BCAJ | Bombay Chartered Accountant Journal

BOOK REVIEW

FORENSIC INVESTIGATIONS AND FRAUD REPORTING IN INDIA

Authors: Sandeep Baldava and Deepa Agarwal

Reviewed by Satish Shenoy

A home without books is like a body without a soul. My major investment in life is books. I was delighted when my professional colleagues Sandeep and Deepa gave me this book, fresh from the press. Something inside me instantly told me that I need to read this book cover to cover. Our minds are truly shaped by the books we read.

Here are a few thoughts on the book.

This book, aimed to benefit a cross-section of professionals, including Forensic Practitioners, Independent Directors and Audit Committee Members, CEOs / CFOs / CHROs, Statutory Auditors, Internal Auditors, Corporate, Legal, Accounting and Compliance teams and students alike, introduces all the essential ideas that are to be found in the work of Forensic Investigations and Fraud Reporting in India in a concise and straightforward manner. Each activity is described not only in terms of its relevance but also the science and reasoning that underpins it.

Be insatiably curious. Ask ‘why’ a lot – and that’s exactly what the authors did. While employing examples from Forensic Investigation, the book uses principles and ideas applicable to most of the forensic sciences. The authors examine the role of the investigator, describe the fundamental methods for investigation, discuss the optimal way to organise evidence and explore the most common reasons why some investigations fail. The book provides case studies that exemplify proper communication of findings. Concise and illustrative, this volume demonstrates how scientific methods can be applied to investigation in ways that avoid flawed reasoning while delivering convincing reconstruction scenarios. Investigators can pinpoint where things went wrong, providing valuable information that can prevent another catastrophe.

As I dived deep into the book, I told myself, ‘Don’t read the book and be a follower, read the book and be a student’. Covering a range of fundamental topics essential to modern Forensic Investigation, the book presents contributions and case studies from the personal files of experts in the field. It discusses the intersection of law and forensic science, how pieces of information become evidence and how courts decide whether an item or testimony is admissible. It provides insights on how practitioners must follow evidence all the way from the incident scene to laboratory analysis and even on to the judicial authorities. Going beyond theory to application, the book incorporates the wisdom of the authors who discuss anonymous real life case studies and their rich experience in the subject. Each chapter begins with an introduction and ends with a conclusion. The ‘Expert Speak’ sections at the end of a few chapters showcase contributions from high-profile experts in the field.

Life is like a book – don’t jump to the end to see if it is worth it. Going by the size of the book, I was indeed tempted to jump to the end. But my daughter Sneha read my mind (she has this uncanny knack) and remarked, ‘Daddy, just enjoy every page of it and you will find the script more interesting and exciting’. The words hit me like it was the last word said on the subject. So let me continue…

A practical, accessible and informative guide to the science of Forensic Investigations and Fraud Reporting, the book has 20 chapters very logically divided and covering the fundamentals of White Collar crime; Ethics, Integrity and Fraud; Governing Framework including roles and responsibilities of Stakeholders towards prevention, detection and investigation; Financial Statements Fraud, including roles and responsibilities of Statutory Auditors; Evolution, types, methodology and approach to FRM and Forensic Investigation; Frauds at Financial Institutions, including banks; Forensic Standards; Cyber Fraud Risks with illustrative examples of reporting. I particularly enjoyed the case studies which encompassed various facets of business such as procurement, critical information leakage, phishing, window dressing and fund diversion – the learnings are immense. I also appreciate the ease with which the roles of the Boards, the Internal Auditor, the CFOs and other CXOs are explained. The emphasis on the science of law enforcement, how evidence is gathered, processed, analysed and viewed in the courtroom and more, were a delight. This informative book also includes an extensive index, adding to its usefulness. It contains over 100 case studies, case laws and examples.

Good books are like good company. As I read the book, I got the feeling that I am in good company – well done, Sandeep and Deepa. Forensic document examination is a long-established specialty and its practitioners have regularly been shown to have acquired skills that enable them to assist the judicial process. The book introduces all the essential ideas that are crucial in the work of the Forensic Document Examiner and Fraud Reporting in a concise and straightforward manner. Each examination type is well described in detail in chapter 12.

The reader will be able to relate the different kinds of interpretative skills used by the document examiner to those used in other forensic disciplines. Besides being an invaluable text for readers, the book will also be a useful reference for researchers new to the field or practitioners looking for an accessible overview.

Written in an easy-to-understand format, this outstanding guide by two of the leading professionals with wide experience in Forensic Investigations and Reporting introduces you to the basics of Forensic Investigation and Fraud Reporting. It teaches us excellent ways to make our investigation solid and successful. It is packed with valuable information about the details of collecting, storing, and analysing all types of physical evidence.

Life is a book of mysteries; you never know which page will bring a new twist; so keep on reading and happiness will come suddenly – this is precisely what I felt when reading this book. Most investigations begin at the end of the story, namely, after the collapse. In many instances, information about the last event and the starting event is known reasonably well. Information about what occurred between these endpoints, however, is often unclear, confusing and perhaps contradictory. Chapter 13 explains how scientific investigative methods can best be used to determine why and how a particular event occurred and how it is to be reported.

Rules related to admissibility of evidence in India (13.6.4.3) explore the legal implications of forensic science – an increasingly important and complex part of the justice system. In the ‘Expert Speak’ section of chapter 13, Aditya Vikram Bhat, Senior Partner, AZB & Partners, brings out the different facets of applicability and importance of attorney-client privilege.

Assessing the strengths and limitations of each kind of evidence, the authors also discuss how they can contribute to identifying the ‘who,’ ‘how,’ and ‘whether’ questions that arise in criminal prosecutions; they draw on the depth of their Forensic Investigation and Fraud Reporting experience to provide a well-rounded look at these increasingly critical issues. Case studies have very effectively brought the issues to life and show how forensic science has been used in real-world situations.

The reader will learn how real-world forensics experts work every day in fields as diverse as Biology, Psychology, Information Technology and more. If you are interested in a forensics career, you will find out how to break in and the education you will need to do the type of forensics work that interests you the most. Written for the true forensics fan, the book does not shy away from the details – why are frauds committed (1.7), Evolution of Fraud (1.8), Definition of Fraud (chapter 2), Integrity and Ethics (chapter 3), Reporting Regulations under various statutes (chapter 4), Role of Directors (chapter 6), Role of Internal Auditors (chapter 7), Financial Statement Frauds (chapter 9), Identification of Frauds, including role of whistle-blowers (chapter 10), Types of Forensic Investigation in India (chapter 12), Audit vs. Forensic Investigation (chapter 14), Forensic Accounting and Investigation Standards by the ICAI (chapter 18), Cyber Fraud Risk and the Auditor’s Role (chapter 19) and lastly the Illustrative Reporting (chapter 20). What more can one ask from one book?

The book includes coverage of physical evidence, evidence collection, crime scene processing, pattern evidence, fingerprint evidence, questioned documents and computer and digital forensic evidence. The authors’ 40-plus years of investigation, forensic science laboratory experience, regulatory compliance and auditing experience is brought to bear on the application of forensic science to the investigation and prosecution of cases.

A truly international and multi-disciplinary compendium of current best practices authored by the ones amongst the best in the profession, the book covers current trends and technology advances in various disciplines including forensic science. The book serves as an invaluable resource and handbook for forensic professionals, auditors and directors, audit committees and CEOs / CFOs / CHROs in India

Let me list a few new learnings for me from the book – The Fraud Diamond Theory (1.7.2), Theory of Dark Triad Personality (1.7.3), Robinhood Fraudsters (1.7.4), Working of a Ponzi Scheme (Amit Garg ‘Expert Speak’), the Social Psychology of Corruption (3.4), SOX Section 302 (6.2.7), Whistle-blower complaints – CVC (10.14), some of the rules related to Admissibility of Evidence (13.6.4.3), few Insights in using Predictive Analytics for Fraud Prevention (15.6.6) and few aspects of Common Security Elements that entities may use to prevent or detect a cyber-attack (19.6.1).

I particularly liked the way that important topics were handled and here are a few examples – Case studies of White Collar Crime (1.7.6), Social Psychology of Corruption (3.4), Management’s Responsibility to
prevent Fraud (5.2), Internal Auditor in Spotlight (7.6), Stages of Identification of Fraud (8.5), Financial Statement Frauds (9.6), how to Mitigate Common Fraud Risks (9.9), Best Practices for an effective Whistle-blowing Mechanism (10.15), Impact of Whistle-blowing Systems (10.16), Learnings from Arthasastra (11.3 and 11.4), the entire chapters 12 to 14 (which to my mind are the fulcrum of the book), Case Studies on Banking Frauds (16.9 to 16.12), chapter 17 on Case Studies (real life examples based on the rich experience of the authors) and chapter 18 on ICAI Standards (which I am so proud to be an integral part of).

I read with great interest chapter 19 on Cyber Risk which appears towards the end. I must mention that the focus is limited to the role of auditors but the topic deserved more attention. Perhaps the authors will delight us with this and more in the next edition.

Let me read the mind of the authors before they started this book project, ‘If there is a book that you want to read but has not yet been written, write it.’ That’s precisely what Sandeep and Deepa have done.

A few final take-aways:
* It is better to fail with honesty than succeed with fraud.
* One best book is equal to hundred good friends.
* That’s the thing about books. They let you travel without moving your feet.
* A clear sign we are stupid is if we do not read new books.
* The problem with a good book is, the moment you read that last word, you wish you hadn’t.
Well done, Sandeep and Deepa. I am proud of you.

shailesh.kwebmaker

Reassessment – Notice u/s 148 – Validity – Effect of insertion of s. 148A by F.A. 2021 – Taxation and other laws (relaxation of certain provisions) Act, 2020 enabling certain actions of Department in view of pandemic – Notification of Finance Ministry under enabling Act – Notification could not save reassessment proceedings under unamended s. 148 instituted after 1st April, 2021 – Notices issued in pursuance of such reassessment proceedings – Not valid

28 Ashok Kumar Agarwal vs. UOI [2021] 439 ITR 1 (All) A.Ys.: 2013-14 to 2017-18; Date of order: 8th October, 2021 Ss. 147, 148 and 148A of ITA, 1961

Reassessment – Notice u/s 148 – Validity – Effect of insertion of s. 148A by F.A. 2021 – Taxation and other laws (relaxation of certain provisions) Act, 2020 enabling certain actions of Department in view of pandemic – Notification of Finance Ministry under enabling Act – Notification could not save reassessment proceedings under unamended s. 148 instituted after 1st April, 2021 – Notices issued in pursuance of such reassessment proceedings – Not valid

Writ petitions were filed by individual petitioners to challenge the initiation of reassessment proceedings after 1st April, 2021 by issuing notice u/s 148 for different assessment years.

The Allahabad High Court held as under:

‘i) An Act of legislative substitution is a composite Act. Thereby, the Legislature chooses to put in place another or replace an existing provision of law. It involves simultaneous omission and re-enactment. By its very nature, once a new provision has been put in place of a pre-existing provision, the earlier provision cannot survive, except for things done or already undertaken to be done, or things expressly saved to be done. By virtue of section 1(2)(a) of the Finance Act, 2021, the provisions of sections147, 148, 149, 151 (as those provisions existed up to 31st March, 2021) stood substituted and a new provision was enacted by way of section 148A which mandated that the A.O. before issuing any notice u/s 148 shall conduct an inquiry, if required with the prior approval of the specified authority and provide to an opportunity to the assessee of being heard.

ii) The Taxation and Other Laws (Relaxation of certain Provisions) Act, 2020 had been passed to deal with situations arising due to the pandemic. This enabling Act that was pre-existing had been enforced prior to enforcement of the Finance Act, 2021 on 1st April, 2021. In the 2020 Act and the Finance Act, 2021, there is absence both of any express provision in itself or to delegate the function to save applicability of the provisions of sections 147, 148, 149 or 151 of the Act as they existed up to 31st March, 2021. Plainly, the 2020 Act is an enactment to extend timelines only. Consequently, it flows from the above that from 1st April, 2021 onwards, all references to issuance of notice contained in the 2020 Act must be read as a reference to the substituted provisions only. Equally, there is no difficulty in applying the pre-existing provisions to pending proceedings. Looked at in that manner, the laws are harmonised. A reassessment proceeding is not just another proceeding emanating from a simple show cause notice. Both under the pre-existing law as also under the law enforced from 1st April, 2021, that proceeding must arise only upon jurisdiction being validly assumed by the assessing authority. Till such time jurisdiction is validly assumed by the assessing authority evidenced by issuance of the jurisdictional notice u/s 148, no reassessment proceedings may ever be said to be pending.

iii) The submission that the provision of section 3(1) of the 2020 Act gave an overriding effect to that Act and therefore saved the provisions as they existed under the unamended law, cannot be accepted. That saving could arise only if jurisdiction had been validly assumed before the date 1st April, 2021. In the first place section 3(1) of the 2020 Act does not speak of saving any provision of law. It only speaks of saving or protecting certain proceedings from being hit by the rule of limitation. That provision also does not speak of saving any proceeding from any law that may be enacted by Parliament in future. Even otherwise the word “notwithstanding” creating the non obstante clause does not govern the entire scope of section 3(1) of the 2020 Act. It is confined to and may be employed only with reference to the second part of section 3(1) of the 2020 Act, i.e., to protect proceedings already underway. There is nothing in the language of that provision to admit a wider or sweeping application to be given to that clause – to serve a purpose not contemplated under that provision and the enactment wherein it appears. Hence, the 2020 Act only protected certain proceedings that may have become time-barred on 20th March, 2020 up to the date 30th June, 2021. Correspondingly, by delegated legislation incorporated by the Central Government, it may extend that time limit. That time limit alone stood extended up to 30th June, 2021.

