Month: July

Financial leverage is an important aspect in outbound tax
planning and the planning is typically aimed at effective use (deductibility) of
interest on debt incurred (whether third-party or internal) in conjunction with
a transaction. It may also be possible to claim deduction for interest in more
than one tax jurisdiction through judicious planning.

This can be illustrated as below :

In the above illustration, it may be possible to claim a
deduction for the interest in India and also in Country B. Further, if tax
consolidation is possible in Country B, then interest costs of the Buy Company
can be offset against the profits of the Target Company. At best, the home
country would only be able to retain a withholding tax on interest payments,
which may again be mitigated or reduced through proper treaty planning.

The expression ‘thin capitalisation’ is commonly used to
describe a situation where the proportion of debt to equity exceeds certain
limits. Thin capitalisation legislation is a tool used by tax authorities to
prevent what they regard as a leakage of tax revenues as a consequence of the
way in which a corporation is financed. Financing a resident corporation with
debt is considerably more efficient from a tax point of view than financing with
equity. The difference in tax treatment is an incentive to provide capital to
the corporation in the form of debt instead of equity. If there are no thin
capitalisation rules, it is relatively easy for a non-resident to advance funds
to a resident corporation in a way that is characterised as debt, so that the
payments on the debt are deductible as interest payments. This is true for
controlling shareholders in particular, because they are probably indifferent to
the form in which their investment is structured, and thus are likely to be
guided by tax considerations when structuring the legal form of their
investment.

The object of Thin Capitalisation Regulations is to prevent the use of excessive ‘in-house’ loans which would be detrimental to the revenue of home country (where the borrower is resident), by reason of the fact that profits would effectively be shifted to the foreign lender, as the interest payments would be tax deductible in the home country.

Countries, through Thin Capitalisation Regulations ensure that the deductions for interest on debt owed to connected parties, is allowable in the home country as a deduction in the hands of the borrower, only if within the permissible limits. While financial leverage has, on its own standing, its own value, this is definitely impaired when interest is not deductible either wholly or partially.

Overview of the Thin Capitalisation Regulations in some key jurisdictions:

A wide variety of methods are used to deal with thin capitalisation in various countries. These approaches range from complex legislation to no specific thin capitalisation legislation at all.

Within this range {our general approaches may be distinguished: (1) the fixed ratio approach (2) the subjective approach (3) application of rules concerning hidden profit distributions; and (4) the ‘no rules’ approach.

The emphasis on the above factors or combinations of factors often varies from country to country. Measures taken by countries to limit excessive debt financing by shareholders are either based on specific legislation or administrative rules or on practice.

Under the ‘fixed ratio’ approach, if the debtor company’s total debt exceeds a certain proportion of its equity capital, the interest on the loan or the interest on the excess of the loan over the approved proportion is automatically disallowed and/or treated as a dividend. The ratio may be used as a safe-haven rule. In this backdrop it should be noted that countries which use the fixed ratio approach usually have specific thin capitalisation legislation.

The basis of the ‘subjective’ approach is to look at the terms and nature of the contribution and the circumstances in which the financing has been made and to decide, in the light of all facts and circumstances, whether the real nature of the contribution is debt or equity. Some countries using the subjective approach have specific legislation. Other countries use more general rules if these are available, such as general anti-avoidance legislation, provisions on ‘abuse of law’, provisions on substance over form. There are also countries that apply ‘hidden profit distribution’ rules to reclassify interest as dividends. In some of these countries the hidden profit distribution rules are applied along , with specific rules which limit the deduction of interest on loans from shareholders. The general principles of transfer pricing rules may also playa role in this respect. The underlying idea is that if the loan exceeds what would have been lent in an arm’s-length situation, the lender must be considered to have an interest in the profitability of the enterprise and the loan, or any amount in excess of the arm’s-length amount, must be seen as being designed to procure share in the profits.

This article provides an overview of the the Thin -‘” Capitalisation Regulations in five major world economies: France, Germany, the Netherlands, the United Kingdom (UK) and the United States (US).

While some countries, like France, have detailed regulations, others like the UK, do not specify a debt: equity ratio, but merely give the right to the Inland Revenue to challenge the interest deductions keeping in view the arm’s-length principle.

France:

Deductibility of Interest – an overview:

New Thin Capitalisation Regulations were introduced for the financial year beginning on or after January 1, 2007. Related party interest falling within the scope of the new Regulations is tax-deductible only to the extent that it meets two tests, which are applicable on a standlone basis at the level of each borrowing company, as opposed to a consolidated basis.

These tests are the Arm’s-Length Test and the Thin Capitalisation Test.

Conditions for disallowance:

Under the Arm’s-Length Test, the interest rate is capped to the higher of the following two rates:

• The average annual interest rate on loans granted by financial institutions that carry a floating rate and that have a minimum term of two year; and

• The interest rate at which the French Company ould have borrowed from any unrelated financial institution (for example, a bank) in similar circumstances.

The portion of interest that exceeds the higher of the above thresholds is not tax-deductible and must be added back to the French Company’s taxable income for the relevant financial year.

Under the Thin Capitalisation Test, the deductibility of interest may be restricted, even if the conditions specified under the Arm’s-Length Test have been met with.

Here, the interest paid in excess of the following three thresholds is not tax-deductible:
 
The Thin Capitalisation Regulations now stand combined with the General Interest Limitation rules.
 
