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Shift In US Trade Policy on Tariffs – Impact on the Indian Economy and the World

The Trump Administration 2.0 began with an ‘America First Trade Policy’. Mr. Trump has issued several Executive Orders and Proclamations since assuming his office on January 20, 2025. The significant among them is an increase in tariffs across the board by 10 per cent which is slated to increase to higher tariffs on some select 57 countries with which the US has major trade deficit in goods. Although the latter hike in tariffs is put on hold till July 8 2025, the actions by the US have created enough turmoil in international trade, with some countries imposing retaliatory tariffs, while other countries, including India, having chosen to negotiate a trade deal with the US. This article covers various aspects of tariffs by the US, the background and the impact of these measures on the Indian economy and the World.

INTRODUCTION

The recent tariff measures by the United States of America (“US”) have thrown much of the global trade in goods into disarray. The frequent changes to the policy, particularly the ‘tariff-on’ and ‘tariff-off’ policy, have made business planning difficult for companies, particularly those having exposure to the US. The threat of tariffs has made many countries rush to the US to secure trade deals to avoid punitive tariffs for their export goods. Businesses thrive when there is certainty in policy measures, but in the face of these frequent threats and policy changes, is it possible for a country or business to avoid the US market? The answer lies in some numbers. The US is the largest economy in the World, with a GDP of $29.18 trillion, i.e. about 26% of the World’s GDP.1 According to the World Bank, the US is the largest consumer in the World with an annual consumption expenditure of $22.54 trillion, which represents about 30% of the World’s annual consumption expenditure2 despite having only 4.22% of the World’s population3, giving it a high annual GDP per capita of $85,810. The American consumers spent about $6.1 trillion on goods alone in 2024.4 Hence, in today’s globalised economy, it may not be possible for a business to simply ignore the US consumer. This brings us to the issues which this Article wishes to address, namely, to understand the recent measures by the US and their rationale, their basis in law – both the local US law and the World Trade Organization (“WTO”) law and analyzing its impact on the economy and business.


1 GDP of 2024 at current prices as per International Monetary Fund (IMF)
https://www.imf.org/external/datamapper/profile/USA
2 Source: World Bank, 2023 estimates, https://data.worldbank.org/ [both goods and services, household final consumption expenditure (private consumption) and general government final consumption expenditure]
3 https://www.worldometers.info/world-population/us-population/
4 https://www.visualcapitalist.com/americas-19-trillion-consumer-economy-in-one-chart/#:~:text=Where%20Americans%20Spend%20Their%20Money,as%20well%20(%2417.8T).

Section I of the Article provides the foundational basis for the current US policy, particularly the shift in policy to tariffs. Section II gives a brief of the US legislation and the actions taken by the US President till date with insights on ongoing litigation in the US courts. Section III discusses the legality of US actions under the GATT/WTO. Section IV discusses the impact of the US tariffs on the global economy with changing supply chain dynamics as well as opportunities and threats for Indian businesses. The Article closes with the concluding remarks on US tariffs and their impact.

I. SHIFT IN US TRADE POLICY TO TARIFFS

On 20th January, 2025, the first day of taking charge as the US President, Mr. Donald J. Trump (“Trump”) issued a series of Executive Orders (“EO”) and proclamations. Among them was the EO titled ‘America First Trade Policy’ (“AFTP EO”) which gave insights into the policy which the President would be following in days to come. The AFTP EO stated that the American economy, the American worker, and the National security of America will be at the forefront of US policy decisions. It also stated that the aim of the new US administration is to promote investment and manufacturing in the US. One of the ‘National Security’ risks highlighted in the AFTP EO was the ‘unfair and unbalanced trade’ with its major trading partners. To put a perspective, the table below provides the trade balance of the US with its major trading partners.

The table shows that in 2024, the US had an overall trade deficit in goods of $1.29 trillion, which means that the US imported more goods than it exported to other nations. The highest trade deficit was with China, at $319 billion, followed by the EU at $203.5 billion, Mexico at $176 billion and Vietnam at $129.37. There was a trade deficit even with Canada, India and other nations. On the services front, in 2024, the US’s exports were $1107.8 billion, and imports were $814.4 billion, giving a surplus of ~ $293.4 billion.5 Even if one offsets this surplus, the overall trade deficit in goods and services for the US in 2024 was close to $1 trillion.


5 https://www.bea.gov/news/2025/us-international-trade-goods-and-services-december-and-annual-2024

The ever-increasing trade deficit in goods has been a subject matter of debate between economists in the US for several decades. The trade deficit in goods has continuously increased from $690.16 billion in 2010 to $1.29 trillion in 2024, as shown in the graph below.

The burgeoning US trade deficit can be explained with the textbook theory of macro-economic factors of disbalance between savings and investment rates. In simple terms, this implies that Americans have been spending more money on consumption expenditure (i.e., buying more goods than they produce) with low savings and investment spending rates. This additional spending goes to foreign goods, which is then financed through borrowing from foreign lenders (US treasury bonds) or foreigners purchasing US assets.

Some policymakers argue that macro factors of the stronger dollar (which encourages imports and discourages exports), more buying power of consumers in the US, and manufacturing shift to lower labour cost jurisdictions would naturally lead to higher trade deficits. While others argue that shifting manufacturing to low-cost jurisdictions like the ASEAN (Thailand, Vietnam, Malaysia, Indonesia, etc.) and other parts of the World like China has been a result of unfair foreign government policies and incentivisation. It is argued that the rise of China during the last three decades as a World’s powerhouse of manufacturing, resulting from unfair trade practices of the Communist regime in Beijing, is a major cause of the situation. In particular, it is argued that Beijing’s State control and subsidisation of manufacturing led to the establishment of huge capacities in China far exceeding the domestic demand, boosting of exports through unfair incentives, tax enforcement of the IPR regime, manipulation of currency through devaluation to boost exports, unfair labour and environmental practices of China has led to the situation.

One set of policymakers focused their efforts on tackling this situation by addressing the inherent deficiencies like boosting investments in infrastructure and targeted incentives to increase the domestic manufacturing base. The previous US President Biden’s policy initiatives were efforts in that direction, such as the Bipartisan Infrastructure Law (BIL), formally known as the Infrastructure Investment and Jobs Act (IIJA) which focused on funding a wide range of infrastructure projects, the Build America, Buy America Act (BABA) which mandated that iron, steel, manufactured goods, and construction materials used in US federal funded infrastructure projects must be produced in the US, the CHIPS and Science Act which focused on boosting US semiconductor manufacturing. A similar set of policy initiatives may also be seen in the Indian context, like the ‘Make in India’ policy and infrastructure parks (Electronics Parks, Plastic Parks, PM MITRA Textile Parks, Mega Food Parks, etc.).

The other set of policymakers believe that directly disincentivizing or curtailing imports, inter alia through Tariff measures, is an immediate solution to the situation. The current US President Trump’s policy measures by imposing punitive import tariffs are efforts in that direction, even if it involves disrupting the rule based international trade and the principles established by the WTO.

Hence, there is a clear shift in the US policy under the new administration with tariffs as one of the main policy instruments. Tariffs have also been used by the US as a threat to negotiate better trade deals with its trading partners. With this background in mind, the next section looks at the relevant legislation used by the US in its renewed policy.

II. LEGISLATION USED BY THE US FOR IMPOSING TARIFFS AND ACTIONS TAKEN THEREUNDER

In his first term (2017-2021), Trump had used Section 232 of the Trade Expansion Act, 1962 (“TEA”) in 2018 to impose import tariffs of 25% and 10% on Steel and Aluminium, respectively, subject to some product / country-specific exemptions. These tariffs were expanded to include specified derivatives of Steel and Aluminium in 2020. In 2018, Trump also used Section 301 of the Trade Act, 1974 (“TA”) to impose tariffs ranging from 7.5% to 25% on several goods of China (covered in four lists ranging from $34 billion in list 1 to $300 billion in list 4). These tariffs continue to exist today and have been further expanded in Trump’s second term.

