnity cover is a consideration to be mindful of while structuring any indemnity. As a matter of precaution, provision may be made to ensure that the indemnifying party or its representatives maintain sufficient financial solvency to defray all obligations under the indemnity. In this regard, the shareholder/s of the indemnifying party may be required to infuse necessary capital into the indemnifying party to maintain solvency. Sometimes back-to-

back obligations with the parent entities of the indemnifying parties may also be entered into in order to secure the interest of the indemnified party.

D. Conduct of Proceedings

The indemnity clauses often contain detailed provisions on the manner in which the tax proceedings associated with any claim arising under the indemnity clause may be conducted.

E. Dispute Resolution Clause

Given that several issues may arise with respect to the interpretation of an indemnity clause, it is important that the dispute resolution clause governing such indemnity clause has been structured appropriately and covers all important aspects including the choice of law, courts of jurisdiction and/or seat of arbitration. The dispute resolution mechanism should take into consideration urgent reliefs and enforcement mechanisms, keeping in mind the objective of the parties negotiating the master agreement and the indemnity.

TP Janani and Ruchir Sinha


Specific Tax Risk Mitigation Safeguards for Private Equity Investments



India has entered into several BITs and other investment agreements. Relying on the BITs in structuring investment into India, may be the best way to protect a foreign investor’s interest. Indian BITs are very widely worded and are severally seen as investor friendly treaties. Indian BITs have a broad definition of the terms ‘investment’ and ‘investor’. This makes it possible to seek treaty protection easily through corporate structuring. BITs can also be used by the investors to justify the choice of jurisdiction when questioned for GAAR.

The model clauses for Indian BITs include individuals and companies under the definition of an “investor”. Further, companies are defined to include corporations, firms and associations. More importantly, Indian BITs adopt the incorporation test to determine the nationality of a corporation. This is a very beneficial provision as a holding company, which even though is merely a shell company, would not be excluded from treaty benefits.

Further, the word “investment” is defined to include every kind of asset established or acquired including changes in the form of such investment, in accordance with the national laws of the contracting party in whose territory the investment. It specifically includes the following within the ambit of investment:-

i. movable and immovable property as well as other rights such as mortgages, liens or pledges;

ii. shares in and stock and debentures of a company and any other similar forms of participation in a company;

iii. rights to money or to any performance under contract having a financial value;

iv. intellectual property rights, in accordance with the relevant laws of the respective contracting party; and

v. business concessions conferred by law or under contract, including concessions to search for and extract oil and other minerals.

The benefit of this is that even if the foreign parent or subsidiary is merely a shareholder in a locally incorporated Indian company, they would be able to espouse claims under the treaty by the virtue of their investment in the nature of shares in India. This again aids corporate structuring and enables an investor to achieve maximum treaty benefits. Thus, if the parent company incorporated within a non-treaty jurisdiction (P), carries out operation in India through an Indian subsidiary (S) which is held through an intermediary incorporated within a treaty jurisdiction (I), the parent company can seek protection of their investment in the subsidiary through the treaty benefits accrued to the intermediary (See fig 1).

Annexure XIBilateral Investment Treaties

Fig 1: Operations through an India subsidiary which is held through an intermediary in a treaty jurisdiction.

I Intermediary

P Parent Company

Incorporation in a Treaty Jurisdiction

Incorporation in USA

Indian Subsidiary

Shareholder

Shar

ehol

der

S Subsidiary



Further, it is an established principle under international law that minority shareholder rights too are protected under BITs. This gives a right to the non-controlling shareholders to espouse claims for losses to their investments. This also enables an investor to diversify its investments through different treaty jurisdictions which will enable the

investor to bring multiple claims under different proceedings to ensure full protection of one’s investment (See fig. 2). The exact right guaranteed to a particular structure will vary on case to case basis and can be achieved to the satisfaction of the investors by pre-analyzing treaty benefits at the time of making the investments.

Fig 2: Investment in Indian Investee Company through multiple Subsidiaries in different treaty jurisdiction.

Subsidiary No.1 (Mauritius)

Parent Co. (USA)

Subsidiary No.2(Netherlands)

Shareholder

Shareholder

Shareholder

Shareholder

Shar

ehol

der

Shareholder

Investee Co. (India)

Subsidiary No.1 (Cyprus)

An important point further in favour of the foreign investor investing in India is that India has lucrative BITs with almost all tax efficient jurisdictions including Mauritius, Netherlands, Switzerland,

Cyprus, Singapore etc. This enables an investor to achieve maximum benefit from one’s investment.