•    The debt-to-equity  ratio threshold,  which is calculated in accordance with the following for- The Business Tax Reform (2008), introduced a new mula (The amount of interest that meets the concept for restriction of the interest deduction. The Arm’s-Length Test x 150% of the net equity of restriction applies regardless of whether the inter-the borrower at either the beginning or end of est is paid to a related party or an unrelated lender, the financial year. The total indebtedness of the such as a bank. French borrowing company resulting from borrowing from related companies);

•    The earning threshold, which equals 25% of the adjusted current income. The adjusted current income is the operation profit before deducting the following items: tax; related-party interest; depreciation and amortisation; and certain spe-cific lease rents;

• The interest income threshold, which equals interest received by the French Company from related companies.

If the interest that is considered to be tax-deductible under the Arm’s-Length Test exceeds all three of the above thresholds, the portion of the interest that exceeds all three of the above thresholds is not tax-deductible, unless the excess amount of interest lower than Euro 150,000.The nondeductible portion of interest is added back to the taxable income of the borrowing entity. However, it can be carried forward for deduction in subsequent financial years. A 5% reduction applies each year to the balance of the interest carried forward to future financial years beginning with the second subsequent financial year .

Exemptions:
The above thresholds that limit the deductibility of interest do not apply if the French borrowing company can demonstrate that the consolidated debt-to-equity ratio of its group is higher than the consolidated debt-to-equity ratio of the French borrowing Company on a standalone basis (based on its statutory accounts). In determining the consolidated debt-to-equity ratio of the group, French and non-French affiliated companies and consolidated net equity and consolidated group indebtedness (excluding inter-company debt) must be taken into account.

Germany:
Deductibility of Interest – An overview:
The Thin Capitalisation Regulations now stand combined with the General Interest Limitation rules.

The Business Tax Reform (2008), introduced a new concept for restriction of the interest deduction. The restriction applies regardless of whether the interest is paid to a related party or an unrelated lender, such as a bank.

This new Regulation, which is effective for tax years beginning after 25 May 2007 and ending on after 1 January 2008, applies to companies resident in Germany, companies residing abroad but maintaining a permanent establishment in Germany and partnerships with German branch.

Conditions for disallowance:
The new rule disallows’ excess net interest expense,’ which is defined as the excess of interest expenses over interest income if such excess exceeds 30% of the earnings before (net) interest, tax, depreciation and amortisation (EBITDA).

Exemptions:
The limitation rule does not apply if any of the following conditions is satisfied:

•    The net interest expense is less than Euro 1 million;

•    The Company is not a member of a consolidated group (a group of companies that can be consolidated under International Financial Re-porting Standards);

•    The equity ratio of the German subgroup is equal to or higher than the equity ratio for the group as a whole, as shown on the balance sheet of the preceding fiscal year (so-called ‘escape clause’). A ‘group’ is defined as a group of entities that could be consolidated under IFRS, regardless of whether a consolidation has been actually carried out. The escape clause does not apply if any entity in the worldwide group has received loans from a related party not included in the group and if the interest paid on such debt exceeds 10% of the net interest expense.

The Netherlands:

Deductibility  of Interest –    An overview:

Since 1 January 2004, when the Thin Capitalisation Regulations first came into effect, there have been several amendments, such as broadening the definition of debt.

In general, in the Netherlands, interest expenses (and other costs) with respect to related party loans (or deemed related party loans) may be partly or completely disallowed if the taxpayer is part of a group, as defined under Dutch generally accepted accounting principles (GAAP /international financial reporting standards (IFRS). Further, even if an external debt is formally granted by a third party but is in fact owed to a related party, the Thin Capitalisation Regulations apply.

Conditions for disallowance:

The Regulations provide two ratios to determine the amount of excess debt.

Under the first ratio, which is a fixed ratio, the average fiscal debt may not exceed more than three times the Company’s average fiscal equity plus Euro 500,000. For the purpose of this ratio, debt is defined as the balance of the company’s loan receivables and loan payables. The balance sheet for tax purposes is used to determine the average debt and equity.

The second ratio is  the group ratio. When the Company files its corporate tax return, it may elect to apply for the group ratio. Under this alternative, the Company may look at the commercial consolidated debt-to-equity ratio of the (international) group of which it is a member. If the Company’s commercial debt-to-equity ratio does not exceed the debt-to-equity ratio of the group, the tax deduction for interest on related-party loans is allowed.

In certain circumstances, The Dutch Supreme Court has also in its judgements re-characterised loans as informal capital contributions.

The deduction of interest paid including related costs and currency exchange results, by a Dutch company on a related-party loan is disallowed to the extent that the loan relates to one of the following transactions:

•    Dividend distributions or repayments of capital by the taxpayer or by a related company or
a related  individual  resident  in the Netherlands;

•    Capital contributions by a taxpayer, by a related Dutch company or by a related individual resident in the Netherlands into a related company; or

•    The acquisition or extension of an interest by the taxpayer, by a related individual resident in the Netherlands in a company that is related to the taxpayer after this acquisition or extension.

Exemptions:

This interest deduction limitation does not apply  if either of the  following conditions are  satisfied:

•    The loan and the related transaction are primarily based on business considerations;

•    At the level of the creditor, the interest on the loan is subject to a tax on income or profits that results in a levy of at least 10% on a tax base determined under Dutch standards, disregarding the patent and group interest boxes (which offer certain tax concessions. However, effective from 1 January 2008, even if the income is subject to tax of at least 10% at the level of the creditor, interest payments are not deductible if the tax authorities can demonstrate it to be likely that the loan or the related transaction is not primarily based on business considerations. The measure described in the preceding sentence applies to loans that were in existence on 1 January 2008, with no grandfathering.