In his second term (2025-), effective March 12, 2025, Trump used Section 232 of the TEA to expand the scope of import tariffs on Steel and Aluminium by bringing both on par at 25% each, withdrawing all previous exemptions, and significantly increasing the scope of coverage of derivatives products. The President has also used the same section to impose tariffs of 25% on specified Automobiles (“Auto”) and Auto parts from all countries, subject to quota-based exemptions.6 Due to the close integration of Auto supply chains between the US, Canada and Mexico, the Tariffs on Autos, which qualify the USMCA rules of origin,7 have been exempted to the extent of US content of such vehicles. Further, the USMCA qualified Auto parts imported into the US from Canada and Mexico have also been exempted.


6 Auto Tariffs apply only to passenger vehicles (sedans, sport utility vehicles, 
crossover utility vehicles, minivans, and cargo vans) and light trucks. 
Auto parts cover Engines and engine parts, Transmissions and powertrain parts, 
and Electrical components of passenger vehicles and light trucks. 
Auto tariffs were effective April 3, 2025, and Auto parts Tariffs were effective May 3, 2025.

7 USMCA is the United States-Mexico-Canada Free Trade Agreement which 
replaced the North American Free Trade Agreement (NAFTA) and become 
effective July 1, 2020, in Trump’s first term.

In addition, Trump has extensively used another US Act, called as International Emergency Economic Powers Act, 1977 (“IEEPA”), to impose import tariffs on Canada, Mexico and China (including Hong Kong) by taking the cue of fentanyl trade8, which has claimed to cause a situation of ‘National Emergency’ and public health crisis in the US. A tariff of 10% was imposed on goods from China and Hong Kong with effect from 4th February, 2025, which was increased to 20% effective 12th March, 2025. Similarly, effective 4th March, 2025, the goods from Mexico and Canada have imposed a tariff of 25% (except potash/specified energy products having a tariff rate of 10%). This tariff measure was later amended to exempt USMCA-qualified goods.

The US President has also used IEEPA to impose a baseline tariff of 10% with effect from April 5, 2025, on all countries (including India)and a higher-country specific reciprocal tariff on 57 listed countries varying from 11% to 50%9 with effect from April 9, 2025 (currently on pause for 90 days, till 8th July, 2025). For China10, the reciprocal tariffs were increased to 125% from April 10, 2025, due to retaliation by China with similar tariffs on US goods (the 125% tariff has been suspended for 90 days and rolled back to 10% with effect from 14th May, 2025, pending negotiations between US and China).


8 Fentanyl is a synthetic opioid drug used for pain relief and anesthetic. 

The US has argued that Canada and Mexico have permitted the Fentanyl 

drug to flow into the US through its porous borders creating a 

situation of National Emergency and public health crisis in the US.

9 India is amongst the 57 countries and India’s tariff rate is specified to be 26%.

10 Includes Hong Kong and Macau

Further, under the IEEPA, the US has withdrawn the de-minimis exemption11 for goods, including international parcels from China and Hong Kong (effective 2nd May, 2025).


11 A de-minimis exemption is exemption given under US law to goods of value less 
than $800 from duties and certain procedural requirements at the time of imports into the US.

The above tariffs imposed by the US are in addition to normal customs duties (called MFN rates), fees, taxes, exactions, or charges applicable to imported articles. Further, the above tariffs stack on each other, i.e., becomes cumulative unless otherwise specified.12

Legislations Conditions and Actions Previous illustrative uses and the current usage
Sec 232 of TEA » If certain imports threaten the ‘National Security’ of the US.

» Authorises the President to bypass Congress and modify /adjust the imports by tariffs/quotas.

» Investigation by the Department of Commerce (“DOC”) and a report by the Secretary of Commerce to the President is a pre-condition to take action.

» Last imposed tariffs or other trade restrictions three decades before in 1986.

Shift in policy under Trump’s first term.

» The President opened 8 investigations, and Tariffs were imposed under 2 such cases on Steel and Aluminium.

» Other investigations were on Auto and Auto parts, etc. but no actions were taken, or agreements were reached with countries.

Continued actions under Trump’s second term

»  Expanded the tariffs on Aluminium and Aluminium derivatives to 25%.

» Expanded the coverage of derivatives of Steel and Aluminium.

» Imposed Auto and Auto parts tariffs of 25% from all countries, subject to some quota-based exemptions for Auto parts (acting on the 2019 report of the Secretary of Commerce).

Sec 301 of TA » United States Trade Representative (“USTR”) does an investigation and recommends action to enforce US rights under a trade agreement or to respond to certain foreign unfair trade practices.

» Consultations by USTR with targeted Government.

» If the determination is affirmative, it decides actions to be taken.

» Authorises the President to impose duties or other import restrictions and actions.

 

» Since the formation of WTO in 1995, the US used this measure to build cases and pursue dispute settlement at the WTO.

Shift in policy under Trump’s first term.

» 2018 – China was acted against due to its IPR violations.

» 2019 – The EU (including the UK) were acted against due to their subsidies on large civil aircraft (Tariffs later suspended in July 2021)

» 2019 – Investigation on France against its ‘discriminatory’ Digital Services Taxes (DST) (Tariffs later suspended due to larger investigation on countries adopting similar taxes).

» 2020 – Several countries, including India, were investigated for their ‘discriminatory’ foreign DST laws (No tariffs currently, pending negotiations).

» 2020 – Vietnam was investigated for their ‘unfair currency valuation’ and use of ‘illegally harvested timber’ (Tariffs not imposed based on an agreement with Vietnam to improve its currency valuation and timber trade practices)

IEEPA » Unusual and extraordinary threat, which has its source in substantial part outside the US, to the National Security, foreign policy, and economy of the US.

» Power given to the President with some exceptions and checks

»Report to be submitted later to Congress on actions taken.

»Trump, in his second term, has used this legislation extensively to impose tariffs on China / Mexico /Canada for failure to check the Fentanyl trade.

» Imposed baseline tariff of 10% on all countries due to ‘unfair and unbalanced trade” position with trading partners.

» Higher country specific reciprocal tariff on 57 countries (currently on pause for 90 days, till 8th July, 2025).

»Tariffs on de-minimis shipments from China and Hong Kong.


12 As per another executive order issued on April 29, 2025, 
the goods which are subject to Auto/Auto parts tariffs under
 Sec 232 of TEA will not be subject to Tariffs imposed on Canada/Mexico
 under IEEPA or Tariffs on Steel/Aluminium under Sec 232 of TEA. Further, 
the goods which are subject to IEEPA tariffs on Canada/Mexico will not be 
subject to Tariffs on Steel / Aluminium under Sec 232 of TEA.

The tariffs imposed by the US have been challenged in several lawsuits filed across the US, particularly by the Democratic States, including the States of Arizona, Colorado, Connecticut, Delaware, Illinois, New York and Oregon. In particular, the reciprocal tariffs have been challenged in the US courts on the grounds that the IEEPA does not specifically authorise the President to impose tariffs and that the US trade deficit cannot be equated to a “National Emergency” as contemplated under the IEEPA. In addition, the State of California has also filed a lawsuit to halt the tariffs imposed by the Trump administration, which the State believes was not taken with Congressional approval and will negatively impact its economy. In a recent decision of the Court of International Trade (CIT) in V.O.S. Vs. The USA, the CIT at Manhattan, New York has set aside all Trump’s actions under IEEPA and accordingly invalidated the reciprocal tariffs (10% baseline and higher country specific tariffs) and tariffs imposed on China/Canada/Mexico for failure to curb the fentanyl trade. The CIT held that Trump exceeded his authority granted by the Congress under the IEEPA to impose tariffs. The US government has appealed this decision before the Court of Appeals for Federal Circuit which has temporarily granted a stay on the CIT’s decision until the court hears both parties.

III. WTO/ GATT PERSPECTIVE OF US TARIFFS

“In the pre-World War II era, the market access for trade in goods was based on trading partners’ economic or political clout. With uncertainty and protectionist measures by different countries to further their economic objectives, several countries got together and entered into an agreement called the General Agreement on Tariffs and Trade (GATT, 1947), which formed the basis for rule-based international trade. This agreement was signed in Geneva in 1947 by 23 countries. Both India and the US were parties to the GATT. The GATT was a crucial step towards rebuilding the global economy after World War II with an aim to reduce trade barriers and promote free and fair trade among partner nations. The GATT aimed to reduce tariffs and eliminate other trade barriers to promote free trade. Importantly, it was the US which played a leading role in the creation of GATT because it wanted liberalisation of protectionist policies to help the US export more goods to other countries. It was the GATT, 1947, which, after several rounds of multilateral negotiations, led to the formation of WTO in 1995 by the Marrakesh Agreement, signed in Marrakesh, Morocco. While the WTO replaced GATT, the principles of GATT are still incorporated into the WTO agreement.