By Notification No. 3814 dated 17th September, 2021 ([2021] 437 ITR (St.) 16)], issued u/s 3(1) of the 2020 Act, further extension of time has been granted till 31st March, 2022. In the absence of any specific delegation, to allow the delegate of Parliament to indefinitely extend such limitation would be to allow the validity of an enacted law, i.e., the Finance Act, 2021 to be defeated by a purely colourable exercise of power, by the delegate of Parliament. Section 3(1) of the 2020 Act does not itself speak of reassessment proceeding or of section 147 or section 148 of the Act as it existed prior to 1st April, 2021. It only provides a general relaxation of the limitation granted on account of general hardship existing upon the spread of the Covid-19 pandemic. After enforcement of the Finance Act, 2021 it applies to the substituted provisions and not the pre-existing provisions.

iv) The mischief rule has limited application in the present case. Only in case of any doubt existing as to which of the two interpretations may apply or as to the true interpretation of a provision, the court may look at the mischief rule to find the correct law. However, where plain legislative action exists, as in the present case (whereunder Parliament has substituted the old provisions regarding reassessment with new provisions with effect from 1st April, 2021), the mischief rule has no application. There is no conflict in the application and enforcement of the 2020 Act and the Finance Act, 2021. Juxtaposed, if the Finance Act, 2021 had not made the substitution to the reassessment procedure, the Revenue authorities would have been within their rights to claim extension of time under the 2020 Act. However, upon that sweeping amendment made in Parliament, by necessary implication or implied force, it limited the applicability of the 2020 Act and the power to grant time extensions thereunder, to only such reassessment proceedings as had been initiated till 31st March, 2021. Consequently, the notifications had no applicability to reassessment proceedings initiated from 1st April, 2021 onwards. Upon the Finance Act, 2021 being enforced with effect from 1st April, 2021 without any saving of the provisions substituted, there is no room to reach a conclusion as to conflict of laws. It is for the assessing authority to act according to the law as it existed on and after 1st April, 2021. If the rule of limitation is permitted, it could initiate reassessment proceedings in accordance with the new law, after making adequate compliance therewith.

v) A delegated legislation can never overreach any Act of the principal Legislature. Secondly, it would be over-simplistic to ignore the provisions of either the 2020 Act or the Finance Act, 2021 and to read and interpret the provisions of the Finance Act, 2021 as inoperative in view of the fact and circumstances arising from the spread of the Covid-19 pandemic. Practicality of life de hors statutory provisions may never be a good guiding principle to interpret any taxation law. In the absence of any specific clause in the Finance Act, 2021 either to save the provisions of the 2020 Act or the notifications issued thereunder, by no interpretative process can those notifications be given an extended run of life beyond 31st March, 2020. They may also not infuse any life into a provision that stood obliterated from the statute with effect from 31st March, 2021. Inasmuch as the Finance Act, 2021 does not enable the Central Government to issue any notification to reactivate the pre-existing law (which that principal Legislature had substituted), the exercise by the delegate / Central Government would be de hors any statutory basis. In the absence of any express saving of the pre-existing laws, the presumption drawn in favour of that saving is plainly impermissible. Also, no presumption exists that by the notification issued under the 2020 Act the operation of the pre-existing provision of the Act had been extended and thereby the provisions of section 148A (introduced by the Finance Act, 2021) and other provisions had been deferred. Such notifications did not insulate or save the pre-existing provisions pertaining to reassessment under the Act.

vi) Accordingly, the Revenue authorities had admitted that all the reassessment notices involved in this batch of writ petitions had been issued after the enforcement date of 1st April, 2021. As a matter of fact, no jurisdiction had been assumed by the assessing authority against any of the assessees under the unamended law. Hence, no time extension could be made u/s 3(1) of the 2020 Act, read with the notifications issued thereunder. All the notices were invalid.’

shailesh.kwebmaker

Educational institution – Exemption u/s 10(23C) – Scope of s. 10(23C) – Benefit granted with reference to educational activity – Society deriving income from running educational institution having other income – Separate accounting for such other income – Income of society could not be aggregated for purposes of s. 10(23C)

27 Manas Sewa Samiti vs. Addl. CIT [2021] 439 ITR 79 (All) A.Y.: 2007-08; Date of order: 5th October, 2021 S. 10(23C) of ITA, 1961

Educational institution – Exemption u/s 10(23C) – Scope of s. 10(23C) – Benefit granted with reference to educational activity – Society deriving income from running educational institution having other income – Separate accounting for such other income – Income of society could not be aggregated for purposes of s. 10(23C)

The appellant-assessee is a society registered under the Societies Registration Act, 1860. Under its registered objects, it established an educational institution in the name of Institute of Information Management and Technology at Aligarh. For the previous year relevant to the A.Y. 2007-08, the Institution received fees of Rs. 85,95,790 and interest on fixed deposit receipt of Rs. 86,121. Thus, the total receipts of the institution were Rs. 86,81,911. After deducting expenditure of the institution, the excess of income over expenditure, Rs. 38,54,310 was carried to the income and expenditure account of the society. Also, the society received donations or subscriptions amounting to Rs. 47,62,000 and interest on fixed deposit receipt of Rs. 18,155. The A.O. denied exemption claimed u/s 10(23C)(iiiad).

The Tribunal upheld the denial of exemption.

In the appeal before the High Court the following question of law was raised by the assessee:

‘Whether, in view of the law laid down in CIT vs. Children’s Education Society [2013] 358 ITR 373 (Karn) and the order passed by this Court in CIT (Exemption) vs. Chironji Lal Virendra Pal Saraswati Shiksha Parishad [2016] 380 ITR 265 (All), the order of the Tribunal denying the exemption u/s 10(23C)(iiiad) and clubbing the voluntary contributions received by the appellant with the receipts of the educational institution is justified in law?’

The Allahabad High Court held as under:

‘i) Under the provisions of section 10(23C), any income received by any person on behalf of any university or other educational institution existing solely for educational purposes and not for purposes of profit, if the aggregate annual receipts of such university or educational institution do not exceed the amount of annual receipts as may be prescribed… in the A.Y. 2007-08 the upper limit prescribed for such receipts was Rs. 1 crore under Rule 2BC of the Income-tax Rules, 1962.

ii) The benefit of section 10(23C)(iiiad) being activity-centric, the limit of Rs. 1 crore prescribed thereunder has to be seen only with reference to the fee and other receipts of the eligible activity / institution. Admittedly, those were below Rs. 1 crore. The eligibility condition prescribed by law was wholly met by the assessee. The fact that the institution did not exist on its own and was run by the society could never be a valid consideration to disallow that benefit. Merely because the assessee-society was the person running the institution, it did not cause any legal effect of depriving the benefit of section 10(23C)(iiiad) which was activity specific and had nothing to do with the other income of the same assessee; the Tribunal had also erred in looking at the provisions of section 12AA and the fact that the donations received by the society may not have been received with any specific instructions.

iii) It was not relevant in the facts of the present case because here the assessee had only claimed the benefit of section 10(23C)(iiiad) with respect to the receipts of the institution, and it had not claimed any benefit with respect to the donations received by the society. There could be no clubbing of the receipts of the institution with the other income of the society for the purpose of considering the benefit of section 10(23C)(iiiad).

iv) The question of law is answered in the negative, i.e., in favour of the assessee and against the Revenue.’

shailesh.kwebmaker

Business income – Meaning of business – Lease rent whether business income – Tests for determination of question – Assessee-company incurring losses – Scheme sanctioned by BIFR to help assessee – Scheme providing for lease of entire production unit of assessee – Lease rent constituted business income

26 CIT vs. Premier Tyres Ltd. [2021] 439 ITR 346 (Ker) A.Ys.: 1996-97 to 2003-04; Date of order: 19th July, 2021 Ss. 14 and 28 of ITA, 1961

Business income – Meaning of business – Lease rent whether business income – Tests for determination of question – Assessee-company incurring losses – Scheme sanctioned by BIFR to help assessee – Scheme providing for lease of entire production unit of assessee – Lease rent constituted business income

The assessee was a company engaged in the manufacture and sale of tyres. Since the assessee had a business loss in excess of the paid-up capital, it moved an application u/s 15 of the Sick Industries (Special Provisions) Act, 1985 before the Board for Industrial and Financial Reconstruction (BIFR) for framing a scheme under the 1985 Act. The BIFR, through its order dated 17th April, 1995, approved a scheme for the rehabilitation and revival of the assessee. While sanctioning the rehabilitation scheme for the assessee, the BIFR approved the arrangement between the assessee and ATL, viz., that ATL under an irrevocable lease of eight years would operate the plant and pay a total lease rental of Rs. 45.5 crores over the period of rehabilitation to the sick industrial company, i.e., the assessee, and that ATL would take over the production made at the assessee plant. The assessee made over the plant operation to ATL for manufacturing tyres. Thus, the plant and machinery were given on lease by the assessee to ATL for eight years stipulated in the scheme. For the A.Y. 1996-97, the assessment was completed treating the lease rent received from ATL amounting to Rs. 6,61,75,914 as income from business of the assessee. Thereafter, the A.O. issued notice and reopened the assessment u/s 148 and through the reassessment order treated the receipt from ATL as income from other sources.

The Tribunal held that the lease rental received by the assessee from ATL under the rehabilitation scheme came within the meaning of business income especially in the circumstances of the case.

On appeal by the Revenue, the Kerala High Court upheld the decision of the Tribunal and held as under:

‘i) The word “business” in section 14 is not a word of art but a word of commercial implication. Therefore, in any given year or situation, the activity claimed by the assessee is neither accepted through interpretative nor expressive narrative of the activity claimed by the assessee, nor is the claim for business income refused through the prism of the Revenue. The bottom line is the availability of assets, activities carried out for exploiting the assets, that the assessee is not a mere onlooker at the activities in the company or a passive recipient of rent for utilisation of facilities other than business assets. The net income of business presupposes computation of income after allowing permissible expenses and deductions in accordance with the Act. Therefore, denying eligible deductions or expenses treating business activity as any other activity, and on the other hand allowing deductions or expenses without just eligibility is equally illegal. The circumstances therefore are weighed in an even scale by the authority or court while deciding whether the activity stated by the assessee merits inclusion as income from business or other sources. These controversies are determined not only on case-to-case basis but also on year-to-year basis as well.

ii) The assessee was obligated to work under a statutorily approved scheme; the lease of eight years was to ATL, which was in the same business, and the lease was for utilising the plant, machinery, etc., for manufacturing tyres; the actuals were reimbursed to the assessee by ATL; the work force of the assessee had been deployed for manufacturing tyres; the total production from the assessee unit was taken over by ATL; the overall affairs of the assessee company were made viable by entering into the settlement; coupled with all other primary circumstances, the assessee employed commercial assets to earn income. The scheme was for providing a solution to the business problem of the assessee. The claim of lease rental receipt as income of business was justifiable for the assessment years.’

shailesh.kwebmaker

Benami transactions – Prohibition – Act not applicable to companies – Action under Act should be taken within reasonable period

25 Kalyan Buildmart Pvt. Ltd. vs. Initiating Officer, Dy. CIT (Benami Prohibition) [2021] 439 ITR 62 (Raj) Date of order: 6th October, 2021 Prohibition of Benami Property Transactions Act, 1988

Benami transactions – Prohibition – Act not applicable to companies – Action under Act should be taken within reasonable period

In this writ petition, the petitioners assail the provisional attachment orders dated 12th January, 2018 passed by the Initiating Officer u/s 24(4) of the Prohibition of Benami Property Transactions Act, 1988 and the confirmation orders dated 30th January, 2019 passed by the adjudicating authority u/s 26(3) of the Prohibition of Benami Property Transactions Act, 1988 (hereinafter referred to as ‘the Benami Act, 1988’).

The Rajasthan High Court held as under:

‘i) The Prohibition of Benami Property Transactions Act, 1988 would not extend to properties purchased by a company.

ii) The very purpose of coming into force of the Prohibition of Benami Property Transactions Act, 1988 was to implement the recommendations of the 57th Report of the Law Commission on benami transactions and was to curtail benami purchases, i.e., purchase in the name of another person who does not pay the consideration but merely lends his name while the real title vests in another person who actually purchased the property. Upon reading the provisions of the Act and the definitions, it is apparent that a benami transaction would require one transaction made by one person in the name of another person where the funds are owned and paid by the first person to the seller while the seller gets the registered sale deed executed in favour of the second person, i.e., from the account of A, the amount is paid to C who sells the property to B and a registered sale deed is executed in favour of B. While in the case of an individual this position may continue, a transaction for purchase of property by a company in favour of any person or in its own name would not come within the purview of a benami transaction because the funds of the company are its own assets.

If the promoters of the company, namely, the shareholders, their relatives or individuals invest in the company by way of giving land or by way of gift or in any other manner, then such amounts or monies received would be part of the net worth of the company and the company would be entitled to invest in any sector for which it has been formed. The persons who have put monies in the company may be considered as shareholders but such shareholders do not have the right to own properties of the company nor can it be said that the shareholders have by virtue of their share in the company invested their amount as benamidars. The transactions of the company are independent transactions which are only for the purpose of benefit of the company. It is a different aspect altogether that on account of benefit accruing to the company the shareholders would also receive benefit and they may be beneficiaries to a certain extent. This would, however, not make the shareholders beneficial owners in terms of the definition as provided u/s 2(12) of the 1988 Act. A “company” as defined under the Companies Act, 1956 and incorporated thereunder, therefore, cannot be treated as a benamidar as defined under the 1988 Act. The company cannot be said to be a benamidar and its shareholders cannot be said to be beneficial owners within the meaning of the 1988 Act.

iii) Transactions done legally under the Companies Act of transferring shares of one shareholder to another, the benefit, if any, of which may accrue on account of legally allowed transactions, cannot be a ground to draw a presumption of benami transaction under the 1988 Act. Strict proof is required to be produced and there is no room for surmises or conjectures nor presumption to be made as the 1988 Act has penal consequences.

iv) The prayer of the respondents for lifting the veil to examine the original sale deed dated 24th August, 2006 in relation to the 1988 Act was correct. However, the original transaction of 2006 was between the company and the sellers and the sale deed was executed in favour of the company. Therefore, a subsequent registered sale deed executed by the Development Authority did not warrant interference and it was not a case of proceeds from the property acquired through benami transaction. Once land had been surrendered and order had been passed by the Development Authority u/s 90B of the Rajasthan Land Revenue Act, 1956 and the land had been converted from agricultural to commercial use and registered lease deed had been executed by the Development Authority in favour of the company, the transaction was not a benami transaction.

v) Ordinarily, any proceeding relating to benami transactions ought to be taken up immediately or at least within a reasonable period of limitation of three years as generally provided under the Limitation Act, 1963. Moreover the proceedings initiated after ten years of the purchase were highly belated.

vi) The action of the respondents in attaching the commercial complex which had been leased out to the company by the Development Authority was illegal and unjustified and without jurisdiction.’

shailesh.kwebmaker

Article 12 of the India-Germany DTAA – Assessee was not liable to tax on royalty accrued but not received since it was chargeable to tax under DTAA on receipt basis

5 Faber Castell Aktiengesellschaft Numberger vs. ACIT [TS-1112-ITAT-2021 (Del)] ITA No.: 7619/Del/2017 A.Y.: 2014-15; Date of order: 9th December, 2021

Article 12 of the India-Germany DTAA – Assessee was not liable to tax on royalty accrued but not received since it was chargeable to tax under DTAA on receipt basis

FACTS

The assessee (FC Germany) had entered into an agreement with FC India for use of the trademark owned by the assessee for marketing and sale of products procured by FC India for sale within India. In its return of income, FC Germany offered to tax the consideration received under the agreement as royalty and had further offered certain interest income.

The assessee followed the cash method of accounting. In the course of the assessment proceedings for F.Y. 2014-15, it explained that it had not received royalty and it had inadvertently included the same in its tax return. The assessee further explained that since FC India was facing a liquidity crisis it was unable to make royalty payment. Hence, the assessee had entered into a termination agreement with FC India pursuant to which the liability for payment of royalty from F.Y. 2011-12 to 2015-16 was waived. In support of its contention, the assessee submitted a no-objection certificate dated 26th October, 2016 issued by the RBI. The A.O. held that the royalty agreement could not be terminated on a back date as FC India had already used the brand and, hence, income had accrued to FC Germany.On appeal, the CIT(A) upheld order of the A.O.Being aggrieved, the assessee appealed before the ITAT.