The United States:

Deductibility of Interest – An overview:
The US has thin capitalisation principles under which the Internal Revenue Service (IRS) may attempt to limit the deduction for interest expenses if a US corporation is thinly capitalised. In such case, funds loaned to it by a related party may be recharacterised by the IRS as equity. As a result, the corporation’s deduction for interest expense may be considered distributions to the related party and be subject to withholding tax.

Conditions for disallowance:
It can be said that the US adopts a facts-and-circumstances approach in determining whether or not a US corporation is thinly capitalised and whether an instrument should be treated as equity or debt.

While no fixed rules exist, a debt-to-equity ratio of 3 : 1 or less is usually acceptable to the IRS, provided the US corporation can adequately service the debt without the help of related parties.

However, a deduction is disallowed for certain ‘disqualified’ interest paid on loans made or guaranteed by related foreign parties that are not subject to U.S. tax on the interest received. This disallowed interest may be carried forward to future years and allowed as a deduction.

In addition under the US Treasury Regulations, interest expense accrued on a loan from a related foreign lender must be actually paid before the US borrower can deduct the interest expense.

Exemptions:
No interest deduction is disallowed under the above provision if the payer corporation’s debt-to-equity ratio does not exceed 1.5. If the debt-to-equity ratio exceeds this amount, the deduction of any ‘excess interest expense’ of the payer is deferred.

The United Kingdom:

 As mentioned earlier, the Regulations in the UK are broad based rather than specific. In other words, UK’s transfer pricing measures apply to the provision of finance (as well as to trading income and expenses). As a result, Companies are required to self assess their tax liability on financing transactions using the arm’s length principle. Consequently, the Inland Revenue may challenge interest deductions on the grounds that, based on all of the circumstances, the loan would not have been made at all, or that the amount loaned or the interest rate would have been less, if the lender was an unrelated third party acting at arm’s length.

European Union (EU) aspects of Thin Capitalisation Rules:

In the case of EU countries, the tax environment is subject to significant external influence in the form of the Ee Treaty and decisions of the European Court of Justice (ECJ). The ECJ decision in the Lankhorst-Hohorst has revived discussions on the compatibility of thin capitalisation rules with the non-discrimination principle of the EC Treaty. The ECJ held in that case that the German thin capitalisation rules which applied only to non-resident companies violated the freedom of establishment provision contained in Article 43 of the EC Treaty. A number of EU countries have thereafter decided to amend their thin capitalisation rules and extent their applicability to resident companies as well.

Thus, in any tax planning exercise involving a financial leverage, Thin Capitalisation Regulations must be taken into cognisance, especially if one of the objectives of such an exercise is to minimise the Global Effective Tax Rate.

While in most of the countries in the world, the top
executives are trying to survive their jobs and positions and while this is the
first time when maximum CEOs are hated by their shareholders, the independent
Directors are trying to run away from their current position. One of the reports
of Economic Times says that, since Satyam scandal and Nagarjuna case, “there are
over 500 independent directors in India who have resigned from their respective
positions on the Board citing reasons ranging from ill-health to work
pressures”. The resignation of one director or a succession of them,
particularly of independent directors, may indicate something untoward in terms
of corporate governance or commercial developments. Investors should be made
aware of these changes. There is almost a situation of fear-psychosis amongst
almost all Boards where Directors who hardly spend any time and who are hardly
paid anything are expected to perform much more with all the responsibilities
and liabilities of the CEO or an executive director. This is not to suggest that
there is something untoward in every Indian company where independent directors
have resigned in the past. That would be too rash a conclusion to draw. It could
also be the fear of potential liability. Independent directors are often
understandably fearful about this issue for two reasons :

I think the first category of companies are not finding it
difficult to get the independent directors as they are looking for true trouble
shooters and expert professionals to come on the Board whereby reputation of
both, the company and the director, will be elevated by such person coming on
the Board. Such directors are well remunerated and spend reasonable time in the
committees and the Board meetings, asking all odd questions and seeking
clarifications to ensure that the company does not knowingly take any decision
against the interest of any of the stake holders. There is a misconception that
independent directors are sitting on the Board only to take care of the minority
shareholders’ interest. Legally that may not be the correct position.
Independent directors are expected to use their experience and professional
skills to take care of the interest of all the stakeholders, i.e.
shareholders, suppliers, customers, employees, regulators and the society at
large. Thus decisions like payment of dividend need not be looked at if they
benefit majority or minority shareholders but need to be verified with general
principles of the dividend payments, cash outflows, payout ratios, etc.

The second categories of companies generally appoint their ‘own’, ‘known’, ‘friendly’ independent directors. These directors are expected to create least resistance in the Board meeting on any proposal that promoter may bring in. If the family or group does not hold majority stake in the company, they are more careful while appointing independent directors. Though. the law prescribes the criteria of independent directors, such promoters like to have supportive board members rather than trouble-shooters. Thus, though these companies seemingly comply with the Board composition requirements, the independent directors may not act independently as expected by law and regulators. The paperwork of the board may be kept compliant with all the laws and regulations but in spirit, the Board may not be performing their expected duties. The public shareholders need to be more vigilant while investing in such companies.

The third category is more interesting. As per earlier SEBI observation, maximum non compliant companies to clause 49 so far as Board composition is concerned, were PSUs. The enormous delays in appointing independent directors by respective Government departments or ministries on PSU Boards were quite glaring. Here the independent directors are ‘nominated’ by Government who also happens to be the majority shareholder of the Company. How can one be sure that such directors nominated by the majority shareholders can act as independent directors? This particular point was raised at a few forums in front of Government officials but is never satisfactorily answered to my knowledge.