One of the basic principles enshrined in GATT/WTO is the Most Favored Nation (MFN) principle under Article I. The MFN principle essentially states that if a country grants a trade advantage (like lower tariffs) to one trading partner, it must unconditionally and immediately extend the same advantage to all other WTO members. Another important Article II of GATT is the schedule of concessions of each member nation, which binds the member not to increase the customs duty rates beyond the bound rate given in its schedule.

Article XXI(b)(iii) of GATT covers the national security exception, which allows the members to violate the GATT principles if such actions are “taken in time of war or other emergency in international relations”. The US has lost several cases at the WTO wherein it violated the GATT principles by invoking the national security exception under Article XXI(b)(iii). The argument of the US before the WTO’s judicial Panels, that this exception is ‘self-judging’ and cannot be subject matter of judicial review, has been rejected by the WTO panels. In the US-Origin Marking (Hong Kong, China) case,13 the argument raised by the US that human rights violations in Hong Kong can be used as a basis to violate the GATT disciplines was rejected by the WTO panel. It was held that such human rights violations in HK, even if evidenced, cannot be escalated to the threshold of requisite gravity to constitute an “emergency in international relations”. This phrase was held to refer to a state of affairs of the utmost gravity – a breakdown or near-breakdown in the relations between states.


13 WT/DS597/R (WTO Panel Report dated 21 December 2022)

More importantly, the US also lost WTO cases relating to the imposition of tariffs under Sec 301 of the TA against China14 and under Sec 232 of the TEA on Steel and Aluminium.15


14 The US defense built under Article XX(a) which deals with general exception of 
“necessary to protect public morals” was rejected on the ground that there was 
no genuine relationship of “ends and means” and hence it was held that the US had 
violated GATT disciplines relating to MFN and bound rates (WT/DS543/R WTO Panel 
Report dated 15 Sep 2020)
15 US’s defense under Article XXI(b)(iii) was rejected – measures not 
“taken in time of war or other emergency in international relations” and hence it
 was held that the US had violated MFN, bound rates and Quantitative Restrictions 
under GATT (WT/DS544/R WTO Panel Report dated 9 Dec 2022)

It may be worthwhile to note that since 2017 the US has blocked the appointment of new judges to the WTO’s Appellate Body (AB) due to complaints over judicial activism at the WTO and concerns over US sovereignty.16 This has brought the WTO’s dispute settlement system to a standstill making it effectively non-functional. There are currently no members in the seven member AB with the term of the last sitting member expired on 30th November, 2020.17 Hence, today, all appeals filed by the WTO members including the US against the Panel rulings are pending adjudication at WTO’s AB with no judges in place. It would not be out of place to say that the country which argued for liberalisation leading to the creation of GATT / WTO has itself turned back full circle to bring in an era of protectionism in trade.


16 The World Trade Organization: The Appellate Body Crisis | Economics Program and Scholl Chair in International Business | CSIS
17 https://www.wto.org/english/tratop_e/dispu_e/ab_members_descrp_e.htm

IV. IMPACT OF THE US TARIFFS ON THE INDIAN ECONOMY AND THE WORLD

In today’s globalised World, supply chains are integrated across nations, and most products pass through manufacturing stages in several countries before landing in the hands of the consumer in the country of consumption. If the country of consumption is the US, the moot question which arises is what will be the tariff rate applicable to such product at the time of import into the US? Whether it is the country where the principal raw material was manufactured (say, China) or where further processing on it was undertaken (say, India). This question assumes importance because US tariffs are now based on the country to which the product belongs. Complicating the situation is the test of the last ‘substantial transformation’ applied by the US in judging this criterion with a plethora of complex judicial rulings in the US courts. This has led to several supply chain shifts by companies away from China to avoid punitive US Tariffs.

In addition, reciprocal tariffs under IEEPA provide an exemption to the US content of the product if such US content is at least 20% of the total value of the product. Further, tariffs under Sec 232 on Steel and Aluminium derivatives are exempt if the Aluminum is smelted and cast in the US or Steel is melted and poured in the US. These issues are leading the companies to rethink their supply chain modelling to reduce the impact of US tariffs and stay export competitive.

While the threat of US tariffs remains, there are certain opportunities for Indian businesses looking to export more to the US. A look at the table below shows that India is exporting products to the US under Chapters overlapping with China, which gives an opportunity to the Indian business to increase their exports on account of the present 30% tariffs on China vs. 10% tariffs on Indian goods under the IEEPA.

With the India-US currently engaged in intense negotiations for the Bilateral Trade Agreement (BTA), it still needs to be seen whether the Indian Government can negotiate a deal with the US which can lead to enhanced export competitiveness of Indian goods to the US, particularly in labour-intensive sectors like plastics, textiles, gems and jewellery, electronics, pharma and chemicals.

V. CONCLUSION

The US concern stems from an ever-increasing trade deficit in goods with most of its major trading partners. This has led to a discernible shift in the US trade policy to tariff measures. With the WTO in a state of limbo particularly due to the non-functional Appellate Body (AB) mechanism, the US seems to be not concerned with the legality of its measures with the GATT / WTO disciplines. As a result of US tariffs, the businesses World over, including in India, are forced to rethink the supply chains of their goods. The present situation is both a threat and an opportunity for Indian businesses and the success will depend upon how the businesses can rekindle their decision-making and whether the Indian government is able to negotiate a good deal with the US helping the Indian exporter community.

Rights of the Accused under PMLA for Obtaining Copies of the Records / Documents

This article deals with the Judgement of the Supreme Court in Sarla Gupta & Onr. vs. Directorate of Enforcement and the right of an accused to obtain copies of the Records / Documents collected by the Investigative Agencies under the PMLA.

INTRODUCTION

The saying that “Information is power” is age-old. Investigating agencies, while investigating a certain offence, tend to collect a large amount of data and information in the quest for justice. An investigation, as well as the resulting prosecution (if any), is supposed to be fair and unbiased. An officer administering certain provisions of an act also conducts inquiries from time to time. This also leads to the collection and compilation of a large amount of data. This data is relevant not only because it could be used to establish that a certain accused is involved in the offence of money laundering but also to give rise to reasonable doubt as to his complicity. The burden of proof to convict an accused in a criminal trial is “beyond reasonable doubt”. If the prosecution cannot prove its case beyond a reasonable doubt, the accused has to be acquitted. Just as the information conducted during an inquiry or an investigation forms the basis of the prosecution case, the same can also be pressed into service for defence. For a criminal trial to be fair to the accused, it is essential that the defence has access to all the material that is at the command of the prosecution. This is particularly relevant for the material that is relied on by the prosecution. The fundamental principle of criminal law is that an accused has the right to confront their accuser and also confront the evidence produced against them.

SECTION 207 & 208 OF CRPC AND PMLA PROCEEDINGS AND SUPPLY OF ‘RELIED UPON DOCUMENTS’

The three-Judge division bench judgement of the Supreme Court in Sarla Gupta & onr. vs. Directorate of Enforcement 2025 SCC OnLine SC 1063 strikes a win for fairness in prosecutions under the Prevention of Money Laundering Act, 2002 (better known as the PMLA).

In modern-day criminal law jurisprudence, due weightage needs to be given to fairness. After all, justice must not only be done but must also be seen to be done. Just like it would not be fair for a person to be made to participate in a fist-fight with one of his hands tied behind him, it would hardly be fair if an accused was not granted copies of the material relied on against him. There are two important provisions under the Code of Criminal Procedure (CrPC) which deal with the supply of documents – Sections 207 and 208. The corresponding Sections of the Bharatiya Nagrik Suraksha Sanhita (BNSS) are Sections 230 and 231 respectively. Section 207 of the CrPC applies when the proceedings have been instituted on a police report and are triable by the magistrate. Section 208 applies to a case that is instituted otherwise than on a police report, and the Magistrate is of the view that the case is exclusively triable by the Court of Session.