HELD

It was noted that the assessee had waived royalty payment since FC India was facing liquidity crisis. And it could not be said that the waiver agreement was an arrangement of convenience as it was backed by a no objection certificate issued by the RBI.

Articles 12(1) and 12(3) require royalty to be received by the non-resident. Factually, even prior to the waiver of royalty, neither FC India had paid royalty nor had the assessee received royalty.

In support of its contention, the assessee relied on several decisions1 in which the judicial authorities have held that under the DTAA royalty is chargeable to tax in the hands of the non-resident on receipt basis.

Hence, royalty payable by FC India (but not paid) to the assessee was not taxable in India.

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Article 12 of the India-USA DTAA – Consideration received for grant of access to database (without right of reproduction or adaptation of data) is not in nature of royalty under Article 12 of the India-USA DTAA

4 Dow Jones & Company Inc. vs. ACIT [TS-1114-ITAT-2021 (Del)] ITA No: 7364/Del/2018 A.Y.: 2015-16; Date of order: 14th December, 2021

Article 12 of the India-USA DTAA – Consideration received for grant of access to database (without right of reproduction or adaptation of data) is not in nature of royalty under Article 12 of the India-USA DTAA

FACTS
The assessee was a tax resident of the USA engaged in the business of providing information products and services comprising global business and financial news to organisations worldwide. It had appointed ‘D’, an Indian company, for distributing its products in India. During the relevant A.Y., the assessee had received subscription fee from ‘D’ for granting access of database to customers of ‘D’ in India. The A.O. taxed the receipt as royalty under the Act as also the India-USA DTAA. This addition was confirmed by the DRP.

Being aggrieved, the assessee appealed before ITAT.

HELD
Payments that allow a payer to use / acquire a right to use a copyright in a literary, artistic or scientific work are covered within the definition of royalty.Payments made for acquiring the right to use the product itself, without allowing any right to use the copyright in the product, are not covered within the scope of royalty.In this case, all rights, title and interest in licensed software continued to remain the exclusive property of the assessee. ‘D’ had no authority to reproduce the data in any material form, or to make any translation of data, or to make any adaptation of the data.

Further, even the end-user could not be said to have acquired any copyright or right to use the copyright in the data. Accordingly, payments made by ‘D’ for merely accessing the database were not in the nature of payments for use of copyright as contemplated in Article 12 of the India-USA DTAA.

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Articles 22 and 23 of the India-UAE DTAA – On facts, unexplained investment taxed under sections 68 and 69 was not in nature of ‘Other Income’ contemplated under Article 22 and hence was not taxable in India – Article 23 deals with taxation of capital, whereas issue under consideration pertains to unexplained investment in immovable property and hence is not taxable in India

3 ITO vs. Rajeev Suresh Ghai [(2021)] 132 taxmann.com 234 (Mum-Trib)] ITA No: 6920/Mum/2019 A.Y.: 2010-11; Date of order: 23rd November, 2021

Articles 22 and 23 of the India-UAE DTAA – On facts, unexplained investment taxed under sections 68 and 69 was not in nature of ‘Other Income’ contemplated under Article 22 and hence was not taxable in India – Article 23 deals with taxation of capital, whereas issue under consideration pertains to unexplained investment in immovable property and hence is not taxable in India

FACTS
The assessee was a non-resident Indian settled in the UAE for three decades. He invested a certain amount to purchase a residential flat from AB. In the course of search and seizure operations carried out by the investigation wing of the Income-Tax Department on AB, it found certain data. Relying on this data, the A.O. concluded that the assessee had paid cash amounts of Rs. 2.5 crores to AB. He treated the said amount as an ‘unexplained investment’ u/s 69. The A.O. further noted that a sum of Rs. 4.47 lakhs was probably interest on loan and brought it to tax as such u/s 68.On appeal the CIT(A) deleted the addition on the ground that income taxed under sections 68 and 69 falls under Article 22 – ‘Other Income’ of the India-UAE DTAA – which is not taxable in India.The aggrieved Revenue appealed before the ITAT.

HELD
Article 22 of the India-UAE DTAA – Other income
* Unexplained investments were in the nature of application of income and not income per se. Hence, they could not be taxed in India under Article 22(1) of the India-UAE DTAA.
* Article 22(2) provides for taxation of income arising from immovable property. The issue under consideration was not about income from immovable property, but income said to have been invested in immovable property.Article 23 of the India-UAE DTAA – Capital
* Article 23(1) deals with taxation of capital represented by immovable property. It deals with taxation of capital but does not provide for taxation of unexplained investment in immovable property.

Interest income
* There was no evidence of interest income as even the finding of the A.O. states that the related entry ‘probably’ refers to interest.

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Merely because a property is called a farmhouse it does not become a non-residential house property unless otherwise proved

21 ACIT vs. Rajat Bhandari [TS-892-ITAT-2021 (Del)] A.Y.: 2011-12; Date of order: 16th September, 2021 Section: 54F

Merely because a property is called a farmhouse it does not become a non-residential house property unless otherwise proved

FACTS
The assessee sold a property at Patparganj, Delhi for Rs. 3.10 crores on 20th October, 2010 and claimed exemption u/s 54F stating that he had purchased a new farmhouse at Sainik Farms, New Delhi in September, 2011. The A.O. denied exemption u/s 54F without disputing the fact of the transactions, but merely noting that the assessee has more than one house and is also owner of many residential houses. For this proposition, the A.O. noted the address of the assessee on the return of income, on the bank account, on the insurance receipts as well as on the other legal documents placed before him.
He noted that the assessee has many residential houses and therefore deduction u/s 54F cannot be claimed. Therefore, the A.O. was of the view that the assessee is not entitled to deduction u/s 54F. He held that it is not possible to collect the direct evidence to prove that the assessee owned more than one residential house on the date of transfer of the original asset. He further noted that after taking consideration of the totality of the facts and circumstances of the case, one could draw the inference that the assessee did not fulfil the conditions for exemption u/s 54F. Even otherwise, he held that the assessee has purchased a farmhouse and no deduction u/s 54F should be allowed on that as income from a farm is not taxable.

Aggrieved, the assessee preferred an appeal to the CIT(A) who allowed the appeal. But the Revenue felt aggrieved and preferred an appeal to the Tribunal.

HELD
The Tribunal observed that the DR could not show that the assessee has more than one property. It noted that the A.O. himself says that he could not prove whether the assessee has more than one property. The objection of the A.O., that the assessee has purchased a farmhouse and therefore it is not a residential house property, was devoid of any merit. It held that ‘Farmhouse can be residential house also’. It is not the case of the Revenue that the assessee has purchased excessive land and has constructed a small house thereon, thereby claiming deduction on the total value of the land and the small property constructed thereon. If that had been the case, perhaps the assessee would have been eligible for proportionate deduction to the extent of residential house property as well as land appurtenant thereto.

The Tribunal observed that there is no finding by the A.O. that the assessee has purchased excessive land which would be used as a farmland and has for name’s sake constructed a residential house property. It held that ‘Merely because a property is called a farmhouse, it does not become a non-residential house property unless otherwise proved.’This ground of appeal filed by the Revenue was dismissed.

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The scope of the fifth proviso to section 32(1) cannot be extended to transactions of purchases between two unrelated parties

20 TUV Rheinland NIFE Academy Private Limited vs. ACIT [TS-1097-ITAT-2021(Bang)] A.Y.: 2016-17; Date of order: 1st November, 2021 Section: 32

The scope of the fifth proviso to section 32(1) cannot be extended to transactions of purchases between two unrelated parties

FACTS
The assessee, a private limited company, engaged in the business of providing vocational training to students in the fields of fire safety, lift technology, fibre optics, etc., is a subsidiary of TUV Rheinland (India) Pvt. Ltd. The A.O. noticed that the assessee had acquired a vocational training institute giving training to students from a person named Mr. M.V. Thomas who was running the said institution under the name and style of ‘Nife Academy’. It was observed that the holding company of the assessee had entered into a business transfer agreement (BTA) on 4th December, 2013 with Mr. M.V. Thomas for acquiring his academy for a lump sum amount of Rs. 28.50 crores plus some adjustment on slump sale basis. In pursuance of the said agreement, the assessee had paid an aggregate amount of Rs. 30.56 crores (Rs. 25.38 crores plus Rs. 5.18 crores). The purchase consideration paid over and above the value of tangible assets was treated as ‘goodwill’ and depreciation was claimed thereon. The A.O. held that the spirit of the fifth proviso to section 32(1) would suggest that the successor to an asset cannot get more depreciation than the depreciation which the predecessor would have got. He also noticed that the said Academy did not possess the asset of ‘goodwill’ and accordingly held that when an asset does not exist in the depreciation chart of the seller, then it cannot have a place in the depreciation chart of the buyer. Therefore, he disallowed the depreciation claimed on ‘goodwill’.

Aggrieved, the assessee preferred an appeal to the CIT(A) who confirmed the view of the A.O. The assessee then preferred an appeal to the Tribunal.

HELD
The Tribunal observed that in view of the decision of the Delhi High Court in the case of Truine Energy Services Pvt. Ltd. vs. Deputy Commissioner of Income-tax (2016) 65 Taxmann.com 288, the payment made over and above the net asset value, while acquiring a business concern, shall constitute goodwill. Upon considering the language of the fifth proviso to section 32(1), the Tribunal held that a careful perusal of the above proviso would show that the same is applicable to the cases of ‘succession’, ‘amalgamation’ and ‘demerger’, i.e., transactions between related parties. In the instant case, Nife Academy has been acquired through a business transfer agreement by the holding company of the assessee from Mr. M.V. Thomas. It is not the case of the Revenue that this transaction is between two related parties. Hence this purchase would not fall under the categories of succession, amalgamation and demerger. The Tribunal held that it does not agree with the view of the lower authorities that the spirit of the proviso should be applied to the present case.The Tribunal set aside the order passed by the CIT(A) on this issue and restored the matter to the file of the A.O. to examine certain factual aspects.

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The ALV of the property, which could not be let out during the year, would be nil in accordance with the provisions of section 23(1)(c)

19 Purshotamdas Goenka vs. ACIT [TS-984-ITAT-2021 (Mum)] A.Y.: 2016-17; Date of order: 13th October, 2021 Section: 23

The ALV of the property, which could not be let out during the year, would be nil in accordance with the provisions of section 23(1)(c)

FACTS
The assessee owned four properties of which one was let out and three were vacant throughout the previous year relevant to the assessment year under consideration. The assessee offered for taxation the rental income in respect of the let-out property. As for the properties that were vacant, he claimed vacancy allowance u/s 23(1)(c). The A.O., while assessing his total income, made an addition of Rs. 1,09,624 on account of deemed rent for vacant properties after granting deduction for municipal taxes and statutory deductions u/s 24(a).Aggrieved, the assessee preferred an appeal to the CIT(A) who confirmed the action of the A.O. The Assessee then
preferred an appeal to the Tribunal.

HELD
The Tribunal noted that the three properties which were vacant during the year under consideration have been let out by the assessee in the subsequent assessment year and their rental income has been offered for taxation. It observed that the issue before it is whether the deemed rent of the assessee has to be taken as annual value (ALV) u/s 23(1)(a) for the purpose of assessment of income u/s 22, or whether the assessee is entitled to vacancy allowance as provided u/s 23(1)(c).It held that the ALV of the property which could not be let out during the year would be nil in accordance with the provisions of section 23(1)(c). The assessee was entitled to vacancy allowance in respect of the said properties. Since the properties have not been let out at all during the year, the ALV has to be taken as nil. It observed that the case is covered by the decision of the coordinate Bench in the case of M/s Metaoxide Pvt. Ltd. vs. ITO in ITA No. 5773/M/2016 A.Y. 2010-11.

The Tribunal set aside the order of the CIT(A) and deleted the addition of Rs. 1,09,624 in respect of the three vacant properties.

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SMALLCASE INVESTING – AN INNOVATIVE CONCEPT FOR RETAIL INVESTORS

A mutual fund investor spreads his investment across a basket of stocks by investing in units of mutual funds. An investor can also invest in Sectoral Mutual Funds like Pharma, Banking, Infrastructure etc.

Thematic investments is a broader approach to identify financially sound and sustainably growing companies whose business models are based on particular themes or ideas and would include companies across market capitalization and sectors. Thematic investment philosophy involves identifying curated or theme-based stocks which support a particular idea or theme like Rural Development, Robotics, Future Mobility, Make in India etc. However, an investor willing to invest in direct equity would have to spend considerable time in identifying such stocks and executing individual orders for stocks instead of a single click order to invest in a basket of the thematic or curated portfolio of stocks.

If you have a perfect investment methodology and philosophy but lack time of investing in specific stocks or funds, then Smallcase Investing is an option for you.

Bengaluru-based Smallcase Technologies is a start-up by three IIT graduates, which have introduced an exciting technology-based platform for modern retail investors allowing them to invest in a basket of stocks / mutual funds that reflects an idea or a theme. Each theme consists of professionally tailored baskets of stocks that reflect an investing theme, idea or strategy.

This concept is very popular in the developed markets and is made available by various intermediaries like Motifs, Personal Capital, Tiger Brokers, Cazenove Capital and Jarvis Securities.

While Smallcase was initially incubated by Zerodha but have now collaborated with several online brokers (13 as of now) including Kotak Securities, HDFC Securities, 5paisa, Edelweiss, Zerodha and Axis Securities. Smallcase has gained popularity among new and young investors and has become synonym with a curated portfolio-based investment strategy. An attempt has been made in this article to explain the concept illustrating the platform provided by Smallcase and can be applied by investors to other service providers offering a similar platform.

Smallcase ecosystem consists of:

•    Technology platform provided by Smallcase – They charge fees to Smallcase managers for providing the platform.
•    Trading platform provided by Stock Brokers for the execution of trades by investors – They charge commissions to investors for the execution of trades through their trading platform.
•    Research and Advisory Services provided by Smallcase managers who are SEBI registered Investment Advisors, Research Analysts or Portfolio Managers (PMS) – They charge fees to investors (either a fixed fee or percentage-based fee).
•    Investors – Investors have the option of investing on a thematic basis.