SEBI as the custodian of the shareholders’ interest, appointed various committees to advise on the Corporate Governance. Kumarmangalam Birla Committee (1999), Naresh Chandra Committee (2002), Narayan Murthy Committee (2003). Every report added a few more suggestions on Board composition, Board Remuneration, Board meeting Pro-cedure, disclosure of Directors’ interests, code of conduct for the Board and definition of independent directors. However, the law has sufficient scope for the improvement based on practical difficulties. While all the committee reports have the same objective of improving corporate governance, what needs to change is the mindset of the promoters and the independent directors. Legally one may’ qualify’ as independent director but what is important is if such person indeed acts independently and asks right probing questions. I think, currently importance is given more to ‘form’ than ‘substance’ and that has its own repercussions. On one side the independent directors of Satyam get clean chit while those who were members of the Board of Nagarjuna in 1999 get arrested in 2009 !

Liabilities of the Board Members:

Every law needs to have punishments and liabilities prescribed to ensure that the law is complied with. The economies in United States of America thrived due to various reasons, but one of them was promoters and owners had limited liability. This allowed them to take risks in the business. Some failed but many flourished. Post Enron, the laws like SOX put the limited liability concept to an end. The CEO and CFO of the company now are personally liable for various things. More than the actual liability, the fact that one is vulnerable to such draconian fines and/ or arrests has literally made senior management paranoid about day to day business of the business that they run. No business can progress when the Board, CEO and CFOs are running business in paranoia. In India, we are entering similar scenario after the non executive Board members were arrested in 2009 for something to the best of their recollection happened in 1999 or prior to that. Satyam is another example. While the law and regu-lators moved very quickly against the culprits, the fraud was disclosed by the confession letter from one of the promoters. Till then, even the Board, the regulators and the auditors and senior management of the company and the market analysts, who tear your numbers every quarter, had not doubted that the company had serious problems to the extent of Rs.7000 crores. On the other hand, the company was growing normally and receiving corporate governance awards! I think both these instances have put many independent directors in dilemma. I have seen the changed atmosphere in the Board meetings post Satyam. The questions that are asked to the Auditors are as basic as if they verified Bank Statements! This fear is forcing many independent directors to resign from their position.

In the recent past, independent directors were perceived as playing a passive role in the company. The recent resignation phenomenon may not be because the directors suspect any messy stuff in the company but god forbids, if there are skeletons in the cupboard, your reputation is at stake. The job of the Directors is truly becoming difficult. For mere Rs.20,000 sitting fees per quarter, it may not be worth making one vulnerable to bad publicity, financial fines and may be arrest. In reality, as independent director, one spends a few hours in the quarter in the Board room. The audit committee spends a few more hours with CFO and Auditors and goes through what is presented to them. With their experience, they can ensure that there does not seem any apparent wrong in the numbers and there is no ground not to believe the numbers based on variances and QoQ and YoY analysis. In the current recessionary conditions, many directors may suspect that the managements and promoters may have more tempting reasons to take extra business risks and do any unacceptable adjustments in the numbers. Such  distrust might have made many sitting directors very uncomfortable. These circumstances taken together might have led to a situation where companies are finding very difficult to get independent directors on the board.

Having said that, the past track-record of directors being held liable for actions of the company favours independent directors. In an influential series of studies carried out across several countries (though not including India), it was found that the risk of liability on independent directors is far lower than what commentators and directors themselves believe. Even in a litigious society such as the U.S., it was shown that there were only a handful of cases where directors in fact had to make payments (and these include the high profile Enron and WorldCom settlements). The researchers show that these were cases where there was a ‘perfect storm’ scenario (e.g. where the company was in bankruptcy, the D&O insurance was inadequate, and so on), unlikely to occur in most circumstances. However, independent directors are indeed concerned not about direct financialliability but the time, cost, lost opportunity and reputational risk that accompany the mere initiation of legal action against them, even if that action does not succeed in the end. In the past the financial liabilities under company law were insig-nificant and in most of the cases, matters used to get settled between company secretary and the regulators without directors even being aware of it. However, now fear of arrest/imprisonment has really put a lot of scare in the minds of people. For example, the Chairman of the Audit Committee can be arrested for not attending the AGM. Empirical study may not reveal alarming examples in India in the past but the current instances make one feels vulnerable. On February 1 of this year the cn has made the representation to the Parliamentary Standing Committee on the subject suggesting that the liabilities of independent directors should be handled in a different way than that of the executive directors or non independent directors as independent directors are not involved in the day-to-day working of the company. Unless personally involved, there should not be any criminal liability attached to independent director.

Peculiar Indian  scenario:

In a few international studies, India was found culturally in a unique situation. I am sure countries like Japan also would fall under similar situation. The study observed that in most of the cases in India, Chairman/Chairperson of the Board is a very senior (both by age, stature or experience) and hence it is not considered prudent to question the Chairman in the meeting on any matter. This kind of culture restricts the independence of a director. If you are an independent director, and if you feel the decision that is sought by the Board is not in the interest of the stakeholders, you must raise the point and question the decision. In the process of Board discussion, you may get convinced or you may convince the board. But having no discussion as a part of the culture is very harmful for the corporate governance process in the company.

A similar situation is observed in the PSUs as well. If the independent director, appointed by the Government is a person junior to the Chairman (which is normally the case), he or she does not contradict or question the Chairman of the Board. His or her organisational hierarchy comes in the way and prevents him/her from questioning the Chairman in the Board meeting.