The complaint based on which the Special Court for the PMLA takes cognisance of an offence has documents annexed to it in order to support its contents. These are the documents ‘relied upon’ in this context to make its case. In Criminal Appeal No. 730 of 2024, which is a part of the common judgement reported in Sarla Gupta, the Supreme Court held that “Both Sections 207 and 208, on the face of it, do not specifically apply to a complaint under Section 44(1)(b) of the PMLA. But, there is no reason why the principles laid down under Sections 207 and 208 should not be applied to a complaint under Section 44(1)(b) of the PMLA”. Relying upon the concept of fair play and Article 21 of the Constitution of India, the Supreme Court made sections 207 & 208 of CrPC applicable to cases under the PMLA. The Court went on to read in the protections that are afforded by sections 207 & 208 of the CrPC into the PMLA in the form of these Directions:

“Therefore, once cognizance is taken on the basis of a complaint under Section 44(1)(b) of the PMLA, the learned Special Judge must direct that along with the process, a copy of the complaint and the following documents must be provided to the accused:

a. Statements recorded by the learned Special Judge of the complainant and the witnesses, if any, before taking cognizance;

b. The documents, including the copies of the Statements under Section 50 of the PMLA produced before the Special Court, along with the complaint, and the documents produced subsequently by the ED till the date of taking cognizance; and

c. Copies of the supplementary complaints and the documents, if any, produced with supplementary complaints.

After cognizance is taken on the basis of the complaint, the ED cannot be heard to say that a document has been produced with the complaint or in the proceedings of the complaint, but it is not a relied-upon document. The copies of documents must be supplied along with a copy of the complaint as required by subsection (3) of Section 204 of the CrPC (sub-section (3) of Section 227 of the BNSS).”

Thus, the directions of the Supreme Court to the Special Court for the trial of PMLA offences is quite clear – documents, as mentioned in the directions reproduced above, must be made available to the Accused once the Special Court take cognizance of an offence under the PMLA. This would equip the accused to take an informed decision on the defence that they wish to take up during trial. But this by itself is not enough. The Judgement of the Court also makes it mandatory that copies of the document produced with the complaint or the proceedings of the complaint must be supplied to the Accused and that the Directorate of Enforcement cannot refuse to furnish any such document by stating that it is not a ‘relied upon document’ in the complaint. This act of the Supreme Court in bringing in these safeguards based on sections 207 & 208 of CrPC is a significant development in PMLA jurisprudence.

SUPPLY OF DOCUMENTS IN THE POSSESSION OF THE DIRECTORATE, NOT RELIED UPON

The ED does not need to rely upon all the documents that it collects during its investigation. There is no obligation on the investigating agency to rely upon all the data that it so collects. However, some of this data could be beneficial to the Accused in preparing their defence. Just like statutes, the interpretation or inferences drawn from data can be different by a different set of eyes. Our system of law administration is fundamentally adversarial in nature unlike in some of the countries that follow ‘civil law’ or the ‘continental system of law’. This gives rise to the danger of the prosecution withholding exculpatory documents from the accused while only relying upon the incriminating documents. The danger of this situation actually arising cannot be ruled out, and the consequences can be severe.

In the year 2021, another three-judge Division bench of the Supreme Court in Criminal Trials Guidelines Regarding Inadequacies and Deficiencies, In re, (2021) 10 SCC 598 observed, “The Amici Curiae pointed out that at the commencement of trial, accused are only furnished with list of documents and statements which the prosecution relies on and are kept in the dark about other material, which the police or the prosecution may have in their possession, which may be exculpatory in nature, or absolve or help the accused. This Court is of the opinion that while furnishing the list of statements, documents and material objects under sections 207/208 CrPC, the Magistrate should also ensure that a list of other materials (such as statements or objects/documents seized, but not relied on) should be furnished to the accused. This is to ensure that in case the accused is of the view that such materials are necessary to be produced for a proper and just trial, she or he may seek appropriate orders under CrPC”. This right was also reiterated in the case of Manoj vs. State of M.P., (2023) 2 SCC 353 where the Supreme Court reiterated its stand that “this Court holds that the prosecution, in the interests of fairness, should as a matter of rule, in all criminal trials, comply with the above rule, and furnish the list of statements, documents, material objects and exhibits which are not relied upon by the investigating officer. The presiding officers of courts in criminal trials shall ensure compliance with such rules”.

In Criminal Appeal No. 730 of 2024, which is a part of the common judgement reported in Sarla Gupta, the Supreme Court observed these prior Judgements and agreed that these documents had to be furnished to the Accused. However, the Court proceeded to analyse at what stage the Accused is entitled to seek copies of the Documents not relied on by the prosecution. The Supreme Court observed that “at the time of hearing for framing of charge, reliance can be placed only on the documents forming part of the charge sheet. In case of the PMLA, at the time of framing charge, reliance can be placed only on those documents which are produced along with the complaint or supplementary complaint. Though the accused will be entitled to the list of documents, objects, exhibits etc. that are not relied upon by the ED at the stage of framing of charge, in ordinary course, the accused is not entitled to seek copies of the said documents at the stage of framing of charge.”

It is, therefore, rare that copies of all the documents are given to the Accused before the framing of the charge. To give or not to give would still be the discretion of the court. However, after the charge is framed, under Section 233 of the CrPC (Section 256 of the BNSS), there is less latitude given to the Courts to refuse the production of documents.

In Criminal Appeal No. 730 of 2024, which is a part of the common judgement reported in Sarla Gupta, the Supreme Court observed, “On plain reading of sub-section (1) of Section 91, the power of the court is discretionary. The word ‘may’ appears in sub-section (1) of Section 91. However, if we peruse sub-section (3) of Section 233 and sub-section (2) of Section 243, the word ‘shall’ has been used. The reason is that these two provisions apply at the stage of the accused leading defence evidence. Therefore, it is provided that if the accused applies for the issue of any process for compelling the attendance of any witness or the production of any document or thing, the court must issue such process. The prayer for issue of such process cannot be denied unless the court, for reasons to be recorded, holds that the application is made for the purposes of vexation or delay or for defeating the ends of justice.”

The Court, therefore, went on to hold that “After carefully perusing the provisions of the PMLA, we did not find any provision of the PMLA which is inconsistent with Section 91 of the CrPC. The power under sub-section (1) of Section 91 can be exercised by a Court when the production of any document or any other thing is necessary or desirable for the purposes of any investigation, inquiry, trial or other proceedings under the CrPC. The consistent line of judgments of this Court hold that at the stage of framing of charge, the accused is ordinarily not entitled to apply under Section 91 of the CrPC for producing the documents which are not relied upon by the complainant. For the purposes of his defence, the accused has a right to seek production of a document or a thing at the stage of leading defence evidence as Section 233 of CrPC will apply to the trial of an offence under the PMLA, due to the fact that Chapter XVIII of the CrPC is made applicable to such trial in view of clause (d) of Section 44(1) of the PMLA.” It also observed that in the light of the negative burden of proof that is placed by Section 24 of the PMLA on the accused, Section 233(3) of the CrPC should be liberally construed in favour of the Accused. This is also because the constitutional validity of Section 24 of the PMLA has been upheld on the ground that the accused has full opportunity to show that he has not violated the provisions of the PMLA and rebut the presumption. If the Special Court refuses the prayer for documents u/s 233 of the CrPC, the accused will not be able to discharge the burden, and the Supreme Court, therefore, held that this right of the Accused must be protected.

CAN DOCUMENTS BE SOUGHT BY THE ACCUSED DURING BAIL PROCEEDINGS UNDER THE PMLA?

The primary reason why PMLA is so feared is the difficulty that an arrested accused faces in order to obtain bail. Getting bail under the PMLA is infamously difficult and is the primary reason that the PMLA is considered draconian. The offence of money laundering is non-bailable, i.e. bail cannot be obtained as a matter of right but is subject to judicial discretion. There are various factors that weigh in with a Court while deciding whether or not to release an accused on bail. The PMLA, through Section 45(1)(ii), adds the ‘twin conditions’ that must be fulfilled over and above this in order for the accused to secure bail. Therefore, if an accused makes an application for bail u/s 45 of the PMLA and the prosecutor opposes the grant of bail, the Court cannot grant bail to the Accused unless “the court is satisfied that there are reasonable grounds for believing that he is not guilty of such offence and that he is not likely to commit any offence while on bail”.