The following table shows the comparison with a mutual fund:

PARTICULAR	MUTUAL FUND	SMALLcase
Ownership	You own units of the mutual funds and not the underlying stocks	In the case of Smallcase, you directly own the stocks. Equity Mutual Funds only need to disclose their holdings once a month, so you don’t necessarily know what your fund owns at any given time (this is not necessarily a bad thing given you have delegated the task of picking stocks to the fund manager). With Smallcase, you know exactly what you own because the holdings sit in your Demat account
Holding Pattern	Mutual funds investors own units of mutual funds, which are separate from stocks. So, the holding pattern is based on mutual funds units and not related to stock	Smallcase investments give direct control over the holdings. The shares are held directly in the investor’s Demat account, and the dividends are transferred to the bank account. Also, in case a particular stock isn’t performing well, the investor can sell those shares and continue to hold the remaining part of the Smallcase
Taxes	A mutual fund where the investor pays tax only upon redemption of units. Hence the overall tax burden in this structure is expected to be higher	Every time investor sells the stock, he shall pay short-term capital gains tax
Lock-in	If mutual funds investment is redeemed before the expiry of the lock-in period, it may even attract an exit load	Investment through the Smallcase platform does not have a lock-in period
Portfolio Diversification	Mutual funds offer a wide variety of diversification, as mutual funds can invest in 100+ companies	Smallcase follows a strategy, idea or theme and investment in a particular Smallcase is restricted to a particular strategy, idea or theme. So, the diversification is limited to a particular strategy, idea or theme
Capital requirement	Mutual funds investors have the option of buying mutual funds units, thereby even small investment by investors is feasible	Smallcase requires a higher capital for investing in comparison to mutual funds. In a Smallcase portfolio, one has to invest in at least 1 share of particular shares, thereby requiring higher capital investment
Expense Ratio	The mutual fund expense ratio is determined by SEBI and its range is between 1-2%	Some Smallcase are open to the public, while some are with a subscription. Some cases are created by the in-house teams, while some by external analyst companies. Therefore, the charges vary accordingly
Exit load	Some scheme of mutual funds can charge up to 1-2%	There is no exit load in Smallcase

HOW IT WORKS
The platform offers a user interface to invest in multiple baskets of stocks / ETFs based on a theme selected by the investor. An investor can either invest in a Smallcase created by SEBI registered individuals / entities such as registered investment advisors, research analysts or portfolio managers or create his or her own Smallcase with two or more stocks or ETFs.

For Example, if an investor wants to invest in the theme of growing rural consumption in India, they can directly buy a Smallcase that is curated by experts representing this particular theme. The underlying constituents of the Smallcase would have stocks that would form part of the underlying theme along with the weightage assigned to their share in the overall basket.

The investor can place a consolidated order for all the underlying stocks with a single click through his respective broker. In case of any issue of order fulfillment, the investor can repair the Smallcase later by replacing the fresh order and ensuring the portfolio complements the original theme.

The professionally managed Smallcase are periodically updated by the Smallcase manager to continue tracking the underlying strategy or theme. These updates in the portfolio composition are shared through the platform to the investor so that the investor can make the changes to reflect the updated composition.

The investor has the option to exit the Smallcase which would trigger sell orders across all the underlying securities within a Smallcase. In every Smallcase, investors can set up a SIP (Systematic Investment Plan) to invest a fixed amount to the selected portfolio every month following the first investment.

USING SMALLcase INVESTING OPTION
• Choose: Go to the Smallcase website and click on login. You have to use the credentials provided by your broker to log in. However, if you use any other broker other than mentioned above, you may not be able to access the services.

• Buy: Once logged in, the investor has the option to choose from the array of themes such as all-weather, smart beta, bargain buys, electronic vehicles among others.

• Track: You will now be able to see stocks that form part of the portfolio, their proportion and the rationale behind their inclusion. You can customize the Smallcase by adding or removing stocks.

• Manage: While some brokers allow you to create your personalized Smallcase, others offer curated Smallcase.

It offers the convenience of one-click investing for transacting in a basket of stocks. Once the theme is selected, an investor can also opt for SIP (Systematic Investment Plan) similar to Mutual Funds.

Any investor can create its own model portfolio (Smallcase) or invest in professionally managed Smallcase created by SEBI registered entities or individuals such as research analysts, registered investment advisor (RIA) etc. The creation and management of Smallcase are restricted to registered entities only.

The concept of thematic investing is fast gaining popularity among retail investors who prefer DIY (Do it Yourself) stock / MF selection. In fact, theme-based stock / ETF investments are becoming akin to Smallcase. The concept is riding on the bull market and is yet to face a major market correction that will test the inherent quality of underlying research. It is advisable that investors should do their own due diligence before investing instead of just getting carried away with market sentiments.

Note: The purpose of this article is only to make the readers aware of the concept which is gaining popularity amongst investors and is not to influence readers to trade or invest. The reader should exercise caution before they start using the platform.

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SEBI TIGHTENS REGULATIONS FOR RELATED PARTY TRANSACTIONS – KEY AMENDMENTS AND AUDITOR’s RESPONSIBILITIES

Corporate Governance standards are being continuously strengthened with the focus on improving the quality of governance norms and disclosures by listed entities. Related party transactions have always been a key focus area for the regulators. Significant amendments have been made in the Companies Act, 2013 (2013 Act) as well as in the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (Listing Regulations) to regulate such transactions and their disclosure in financial statements. The regulators made various amendments in the 2013 Act and Listing Regulations to align the requirements prescribed under the two, for example, omnibus approval by Audit Committee for repetitive related party transactions; however, SEBI regulations continue to be more stringent, for instance, the definition of related party under the Listing Regulations will result in the identification of significantly higher number of related parties vis-à-vis those under the 2013 Act.

The three important aspects of related party transactions which merit consideration are (a) Identification [who are considered related parties (RP) and when], thresholds (values or %), approvals (depending on the former who will approve – Audit Committee / Shareholders / Government) and disclosure (and their timelines) in financial statements and to be filed with the regulators. For minority shareholders such steps are of great importance to protect their interests and allow them to take decisions…Information on RPs also give better insight into performance and monitoring of movement of funds.

Section 188 of the Companies Act, 2013 deals with ‘related party transactions’, i.e., transactions specified in the section with any person who falls within the definition of ‘related party’ as per section 2(76) of the Act. Apart from section 188, there are several other provisions in the 2013 Act that deal with specific types of transactions with specific types of parties which may be covered within the definition of ‘related party’, for example, section 185 deals with loans to Directors and to certain other parties in which the Directors are interested; section 192 places restrictions in respect of non-cash transactions with Directors and certain other specified persons; and a number of sections that deal with managerial remuneration.

Further, the Listing Regulations also prescribe specific regulations which govern RPTs for the listed entities. While some provisions are common, however, with the recent amendment to the regulations, the Listing Regulations have been made much more stringent as discussed in this article.

With the aim to review and strengthen the regulatory norms pertaining to RPTs, undertaken by listed entities in India, SEBI constituted a Working Group in November, 2019 comprising members from the Primary Market Advisory Committee (PMAC)1, including persons from the industry, intermediaries, proxy advisers, stock exchanges, lawyers, professional bodies, etc.

On the basis of the recommendations of the working group, SEBI as per Notification dated 9th November, 2021 has further amended provisions relating to RPTs under the SEBI Listing Regulations.

____________________________________________________________

1 Reference may be made to SEBI Meeting – Review of Regulatory Provisions

EFFECTIVE DATE
The SEBI LODR Amendment Regulations are applicable in a phased manner; certain amendments will be effective from 1st April, 2022, while the remaining amendments will be effective from 1st April, 2023 (as specified in the regulations).SEBI LODR has been amended, inter alia, in respect of the following:
* Definition of ‘related party’ (RP) and ‘related party transactions’ (RPT),
* Change in monetary limits for classification of material RPTs,
* Disclosure requirements for RPTs,
* Process to be followed by Audit Committee for approval of RPTs.

The objective of this article is to provide an overview of the recent amendments made by SEBI and the auditor’s role in the audit of RPTs.

OVERVIEW OF THE AMENDMENTS
Definition of related party
The working group constituted by SEBI felt that the promoter or the promoter group may exercise control over and influence the decision-making of the listed entity. Accordingly, the recommendation was made to consider every person or entity forming part of the promoter or promoter group, irrespective of their shareholding in the listed entity, as a related party.

Existing regulations consider any person or entity to be a related party if he / she or it belongs to the promoter or promoter group of the listed entity holding 20% or more of shareholding in the listed entity.

The amended regulations consider any person or entity to be a related party if
* he / she / it is belonging to the promoter or promoter group of the listed entity (i.e., irrespective of shareholding) or
* if any person or entity is holding 20% or more equity shares either directly or on a beneficial interest basis as per section 89 of the 2013 Act at any time during the preceding financial year and effective from 1st April, 2023 if any person or entity is holding 10% or more of equity shares at any time during the immediately preceding financial year. This amendment will cover persons or entities holding shares as above even if he / it does not form part of the promoter or promoter group of the listed entity.

The rationale behind lowering of these amendments has been explained in the SEBI agenda2 which states that a significant percentage of Indian businesses are structured as intrinsically linked group entities that operate as a single economic unit, with the promoters exercising influence over the entire group. Thus, the promoter or promoter group may exercise control over a company irrespective of the extent of shareholding. There is also the possibility of a shareholder not being classified as a promoter but who may be exercising influence over the decisions of the listed entity by virtue of shareholding.

With the revised definition of related party and the changes in threshold to 10% w.e.f. from 1st April, 2023 it may pose a practical challenge for companies in identification of related parties, in conducting their day-to-day business since companies will need to keep track of such entities at any time during the past financial year, and transactions with such entities will require Audit Committee approval. Companies need to evaluate whether such a shareholder may have ceased to hold any shares in the listed entity in the year of applicability of the amended regulations or in a subsequent year.

_________________________________________________________

2 Reference may be made to the SEBI meeting – Review of Regulatory Provisions

DEFINITION OF RELATED PARTY TRANSACTIONS
The scope of the term has been made significantly wider, principally with a view to bring transactions with subsidiaries (listed or unlisted, Indian or foreign) within its ambit.As per existing regulations, the definition covers transfer of resources, services or obligations between a listed entity and an RP, regardless of whether a price is charged, whether there is a single or a group of transactions.

Some of the corporate actions such as issue of securities on preferential basis, rights issue, buy-backs, payment of dividend, sub-division or consolidation, etc., where these provisions are uniformly applicable / offered to all shareholders in proportion to their shareholding, have been excluded from the ambit of the definition.

SEBI has also revised thresholds for determining ‘materiality’ of an RPT. A transaction with a related party shall be considered material if the transaction(s) to be entered into individually or taken together with previous transactions during a financial year, exceed Rs. 1,000 crores or 10% of the annual consolidated turnover of the listed entity as per its last audited financial statements, whichever is lower (as per existing regulations, the threshold was only 10% of the annual consolidated annual turnover of the listed entity).

It is noteworthy that the scope of RPTs has been extended to include transactions that not only have a direct nexus with an RP but eventually also those which would indirectly benefit the RP. This will entail significant efforts from companies, and they will be required to scrutinise individual transactions with a third party and may also require listed entities to demonstrate that the RP is not benefited from a third-party transaction.

The meaning of purpose and effect’ has not been defined in the SEBI Regulations. In common parlance, purpose would mean to have an intent to benefit the RP and effect is that it actually happens indirectly; it is more of substance-based assessment and management will require to undertake critical evaluation of documentation and the commercial intention of the transaction.

PRIOR APPROVAL FROM AUDIT COMMITTEE AND SHAREHOLDERS
The amended regulations require prior approval of the Audit Committee and shareholders of the listed entity for all related party transactions and subsequent material modifications thereto… Provided that only those members of the Audit Committee, who are Independent Directors, shall approve related party transactions.

There is no need to have prior approval of the Audit Committee and shareholders of a listed entity for a related party transaction where the listed entity is not a party and its listed subsidiary is a party if Regulations 23 and 15(2) of SEBI Listing Regulations are applicable to such listed subsidiary.

1. The definition of the term ‘material modifications’
will be required to be defined by the Audit Committee and disclosed as part
of the policy on materiality.

An RPT to which a subsidiary of a listed entity
is a party (even if the listed entity by itself is not a party) shall require
prior approval from the Audit Committee of the listed entity, if the value of
such transaction (individually or together with previous transaction during
the F.Y.) exceeds

I. 10% of the annual consolidated turnover, as
per the last audited financials of the listed entity (with effect from 1^st
April, 2022)

II. 10% of the annual consolidated turnover, as
per the last audited financials of the subsidiary (with effect from 1^st
April, 2023)

The scope of an RPT which requires prior shareholders’ and Audit Committee approval has been expanded. Depending on the type of approval, prior approval may be taken, for example, for omnibus approval it may be before the next financial year, while for contract or transaction-based approval, it may be immediately before entering into an RPT. It is not clear whether the regulations will apply to RPTs which were entered into before 1st April 2022. While SEBI may issue a clarification in this regard, one may take a view that the regulations will be applicable prospectively considering there are no specific transitional provisions specified in the amended regulations.

DISCLOSURES
Schedule V to the Listing Regulations specifies the additional disclosures required to be provided by listed entities in their annual report. This, inter alia, includes related party disclosures and disclosures pertaining to the corporate governance report.

Existing timeline is as under:

For equity listed entities – disclosure for the
half year to be submitted within 30 days from the date of publication of its
standalone and consolidated financial results for the half year.

For high value debt listed entities – disclosures
for the half year at the time of submission of their standalone financial
results (on a comply or explain basis up to 31^st March, 2023) and
on a mandatory basis from 1^st April, 2023.

Revised timeline is as under:

For equity listed entities – within 15 days from
the date of publication of standalone and consolidated financial results for
the half year.

With effect from 1^stApril, 2023 – on
the date of publication of its standalone and consolidated financial results.

For high value debt listed entities – along with
its standalone results for the half year.

SEBI has issued another Circular dated 22nd November, 2021 which provides detailed disclosure formats of RPTs and information to be placed before the Audit Committee and the shareholders for consideration of the same.

AUDITORS’ ROLE IN AUDIT OF RELATED PARTY TRANSACTIONS
The corporate scandals over a period of time have indicated that related parties are often involved in cases of fraudulent financial reporting. The RPTs may provide scope for distorting financial information in financial statements and not presenting accurate information to the decision-makers and stakeholders. The audit of RPTs and transactions presents a particular challenge to auditors due to many reasons, including the following:
(1) Related party relationships and transactions are not always easy to identify due to complex structures
and arrangements;
(2) Management is responsible for identifying all related parties yet may not fully understand the definition of a related party under various regulations or may not want to provide information on the grounds of sensitivity;
(3) Many companies may not have effective internal controls in place for authorising, recording and tracking related party transactions.
(4) Auditors of smaller companies may find it difficult to identify related party relationships and transactions because management may not understand the related party disclosure requirements or their significance. It is therefore important for auditors to be clear about what needs to be disclosed so that they can advise management on the responsibility to prepare financial statements that comply with the relevant accounting framework.

ICAI issued SA 550 Related Parties which deals with the auditor’s responsibilities regarding related party relationships and transactions. Under the current auditing framework, auditors are required to focus on three areas:
1) identification of previously unidentified or undisclosed related parties or transactions.
2) significant related party transactions outside the normal course of business. Related parties may operate through an extensive and complex range of relationships and structures, with a corresponding increase in the complexity of related party transactions.
3) assertions that related party transactions are at arm’s length.

Auditors are required to evaluate whether the effects of RPTs are such that they prevent the financial statements from achieving a true and fair presentation.

With the given plethora of amendments in SEBI regulations, the responsibilities of auditors have been enhanced even further. The auditors need to understand the implications of the amendments on the company’s systems and processes of identification and disclosure of RPTs. The auditor may consider the following illustrative work-steps while conducting an audit of related party relationships and transactions to enhance the quality of the audit.