I have seen in some cases where such directors discussing a situation what they call ‘off line’. However, such practices are not healthy from corporate governance point of view. Such discussions also do not get recorded in the minutes of the Board and hence are forgotten about later. I feel, once you are sitting on the Board, you are personally responsible for all the acts of the Board and one must act to the best of his or her ability to ensure that healthy, transparent and useful discussions take place in the Board irrespective of your positions outside the Board.

Going  forward:

I think, globally, we have same issue on independent directors. The mind set of the person getting appointed as director must be of one to act without fear or favor. If in your professional capacity, you feel the company is not acting in the interest of the stakeholders, you must question such actions and ensure that they are recorded in the minutes. We may not overcome the problem overnight but to slowly get over this issue, I have following quick suggestions-:
 
1. Independent Directors must be appointed/ nominated by a separate meeting of the minority shareholders, not representing the majority investors. A separate meeting of such minority shareholders must be conveyed prior to the AGM to nominate such independent directors and AGM should formally appoint such independent directors. The majority shareholders should not play any role in such appointments directly or indirectly. Any vacancy of the Board seat between two AGMs may be filled in by other independent directors continuing on the Board like Additional Director.

2. To ensure that the independent directors spend adequate time, they must be compensated well. Mere sitting fees of Rs.20,000 is obviously not enough. Such fees can be capped based on profits of the company or can be a fixed sum.

3. Independent Directors should not get any options. Having options, generally may affect their independent status.

4. Chairmen of the committees must be a rotating position. At least in three years, a new member must be appointed as chairman of Audit /Compensation committee. Such provision would help a board to get new and fresh views.

5. Liability of independent directors should be distinguished from the executive directors and non independent directors. No criminal liability should be attached to independent director for the acts of the company or other executive directors unless the independent director has personally committed a willful criminal act. This obviates the situation where independent directors can not be arrested unless personally and willfully involved in a criminal act.

I feel, the above changes will bring some sanctity in the process and intent of having independent directors on the board.

Post Satyam, it is not only necessary that culprits are punished quickly but also the process is cleansed to achieve intended results that regains investors’ confidence in Indian Companies.

The basic objective of corporate governance is to segregate
the functions of governing the company and managing the company. This is done by
establishing a governing body (alias the Board) and giving it adequate
independence to direct and supervise the actions of management. To strengthen
its independence, the governing body is constituted through a mix of internal
and external parties. Board’s independence is a sine qua non for
effective governance.

Clause 49 does make demarcation between Governing Body and
Managing Body; this ensures independence to an extent. But at the end of the
day, the leader of both the bodies is the same person i.e., the CEO.
Unlike the Combined Code in the UK, Clause 49 does not mandate splitting of
roles of Chairman and CEO. So in effect, the person responsible for managing the
company is also responsible for managing the Board — which further implies that
the functions of managing and governing are effectively in the hands of the same
person, thereby violating the basic principle of independence and concept of
corporate governance.

In theory, the Board and the Chairman are responsible to
critically evaluate and challenge the actions of the management and the CEO. But
in a scenario where the Chairman of the Board and CEO of the company is the same
person, the Chairman becomes responsible for evaluating his own performance and
challenging his own decisions, which at first instance sounds grotesque, if not
impudent. Albeit, there are other members also on the Board along with CEO, who
are responsible for ensuring independence — combining or not splitting two roles
does jeopardize and weaken the Board’s independence, particularly in Indian
context, where the Board Meetings are largely influenced and driven by its
Chairman making Board Meetings person-driven instead of process-driven. It has
been often evidenced that such meetings are largely led by the Chairman,
undermining and suppressing the roles of other independent directors who often
are fairly new on the Board and thereby putting the Chairman-cum-CEO in further
advantageous position.

Clause A.2 of the Combined Code succinctly provides that –
‘There should be a clear division of responsibilities at the head of the company
between the running of the Board and the executive responsibility for the
running of the company’s business. No one individual should have unfettered
powers of decision’.

It further states — The division of responsibilities
between the chairman and chief executive should be clearly established, set out
in writing and agreed by the Board. A chief executive should not go on to be
chairman of the same company. If exceptionally a Board decides that a chief
executive should become chairman, the Board should consult major shareholders in
advance and should set out its reasons to shareholders at the time of the
appointment and in the next annual report.

While the UK law makers do endorse that splitting of roles is
an indispensable component of Board’s independence, they further go to criticise
the consolidated model on the grounds that management might be more tempted, and
more able, to withhold information (which generally means bad news) from the
Board, thereby reducing its ability to assess the company’s performance.
Independence apart, many argue that one person can’t carry out two such
increasingly difficult jobs. Separating them frees the CEO to focus on running
the business and the Chairman to discharge the board’s expanding
responsibilities.

In the United Kingdom, about 95% of all FTSE 350 companies
adhere to the principle that different people should hold each of these roles.
In the United States, by contrast, nearly 80% of S&P 500 companies combine them
— a proportion that has barely changed in the past 15 years.

Clause 49 partly addresses the issue of independence by
mandating that if the Chairman is an executive director, at least fifty percent
of the Board members shall comprise of ‘independent directors’. In case, the
Chairman is a non-executive director, then the minimum number of independent
directors shall be one-third. However, the clause does not mandate that only an
independent director shall be chairman of the Board and that there should be a
clear division of responsibilities between the running of the Board and running
of the company’s business.

Separating the two roles in itself, is not the panacea for
making Boards more effective and even after such separation there is no
guarantee of improvement in the Board’s performance; however, such separation
will indubitably add to the Board’s independence and empower it to critically
challenge the actions of management and CEO. Clause 49 should mandate the
separation of the two functions; in other words, the Chairman of the Board and
CEO of the company shall be two distinct persons.