The first of the twin conditions requires that the accused demonstrate to the court that there are ‘reasonable grounds’ for believing that he is not guilty of such offence. This can be very difficult to do if the Accused does not have access to the documents and data that can help him discharge the burden. The Supreme Court in Criminal Appeal No. 730 of 2024, which is a part of the common judgement reported in Sarla Gupta, held that “If a narrow view is taken, by denying this opportunity to the accused, he will not be in a position to discharge the burden on him, and therefore, it will affect his right to liberty as he may be denied bail. This denial will amount to a violation of his rights guaranteed under Article 21. Therefore, at the stage of hearing of a bail application to which stringent provisions of Section 45(1)(ii) of the PMLA are applicable, the accused must be allowed to invoke the provision of Section 91 of the CrPC for seeking production of the documents not relied upon by the ED. But, when the investigation is pending while permitting the accused to seek production of documents that are not relied upon by invoking Section 91 of the CrPC, care has to be taken to ensure that the investigation is not prejudiced. Therefore, when such an application is made, the ED is entitled to resist the production of documents that are not relied upon on the ground that if the said documents are disclosed at that stage to the accused, it may prejudice the investigation. Though the ED is entitled to raise the said plea, it will have to show the documents to the Court. The Court can, for reasons recorded, deny production of documents only if it is satisfied that the disclosure of the documents may prejudice the ongoing investigation. Needless to add that the ED cannot raise such an objection after the investigation is complete.” It is important to note that the Court considered Article 21 of the Constitution of India as the fountain from which the right to receive the documents springs. This Judgement, therefore, is a big step in defending the fundamental rights that have been guaranteed under the Constitution of India. The Court specifically observed that “ When the Legislature has felt a need to bring out a legislation like the PMLA, it is the duty of the Court to interpret Article 21 in such a way that the right of a fair trial available to the accused is not affected. The object of the provisions of Section 24 or 45(1)(ii) is not to take away the fundamental right of fair trial conferred on the accused. These provisions are different in the sense that they put a burden on the accused. When such a burden is put on the accused, it is all the more necessary that the right of fair trial guaranteed under Article 21 to the accused is protected by permitting the accused to lead defence evidence by seeking the production of witnesses and documents not relied upon by the prosecution. Similarly, for discharging the burden under Section 45(1)(ii), the accused has the right to invoke Section 91 of CrPC (Section 94 of the BNSS) for seeking production of documents at the stage of hearing of bail application.”

THE RIGHTS OF THE ACCUSED TO GET COPIES OF RECORDS / DOCUMENTS SEIZED AS PER SECTION 17 & 18 OF THE PMLA

The Supreme Court in Sarla Gupta was also concerned with the rights of the Accused under the PMLA to get copies of Records and Documents that have been seized u/s 17 (Search & Seizure) or Section 18 (Search of Persons). Section 21(2) of the PMLA, that deals with the retention of records, specifically mentions that the person from whom the records are seized or frozen shall be entitled to obtain a copy of the records. Section 2(b) of the PMLA includes deeds and instruments evidencing title or interest in property or asset.

The Supreme Court held that the order of retention under section 20 of the PMLA does not refer to the forfeiture of the property and that the seized property does not vest with the ED. The Supreme Court went on to hold that “There is no prohibition on providing copies of the deeds or instruments evidencing title to the person from whom or from whose premises the deeds or instruments are seized. If the provision is interpreted to mean that the person from whom such deeds or instruments are seized is not entitled to receive even copies of the same, the provision will be rendered arbitrary and violative of Article 14 of the Constitution. Therefore, as far as the seized documents and records are concerned, the person from whom or from whose premises the seizure has been made is entitled to get the true copies thereof. As far as the other property seized is concerned, the person from whom the property is seized is entitled to a copy of the seizure memo and the list of the properties seized.” It held that if the documents are bulky, then soft copies can be furnished and that even if seized records or documents are not relied upon in the Complaint, copies must be supplied, though the accused will not be entitled to rely upon them at the time of framing of charge.

CONCLUSION

In an adversarial system like ours, the ED has often resisted the furnishing of certain documents to the Accused, an example being the non-furnishing of grounds of arrest to the accused in writing, as remedied by the Supreme Court in the case of Pankaj Bansal vs Union of India, (2024) 7 SCC 576 where the Court held that There is no valid reason as to why a copy of such written grounds of arrest should not be furnished to the arrested person as a matter of course and without exception. There are two primary reasons as to why this would be the advisable course of action to be followed as a matter of principle. Firstly, in the event such grounds of arrest are orally read out to the arrested person or read by such person with nothing further and this fact is disputed in a given case, it may boil down to the word of the arrested person against the word of the authorised officer as to whether or not there is due and proper compliance in this regard. In the case on hand, that is the situation in so far as Basant Bansal is concerned. Though ED claims that witnesses were present and certified that the grounds of arrest were read out and explained to him in Hindi, that is neither here nor there as he did not sign the document. Non-compliance in this regard would entail the release of the arrested person straightaway, as held in V. Senthil Balaji vs. State, (2024) 3 SCC 51. Such a precarious situation is easily avoided, and the consequence thereof can be obviated very simply by furnishing the written grounds of arrest, as recorded by the authorised officer in terms of Section 19(1) PMLA, to the arrested person under due acknowledgement, instead of leaving it to the debatable ipse dixit of the authorised officer.”

In fact, in the case of Arvind Kejriwal vs. Enforcement Directorate, (2025) 2 SCC 248, the Supreme Court specifically held that it is not only the grounds of arrest that need to be given to the Accused but also the ‘reasons to believe’ that have been recorded. The Court held that this is because “it would be incongruous, if not wrong, to hold that the accused can be denied and not furnished a copy of the reasons to believe. In reality, this would effectively prevent the accused from challenging their arrest, questioning the “reasons to believe”.. .. “It follows that the “reasons to believe” should be furnished to the arrestee to enable him to exercise his right to challenge the validity of arrest.”

The phrase ‘Information is power’ is especially relevant in the realm of criminal defence law in general and in special laws like the PMLA in particular. While economic offences are to be considered a class apart, it cannot be denied that the process of prosecution of one accused of a crime must be fair. Jurisprudence with regard to the PMLA has grown by leaps and bounds over the last few years. The Supreme Court has, from time to time, sought to balance the fairness of proceedings under the PMLA, which otherwise can be considered quite draconian. The Judgement in the case of Sarla Gupta shall undoubtedly be useful for those caught in the clutches of this law to get a fair trial.

Dematerialisation of the Securities of Private Company

INTRODUCTION

Dematerialisation (Demat) of securities has gained its importance for a very long time. The Government has, from time to time, widened the scope and applicability of the same from listed companies to closely held public companies and now private limited companies.

As per the Companies Act, 2013, it is mandatory for all listed companies to have their shares and other securities1 in demat form for their smooth trading on Stock exchanges. The Ministry of Corporate Affairs (MCA), vide notification dated 10th September, 2018, inserted Rule 9A in the Companies (Prospectus and Allotment of Securities) Rules, 2014 (‘PAS Rules’), mandating every unlisted public company to hold and issue securities only in demat form.


1.“Securities” shall include all kinds of securities – shares, debentures, preference shares etc.

Recently, the Ministry of Corporate Affairs (MCA) vide notification No. GSR 802 (E) dated 27th October, 2023, has introduced Rule 9B after Rule 9A vide — Companies (Prospectus & Allotment of Securities) Second Amendment Rules, 2023 (‘Present Amendment’), and has extended such requirements for private companies.

Compliances under the new notification for the dematerialisation of the Securities shall have twofold compliances to be observed: One by Companies and the other by the security holders of such companies, making this a very important provision to be understood by the private limited corporate entities as well as security holders.