Bilateral Investment Treaties



One of the means of exit for shareholders of a real estate company and also a way of accessing global public capital is by way of flipping the assets of the real estate company into the fold of an offshore REIT vehicle.

Herein below, is a typical structure that may be adopted for flipping the assets into REIT vehicle structured as a Singapore business trust that could be listed on the Singapore stock exchange.

Annexure XIIFlips and Offshore REITs

Investors

Real Estate Company Indian SPV

Promoter

Investors

Trust Management Company

Singapore SPV

Investors

Singapore

Offshore

Units in the trust

100% owner

100% Equity /Listed NCDs

India

Real Estate Project

SBT

In this structure the promoter flips its interest in the real estate asset in India offshore which can then be utilized to raise global capital offshore or to give an exit to offshore investors.

I. In this Structurei. The individual shareholders of the Promoter

entity acquires an interest in the management company in Singapore under the liberalized remittance scheme (“LRS”) which sets up the Singapore business trust (“SBT”). LRS permits an Indian resident individual to remit upto USD 125,000 in any financial year for most capital / current account transactions.

ii. SBT in turn sets up an SPV in Singapore to invest in India. This is because a trust is not eligible to treaty benefits under the Indian Singapore tax treaty.

iii. The SPV then sets up the Indian SPV.

iv. The Indian SPV can then either purchase the real estate project on a slump sale basis on deferred consideration.

v. SBT can then raise monies by way of private placement or through listing of its units on the Singapore stock exchange. These monies can then be utilized to settle the deferred purchase consideration or purchase the real estate project.



vi. The proceeds from the sale of the real estate project may then be utilized to provide an exit to the shareholders in India, in particular the foreign investor in the real estate company.

II. Key ConsiderationsSome of the key considerations that may be considered while flipping assets into an offshore entity are as follows

i. Jurisdiction of the offshore entity and amenability to public markets

ii. Choice of Yield generating stabilized assets vs. developing assets as most offshore markets favor yield generating assets

iii. Need for on the ground presence and domestic sponsor and track record

iv. Appetite for Indian assets

v. Tax Challenges

vi. Regulatory Challenges

III. Tax and Regulatory Challenges

A. FDI Policy

A foreign company or a subsidiary of a foreign company is not permitted under the FDI Policy to acquire completed real estate assets, and can only invest in developmental assets as set out earlier in this paper. To that extent, either the SBT can acquire under construction real estate assets or other FDI Compliant assets such as SEZs, industrial parks, hospital etc. as provided in the FDI Policy and set out above. Also, other restrictions of FDI in real estate as set out earlier such as 3 year lock-in, DCF valuation and other issues as set out earlier in this paper also become applicable.

B. Holding of the Trustee Manager

Under the extant Indian exchange control regulations, only an Indian financial services company can invest in another financial services only with prior approval of the Indian financial services regulator (department of non-banking financial services in case of an NBFC investing overseas) and the overseas financial services regulator. However, based on our experience, such approval from the Indian regulator may be difficult to come through if the purpose of the overseas investment is to reinvest the proceeds in India, or

manage a trust that is entrusted with investing India. Accordingly, whilst an Indian real estate company will find it impossible to invest in the asset management company overseas (referring to the trustee-manager), even if the investment were through an affiliated Indian NBFC, regulatory approval may be challenging.

Accordingly, the promoters of the Indian Promoter entity may subscribe to units of the trustee manager under the LRS, which permits an Indian resident individual to remit upto USD 125,000 in any financial year to acquire shareholding in the trustee-manager. In our experience, Sponsor brand name typically is necessary for marketing the SBT.

C. Need for Indian SPV

Typically, any fundraise initiative by the SBT may not be received well by the investors unless the SBT has the real estate project in its fold. Since the SBT may not have adequate funds to purchase the real estate project initially, it may like to purchase the real estate project on a deferred consideration basis. However, since purchase of Indian securities on a deferred consideration is not permitted, the SPV may setup the Indian SPV, which could purchase the real estate project on deferred consideration basis, which shall be discharged in manner set out above.

D. Transfer Taxes on Flips

Any transfer of immoveable property is subject to stamp duty to be paid to state government where the property is located. The extent of stamp duty varies from state to state usually ranging from 5 - 8% on the market value of property or the actual sale consideration whichever is higher. To determine the market value, the local authorities have prescribed the reckoner / circle rates for each area which are generally revised on an annual basis.