Whether one agrees or not, whistleblowers have a
crucial role to play in corporate governance and can save a corporate
titanic from hitting an ice berg by striking the bells at the right
time. The Enron saga and its downturn started with whistleblowers.

Clause
49 does have a provision for a whistleblower policy, but the provision
is recommendatory in nature. While many of large cap companies have
voluntarily formulated a whistleblower policy, not many companies listed
on stock exchange have a ‘whistleblower’ policy.

Even in those
companies which have implemented a ‘Whistleblower’ policy, it is evident
that the Policy, akin to many other policies, becomes a mere paper
document posted on company’s website. The Policy therefore, is
implemented in letter and not in spirit. There are very few instances on
record wherein the policy has been able to bring out the issues buried
underground and take apposite actions. In majority of companies, the
employees are either oblivious of such a policy or are not willing to
take its recourse and have selected silence as an option.

To boil down, there are two reasons for whistle-blowing not being effective in the Indian scenario

Firstly, having a formal whistleblowing policy is still not mandatory.

Secondly,
the existing corporate culture does not support or rather empower an
employee to stand up and blow the whistle – it is cultural and other
soft factors that impede an employee from coming forward and blowing the
whistle despite formal protection available under the policy.

Whistle
blowers normally lose their jobs and find difficult to get employment
elsewhere. Even in the U.S. Government, whistleblowers get shunted
(source: Financial Express, 12-5-2008).

The cultural deficit
exists because there is lack of adequate commitment and communication
from the Board and management who are reluctant to empower its employees
– in some cases, the reluctance is deliberate while in other cases it
is due to the fact that implementing such a policy requires change, and
any change, particularly cultural change, is difficult to implement.
While latter cases can be pardoned, the former cannot be; deliberate
reluctance from management and Board might be due to fear that such a
policy may act as a key to ‘Pandora’s Box’ and may become’ Achilles
Heel’ of the management by exposing its wrong deeds.

Suggestive prescription:
Following is the suggestive prescription to make whistleblowing an effective tool of corporate governance in Indian scenario.

Giving regulatory hue:
At
the outset,’ prescribing a ‘whistleblower’ policy should be made
mandatory. This will at least initiate formal adoption of the policy and
its implementation, at least in letter, if not in spirit. The auditors/
company secretary, while issuing certificate on corporate governance,
should be required to comment on the adequacy of such a policy.

Allow Anonymous Whistle Blowing:
Despite
the existence of formal policy and conducive culture, employees don’t
consider this tool as a preferred option to highlight wrongdoing within
the organisation. One way to overcome this impediment is to allow
anonymous whistleblowing. Under anonymous reporting, the whistleblower
is not required to disclose his/her identity at the initial stage. Being
anonymous provides an innate protection to the complainant.

This
mechanism however has a risk of impudent issues being reported to Board
and the Board may find itself being mingled among trivial issues which
could have been easily resolved by the management. Also, anonymous
whistleblowing is feasible only at the initial stage of screening of the
issue; once the investigation begins, the anonymous whistleblower
should be willing to come out and testify as a witness. As a matter of
fact the anonymous whistleblower in an anonymous complaint should offer
to do so. In the absence of his willingness, unless a prima facie case
exists, it is likely that the enquiry would be dropped.

Allowing external whistleblowing :
Enact
a law as in the Philippines, where there is a separate law called
‘Whistleblower Protection Act’, which provides legal protection to
whistleblowers for voicing against corruption practices within an
organisation.

Raise the issue with external independent agency,
like company’s auditors who whilst conducting their audit would take
cognizance of such an issue. However, the problem with the above model
is – once a fraud/corruption issue is reported to an external agency, it
becomes rhetoric and has the risk of sabotage to company’s reputation.

Extending Whistleblower policy to other stakeholders:
Whistleblowing,
as a tool to disclose misconduct and graft, is used in a restrictive
sense and embraces only employees within the company including
directors. Under the existing model of whistleblowing, it is only the
employees who are empowered to blow whistle.

An organisation
constitutes of several other stakeholders apart from employees and
includes suppliers, customers, government and local community. Quite
often these stakeholders are confronted with an act of corruption or
misconduct while dealing with the company, especially the suppliers and
customers. Such transactions are not reported by internal employees to
conceal their unscrupulous deeds. In such a scenario the external
stakeholders, say, suppliers or customers should have an opportunity to
disclose such scheming conduct to company’s governing body. There should
be some mechanism whereby even the external stakeholders have an
opportunity of blowing whistle to the Board of Directors.

The
mechanism suggested is akin to ‘grievance cell’ found in many companies,
where the customers have a right to file a complaint in case of any
dis-satisfaction. However, unlike a grievance cell, under this mechanism
an external stakeholder has the right to report any misconduct on the
part of company to the Board of Directors.

It is hoped that
extending the whistleblower mechanism to other stakeholders will promote
greater transparency in company’s conduct of business and improve its
value among the stakeholders at large.

Cons of the idea:

Despite
its benefits, the idea of extending whistle-blowing model to other
stakeholders has not been widely acclaimed. One contention is – what
would an external stakeholder gain by whistle blowing particularly when
he himself has benefited from such fraudulent conduct. However, the
argument against this contention is that corporate governance is meant
to protect interest of all the stakeholders and not just the
shareholders or employees; by disclosing solecism conduct he not only
benefits the company, but also protects his own interest and long-term
value; in fact, it becomes his ethical responsibility to make such
disclosure, as he is also economically associated with the organisation.