UNDERSTANDING THE COMPLIANCES TO BE FOLLOWED BY THE COMPANIES:

Every private company that is not a small company as per the audited financial statements as on the last day of the financial year ending on or after 31st March 2023, shall, within 18 months from the closure of such financial year, ensure that it:

  • issues the securities in dematerialised form only;
  • facilitates the dematerialisation of its securities;

in accordance with the provisions of the Depository Act, 1996 (22 of 1996) and regulations made thereunder.

and

  • dematerialises the entire holding of securities of its promoters, directors and key managerial personnel before making any offer for the issue of any securities, buyback of securities, issue of bonus shares or rights offer after the above-ascribed timelines.

With this Notification, all private Companies which are not small companies as of the last date of the financial year end on or after 31st March, 2023 are under a mandatory requirement of dematerialising their securities.

The applicability test begins with deciding the status of the company, whether a company being a private company is a small company or not. As per the revised definition of the “small company” (as per the amended Rule under the Companies (Specification of Definition Details) Amendment Rules, 2022, effective from 15th September, 2022), a small company is such a company,

a. Whose paid-up capital does not exceed ₹4 crore and

b. Whose turnover [as per profit and loss account for the immediately preceding financial year (for this Rule, it is 31st March, 2022] does not exceed ₹40 crores.

c. There are other categories of companies which are exempted from the definition of the small company, i.e., they are not considered as a small company irrespective of their paid-up capital and turnover.;

i) a holding company or a subsidiary company;

ii) a company registered under section 8; or

iii) a company or a body corporate governed by any special Act;

Let us understand these criteria with the help of the following examples:

Paid-up capital and Turnover as of the last date of the financial year ending on (Paid capital R4 core or more and Turnover above R40 crore or more) Demat applicability (mandatory)
31st March, 2022 31st March, 2022 31st March, 2022 Effective date (18 months from the date of such financial year end when the private Company cease to be a small company.
Company A -Less than the limit prescribed -small company. -Less than the limit prescribed –small company. -Less than the limit prescribed –small company. Not applicable.
Company B -More than the limit prescribed –Not a small company. -Less than the limit prescribed – small company. -Less than the limit prescribed –small company. To demat before 30th September, 2024.
Company C More than the limit prescribed – not a small company. More than the limit prescribed – not a small company. Less than the limit prescribed –small company. To demat before 30th September, 2024.
Company D Less than the limit prescribed –small company. More than the limit prescribed –Not a small company. Less than the limit prescribed –small company. To demat before 30th September, 2025.
Company E Less than the limit prescribed –small company. Less than the limit prescribed –small company. More than the limit prescribed –not a small company. To demat before 30th September, 2026. (Company E shall cease to be a small company as of 31st March, 2025)
A Holding Company, A Subsidiary Company, a Section 8 Company (except a company limited by guarantee), a company or body corporate governed by any special Act; Not a small company by definition, irrespective of paid-up capital and turnover Not a small company by definition, irrespective of paid-up capital and turnover Not a small company by definition, irrespective of paid-up capital and turnover To demat before 30th September, 2024.
a Government Company. Not a small company by definition, irrespective of paid-up capital and turnover Not a small company by definition, irrespective of paid-up capital and turnover Not a small company by definition, irrespective of paid-up capital and turnover Not applicable, as the Government company is not covered

 

CONCERNS FOR PRIVATE LIMITED COMPANIES

Correctly identifying the promoters and Key Managerial Personnel (KMP)

To observe the proper implementation of the rules, the Government has also mandated events relating to share capital like right issues, bonus issues, private placement, etc., which can be exercised by the Company only and only if the securities held by the promoters, directors and KMP of the Company are dematerialised before making any such offer for the issue of any securities.

This means that the persons who are promotors, directors and KMP as of 31st March, 2023 and thereafter must have their respective securities in demat form.

This could be a challenging exercise as the private companies are not under a mandatory requirement of appointing KMP under Section 203 of the Companies Act, 2013, except for the appointment of a Company Secretary on exceeding the threshold limit of paid-up capital of ₹10 Crores or more. Hence, such Companies shall exercise due care in identifying the promoters and KMP as per the Companies Act, 2013 and rules made thereunder before making any further issue of the securities.

Transfer of securities

Private companies, by their Articles, restrict/control the transfer of securities, with the Board having the power to approve or deny the said transfer in the best interest of the Company.

It was possible to adhere to these provisions of the Articles of Association where the shares are in
physical form. Now, with the dematerialisation of securities, the shares become freely tradable, and the Depository Act, of 1996, do not restrict any such transfer. It may lead to a dangerous situation for Private Limited Companies and may result in hostile takeovers. In addition to that, these provisions may result in transfer-related issues wherein the Articles relating to the transfer of shares, especially the clause related to the “Right of First Refusal”, may need to be amended or redrafted in accordance with the said amendment.

One solution to the above problem could be to use the facility of freezing one’s account with the Registrar and Transfer Agents (RTA). RTA provides ‘freeze–unfreeze’ options to the companies, wherein the debit of securities is frozen by the RTA under the company’s mandate and shall only unfreeze for a day or more as per the company’s instructions in writing. The companies will have to check for the cost involved in the same for the arrangement with RTA.

Non-Applicability of Rules

As per Rule 9B sub-rule 6 of the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023, the provisions of these rules are not applicable to Government Companies.

In conclusion, a company which is not a small company as defined above and which meets the criteria mentioned in the table above, needs to demat its securities by 30th September, 2024 or any other date, as may be applicable.

Procedure for Dematerialisation of Securities

To comply with the abovementioned provisions of the Companies Act, 2013 and the Rules made thereunder, a company should take the following steps:

a. Appoint RTA for Dematerlising its securities

b. Register itself with Depository (NSDL/CSDL). (India has two registered depositories, National Securities Depository Limited (NSDL) and Central Depository Services (India) Limited (CDSL).)

c. Obtain ISIN (International Security Identification Number) for all existing securities issued by the Company;

d. Facilitate dematerialisation of all existing securities (as and when a request is received from the holder of such securities);

e. Ensure that the entire holding of its promoters, directors and KMP are held in dematerialised form only prior to making any offer for issuance or buyback of securities on or after 30th September, 2024, or any other applicable relevant date.

f. Issue all securities in dematerialised form only after the due date;

Compliances by a Security Holder

Each holder of the securities of a private company that satisfies the abovementioned conditions shall mandatorily dematerialise the securities before

  • initiating the transfer of such securities

and

  • subscribing to any private placement offer, bonus shares or rights offer of such private company.

Process to be followed by a Security Holder

1. A Security holder needs to have a PAN or obtain a PAN number (This is also mandatory for foreign security holders)

2. Depository: India has two registered depositories, National Securities Depository Limited (NSDL) and Central Depository Services (India) Limited (CDSL).

3. Depository Participant (DP): The Investors (security holders) have to interact with the Depository through DPs, which are entities like public financial institutions, stock brokers, banks, clearing corporations/clearing houses, etc. The investor can choose a DP and either of the depositories to have their shares into a demat account.

4. Open a demat account with Indian Depository Participants (List of SEBI registered participants can be accessed through the NSDL and CDSL site.) and undertake the process of demat by filing a demat request form. If the investor already has a demat account then, he need not open a separate account.

5. Deposit the share certificates along with the DRF (Dematerialised Request Form) and all other documents and forms as required by the Depository Participants (DP).

6. The DP shall take up the further process and on cross-checking the correctness of all documents with the RTA, shall register the dematerialisation of shares.

Key points to be noted by the Security Holders

– Security holder can dematerialise only those security certificates that are already registered in the security holder’s name in the records of the issuing company/its RTA. i.e., he shall be a registered owner.

– The shares must be free from any lien, charge or encumbrance.

– In a case, where the security certificates are in joint names, the demat account shall also be opened in the same order of names.

– The new Rules do not mandate the security holders to have the securities in demat; they can continue to have the securities in physical form. However, after the due date, they will not be able to transfer the securities unless they are demated. Similarly, they will not be able to subscribe to new securities unless they have a demat account.

Private limited companies which are under the ambit of provisions under Rule 9B of Companies (Prospectus & Allotment of Securities) Second Amendment Rules, 2023, shall note the following:

– After 30th September, 2024, the securities which are in physical form will not allowed to be transferred unless they are dematerialised. (The securities can be transferred before 30th September, 2024).