In addition to the stamp duty, the Seller is obligated to pay tax on the capital gains received by it from the sale of the immovable property. If however, the sale consideration is lower than the reckoner rate, per Section 50C of the ITA the reckoner rate shall be deemed to be the consideration for the transfer of immovable property and the seller shall be taxed accordingly. Having said that, Section 50C is not applicable to immovable property which is held as stock-in-trade and not capital asset however, the Finance Bill, 2013-14 has inserted section 43CA (Special provision for full value of consideration for transfer of assets other than capital assets in certain cases) in the ITA which is a provision similar to Section 50C but applicable for assets other than capital assets, and since most developers record the

Flips and Offshore REITs



real estate project as stock-in-trade, to that extent also unlike before, the seller would now be taxed on the value adopted/assessed/assessable by any authority of a state Government for the purpose of payment of stamp duty on such transfer, thus denying the tax advantage of allowing the sale of the immoveable property at book value.

E. Structured Debt Instruments

Considering the restrictions of FDI in real estate (minimum area requirement, lock - in etc.) and the limited asset classes that can be rolled into an offshore REIT (being only FDI Compliant assets), SBT

may consider investing in the Indian SPV by way of acquiring listed NCDs of the Indian SPV or the real estate company under the FPI route as set out earlier in this paper.

In addition to the above, NCDs may also be issued where the investors are offered assured regular returns and exit. This is because, the interest on compulsorily convertible debentures may be capped at SBI PLR + 300 basis points and any returns beyond that may have to be structured by way of buy-back or dividends which entails a higher tax rate.



The Bombay High Court in Konkola Copper Mines (PLC) v. Stewarts and Lloyds of India Ltd.1 has now clarified that it would not be appropriate to hold that the reasons which are contained in the ruling in Bharat Aluminium Company and Ors. v. Kaiser Aluminium Technical Service, Inc. and Ors.2 (“BALCO”) would operate with prospective effect, and thereby to a certain degree have removed the ambiguity prevailing over the nature of prospective application of the BALCO judgment. The court explained that while the ratio of the BALCO judgment i.e. Part-I of the Arbitration and Conciliation Act, 1996 (“Act”) would apply only to arbitrations seated in India, operates with prospective effect, the interpretation of Section 2(1)(e)3 of the Act as provided by the Supreme Court would not be limited to a prospective application.

I. FactsThe Appellant had entered into certain contracts with the Respondents for the supply of particular materials. Dispute arose between the parties which were then referred to arbitration. The contracts entered into by the parties provided that the arbitration shall be conducted in accordance with the rules of arbitration of the International Chamber of Commerce and that the venue of arbitration shall be New Delhi. However, upon invocation of the arbitration, the Appellant proposed Mumbai as the ‘place of arbitration’. Such proposal was accepted by the Respondent. The arbitral tribunal constituted, passed an award in favour of the Appellant and the Appellant prior to enforcement of the award filed a petition under Section 9 of the Act, seeking certain interim reliefs requiring disclosure and freezing of assets.

The single judge hearing the petition under section 9 of the Act dismissed the same stating that in view of the agreement between the parties Part I of the

Act stood excluded and the mere fact that parties had agreed to the venue/place of arbitration as Mumbai, would not confer jurisdiction on the court in India.

Both parties were aggrieved by the order, filed an appeal as both parties asserted Part I of the Act applied however, the dispute was whether the jurisdiction was vesting with the High Court of Bombay or with High Court of Kolkata where the cause of action is said to have arisen.

The Respondent submitted that as the cause of action for the dispute has arisen in Kolkata, the Calcutta High Court would have jurisdiction over the dispute. The Respondents provided that by virtue of the judgment in Bhatia International v. Bulk Trading S.A.4 (“Bhatia International”), Indian courts may have jurisdiction even though the place of arbitration was not in India and accordingly various High Courts had held that place of arbitration was irrelevant for deciding the question of jurisdiction under Section 2(1)(e) of the Act. It was submitted that the court which would have territorial jurisdiction over the place where the cause of action is said to have arisen in relation to the dispute would be the court for the purposes of section 2(1)(e) of the Act.

The Appellants on the other hand argued that Parties had agreed to Mumbai as the place of arbitration. Further the in the BALCO judgment, the Supreme Court had clarified that the meaning of ‘Court’ as provided under Section 2(1)(e) of the Act would include the court of the place of arbitration. Therefore, the Bombay High Court had jurisdiction to hear the petition under Section 9 of the Act.

Thus, the issue inter alia was whether the interpretation of Section 2(1)(e) as provided under the BALCO judgment would apply only prospectively or would the interpretation be also applicable to agreements entered into by the parties prior to September 6, 2012.