It
is also argued that the above mechanism may lead to trivial issues
being escalated and may in fact become a mode to express dissatisfaction
rather than expose misconduct. Embedded therein is also the risk of it
being deliberately misused by external stakeholders whose relationship
with the company has soured.

Evaluating performance of non-executive and independent directors:

The
primary role of non-executive and independent directors on the Board is
to critically challenge the actions and decisions of Executive Board
and management. Apart from maintaining independence and integrity, they
are also expected to provide fresh insights and bring their
competencies, thereby enhancing the value to stakeholders.

Evaluation of NED under Clause 49 is currently recommendatory. Such evaluation is necessary for the following reasons:

1. To determine whether a non-executive director has delivered on his/her expectations.
2. To determine whether he has contributed to enhance overall effectiveness of the Board.
3. To determine whether a particular director should continue on the Board.
4. To link remuneration of non-executive directors to their performance.

In
the current scenario, majority of the Indian companies do not have a
formal process in place to evaluate performance of non-executive
directors. The primary reason is that:

Suggestive prescription:
The
evaluation can be done by establishing a peer review committee which
should consist of Board members other than the director whose
performance is being evaluated. The peer review committee can meet on
periodic basis (say, on bi-annual or annual basis) to evaluate
performance of directors.

The following are the suggestive
criteria for evaluating performance of non-executive and independent
directors. The criteria are only illustrative and may vary depending on
requirement of each Board:

Practical Case: Infosys Technologies Limited
Currently,
there are very few companies in India which have voluntarily instituted
a formal mechanism for evaluation of non-executive members. For
instance – In Infosys, the performance of NED is evaluated through ‘peer
evaluation process’, wherein each external Board member is required to
present before the entire Board on how he has performed or added value;
the performance is evaluated on a scale of 1 to 10 based on set
performance criteria. The criteria used by Infosys are:

Conclusion:
The
aspects covered present potential pitfalls and areas of improvement in
existing Clause 49. While the suggestive prescriptions are not foolproof
and exhaustive, the purpose is to trigger a thought process and
initiate ‘deliberation’, which can lead to strengthening of corporate
governance.

One can summarise the Balance Sheet of Life in the above
manner.

A professional commands respect in the society because his
motto is ‘Pride of service in preference to personal gain’. He is described as
one who places public good above his personal gain. This is the reason why
Government, financial institutions and members of the public rely on a CA for
his expert advice. This reliance imposes a public interest responsibility on our
members, when they render services in the field of accounting, taxation or other
fields.

For the success of any professional, it is essential that
there is a strong base provided by the regulating body to which he is
answerable. The system of education, training and examination should be such
that he is able to command the respect and confidence of the members of the
society. The users of professional services require an assurance that the member
of the profession whose services are retained is (i) a person of character and
integrity and (ii) competent and knowledgeable to render professional services.

The character and integrity of a professional will depend on
his personal qualities. This will also be guided by the environment in which he
has taken his education and training as well as the environment in which he is
working. His position can be maintained and strengthened only if the regulating
professional body is able to guide and encourage its members to live upto the
high ethical and professional standards. The prestige and confidence enjoyed by
a professional, to a great extent, depends on the strictness and scrupulous
manner in which the professional code is implemented.

Bhagavad Geeta classifies castes (not communal) on the basis of different qualities and actions of a person. According to this classification a ‘Brahmana’, in whatever community the person is born, is one whose wisdom and knowledge is in his nature. Self-restraint, purity, uprightness and wisdom are the qualities of a ‘Brahmana’, It is for this reason that in the Indian Society all professionals, such as a CAs, lawyers, doctors, etc. are considered as Brahmanas. A C.A. professional does not own a business or industry but he does act as advisor of a businessman because of his study and knowledge. For this purpose, he has to keep himself updated in his knowledge as he is in constant touch with his client during his audit, tax and other assignment year after year. In other words, he has to be a student throughout his life.

Fundamental principles:

Our Institute has identified the following fundamental principles by which any professional should be governed in the conduct of his professional relations with others.

i) Integrity:

A professional should be straightforward, honest and sincere in rendering professional services.

ii) Objectivity:

A professional should be fair and should not allow prejudice or bias, conflict of interest or influence of others to override objectivity.

iii) Independence:

When in public practice, a professional should both be and appear to be independent. Integrity and independence are the most essential characteristics of any professional. Independence implies that the judgement of a person is not subordinate to the wishes or directions of another person who might have engaged him or to his own self interest.

iv) Confidentiality:

Information acquired in the course of his professional work has to be treated as most confidential. This should not be disclosed to anyone without specific authority of the client or unless it is required to be disclosed for compliance with legal or professional requirements.

v) Technical standards:

He must discharge his duties in accordance with the technical and professional standards relevant to the work assigned to him.

    vi) Professional  competence:

He must maintain high level of competence throughout his professional career. He should un-dertake only such work which he or his firm is competent to handle and complete within the given time frame.

vii) Ethical behaviour:

A professional should conduct himself in a manner consistent with the good reputation of the profession and refrain from any conduct which might bring discredit to the profession.

A professional who keeps the above seven principles before him and adopts them in his day-to-day practice can achieve great success in his professional practice. One may say it is difficult to adopt all these principles in the present day environment. However, if a professional wants to have peace of mind and get inner satisfaction of having served the society and the profession, he will have no option but to follow the path identified by the above principles.

Conduct in other fields:

Our Institute strives to maintain discipline amongst our members not only on matters relating to their professional conduct but also in relation to their conduct in other fields. It is for this reason that the Institute is given power to take disciplinary action against a member if he is found guilty of ‘Other Misconduct’. This is a very wide term. The Institute has, however, taken the view that a member of the profession is expected to maintain the highest standards of integrity in his personal conduct and any deviation from this high standard, even in personal affairs, would expose him to a disciplinary action.