– The security holders will not be able to subscribe to any private placement offer, bonus shares or rights offer of such private company unless the securities are demated.

– The Companies will mandatorily be required to issue and approve the transfer of the securities from the said date, on or after 30th September, 2024 (or the relevant date).

– A security holder, unless a promoter, director or KMP, may continue to hold shares in physical form even after 30th September, 2024. However, the said securities will not be permitted to transfer until dematerialised.

– Further, the security holder will be able to subscribe to any further issue only after ensuring the dematerialising of the securities. Also, the security holder will have to ensure that he has a demat account.

– The private companies are required to ensure compliances applicable to unlisted public companies under sub-rule (4) to (10) of Rule 9A (RULE 9A: (applies mutatis mutandis to private companies) with respect to payment of timely fees to depository and RTA agent, maintaining the security deposit at all times, adhering to SEBI and Depository guidelines to the extent applicable, grievances to be addressed to Investor Education and Protection Fund Authorities etc.

– Private companies will be required to file Form PAS-6 to the ROC within sixty days from the conclusion of each half-year. Therefore, for the half-year period from April to September, the due date to file Form PAS-6 will be 29th November, and for the period from October to March, the due date will be 30th May every year.

Advantages of Demating Securities

Although there could be teething troubles in following procedural and technical aspects to dematerialise the securities, the demat of securities is a very beneficial and welcome step taken by the Government for the private companies as well as the shareholders. There are certain benefits which are enumerated as under;

1. There is a well-defined electronic system which is well regulated by laws (under SEBI -Securities and Exchange Board of India) for keeping the securities in the demat form.

2. As there are no physical securities, it is safe to hold the securities of a company. There is no fear of loss, deface, mutilation or stealing.

3. Convenient — can be easily transferred electronically from one person to another.

4. Instant transfer of securities on authorisation, No stamp duty on transfer of securities.

5. There is no risk of bad delivery of shares — fake share certificates, delays, bad delivery, missing certificates, etc., Minimal paperwork.

6. Reduction in transaction costs and legal costs for the security holders. However, there is a possibility of an increase in cost due to annual maintenance charges of the demat account by RTA.

7. As there is no security certificate, even one share can be transferred without long paperwork and hassles.

8. All information of the security holder is easily maintained and stored electronically and can be easily amended and changed as required.

9. Automatic credit to account on stock split, bonus, right issues etc.,

10. A single demat account of an investor can hold multiple securities.

11. Better transparency of securities.

12. The security holder can have easy access to his security holding status.

CONCLUSION

The complete essence of the said provisions can only be achieved if it is followed and complied with by the company and its shareholders in their true spirit.

All in all, it is a good move towards disciplining private limited companies and removing manipulations in the case of physical securities. It will also enable investors to find all their holdings in one place and it will help successors to lodge claims and transfer securities in their names.

Decoding Residential Status Under FEMA

INTRODUCTION

This article is the third part of a series on Income Tax and the Foreign Exchange Management Act (FEMA) issues related to NRIs. The first article focused on the provisions of the Income Tax Act, whereas the second one was on the applicability of the treaty on the definition of Residential Status. This article will focus on the definition of Residential status under FEMA regulation.

BACKGROUND

Many professionals get flooded with questions on cross-border transactions day in and day out from their resident and non-resident clients regarding the remittance and capital account transactions to be done by individuals and companies.

FEMA governs the financial aspects of a cross-border transaction. As far as the individuals are concerned, the fundamental issue is determining their residential status under FEMA.

In India, the residential status of an individual is determined under the Income-tax Act as well as under FEMA. People at large get confused in deciding the status under both statutes as the criteria for determination and their impact are pretty different.

We shall try to decode the definition of a RESIDENT under FEMA.

An Individual can be a resident under the Income-tax Act, and a non-resident under FEMA and vice versa. An individual can simultaneously be a non-resident or a resident under both Acts.

Also, under FEMA, a split residency is permitted, meaning a person can be a resident for part of the year and a non-resident for another part and vice versa. However, under the Income-tax Act, a person is either a resident or a non-resident for the entire financial year.

Thus, many permutations and combinations are possible. This leads to further complications in practical application.

The definition of “Resident” for an individual under FEMA is similar to that of erstwhile FERA, as both emphasise on a person’s intention. However, FEMA has included the number of days stay in India (more than 182 days) in the preceding financial year as one of the criteria for determining the residential status.

DEFINITION

A person resident in India is defined u/s 2(v) of FEMA, as follow:

“person resident in India” means —

(i) a person residing in India for more than one hundred and eighty-two days during the course of the preceding financial year but does not include—

(A) a person who has gone out of India or who stays outside India, in either case—

(a) for or on taking up employment outside India, or

(b) for carrying on outside India a business or vocation outside India, or

(c) for any other purpose, in such circumstances as would indicate his intention to stay outside India for an uncertain period;

(B) a person who has come to or stays in India, in either case, otherwise than—

(a) for or on taking up employment in India, or

(b) for carrying on in India a business or vocation in India, or

(c) for any other purpose, in such circumstances as would indicate his intention to stay in India for an uncertain period;

(ii) any person or body corporate registered or incorporated in India,

(iii) an office, branch or agency in India owned or controlled by a person resident outside India,

(iv) an office, branch or agency outside India owned or controlled by a person resident in India;

Whereas,
(w) “person resident outside India” means a person who is not resident in India;

From the above definition, it is clear that section 2(v) defines an individual to be resident in India if he resides in India for more than one hundred and eighty-two days during the course of the preceding financial year, except where he has gone out of India or who stays outside India, (a) for or on taking up employment outside India, or (b) for carrying on outside India a business or vocation outside India, or (c) for any other purpose, in such circumstances as would indicate his intention to stay outside India for an uncertain period. Thus, a person falling under the above exceptions will not be considered a person resident in India even though his stay in India exceeded 182 days in the preceding financial year. This can give rise to a split residency. Consider an individual who leaves India for employment on 1st November, 2023. He can be considered a non-resident under FEMA from that date and would be a resident from 1st April, 2023 till 31st October, 2023. The exceptions will be operative as he is leaving for employment. Hence, although his stay in India during FY 2022-2023 exceeded 183 days, he would be regarded as non-resident w.e.f. 1st November, 2023.

Similarly, in case of a person resident outside India who is coming back to India to take up employment or for carrying on business or vocation in India or for any other purpose, in such circumstances as would indicate his intention to stay in India for an uncertain period, such person would be regarded as a person resident in India from the day he comes to India even if his stay in the preceding financial year in India was less than 183 days.

There is another school of thought, and according to which a person can become non-resident from the date he leaves India for employment, business / vocation or an uncertain period; however, to determine the residential status of an individual returning to India, one has to look at the physical stay of that person in the preceding financial year along with the intentions, such as employment, business / vocation or stay for an uncertain period. This view is applicable in the case of the purchase of immovable property in India as per the Press Release by the Government of India dated 1st February, 2009. As per the said Press Release, to be considered as a person resident in India, a person has not only to satisfy the condition of the period of stay in India (being more than 182 days during the preceding financial year) but also his purpose of stay as well as the type of Indian visa granted to him should indicate the intention to stay in India for an uncertain period.

In this regard, to be eligible, the intention to stay has to be unambiguously established with supporting documentation, including a visa.

Section 7(1) of the Limited Liability Partnership Act, 2008 (LLP Act) stipulates that every LLP should have two designated partners who are individuals, and at least one of them shall be a resident in India. The Explanation further provides that the term “resident in India” means a person who has stayed in India for a period of not less than one hundred and eighty-two days during the immediately preceding year. Thus, an individual must satisfy the 182-day stay criteria to become a designated partner in an LLP.

Determination of the Residential Status of an individual based on his stay in India in the preceding FY may pose serious challenges, as one has to wait for the entire year to become a resident of India that is too subject to stay in the preceding FY of 183 days or more. Therefore, except for buying properties or becoming a designated partner in an LLP, the earlier view seems more practical and workable, i.e., an individual becomes a resident of India from the date he arrives for employment, business/vocation, or stay for an uncertain period.