Annexure XIIIBombayHighCourtClarifiestheProspective

Application of Balco

1. Appeal (L) No. 199 of 2013 in Arbitration Petitioner No. 160 of 2013 with Notice of Motion (L) No. 915 of 2013; and Appeal (L) No. 223 of 2013 in Review Petition No. 22 of 2013 in Arbitration Petition No. 160 of 2013

2. (2012) 9 SCC 5523. “Court” means the principal Civil Court of original jurisdiction in a district, and includes the High Court in exercise of its ordinary original civil

jurisdiction, having jurisdiction to decide the questions forming the subject-matter of the arbitration if the same had been the subject-matter of a suit, but does not include any civil court of a grade inferior to such principal Civil Court, or any Court of Small Causes

4. (2002) 4 SCC 105



II. JudgmentThe court initially taking note of the agreement reached between the parties provided that Mumbai is the seat of the arbitration.

The court then analyzed that if Mumbai was the seat of arbitration does Section 2(1)(e) confer jurisdiction on courts whose original civil jurisdiction extended over the place of arbitration, to deal with petitions under Section 9 of the Act. In this regard, the court noted that in BALCO, the hon’ble Supreme Court had held that section 2(1)(e), grants jurisdiction to both the courts i.e. the court within whose jurisdiction the seat of arbitration is located and the court within whose jurisdiction the cause of action is said to arise or the subject matter of the suit is situated. Accordingly, by virtue of the interpretation of Section 2(1)(e) in BALCO judgment, the Bombay High Court would have jurisdiction over the petition under section 9 as the place/seat of arbitration was Mumbai. The court cited the following text from the BALCO judgment:

“In our view, the legislature has intentionally given jurisdiction to two courts i.e. the court which would have jurisdiction where the cause of action is located and the courts where the arbitration takes place. This was necessary as on many occasions the agreement may provide for a seat of arbitration at a place which would be neutral to both the parties. Therefore, the courts where the arbitration takes place would be required to exercise supervisory control over the arbitral process. For example, if the arbitration is held in Delhi, where neither of the parties are from Delhi, (Delhi having been chosen as a neutral place as between a party from Mumbai and the other from Kolkata) and the tribunal sitting in Delhi passes an interim order under Section 17 of the Arbitration Act, 1996, the appeal against such an interim order under Section 37 must lie to the courts of Delhi being the courts having supervisory jurisdiction over the arbitration proceedings and the tribunal. This would be irrespective of the fact that the obligations to be performed under the contract were to be performed either at Mumbai or at Kolkata, and only arbitration is to take place in Delhi. In such circumstances, both the courts would have jurisdiction i.e. the court within whose jurisdiction the subject matter of the suit is situated and the courts within the jurisdiction of which the dispute resolution i.e. arbitration is located.”

Thus, it was to be understood if such interpretation of section 2(1)(e) as provided under BALCO would be applicable to arbitration agreements entered into prior to September 6, 2012.

The court noted that that the power of prospective ruling has been evolved by the courts to protect the rights of the parties and to save transactions which were effected due to the law which was previously applying.

Accordingly, it was seen that the Supreme Court had given the principle i.e Part I would apply only to arbitrations which have their seat in India, a prospective application to protect the transactions which were effected on the basis of the law laid down in Bhatia International. The court observed that the Supreme Court had molded the relief only to the extent that the ratio i.e. that the Part I shall apply only to arbitrations seated in India was to apply prospectively. This would mean that for international commercial arbitrations where seat is outside India under arbitrations agreements before September 6, 2012, the Part I may still apply unless it is expressly or impliedly excluded.

The court thus noted that it would be inappropriate to also apply the reasons contained in the BALCO judgment prospectively.

Accordingly, the court proceeded to set aside the order of the learned single judge and granted ad-interim reliefs in terms of temporary injunction against disposal of assets and sent the matter back for disposal on the merits of the case.

III. AnalysisA lot of debate surrounded the prospective application of the BALCO ruling. The BALCO judgment completely changed the landscape of the arbitration law in India and along with it the approach which was adopted by the courts towards arbitrations. The judgment discussed at length the meaning, scope and purport of various provisions of the Act before coming to the conclusion. However, the prospective application to the judgment gave rise to a significant amount of ambiguity regarding whether such prospective application would also extend to the reasons as provided or the interpretation provided under the judgment to certain provisions while arriving at the decision.

Accordingly, the present judgment of the Bombay High Court does lend assistance to a certain degree and is indicative of the fact that not everything that has been provided under the BALCO judgment is prospective in nature and the interpretation to



various provisions of the statute as provided would not be limited to a prospective application.