A professional may be holding an office in a social or service organisation in his personal capacity. He may be a member, treasurer, secretary or chainman of such organisation. He may be an arbitrator, executor, liquidator or trustee in any trust, etc. in his personal capacity. In all such situations, his actions and decisions relating to financial, legal and other matters should be above board and he should not take any personal benefit in such capacity. This is because the society expects that a professional person will render service even in his personal capacity in the same manner as he renders his professional service.

When CA. Act was amended in 2006, Part IV was added in the First Schedule to provide that a CA., whether in practice or not, will be guilty of ‘Other Misconduct’ if he is held guilty by any Civil or Criminal Court of an offence which is punishable with imprisonment for a term not exceeding six months. It also provides that, if in the opinion of the Council, an action of any CA brings disrepute to the profession or the Institute, whether or not such action is related to his professional work, he will be held to be guilty of ‘other misconduct’.

Similarly, Part III has been added to the Second Schedule to provide that if a CA., whether in practice or not, is held guilty by any civil or criminal court for an offence which is punishable with imprisonment for a term exceeding six months, he shall be considered  as guilty of ‘Other Misconduct’.

Ethics in profession:

The word ‘Ethics’ is defined to mean ‘moral principles, quality of practice, a system of moral principles, the morals of individual action or practice’. Accordingly, his behaviour towards his professional brothers and sisters, his employees, articled assistants, clients, users of his service and general public should be governed by the above ethical principles. His personal conduct in a capacity other than his professional work should also be governed by these ethical principles.

The C.A. Act and Regulations provide for the Code of Ethics. Our Institute also publishes literature on the subject from time to time. As stated earlier, certain fundamental principles have been identified. Some of the Do’s and Don’ts about ethical behaviour of a c.A. professional are listed as under:

    i) Cannot engage in any business or occupation without the permission of the Council.

    ii) Cannot enter into partnership or share fees with a non-professional. Recently some relaxations are made about sharing of fees/partnership with other designated professionals such as Company Secretaries, Cost Accountants, Advocates, etc.

    iii) Cannot solicit professional work or advertise professional attainments, subject to certain exceptions.

    iv) Cannot charge fees based on percentage/ contingency.

v) Cannot allow a member who is not in practice or not his partner to sign financial statements or audit opinion on his behalf or on behalf of his firm.

    vi) Cannot disclose information acquired during the course of his professional or other engage-ment without the client’s permission.

    vii) Cannot express opinion on financial statements of an enterprise in which he or his relatives have substantial interest. This restriction also applies if his firm or a partner of the firm has substantial interest in the enterprise.

    viii) Performs professional duties without due diligence or is grossly negligent while performing his duties.

    ix) Cannot keep client’s money without opening separate bank account.

    x) Contravences any of the provision of the CA Act, Regulations and directions of the Council of ICAI.

Some quotations:

It may be useful to refer to two quotations of eminent personalities about how one should conduct oneself in life.

i) Oscar Wilde has said about Meanings as under:

Standing for what you believe in,
Regardless of the odds against you,
and the pressure that tears at your resistance,

… means  courage

Keeping a smile on your face,
when inside you feel like dying,
For the sake of supporting others,

… means    strength

Stopping  at nothing,
And  doing what’s  in your heart
You know is right,

… means    determination

Doing more than is expected,
To make another’s life a little more bearable,
Without uttering a single complaint,

… means compassion
 
Helping  a friend  in need,
No  matter the time or effort,
To the best of your ability,

… means    loyalty

Giving  more than you have,
And  expecting  nothing
But nothing  in return,

… means    selflessness

Holding  your head high
And  being the best you know you can be
When life seems to fall apart at your feet,
Facing each difficulty with  the confidence
That time will bring you better tomorrows
And  never giving  up,

… means    confidence.

ii) Late  Shri 1.R.D.  Tata  on Guiding  Principles:

A true professional:

Late Shri Nani A. Palkhiwala has explained as to who can be called a True Professional, as under:

-Not only financial integrity

But

– Intellectual  integrity  also.

    The higher the man goes in life the humbler he should-be.
 

In this context a Bhajan by Narsingh Mehta is most appropriate.

Vaishnav    Jan :

– Who is vaishnav – A person who is nearer to Lord Vishnu.

– He who knows  difficulties of others.

– He who will help the needy person but will not boast about the same.

– He who is humble to all and will never speak ill of others.

– He who is upright in his   

– Speech

– Hearing others

– Mind

– He who will always speak truth.

– He who will never touch monies belonging to others.

– He who is never greedy.

– He who is detached  and never  angry.

If a person can imbibe these qualifies of a true vaishnav he can be a ‘true professional’.

In this article an attempt has been made to explain what qualities a professional has to have in his life.

When a person wants to choose his career and take a decision whether to join a business or profession, he should be ready to make a sacrifice if he selects to join a profession. He will have to keep in mind that motto of a profession is ‘Pride of Service in preference to personal gain’. He has to place public good above his personal gain. He cannot mix profession with business as there will be conflict of interest. As stated earlier, a professional has to keep the fundamental principles enunciated by professional bodies uppermost in his mind while performing his duties. He has to follow these principles even in his personal actions not connected with his professional duties. In short, he has to act as a ‘Vaishnav’ to be a true professional. He has to draw up Balance Sheet of his life at periodical intervals and determine whether it gives a ‘true and fair view’ of his behaviour and actions.