(i) Plan the audit of related party relationships and transactions by updating existing information, and by obtaining a list of related parties from clients, or compile a list based on discussions with clients. Needless to say, the auditor should consider the amendments to related party regulations for listed entities and their subsidiaries while obtaining such information.

(ii) Make inquiries from the management about changes from the prior period, the nature of the relationships, whether any transactions have been entered into and the type and purpose of the transactions.

(iii) Understand the nature, size and complexity of the businesses and use family trees or document group structures under various laws / statutes and regulations (e.g., income-tax – transfer pricing and indirect tax – GST) to help identify related parties and relationships between the client and related parties.

(iv) Consider the impact of undisclosed related party relationships and transactions as a potential fraud risk.

(v) Understand the controls, if any, that management has put in place to identify, account for, and disclose related party transactions and to approve significant transactions with related parties, and significant transactions outside the normal course of business. Also understand management’s plan to update such controls for change in related party regulations.

(vi) Perform procedures to confirm identified related party relationships and transactions and identify others including:
a. inspecting bank and legal confirmations obtained as part of other audit procedures.
b. inspecting minutes of shareholder and management meetings and any other records or documents considered necessary, such as:
*   Other third-party confirmations (i.e., in addition to bank and legal confirmations)
*   Entity income-tax returns, tax filings and related correspondence
*   Information supplied by the entity to regulatory authorities
*   Records of the entity’s investments and those of its pension plans
*   Contracts or other agreements (including, for example, partnership agreements and side agreements or other arrangements) with key management or those charged with governance
*   Significant contracts renegotiated by the entity during the period
c. Ensure compliance with all the requirements of sections 179, 180, 185, 186, 187 of the Companies Act, 2013 and rules thereunder.
d. When there are other components of the company that are not audited by the parent auditor, coordinate audit procedures with the component auditors to obtain necessary information relating to intercompany transactions and balances.
e. Review minutes and other agreements for support for loans or advances and for evidence of liens, pledges or security interests related to receivables from, or loans and advances to, subsidiaries.
f. Examine the agreements entered between the company and the related parties.

(vii) Consider any fraud risk factors in the context of the requirements of SA 240 Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements.
(viii) Establish the nature of significant transactions outside the company’s normal course of business and whether related parties could be involved, by inquiring of management.
(ix) Consider any arm’s length assertions and obtain supporting evidence from third parties.
(x) Document the identity of related parties and the nature of related party relationships.
(xi) Obtain a representation that management has disclosed the identity of related parties, relationships and transactions of which they are aware, and that related parties and transactions have been appropriately accounted for and disclosed.
(xii) Communicate significant related party matters arising during the audit to those charged with governance unless all of those charged with governance are involved in its management.
(xiii) Ensure that the accounting for and disclosure of related parties and related party transactions are appropriate and in accordance with the applicable financial reporting framework.
(xiv) Reporting of Key Audit Matter (KAM) and determining whether identification of related parties and transactions with related parties is a KAM. SA 701 states that events or transactions that had a significant effect on the financial statements or the audit, may include significant transactions with related parties, significant transactions outside the normal course of business, unusual transactions. The auditor should assess whether a KAM on RPT is required and which require significant auditors’ attention.

Amendments in Corporate Governance Report
The companies as well as auditors should take note of additional disclosures in the corporate governance report by the listed entity and its subsidiaries of ‘Loans and advances’ in the nature of loans to firms / companies in which the Directors are interested by name and amount. A compliance certificate from either the auditors or practising company secretaries regarding compliance of conditions of corporate governance is required to be annexed with the Directors’ report.

CONCLUDING REMARKS
The SEBI LODR Amendment Regulations on RPTs will ensure greater transparency and better corporate governance which will safeguard the interests of all stakeholders and strengthen the regulatory framework. These amendments also enhance the responsibilities of the Audit Committees and the Independent Directors with respect to RPT approvals; Audit Committees will need to define ‘material modifications’ to RPTs, require amendment to the RPT policy, revise data base of RPTs with RPTs of subsidiaries and their value. In the light of the amended provisions, listed entities would need to revisit their list of related parties, RPTs, identify material RPTs which need Audit Committee / shareholder approval and comply with the additional disclosure and documentation requirements. The listed entities will be required to identify new related party transactions based on a review of the present arrangements, update the related party policy to capture amendments and recommend updating of processes, controls for capturing additional data requirement.

The auditors have an important role to play in reporting on related party transactions given the existing responsibilities under Standards on Auditing and amendments made in the Companies (Audit and Auditor’s Reporting) Rules applicable for the financial year ending March, 2022 onwards which requires auditors to obtain representations from management that (other than those disclosed in the financial statements) no funds have been provided to intermediaries with an understanding that the intermediaries would lend or invest or provide guarantee, etc., on behalf of the ultimate beneficiaries. A similar reporting requirement has also been prescribed for receipt of funds from funding parties.

shailesh.kwebmaker

CARO 2020 SERIES: NEW CLAUSES AND MODIFICATIONS NON-BANKING FINANCE COMPANIES (NBFCs) [INCLUDING CORE INVESTMENT COMPANIES]

(This is the sixth article in the CARO 2020 series that started in June, 2021)

BACKGROUND

Non-Banking Financial Companies (NBFCs) are entities where generally public money is involved and therefore they have always been subject to greater scrutiny and attention by the regulators (primarily, the Reserve Bank of India [RBI] and the National Housing Bank [NHB]). There are several classes of NBFCs each of which has a separate set of criteria / conditions to fulfil to continue carrying on their business. Core Investment Companies (CICs) are also a separate class of NBFCs which could be used as a tool to camouflage transactions amongst group companies.In the past there have been instances where the general public has lost money in such companies. Hence, to protect the interest of society, responsibilities have been cast on auditors to report some aspects of these companies so that regulators can take necessary action based on the red flags (if any) raised by the auditors.

SCOPE OF REPORTING

The scope of reporting can be analysed under the following clauses:

*Clause No.*	*Particulars*	*Nature of change, if any*
Clause 3(xvi)(a)	*RBI Registration:*	No change*
Clause 3(xvi)(a)	Whether the company is required to be registered u/s 45-IA of the Reserve Bank of India Act, 1934 (2 of 1934) and, if so, whether the registration has been obtained	No change*
Clause 3(xvi)(b)	*Conduct of Business:*	New Clause
Clause 3(xvi)(b)	Whether the company has conducted any Non-Banking Financial or Housing Finance activities without a valid Certificate of Registration (CoR) from the Reserve Bank of India as per the Reserve Bank of India Act, 1934	New Clause
Clause 3(xvi)(c) 3(xvi)(d)	*CICs:*	New Clause
	Whether the company is a Core Investment Company (CIC) as defined in the regulations made by the Reserve Bank of India and, if so, whether it continues to fulfil the criteria of a CIC, and in case the company is an exempted or unregistered CIC, whether it continues to fulfil such criteria
	Whether the Group has more than one CIC as part of the Group; if yes, indicate the number of CICs which are part of the Group

*No change and hence not discussed

PRACTICAL CHALLENGES IN REPORTING

The reporting requirements outlined above entail certain practical challenges in respect of the new clauses which are discussed below:

RBI Registration [Clause 3(xvi)(b)]:

Before proceeding further, it would be pertinent to note the following statutory requirements:

NBFCs

As per section 45-I(f) of the RBI Act, 1934, an NBFC is a company incorporated under the Companies Act, 2013 or 1956 which carries on the business of a financial institution or carries on the principal business of receiving deposits or lending in any manner.

As per section 45-I(c) of the RBI Act, the business of a financial institution means the business of financing by way of loans and advances, hire-purchase finance, acquisition of stocks, equities, debentures, any other marketable securities, etc., insurance business, etc.

Exclusions from definition

The NBFC business does not include entities whose principal business is the following:

• Agricultural activity

• Industrial activity

• Purchase or sale of any goods excluding securities

• Sale / Purchase / Construction of any immovable property – Providing of any services.

The following NBFCs are not required to obtain any registration with the RBI, as these are already registered and regulated by other regulators:

• Merchant Banking Companies

• Stock broking companies registered with SEBI

• Venture capital funds

• Insurance companies holding a certificate of registration issued by IRDA

• Chit Fund Companies as defined in section 2, Clause (b) of the Chit Fund Act, 1982

• Nidhi Companies as notified u/s 620(A) of the Companies Act, 1956.

Meaning of principal business

The RBI has defined¹ financial activity as principal business to bring clarity to the entities that will be monitored and regulated as NBFCs under the RBI Act. The criteria are called the 50-50 test and are as under:

• The company’s financial assets must constitute 50% of the total assets AND

• The income from financial assets must constitute 50% of the total income.

The RBI, vide its Circular Ref: RBI/2011-12/446 DNBS (PD) CC. No. 259/03.02.59/2011-12 dated 15th March, 2012 has clarified that parking of funds in bank deposits without commencing NBFI activities within a period of six months after registration cannot be treated as financial assets and receipt of interest income on fixed deposits with banks cannot be treated as income from financial assets as these are not covered under the activities mentioned in the definition of ‘financial Institution’ in section 45-I(c) of the RBI Act, 1934. This is because bank deposits constitute near money and can be used only for temporary parking of idle funds, and till the commencement of the NBFI business for the initial six months after registration.

1 Vide Circular DNBS (PD) C.C. No. 81 / 03.05.002 / 2006-07

Housing Finance Activities

Housing Finance Activities are carried on by Housing Finance Institutions. The term ‘Housing Finance Institution’ is not defined in the RBI Act. However, reference can be made to the National Housing Bank Act, 1987 which defines such institutions and the definition is as follows: ‘housing finance institution’ includes every institution, whether incorporated or not, which primarily transacts or has as one of its principal objects the transacting of the business of providing finance for housing, whether directly or indirectly; Housing finance companies are defined under the Housing Finance Companies (National Housing Bank) Directions, 2010 as follows:

‘housing finance company’ means a company incorporated under the Companies Act, 1956 (1 of 1956) which primarily transacts or has as one of its principal objects the transacting of the business of providing finance for housing, whether directly or indirectly.Earlier, Housing finance companies were supposed to be registered with the National Housing Bank. However, based on the amendments made to the National Housing Bank Act, 1987 through the Finance (No. 2) Act, 2019 now registrations of HFC’s are within the ambit of RBI. All earlier HFCs having obtained registrations under the National Housing Bank Act, 1987 shall be deemed to be registered with the RBI and such HFCs shall comply with the prescribed conditions. Specific Responsibilities of Auditors (Master Direction – Non-Banking Financial Companies Auditor’s Report (Reserve Bank) Directions, 2016):

Conducting Non-Banking Financial Activity without a valid Certificate of Registration (CoR) granted by the Bank is an offence under chapter V of the RBI Act, 1934. Therefore, if the company is engaged in the business of a non-banking financial institution as defined in section 45-I(a) of the RBI Act and meeting the Principal Business Criteria (Financial asset / income pattern) as laid down vide the Bank’s press release dated 8th April, 1999, and directions1 issued by DNBR, the auditor shall examine whether the company has obtained a Certificate of Registration (CoR) from the Bank.

Categorisation of NBFCs

NBFCs have been categorised as under based on whether they accept public deposits as well as based on their assets size and type of activities.

Systemically Important Non-Deposit-taking NBFC (NBFC-ND-SI):

The following are the key conditions which are required to be complied with by such companies as per the relevant RBI directions:

a) A minimum asset size of Rs. 500 crores is required to be maintained.

b) If the asset size post registration falls below Rs. 500 crores in a given month due to temporary fluctuations and not due to actual downsizing, the NBFCs shall continue to meet the reporting requirements and shall comply with the extant directions as applicable to NBFC-NDSI till the submission of its next audited balance sheet to the RBI. A specific dispensation letter from the RBI should be obtained in this regard.

c) It has net owned funds of Rs. 200 lakhs as per the latest audited balance sheet unless it undertakes specific business activities as indicated subsequently.

Non-Systemically Important Non-Deposit-taking NBFC (NBFC-ND-NSI)

The following are the key conditions which are required to be complied with by such companies as per the relevant RBI directions:

A) Asset size should be below Rs. 500 crores.

B) It has net owned funds of Rs. 200 lakhs as per the latest audited balance sheet unless it undertakes specific business activities as indicated subsequently.

Deposit-taking NBFC (NBFC-D):

A) It has net owned funds of Rs. 200 lakhs as per the latest audited balance sheet unless it undertakes specific business activities as indicated subsequently.

B) It complies with the various operational provisions for acceptance, renewal, repayment of public deposits and other related matters in terms of the NBFC Acceptance of Public Deposits (RBI) Directions, 2016.

Investment and Credit Company:

It is an NBFC which satisfies the following criteria:

a) Any company which is a financial institution carrying on as its principal business – asset finance, the providing of finance whether by making loans or advances or otherwise for any activity other than its own; and

b) Any company which is a financial institution carrying on as its principal business the acquisition of securities and is not in any other category of NBFC as defined by the RBI in any of its Master Directions.

Factoring Companies:

a) They should be registered with the RBI u/s 3 of the Factoring Regulation Act, 2011.

b) The financial assets in the factoring business should constitute at least 50% of the total assets and the income derived from the factoring business is not less than 50% of the total income.

‘Factoring business’ means the business of acquisition of receivables of assignor by accepting assignment of such receivables or financing, whether by way of making loans or advances or otherwise against the security interest over any receivables but does not include –

(i) credit facilities provided by a bank in its ordinary course of business against security of receivables;

(ii) any activity as commission agent or otherwise for sale of agricultural produce or goods of any kind whatsoever or any activity relating to the production, storage, supply, distribution, acquisition or control of such produce or goods or provision of any services (as defined in the Factoring Regulation Act, 2011).

Infrastructure Debt Fund NBFC (IDF-NBFC):

a) The sponsor entity should be registered as an Infrastructure Finance Company [IFC] (see below).

b) The sponsor entity should comply with the following conditions:

(i) It has obtained the prior approval of the RBI to sponsor an IDF-NBFC.

(ii) It shall be allowed to contribute a maximum of 49% to the equity of the IDF-NBFCs with a minimum equity holding of 30% of the equity of the IDF-NBFC.

(iii) Post investment in the IDF-NBFC, the sponsor must maintain minimum Capital to Risk Assets Ratio (CRAR) and Net Owned Funds (NOF) prescribed for IFCs.

c) The IDF-NBFC shall comply with the following conditions:

(i) It has Net Owned Funds of Rs. 300 crores or more.

(ii) It invests only in Public Private Partnerships (PPP) and post commencement operations date (COD) infrastructure projects which have completed at least one year of satisfactory commercial operations.

(iii) It has entered into a Tripartite Agreement (involving the IDF-NBFC, the concessionaire and relevant project authority) in accordance with the prescribed guidelines.

(iv) It shall have at the minimum a credit rating grade of ‘A’ of CRISIL or equivalent rating issued by other accredited rating agencies such as FITCH, CARE and ICRA.