As per the judgment, the question regarding whether Part I would apply to an arbitration where the arbitration agreement was entered into prior to September 6, 2012 would be decided in accordance with the principle laid down in the Bhatia International case. However having once decided that Part I applies, the question which court would have jurisdiction to entertain applications

under Section 9 or Section 34 etc. would be decided in accordance with the principles provided in the BALCO judgment.

Prateek Bagaria, Ashish Kabra and Vyapak Desai


Bombay High Court Clarifies the Prospective Application of Balco



“Promoters of Unitech obtained the injunction due to the unreasonable notice period given to them,” the company said in an email release. “Outstanding loan amount was repaid in full by the promoters within a few days of obtaining the injunction and ahead of the schedule. The pledged shares got released nearly three months ago.”

The pledging of shares is a mechanism through which an investor or a lender can ensure a company or a borrower delivers a promised return or repays a loan within the stipulated period. When the company defaults on the pledge, the shares are sold. PE funds that focus on real estate have got such pledged shares from their portfolio companies.

“The Unitech case has raised concerns among PE investors about the enforceability of the pledge,” said Ruchir Sinha, co-head, real estate investments practice, at law firm Nishith Desai Associates. “Many funds are looking to enforce the pledge today, but are concerned if the company can take them to court and obtain a stay order.”

Realty valuations have been declining as some companies have been facing allegations of wrongdoing relating to bribes given for loans and the allocation of telecom spectrum, besides falling home sales and rising interest rates.

On 30 January, Unitech’s promoters approached the Delhi high court and secured an injunction against a move by debenture trustee Axis Trustee Services Ltd to sell pledged shares. The promoters of Unitech had raised Rs 250 crore from high networth individuals (HNIs) in 2010 through the issue of non-convertible debentures and had pledged their shares in the firm as security to raise these funds.

However, on 28 January, Unitech’s stock price dropped to Rs 51 per share, marking a 38% decline since November 2009 and triggering the default. The same day Axis Trustee Services informed the promoters that it would sell the pledged shares on the next working day, as per their agreement. Unitech moved the high court, which said that if the stay was not granted, the company would suffer “irreparable loss”.

Invoking a pledge can be challenging even in a publicly traded company, since the law requires that a fund must immediately sell the shares upon invocation; funds are often faced with the dilemma of whether to invoke the pledge or not, said Sinha.

“If they invoke the pledge, then they must ensure that the shares are sold, which may, apart from hammering the stock, earn a bad name for the fund,” he said. “If they don’t, and the share value falls, an argument can be made that they suffered the loss due to their failure to exercise their rights on time.”

The situation is even worse in a private company as there is generally no market for such shares, Sinha said.

“Any lender who has pledged shares as collateral runs the risk of ending up in court,” said a fund manager at one of the large domestic real estate funds, who declined to be identified as it was a legal issue.

Ideally, in a case where the lender decides to invoke the pledge even before the company defaults because of weak market conditions, the company should immediately provide for adequate additional security to avoid legal proceedings, he said.

There are three major forms of security that are available to lenders—mortgages, guarantees and share pledging. Realty funds are increasingly making investments through structured debt instruments and are looking at stringent security mechanisms and stock pledges are one of the most liquid form of security.

“This is a strong tool being employed by institutional investors today who are worried about their returns from their investment,” said Amit Goenka, national director of capital transactions at Knight Frank (India) Pvt. Ltd.

According to him, what is prompting investors to enforce pledging of shares is that the risk associated with real estate has risen and investors don’t believe they can get their returns on time.

There have been 10 investments worth $514 million (Rs 2,282.16 crore today) in real estate this year, according to VCCEdge, a financial research platform. Last year, there were 34 investments worth $1.16 million compared with 28 investments worth $870 million in the year earlier.

Some of the big investments in the sector include $450 million investment in DLF Assets Ltd by Symphony Capital Partners Ltd, $296 million invested in Phoenix Mills SPV by MPC Synergy Real Estate AG and $200 million invested in Indiabulls Real Estate Ltd by TPG Capital.

Annexure XIVChallenges in Invocation of Pledge of Shares



“Unfortunately, it is true that real estate funds want to invoke pledges,” said the general counsel of a local PE fund that has raised foreign money. He declined to be identified considering the sensitivity of the issue.

“If you see all the real estate companies, the extent to which shares have been pledged is increasing day by day,” he said. “In some of those companies, it

has reached the limit and they have nothing else to leverage. So, there is no other choice for those lenders, but to invoke the pledge.”

However, Sinha of Nishith Desai cautioned that enforcing a pledge will affect the reputation of the company as borrowers will become apprehensive of taking PE money.

Challenges in Invocation of Pledge of Shares



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