(v) It shall have at the minimum CRAR of 15% and Tier II Capital shall not exceed Tier I Capital.

NBFC – Micro Finance Institutions (NBFC-MFIs):

a) It has net owned funds of Rs. 500 lakhs (except if it is registered in the North Eastern Region, in which case the requirement is Rs. 200 lakhs).

b) It has a capital adequacy ratio consisting of Tier I and Tier II Capital which shall not be less than 15%. The total of Tier II Capital at any point of time shall not exceed 100% of Tier I Capital.

c) It needs to ensure that not less than 85% of the net assets (total assets other than cash and bank balances and money market instruments) are in the nature of qualifying assets. [As defined in the RBI Guidelines.]

NBFC – Infrastructure Finance Company (NBFC-IFC):

a) It does not accept deposits.

b) A minimum of 75% of its total assets are deployed in ‘infrastructure lending’. [See note below]

c) It has Net Owned Funds of Rs. 300 crores or more.

d) It shall have at the minimum a credit rating grade of ‘A’ of CRISIL or equivalent rating issued by other accredited rating agencies such as FITCH, CARE and ICRA.

e) It shall have at the minimum CRAR of 15% (with a minimum Tier I capital of 10%).

‘Infrastructure lending’ means a credit facility extended by an NBFC to a borrower by way of term loan, project loan subscription to bonds / debentures / preference shares / equity shares in a project company acquired as a part of the project finance package such that subscription amount to be ‘in the nature of advance’ or any other form of long-term funded facility for exposure in the infrastructure sub-sectors as notified by the Department of Economic Affairs, Ministry of Finance, Government of India, from time to time.

NBFC Account Aggregator:

a) The entity has net owned funds of Rs. 200 lakhs and above.

b) The entity does not have a leverage ratio [ratio of outside liabilities excluding borrowings / loans from group companies to owned funds] of more than seven.

c) There is a Board-Approved Policy for undertaking the business as an Account Aggregator, including the pricing thereof which at least provides the matters as laid down in the guidelines.

‘Business of an Account Aggregator’ means the business of providing under a contract, service in the following matters:

(i) retrieving or collecting such specified financial information [as prescribed by the RBI] pertaining to its customers, as may be specified by the RBI from time to time; and

(ii) consolidating, organising and presenting such information to the customer or any other financial information user [an entity registered with and regulated by any financial sector regulator{RBI, SEBI, IRDA and PFRDA}] as may be specified by the RBI provided that the financial information pertaining to the customer shall not be the property of the Account Aggregator, and not be used in any other manner.

NBFC Peer-to-Peer Lending Platform (NBFC P2P):

a) The entity has net owned funds of Rs. 200 lakhs and above.

b) There is a Board-Approved Policy for undertaking the business on the Peer-to-Peer Lending platform, including the pricing thereof which at least provides the matters as laid down in the guidelines.

‘Peer-to-Peer Lending Platform’ means an intermediary providing the services of loan facilitation via online medium or otherwise, except as indicated hereunder, to the participants who have entered into an arrangement with an NBFC P2P to lend on it or to avail of loan facilitation services provided by it.

(i) Not to raise deposits as defined by or u/s 45-I(bb) of the Act or the Companies Act, 2013;

(ii) Not to lend on its own;

(iii) Not to provide or arrange any credit enhancement or credit guarantee;

(iv) Not to facilitate or permit any secured lending linked to its platform; i.e., only clean loans will be permitted;

(v) Not to hold, on its own balance sheet, funds received from lenders for lending, or funds received from borrowers for servicing loans; or such funds as stipulated below;

(vi) Not cross-sell any product except for loan-specific insurance products.

Securitisation and Reconstruction Companies

a) The entity has net owned funds of Rs. 200 lakhs and above.

b) It should undertake the business of securitisation and asset reconstruction in accordance with the prescribed guidelines for which there is a proper Board-Approved policy, covering the following matters, amongst others:

(i) Acquisition of financial assets.

(ii) Rescheduling of debts.

(iii) Enforcement of security interest.

(iv) Settlement of dues payable by the borrower.

(v) Conversion of debt into equity.

(vi) Realisation plan. Change / takeover of management.

(vii) Issue of security receipts and related matters.

Keeping in mind the above reporting requirements, the following are some of the practical challenges that could arise in reporting under this Clause:

a) Entities engaged in other than NBFI activities: The auditor may come across situations in which a company engaged in other than NBFI activities holds funds in financial assets which may be in excess of 50%, pending deployment in the business, or due to other business / commercial reasons. In such cases the auditor needs to examine the objects of the company in the Memorandum of Association, minutes of the Board / other committee meetings, business plans, etc., and also whether the company has corresponded with the RBI and accordingly make a factual mention under this Clause. He should use his judgement based on the facts and circumstances and apply professional scepticism. If required, he should obtain management representation only as additional evidence and not as a substitute for other audit procedures.

b) NBFCs not requiring registration under the RBI Act: For such entities as identified above, the auditor should check whether they have obtained registration from SEBI or other applicable regulators since strictly they are also regarded as NBFCs in terms of the RBI guidelines and accordingly appropriate factual reporting is recommended. This aspect is not covered in the Guidance Note and a clarification from the MCA and / or the ICAI on the same is desirable.

c) Withdrawal / revocation / suspension / surrender of Certificate of Registration: The auditor should check whether the certificate of registration is withdrawn, revoked, suspended or surrendered and ascertain the reasons for the same and whether the same could affect the going concern assumption and accordingly ensure consistency in reporting. This is particularly relevant for specific classes of NBFCs as indicated earlier and whether they are undertaking only the prescribed activities and complying with the specific conditions as laid down. He should use his judgement based on the facts and circumstances and apply professional scepticism and ensure factual reporting, as deemed necessary. If required he should obtain management representation only as additional evidence and not as a substitute for other audit procedures. Finally, he should also seek guidance as per SA 250 dealing with reporting responsibilities due to non-compliance with laws and regulations.

d) Reporting under the RBI guidelines: The auditor should keep in mind the specific certification and reporting responsibilities under the NBFC Auditors Report (Reserve Bank) Directions, 2016 to report any non-compliances or exceptions, as prescribed (which includes carrying on business on the basis of a registration certificate), as well as any other deviations, especially those impacting specific classes of companies as indicated above. In such cases there should be consistency in reporting both under the Directions as well as under this Clause with appropriate cross-referencing and linking.

CICs [Clause 3(xvi)(c) and (d)]:

Before proceeding further, it would be pertinent to note the following statutory requirements:

Definition of Core Investment Companies – CIC’s

Core Investment Companies are defined as companies which comply with 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 ten years from the date of issue) in group companies and units of Infrastructure Investment Trust only as sponsor constitute not less than 60% of its net assets as mentioned in Clause (i) above…
provided that the exposure of such CICs towards InvITs shall be limited to their holdings as sponsors and shall not, at any point in time, exceed the minimum holding of units and tenor prescribed in this regard by SEBI (Infrastructure Investment Trusts) Regulations, 2014 as amended from time to time.

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;

iv. it does not carry on any other financial activity referred to in sections 45-I(c) and 45-I(f) of the Reserve Bank of India Act, 1934 except

a. investment in

(i) bank deposits,

(ii) money market instruments, including money market mutual funds and liquid mutual funds,

(iii) government securities, and

(iv) bonds or debentures issued by group companies

b. granting of loans to group companies and

c. issuing guarantees on behalf of group companies.

Definition of Group Companies

‘Companies in the Group’ means an arrangement involving two or more entities related to each other through any of the following relationships:

a) Subsidiary-parent (defined in terms of AS 21),

b) Joint venture (defined in terms of AS 27),

c) Associate (defined in terms of AS 23),

d) Promoter – promotee [as provided in the SEBI (Acquisition of Shares and Takeover) Regulations, 1997] for listed companies,

e) a related party (defined in terms of AS 18),

f) Common brand name, and

g) investment in equity shares of 20% and above.

Note: Even in case of entities which adopt Ind AS, it appears that the group companies would have to be identified as per the criteria prescribed in the respective local Accounting Standards.

Definition of Net Assets:

Net Assets means total assets as appearing on the assets side of the balance sheet but excluding

* cash and bank balances;

* investment in money market instruments;

* advance payments of taxes; and

* deferred tax asset.

2 ‘Public funds’ includes funds raised either directly or indirectly through public deposits, inter-corporate deposits, bank finance and all funds received from outside sources such as funds raised by issue of Commercial Papers, debentures, etc., but excludes funds raised by issue of instruments compulsorily convertible into equity shares within a period not exceeding ten years from the date of issue

Registration requirements

CICs having total assets of Rs. 100 crores or more either individually or in aggregate along with other CICs in the group and which raise or hold public funds2 are categorised as Systematically Important Core Investment Company (CIC-ND-SI). All CIC-ND-SI are required to apply to RBI for grant of certificate of registration. Every CIC shall apply to the RBI for grant of certificate of registration within a period of three months from the date of becoming a CIC-ND-SI.CIC-ND-SI who do not have asset size of more than Rs. 100 crores and Core Investment Companies that do not have access to public funds are exempted from the registration requirement with RBI. This exemption is not applicable to CICs who intend to make overseas investment in the financial sector. However, these CICs shall pass a Board Resolution that they will not, in the future, access public funds.CICs investing in Joint Venture / Subsidiary / Representative Offices overseas in the financial sector shall require prior approval from the RBI.

Raising of Tier II Capital by NBFCs

‘Tier II capital’ includes the following:

a) Preference shares other than those which are compulsorily convertible into equity;

b) Revaluation Reserves at discounted rate of 55%;

c) General provisions (including that for Standard Assets) and loss reserves to the extent these are not attributable to actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, to the extent of one and one fourth per cent of risk weighted assets;

d) Hybrid debt capital instruments [a capital instrument which possesses certain characteristics of equity as well as of debt];

e) Subordinated debt [see below]; and

f) Perpetual debt instruments issued by a non-deposit-taking NBFC which is in excess of what qualifies for Tier I Capital, to the extent the aggregate does not exceed Tier I capital.Subordinated Debt

It means an instrument which fulfils the following conditions:

a) It is fully paid-up;

b) It is unsecured;

c) It is subordinated to the claims of other creditors;

d) It is free from restrictive clauses; and

e) It is not redeemable at the instance of the holder or without the consent of the supervisory authority of the non-banking financial company.

Keeping in mind the above reporting requirements, the following are some of the practical challenges that could arise in reporting under this Clause:

a) Identifying subsidiaries and associates: Since this Clause requires identification of investments in group companies, viz., subsidiaries, joint ventures and associates under the respective Accounting Standards under Indian GAAP, there could be practical challenges for companies adopting Ind AS, since the definitions therein could be different.

There is emphasis on legal control under AS 21, 23 and 27 for companies adopting Indian GAAP. The concept of control and, therefore, subsidiary relationship under Ind AS 110 is much broader. Existence of factors such as de facto control, potential voting rights, control through de facto agents, power to enforce certain decisions, etc., have to be considered, which are not considered for the purpose of section 2(87). Hence, for companies adopting Ind AS there could be differences between what is disclosed in the accounts as group companies and what is required for identifying CICs under this Clause, which would need to be reconciled to ensure completeness of reporting. The auditors of Ind AS companies will need to take utmost care about this distinction while dealing with this Clause.

b) Companies adopting Ind AS: One of the criteria for exemption of CIC-ND-SI with asset size of less than Rs. 100 crores from registration is that it does not accept ‘Public Funds’ as defined above. Companies adopting Ind AS are likely to face certain practical challenges as under:

* The borrowings need to be considered on the basis of the legal form rather than on the basis of the substance of the arrangements as is required in terms of Ind AS 32 and 109. Accordingly, redeemable preference shares from the public though considered as financial liabilities / borrowings under Ind AS, will not be considered in the definition of public funds since legally they are in the nature of share capital. Similarly, optionally convertible debentures raised from the public though considered as compound financial instruments or equity under Ind AS, will be considered in the definition of public funds since only funds raised by issue of instruments compulsorily convertible into equity shares within a period not exceeding ten years from the date of issue are exempted from the definition of public deposits.

* Such NBFCs raising Tier II capital (including any subordinated debt) from the public would need to carefully examine the terms and conditions and accordingly ensure that any instrument which is in the nature of equity in terms of Ind AS 32 and 109 is not considered ‘public funds’ as referred to earlier. In respect of hybrid instruments, the predominant legal characteristics would need to be considered even if certain portion is classified as equity in terms of Ind AS 32 and 109. The auditors of Ind AS companies will need to take utmost care about this distinction while dealing with this Clause.

c) Reporting under the RBI guidelines: Similar considerations as discussed under Clause 3(xvi)(b) earlier would apply.

CONCLUSION

The additional reporting responsibilities have placed specific responsibilities on the auditors in the light of several recent failures in the sector and the expectation bar has been substantially raised amongst the various stakeholders. Accordingly, they would need to be equally adept both at pole vaulting as well as long jump to cross the raised bar!

shailesh.kwebmaker

DO CONGLOMERATE STRUCTURES FACILITATE BUSINESS EFFICIENCY?

A very common business structure used across the world for business control and management is that of Holding Companies. Business Promoter Groups hold shareholding interest in entities through the process of intercompany shareholding, everything finally rising to the top into a company which is called the ultimate Holding Company of that Business Group.

The purpose of this article is not financial analysis but to attempt to understand the reasons for variations and what could be the takeaways for corporate businesses.

These Holding Companies could have reporting entities (mainly subsidiaries) on a geographical basis (subsidiaries overseas) or on different business basis (national or international).

The writer analysed ten entities which have standalone businesses and investments in subsidiaries / joint ventures / associates. For the purpose of further discussion, two entities were dropped – one had losses and the other had negative working capital. The remaining eight entities are:

1. Infosys Ltd.;
2. Hindustan Unilever Ltd.;
3. Tata Chemicals Ltd.;
4. WIPRO Ltd.;
5. Tata Consumer Products Ltd.;
6. Maruti Suzuki Ltd.;
7. Godrej Consumer Products Ltd.;
8. Dr. Reddy’s Labs Ltd.

These entities were analysed for six Key High-Level Ratios at Standalone Business and Consolidated Financials basis:
a) Net Profit Before Tax to Total Revenue – as %;
b) Earnings before Interest and Tax (EBIT) to Total Revenue – as %;
c) Earnings before Interest, Depreciation, Amortisation and Tax (EBITDA) to Total Revenue – as %;
d) Return on Capital Employed – as % of EBIT divided by Capital Employed;
e) Turnover of Capital Employed – Number of Times Capital Employed is turned to get Total Revenue on annualised basis;
f) Working Capital Turnover – Number of times Working Capital is turned to get Total Revenue on annualised basis.

In ratios (a) to (d) above, the higher percentage is better and in the last two turnover ratios, a higher number of times indicates improved efficiency. For all eight companies, a comparison of the ratios at standalone and consolidated entity were done and the following were the results.

Findings from the ratios:
1) In two specific companies all six ratios at the Consolidated Financials stage were lower than at standalone stage;
2) In four companies, five ratios at CFS were lower than standalone entities;
3) In one company, four ratios at CFS were lower than standalone entity;
4) In one company, two ratios at CFS were lower than standalone entity – it was the only case where consolidated financials could be said to be stronger than standalone financials.

Clearly, the performance of the satellite units is NOT adding value to the standalone Holding Company.

The questions that one needs to ask are:
(a) Through the process of creating multiple subsidiaries, are we losing supervision of performance and management control on the business? This is a serious issue at the stage that India is – since inefficiency of Financial / HR / Management resources results in less than optimum performance;
(b) The Holding Company for whatever reasons – emotional on retaining / nurturing businesses or improper analysis of business study – thereby holding on to companies / businesses that it should legitimately divest;
(c) Is the financial reporting of business performance of a good quality so the right red flags are raised, or do matters suddenly blow up and management is left wondering what could have gone amiss;
(d) Are subsidiaries allowed a free run, with inadequate supervision or manned by a management cadre which is not up to the task? Are there no demands of performance on them since the subsidiaries are small businesses, not paid much attention to;
(e) Is there excessive management focus on holding company standalone businesses and the focus on other related entities is much less, resulting in great surprises when things go wrong.

Whatever may be the reasons, the recent IL&FS and DHFL cases have shown the need for much superior monitoring of conglomerate structures. Often, many skeletons start coming out of the closet on a trigger event occurring and they impact the ultimate Holding Company. There is no doubt that Boards of Directors, Auditors, Rating agencies, Capital markets (mainly minority shareholders) have been stung by these two cases. The need to focus on Consolidated Financials Statements is being felt stronger than ever before. CFS is no longer an accounting exercise devoid of practical applications.

One way of improving Indian corporate efficiency is ensuring that the variation in performance parameters in standalone and consolidated financials is not too significant to create cause for concern. In the eight companies forming part of this study, the variations were quite significant, reflecting the need for tighter management review and control.

It is my opinion that all companies which are listed Holding Companies and entities which are not listed but have a certain large size on Total Revenues and / or Net Worth, must have the following done for their fulfilment of legal requirements:

1) Look at the possibility of Holding Company dividends being considered not at standalone entity level but at consolidated financials level so that there is proper emphasis on performance and linking the same with dividends payouts;
2) Managerial remuneration under the Companies Act MUST BE guided not by standalone entity performance but by Holding Company (CFS) level performance.

There is reason to believe that both the above actions will force Promoter Groups to focus on overall performance rather than on standalone performance.

Note – The author wishes to thank the professionals that he has connected with for the purpose of clarifications on the subject of this Article.

shailesh.kwebmaker

MLI SERIES -ARTICLE 10 – ANTI-ABUSE RULE FOR PEs SITUATED IN THIRD JURISDICTIONS (Part 2)

In the first part of this article (BCAJ, December, 2021), the authors covered the background for the introduction of this anti-avoidance rule, its broad structure, some of the issues arising in interpretation of the said rule and the interplay of this rule with the other articles of the MLI and other anti-avoidance measures. In this second part, they analyse some practical challenges arising on account of the difference in the tax rates of the jurisdictions involved and the impact of the anti-avoidance rule on India. This part shall also cover the difference between Article 10 of the MLI and the BEPS Action Plan 6 Report on the basis of which the rule was incorporated in the MLI and Article 29 of the OECD Model

1. DIFFERENCE IN LANGUAGE IN BEPS ACTION 6 AND MLI
As mentioned in the first part of this article, there are certain differences between the suggested language in the final report of the BEPS Action Plan 6 and that in Article 10 of the MLI.

The first major difference is in respect of the implication of the application of the Article. In case Article 10 of the MLI applies, the Source State (State S) shall not be restricted by the DTAA and can tax the said income as per the domestic tax law. The draft language in the BEPS Action Report provided that in case the anti-abuse provisions apply, the Source State (State S) can tax income other than dividends, interest or royalties under the domestic tax law. In respect of the specified income, i.e., dividends, interest or royalties, the tax to be charged by the Source State would be restricted to a rate to be determined.

The other difference is in respect of the exemption from application of the anti-abuse rule. This difference is further explained in para 4 of this article.

Another difference between the BEPS Action Plan 6 report and Article 10 of the MLI is in respect of the conditions for triggering of the rule. Article 10 of the MLI applies if the income is exempt in State R and the tax rate in State PE is lower than 60% of the tax rate in State R. The BEPS Report had provided another optional language which can be used, wherein State S can deny the benefits in the treaty if the tax rate in State PE is lower than 60% of the tax rate in State R. In other words, under this optional language the condition that the income should be exempt in State R was not required to be triggered to apply the rule. Similar language has also been provided in the OECD Model Commentary as an optional language that countries can bilaterally negotiate.

While Article 29 of the OECD Model is largely similar to Article 10 of the MLI, there are two significant differences. The first one is discussed in the above paragraph. Another difference is in respect of the 60% threshold. The OECD Model provides that if the tax rate in State PE is less than 60% of the tax rate in State R, the rule would not apply if the tax rate in State PE is higher than a rate which is to be bilaterally agreed.

2. ISSUES ARISING ON ACCOUNT OF DIFFERENCE IN TAX RATES IN STATE PE AND STATE R
Article 10(1) of the MLI provides that in certain circumstances, benefit of the S-R DTAA shall not be available to any item of income on which the tax in State PE is less than 60% of the tax that would be imposed in the State R on that item of income if that PE were situated in State R.

Therefore, the article requires one to first hypothesise a PE of the taxpayer (A Co) in State R and if the rate of tax in State PE on that item of income is less than 60% of the tax on the same item of income in State R, then the benefit of the R-S DTAA shall not be available in State S.

Hypothesising a PE of the taxpayer in State R can result in various issues, some of which are discussed below.

2.1 Which tax rate is to be considered?
This issue is explained by way of an example. Let us assume gross income of 100, expenses of 80 and the tax rate in State R is 30%, the general corporate tax rate on PE in State PE is 20% but due to certain incentives provided by State PE, the tax on income from financing activities is 10%. In such a scenario, the question is should one compare the 30% rate in State R with 20% in State PE or with the actual tax rate of 10% in State PE? If one takes a view that the headline tax rate is to be considered, Article 10 of the MLI may not have an impact as the tax rate in State PE (20%) is more than 60% of the tax rate in State R (30%).

However, in the view of the authors, as Article 10(1) of the MLI refers to tax on an ‘item of income’, one would need to look at the effective tax rate of 10% in this case in State PE and compare the same with that in State R. This view is keeping in mind the objective of the provisions that the State S should not give up its right of taxation to the State R unless the income is taxed by the PE State at a minimum of 60% of the tax which would have been levied in the State R.

A similar view has also been provided in para 166 of the OECD Commentary on Article 29 wherein the mechanism provides that one should compare the ratio of the tax applicable to the net profit of the PE in both states – State PE as well as State R.

2.2 What would be the case if there is a loss in the State PE?
Another issue which arises is what would be the case if there is a loss in a particular year in the State PE. Let us assume the following facts:

*Particulars*	Year 1	Year 2
Gross income of the PE	100	100
Deductible expenses	120	90
Net taxable income of PE (before set-off of loss)	(20)	30
Tax rate in State PE	20%
Tax rate in State R	30%

In the above case, in Year 1, the tax paid in State PE is Nil on account of the loss. Assuming that the mode of claiming deduction, etc., and the amount of deduction in State R is similar to that in State PE (refer para 3.3.4 for issues arising on account of difference in the mode of computation in both the jurisdictions), no income is taxed in State R and therefore one may be able to argue that in Year 1 Article 10 of the MLI is not triggered as the rate of tax in State PE is more than 60% of the rate of tax in State R on the same item of income.

Now, in Year 2 in State PE the tax payable would be 2 (20% of 10) as one would reduce the loss brought forward from Year 1 while computing the income of Year 2. This would be possible even in the absence of a specific provision in the domestic tax law of State PE on account of Article 24 of the State R-State PE DTAA, dealing with Non-Discrimination, which provides that a PE in a jurisdiction should be taxed in the same manner as a resident of the said jurisdiction1. Now, in State R, assuming that the taxpayer has other income as well, no set-off of loss would be possible as the income of a resident is taxed on a net basis (i.e., by aggregating the income of any PE in that State as well as the head office in that State) and, therefore, there is no loss brought forward. In such a case, the tax paid in State R in Year 2 would be 9 (30% of 30) and as the tax paid in State PE is less than 60% of the tax paid in State R, Article 10 of MLI could trigger even though the tax rate on the item of income in State PE (20%) is more than 60% of the tax rate on the said item of income in State R (30%).

However, in the said fact pattern, in the view of the authors, Article 10 of the MLI should not trigger as the difference is only on account of the losses incurred in State PE and due to the fact that other income earned in State R is used to set-off the loss of the PE in Year 1, resulting in no carry forward of the loss.

Alternatively, a better view of the matter would be to hypothesise the PE as a separate entity in State R and then compare the tax payable in State R and State PE. This view is in line with the objective of the provisions, which is to deny treaty benefits if the tax rate in State PE is less than 60% of the tax rate in State R on that item of income.

___________________________________________________________________

1 Refer para 40(c) of the OECD Commentary on Article 24

2.3 Whether tax credit in State PE or State R of taxes paid in State S to be considered?
The question arises whether one should compare the taxes in State R and State PE or should one ignore the tax credit for such comparison. Let us consider the following illustration:

*Particulars*	*Amount*
Gross amount	100
Expenses deductible	80
Net profit attributable to PE	20
Tax rate in State PE	20%
Tax rate in State R	30%
Tax rate as per State S-State PE DTAA	10%
Tax rate as per State S-State R DTAA	10%

In the above illustration, if one does not consider the tax credit, the tax rate in State PE (20%) is more than 60% of the tax rate in State R (30%) and therefore Article 10 of the MLI should not be triggered. However, assuming that State PE applies the Non-Discrimination article as mentioned in the first part of this article, and grants credit for the taxes paid in State S, the actual tax paid in State PE would be 2.

Further, while State R would actually not provide any tax credit (as it follows the exemption method), when one hypothesises a PE in State R, tax credit for taxes paid under the R-S DTAA would also be considered. In such a scenario, the hypothetical tax payable in State R after tax credit would be 4 and if one now compares the taxes in State PE (2) with that of State R (4), Article 10 of the MLI could be triggered.

However, in the view of the authors, given the objective of the provisions, the comparison should be in respect of the taxes before the tax credit as one is trying to evaluate if the tax in State PE is substantially lower than the tax in State R. One may also draw a similar conclusion from para 166 of the OECD Commentary on Article 29 which refers to ‘tax that applies’ to the relevant item of income and not tax paid.

2.4 Issue relating to difference in the mode of computation of income in State R vs. in State PE
Given that each country has a different set of rules for computing income, there may be a difference in the tax applicable on an item of income on account of the difference in the mode of computation in these jurisdictions.

Let us first take an illustration wherein the income is taxed on a net basis in State PE, but on gross basis in State R. This could be possible, say in the case of dividend received from a foreign company and taxed on gross basis akin to section 115BBD of the Act. The facts of the illustration are as follows:

*Particulars*	*Amount*
Gross amount	100
Expenses deductible	80
Net profit attributable to PE	20
Tax rate in State PE	20%
Tax rate in State R	10% on gross income

In the above illustration, the tax payable in State PE would be 4 (20% of 20). On the other hand, if one hypothesises a PE in State R, given that State R taxes the income on gross basis (irrespective of whether the resident has a PE in the Residence State or not), the hypothetical tax payable in State R would be 10 (10% of 100).

In such a scenario, even though the headline tax rate in State PE is in fact higher than the tax rate in State R, given that State PE taxes the PE on a net basis whereas State R taxes the income on gross basis, Article 10 of the MLI could be triggered as the tax applicable on the item of income in State PE (4) is less than that applicable in State R (10).

Another issue arises where the amount of deduction allowable is different in both the jurisdictions. Let us take an illustration wherein the facts are as follows:

*Particulars*	Amount in State PE	Amount in State R
Gross amount	100	100
Expenses deductible	80	60
Net profit attributable to PE	20	40
Tax rate	20%	30%

In the above illustration, the tax payable in State PE is 4 (20% of 20) whereas the tax payable in State R if the PE was in State R is 12 (30% of 40). Therefore, even though the headline tax rate in State PE (20%) is more than 60% of that in State R (30%), Article 10 of the MLI would trigger as one needs to compare the tax applicable on an item of income in accordance with the provisions applicable in the respective jurisdictions.

This is also in line with the objective of the provisions.

3. PARA 2 OF ARTICLE 10 OF MLI – WHAT IS CONSIDERED AS ACTIVE CONDUCT OF BUSINESS
Para 2 of Article 10 of the MLI provides that the anti-abuse provisions of Article 10 of the MLI shall not apply if the income is derived in connection with or is incidental to the active conduct of a business carried out through the PE. The exception to the exemption is the business of making, managing or simply holding investments for the enterprise’s own account. However, if the business of making, managing or holding investments represents banking, insurance or securities activities carried on by a bank, insurance enterprise or registered securities dealer, respectively, it would be covered under the exemption from the application of the anti-abuse rules.

Paras 167, 74, 75 and 76 of OECD Commentary on Article 29 provide some guidance on what would be considered as income derived in connection with or incidental to the active conduct of business. The Commentary provides that whether an item of income is derived in connection with active business it must be determined on the basis of the facts and circumstances of the case.

Let us look at the following examples to understand whether income in the form of dividend, interest or royalty can be considered as derived in connection with the active conduct of business of the PE:
a. A Co, resident of State R, is in the business of trading securities through its office situated in State PE. As a part of the trading activity, it invests in shares of B Co, a company resident of State S, which pays dividends to A Co. Such dividends may be considered as income derived in connection with the active conduct of business by the PE of A Co in State PE and therefore the anti-abuse provisions in Article 10 would not apply.
b. Similar to the facts above except that instead of investing in shares, A Co invests in debt securities of B Co and trades in such debt securities… In such a scenario, interest earned by A Co may be considered as income derived in connection with the active conduct of the business by the PE of A Co.
c. A Co, a resident of State R, sets up a research and development centre in State PE. It licences the intangible arising out of such R&D to B Co, a company resident of State S, which pays royalty to A Co. Such royalty would be considered as income derived in connection with the active conduct of business by the PE of A Co in State PE.

The draft language in the final BEPS Action Plan 6 report also specifically exempted from the application of the anti-abuse provisions, royalties received as compensation for the use of, or the right to use, intangible property produced or developed by the enterprise through the PE. However, given that such an activity would in any case constitute an active conduct of business by the PE, such language is not provided in the final provisions in the MLI.

4. PRACTICAL APPLICATION OF MLI ARTICLE 10 FOR INDIA TREATIES
4.1 Treaties impacted
The Table below highlights the countries and their position with India in relation to applicability of Article 102:

Sr. No.	Respective countries				*Particulars*	*Impact*
1	1. Australia 2. Belgium 3. Bulgaria 4. Canada 5. Colombia 6. Croatia 7. Cyprus 8. Czech Republic 9. Egypt 10. Estonia	11. Finland 12. France 13. Georgia 14. Greece 15. Hungary 16. Iceland 17. Indonesia 18. Ireland 19. Italy 20. Jordan	21. Korea 22. Kuwait 23. Latvia 24. Lithuania 25. Luxembourg 26. Malaysia 27. Malta 28. Morocco 29. Norway 30. Poland	31. Portugal 32. Qatar 33. Saudi Arabia 34. Serbia 35. Singapore 36. South Africa 37. Sweden 38. Turkey 39. United Arab Emirates 40. United Kingdom 41. North Macedonia	India has not reserved rights for Article 10 of MLI. Other CJs have reserved the rights for non-applicability of the provisions of Article 10 under paragraph 5(a) Thus, Article 10 will not be applicable in entirety	No change in the existing treaty
2	1. Andorra 2. Argentina 3. Bahrain 4. Barbados	11. Costa Rica 12. Côte d’Ivoire 13. Curaçao 14. Gabon	21. Nigeria 22. Pakistan 23. Panama		Not notified as CTA by both the CJs	MLI not applicable
2	(continued) 5. Belize 6. Bosnia and Herzegovina 7. Burkina Faso 8. Cameroon 9. China 10. Chile	(continued) 15. Guernsey 16. Isle of Man 17. Jamaica 18. Jersey 19. Liechtenstein 20. Monaco	(continued) 24. Papua New Guinea 25. Peru 26. San Marino 27. Senegal 28. Seychelles 29. Tunisia
3	1. Germany 2. Hong Kong 3. Mauritius 4. Oman 5. Switzerland				Not notified as CTA by other CJs (Other CJ has not notified its DTAA with India as CTA. Thus, MLI will not be applicable)	MLI not applicable
4	1. Bangladesh 2. Belarus 3. Bhutan 4. Botswana 5. Brazil 6. Ethiopia 7. Kyrgyz Republic 8. Libya 9. Macedonia 10. Mongolia	11. Montenegro 12. Mozambique 13. Myanmar 14. Namibia 15. Nepal 16. Philippines 17. Sri Lanka 18. Sudan 19. Syria 20. Tajikistan	21. Tanzania 22. Thailand 23. Trinidad & Tobago 24. Turkmenistan 25. Uganda 26. USA 27. Uzbekistan 28. Vietnam 29. Zambia		MLI not signed by other CJs	MLI not applicable
5	Iran				Not signed or notified as CTA by India	MLI not applicable
6	1. Albania 2. Armenia 3. Austria 4. Denmark 5. Fiji 6. Japan 7. Kazakhstan 8. Kenya 9. Mexico 10. Netherlands	11. New Zealand 12. Romania 13. Russian Federation (Russia) 14. Slovak Republic 15. Slovenia 16. Spain 17. Ukraine 18. Uruguay 19. Israel 20. Namibia			Neither of the CJs have reserved right for non-applicability and no date has been notified	MLI provisions applicable Will supersede the existing provisions to the extent of incompatibility

_________________________________________________________________

2 These details are updated as on September, 2021

4.2 India as a country of source
Article 10 of the MLI gives the Source State an unhindered right of taxing the income if certain conditions are triggered. As the Source State is denying the benefits of the DTAA, it is important to evaluate from a payer perspective whether the particular provision of the DTAA shall apply in the Source State or not.

Unlike the other TDS provisions in the Act, in most cases section 195 of the Act, in theory, results in the finality of the tax being paid to the Government in the case of payment to a non-resident.

Therefore, the Act places a significant onerous responsibility on the payer to ensure that the due tax is duly deducted u/s 195 of the Act in the case of payments to a non-resident. Keeping this in mind, it is therefore necessary for the payer to evaluate the application of Article 10 of the MLI before granting treaty benefits at the time of deduction of tax u/s 195 of the Act.

Generally, in the background of the application of MLI, a conservative view is to always approach the tax authorities u/s 195(2) or u/s 197 before making any payment. However, from a practical perspective, the same may not be feasible given the timelines for obtaining such a certificate.

On the other hand, while Article 10 of the MLI provides objective tests and does not contain subjective tests such as the Principal Purpose Test, there are certain practical challenges for a payer to apply these objective tests. The payer of the income is expected to analyse the following:
a. Whether the recipient has a PE in a third State;
b. Whether the amount paid by the payer is effectively connected to such PE in the third State;
c. Whether the Residence State exempts such profits of the PE;
d. Whether the tax rate in the third State of PE is less than 60% of the tax rate of the Residence State if such PE were situated in the Residence State.

The above questions would require the payer of income to interpret the tax laws of the third State in which the PE is constituted as well as the Residence State, which may not be possible. It may not be possible for the local consultant to interpret such foreign laws as well.

Therefore, it may be advisable for the payer to obtain a suitable declaration from the recipient while making such payment.

4.3 India as a country having PE
Prior to introduction of the MLI, Article 5 of the DTAA was referred to in order to establish the PE status. However, post introduction of the MLI, the PE status is governed by Articles 12 to 15 which are regarding PE status based on Action 7 of Base Erosion and Profit Shifting (BEPS).

Articles from 12 to 15 are not minimum standards. Thus, each country has an opportunity to reserve or notify applicability of these standards. The provisions of the above mentioned Articles widens the scope of PE as compared to that of the DTAA.

However, India has notified the provisions of Articles 12 to 15. Thus, in cases where the other country’s notification matches with India and India is a third state having PE, one will have to check the DTAA after giving effect to Articles 12 to 15 of the MLI.

However, Indian tax rates are very high, discouraging a potential abuse using India as a third state (State PE). Consequently, Article 10 is likely to have minimal applicability with India as a third state (State PE).

It is important to note that Article 10 does not, in any way, affect India’s right to tax the income attributable to the PE of the non-resident in India in accordance with the relevant DTAA.

4.4 India as a country of residence
As per the existing provisions of the DTAA, India has been following the credit method and not the exemption method. Further, India has reserved its rights regarding the applicability of Article 5 (Application of Methods for Elimination of Double Taxation) of the MLI.

Thus, in cases where India is a Resident State, paragraph 1 of Article 10 may not be of much relevance as India does not follow the exemption method.

5. CONCLUSION
Anti-abuse rules are necessary to prevent abuse of tax treaty provisions. However, when there are multiple anti-abuse rules under the Act as well as treaty, cohesive, coordinated and appropriate application of these anti-abuse rules becomes very necessary to avoid any uncertainty or hardships to the taxpayer. Rational interpretation of these anti-abuse provisions has become of utmost importance so that genuine business structures are not affected and stuck with litigations.

From a payer’s perspective, Article 10 of the MLI can have serious consequences. Further, as highlighted in the earlier paras, there are practical challenges a payer might face while evaluating the application of this Article, particularly as one would need to interpret the tax laws and treaties of other jurisdictions which may not always be possible. A practitioner who is certifying the remittances in Form 15CB may also need to evaluate the impact and, at the very least should seek a suitable declaration from the recipient of the income.

shailesh.kwebmaker

DIFFERENTIATING BETWEEN FACELESS AND BASELESS ASSESSMENTS

Faceless assessments (FA) are meant to serve three critical purposes – bridging the distance / location and time barriers (you don’t have to appear at a location and therefore saving time), removing direct contact between adjudicator and assessee (cause of evil influence on adjudication which now can be done by a process involving a number of people) and creating a trail (online mechanism creates a much better trail). FA is a refreshingly welcome step, but as usual has implementation shortcomings.

In the same breadth, one cannot ignore the overarching, if not the sole purpose of adjudication: giving justice – to let the law prevail, to give a fair and equal opportunity to present and to speed up adjudication. Here potential (what it can deliver) of a system must be evaluated with expectation (what it should deliver).
Some of the recent observations on FA by the judiciary are disheartening and even unnerving when they could have easily been encouraging and ushering in a new era. Let me summarise observations by the courts on FA:

1. Final order passed without issue of show cause notice (say for variation made to income by the A.O.)
2. Non-issue of draft assessment order
3. Non-grant of personal hearing
4. Not granting ‘effective and meaningful’ opportunity to file objections against SCN / Draft Assessment Order (DAO)
5. Assessee not able to file a reply as portal was down
6. Passing order and making additions without giving any reason / basis of addition not furnished to the assessee
7. Failure to deal with assessee’s request for adjournment
8. Undue haste in passing the final order before expiry of time limit to file objections in SCN / DAO
9. Final order passed without considering objections / submissions against DAO
10. Non-grant of reasonable time

Here are some observations by courts (kept short in count and length for brevity):
…assessment order not having been passed in conformity with the requirements of the Faceless Assessment Scheme, 2019 has to be treated as non-est and shall be deemed to have never been passed. [Chander Arjandas Manwani vs. NFAC (2021) 130 taxmann.com 445 (Bom HC)].
…there is a blatant violation of the principles of natural justice as well as mandatory procedure prescribed in ‘Faceless Assessment Scheme’ [Interglobe Enterprises (P) Ltd. vs. NFAC (2021) 130 taxmann.com 54 (Del)].
..The Department shall give the petitioner a personal hearing on a date and at a time which shall be communicated to the petitioner sufficiently in advance. [Orissa Stevedores Ltd. vs. UOI (2021) 128 taxmann.com 163 (Orissa)].
…several requests had been made for personal hearing by the petitioner none of which were dealt with by the respondent / Revenue [Sanjay Aggarwal vs. NFAC (2021) 281 Taxman 282 (Del)].
…Revenue, to our minds, could not have side-stepped such safeguards put in place by the Legislature [YCD Industries vs. NFAC (2021) 437 ITR 119 (Del)].
…failed to deal with the petitioner’s request for a short adjournment. The petitioner… has, correctly, pointed out that there has been an undue haste by respondent… in passing the impugned assessment order… [Blue Square Infrastructure LLP vs. NFAC (2021) 436 ITR 118 (Del)].
…this Court feels that, since the chance of getting a personal hearing is part and parcel of the principles of natural justice, therefore, it comes within the domain of the writ jurisdiction, and on that ground this Court feels that this writ petition can be entertained. [Nagalina Nadar M.M. vs. Addl. / Joint / Deputy / Asst. CIT (2021) 130 taxmann.com 448 (Mad)].

From numerous reported cases, Courts seem to be left with no option but to send matters for fresh adjudication. Although the Courts may not have observed in recent cases, but reassessment does give a second innings to the Department. All this is nothing but loss of time, cost to the taxpayer, fruitless litigation and waste of precious court time with no consequence or accountability cast upon the tax officer to follow minimum standards of administration of law.

The risk in FAs without curtailing the above ‘spread of infection’ could make it rather baseless or lawless assessment. The danger signal is – will the taxpayer be forced to go to Courts to enforce basic rights? In a lighter vein: NeAC which is not giving proper hearing, will perhaps listen to these concerns!

Raman Jokhakar
Editor

shailesh.kwebmaker

TIRUKKURAL ON THE IMPORTANCE OF PRANAYAMA

TirukkuRaL, citing medical experts, states in the verse 941

‘Miginum kuRaiyinum noyceyyum noolor
VaLimudhala eNNiya moondRu’

This is interpreted by many commentators as, ‘Excess or deficiency of the three humours could cause disease; wind begins these humours as listed by experts.’

This extant interpretation of this verse is found in all commentaries right from Parimelazhagar to Dr. Mu. Va and others. A different interpretation is found in the exhaustive commentary by ‘Namakkal Kavingar’ Ramalingam Pillai. He says the three humours are air, water and food and not bile, flatulence and phlegm. The main reason for this unique interpretation is that TiruvaLLuvar addresses this verse to the commoner to easily understand the underlying principle of health management. Everyone cannot understand what are bile, flatulence and phlegm. These are the ‘effects’ caused by the ‘excess or deficiency’ in consumption of air, water and food.

‘VaLimudhala eNNiya moondRu’ means only air, water and food. Nature mandates these three as our main sources of energy, i.e., oxygen. The moment there is excess or deficit in one or more of the three sources of energy, disease results. That is, in simple words, the plain meaning of this verse in KuRaL.

This maxim of KuRaL teaches us to take preventive care and avoid diseases. Once a person falls sick, only then the need to consult a physician arises. In the verses 948 and 949, KuRaL prescribes the method of diagnosis to be employed by the physician. Whereas the verses 941 to 945 bring out the significance of preventive care by self-restraint and self-discipline – in consumption of air, water and food; when to take food and when not to take, what to take and what not to take. Of the three humours only air has to be breathed in and out all 24 hours of the day, while food and water have to be taken only when one is feeling thirsty and / or hungry.

All of us consciously drink water and eat food. But generally we ignore breathing consciously. Whenever we go for clinical examination by a doctor, only then do we take a deep breath, as directed by the physician; otherwise, only when we heave a sigh of relief. Consequently, we generally suffer from a deficit of oxygen because we get oxygen from glucose (C6H12O6) and water (H2O) extracted by our digestive system. Oxygen, by volume, constitutes 21% of the air we breathe in. The other components of air are, by volume, about 78% of nitrogen and about 1% of minor gases like argon, carbon dioxide, etc. Of these constituents (inhaled by us), the entire 78% nitrogen and about 16% of oxygen and balance minor gases are all exhaled. That means when we consciously breathe in and out, about 4% to 5% of oxygen is retained by us.

When we do so conscientiously, we would realise that there is a consequent reduction in our intake of food because our requirement of oxygen is satiated. The result: blood pressure becomes normal, any sugar problem gets resolved and the sense of well-being improves many notches. This noumenon explains how the sages could live hundreds of years in penance without any food or water. That is why we are advised to concentrate on our breath during meditation. In the 1990 World Cub Football final match the German player Brehme stood calmly for about 30 seconds before successfully scoring the winning penalty goal. He said he was meditating for those 30 seconds before taking the strike.

When we do not breathe in adequate air we tend to consume more food and less water and that causes the imbalance leading to many diseases, some chronic and others seasonal. Hence the dictum of TirukkuRaL quoted above.

Indeed, TiruvaLLuvar lays equal emphasis on learning through listening and states in verse 412 that one should eat a little food only when there is no food for thought (through listening)!

Then the question arises how does one ensure that there is no deficiency in the intake of air? That leads us to the importance of Pranayama or any set of breathing exercises. Unfortunately, in all our curricular studies this aspect of breathing properly is not emphasised except in select educational institutions. It is high time that it is mandated in all our schools and colleges. The Japanese have a tradition even in their factories – the first activity in the morning is for all workers, from the Chief Executive down to the last level, to assemble for a physical workout for 15 minutes. The purpose is obvious – to keep fit.

A word of common sense. We neglect the natural ventilator we are bestowed with and ultimately some of us reach a stage when we are put on artificial ventilators. During the pandemic period there was a global crisis on the availability of ventilators. It was mainly due to the fact that we have not realised the importance of conscientious breathing. Significantly, we ensure breathing out the carbon dioxide (CO2) generated from food and water, which is also absolutely necessary.

So, let us all breathe conscientiously, properly and live healthily.

shailesh.kwebmaker

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Year: 2022

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