This view is strengthened by the provisions of Para 7 of Schedule 1 of FEMA Notification 5 (R)/2016 – RB – dated 1st April, 2016, which provides that NRE accounts should be re-designated as resident accounts or the funds held in these accounts may be transferred to the RFC accounts immediately upon the return of the account holder to India for taking up employment or for carrying on business or vocation or for any other purpose indicating intention to stay in India for an uncertain period.

From the above, it is clear that significant focus is being put on the intention of the person going abroad or returning to India.

Thus, we find that determining the residential status of a returning Indian is challenging. One needs to interpret the same in the context in which it is to be determined.

It is interesting to note that section 2(w) of the FEMA defines “person resident outside India” as a person who is not resident in India. Thus, it does not define the term “non-resident”, but for all practical purposes, the term “person resident outside India” is equated to “non-resident of India.” Similarly, the term “Non-Resident of India” (NRI) is not defined in FEMA, but various notifications / Master Directions define the term. For example, Para 2(vi) of the FEMA Notification 5 (R)/2016 – RB – dated 1st April, 2016, as well as defines ‘Non-Resident Indian (NRI)’ as a person resident outside India who is a citizen of India. Rule 2(aj) of the FEMA Non-Debt Instruments Rules, 20191 defines ‘Non-Resident Indian (NRI)’ as an individual resident outside India who is a citizen of India.


1      Also refer Para 2.18 of the Master Direction – Foreign Investment in India RBI/FED/2017-18/60 FED Master Direction No.11/2017-18 dated 4th January, 2018, updated up to 17th March, 2022

ILLUSTRATION

Let’s understand the concept of the Residential Status of an Individual under FEMA with the help of some examples:

1. Mr Raj leaves India for employment on 26th May, 2021. His stay during the preceding Financial Year, i.e., 2020–2021, was 365 days.

Will he be a non-resident as per FEMA?

Answer: Residence for an individual under FEMA has been defined u/s 2(v)(i).

An individual is considered an Indian resident if he has been in India in the preceding financial year for more than 182 days.

To determine the residential status of Mr. Raj as of26th May, 2021, we need to check if in the preceding year, i.e. 2020–21, his stay in India was more than 182 days.

As in preceding year Mr. Raj was in India for more than 182 days; he is a resident of India as on 26th May, 2021 as per FEMA.

However, on 26th May, 2021, Mr Raj went outside India for employment and therefore fell under one of the exclusions in the definition of “person resident in India” hence, he is a Non-resident of India from 26th May, 2021.

2. If Mr Raj returns to India on 31st July, 2023 for employment, what would be his residential status under FEMA for FY 2023–24? (You may assume his stay in India during the FY 2022–2023 period to be less than 182 days).

Answer: To determine the residential status as per FEMA law for the financial year 2023–24, we need to check if his stay in India in the preceding year i.e. 2022–23 was more than 182 days. As in the preceding year, Mr. Raj was in India for less than 183 days. He is a Non-resident as per FEMA till July 2023, after which he shall become a Resident if he intends to stay in India for employment.

However, if Mr Raj intends to buy a property in India, he must complete a stay in India of 183 days or more in the preceding FY. Assuming Mr. Raj’s stay in India during the FY 2023–2024 exceeds 182 days, he can buy a property in the FY 2024–2025.

From the above, it is clear that one needs to apply the test of stay in India as well as the intention of a person depending upon the context for which one determines the residential status.

RESIDENTIAL STATUS OF A STUDENT GOING ABROAD FOR STUDIES

RBI vide its Press Release 2003-2004/710. Circular No. 45 dated 8th December, 20032 has clarified that “taking into account the definition of resident under FEMA and the intention of the student to stay abroad for an uncertain period though not for permanent settlement, it has been decided to treat them henceforth as non-residents from the FEMA angle.” The Circular further clarifies that “as non-residents, students will, in any case, be eligible for receiving remittances from India, as follows: (i) up to USD 100,000 from close relatives from India on self-declaration towards maintenance, which could include remittances towards their studies also, (ii) up to USD 1 million out of sale proceeds / balances in their account maintained with an AD in India, (iii) all other facilities available for NRIs under FEMA, (iv) educational and other loans which were availed (as residents in India) by students would be allowed to continue.”


2      https://www.rbi.org.in/commonman/Upload/English/PressRelease/PDFs/40570.pdf and https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=2763

While taking up studies or further advanced courses, students may have to take up jobs or seek scholarships to supplement income to meet their financial requirements abroad. As they have to earn and learn, their stay for educational purposes gets prolonged than what is intended while leaving India. Thus, the above clarification and NRI status will help students take up jobs and undertake various financial transactions as non-residents without violating FEMA provisions.

A few more examples of residential status are as follows:

 

Sr. No. Purpose Status Reasons
1 A person Leaves India to take up employment for the first time. A person Resident Outside India Since he has left India for employment, he has become non-resident from the day he leaves India.
2 The student leaves for Australia to undertake a Master’s degree course for three years. A person Resident Outside India As per RBI Circular No. 45 dated
8th December, 2003,
3 A person visits India as a tourist. A person Resident Outside India Since he is on a visit for a fixed or specific period.
4 A person goes to Brisbane to participate and represent India. His stay was extended for eight months. A person Resident in India Since he has gone for a fixed period and his coming back is confirmed.
5 A person has gone to the UK. She will return to India after the maternity case of her daughter. A person Resident in India Since the period of stay is definite and not uncertain.
6 A person has taken up American citizenship even though his wife and children are in India. He travels to India to meet his family and is in India for more than 250 days. However, he is employed in the USA and intends to be outside India. A person Resident Outside India Since he has no intention to stay in India for the uncertain period and is employed outside India.
7 A person is serving on board a ship flying the Indian National Flag and has not set up any residence, business, or profession outside India. Person Resident in India A ship with the Indian National Flag is considered a territory of India. He cannot be considered a person who proceeded outside India to take up employment and set up a business or profession.
8 A person employed with an Indian company undertakes export promotion tours to Singapore. He was in Singapore for approximately 201 days. A person Resident in India Since he is employed in India and has not gone to Singapore to take up employment or carry on business for an uncertain period, a visit abroad while exercising employment in India or a business visit cannot make a person non-resident. Also, export promotion tours typically are for a fixed duration; therefore, on all counts, that person will be regarded as a Resident of India.
9 A person leaves India for the US as he received a Green Card but has no employment or business, but he intends to settle or stay there for an uncertain period. A person Resident Outside India The receipt of a Green Card signifies the intention to stay outside India. The said intention is fortified with the person moving to such a country. Therefore, he
will be regarded as
a non-resident from the day he leaves India.
10 A person who is a foreign citizen of non-Indian origin sets up a proprietary concern in India on 1st June, 2019, to carry on business with the intention of settling in India. A person Resident in India Since a person is coming to India to set up Business or Vocation, he will be considered a resident in India.

OVERSEAS CITIZEN OF INDIA (OCI)

Another essential aspect to understand is OCI.

The Constitution of India does not allow holding dual citizenship.

However, to overcome the difficulty for various Indians settled abroad who have taken foreign citizenship (foreign passports), on 2nd December, 2005, the government launched the “Overseas Citizens of India” scheme. Registration as an OCI provides the registrant with a few benefits. An illustrative list is stated below:

 

  • A multiple entry / multi-purpose life-long visa for visiting India.

 

  • OCI may be granted Indian citizenship after five years from the date of registration, provided they stay in India for one year before making the application and are subject to renouncing the citizenship of another country. Employment is allowed to an OCI in all areas except mountaineering, missionary and research work and other work requiring PAP / RAP (PAP – Protected Area Permit, RAP – Restricted Area Permit).

 

A foreign national is eligible for registration as an OCI holder if one falls under any of the below criteria:

  • Who was eligible to become a citizen of India on26th January, 1950** or

 

  • Was a citizen of India on or at any time after26th January, 1950 or

 

  • Belonged to a territory that became part of India after 15th August, 1947

 

  • Person of Indian Origin card holders are deemed to be OCI.

Children and grandchildren, including minor children of the above-referred persons, are also eligible for registration as an OCI, provided their country of citizenship allows the same in some form or other under local laws and are eligible for registration as an OCI.

However, if the applicant had ever been a citizen of Pakistan or Bangladesh, he would not be eligible for registration as an OCI.

  • A spouse of foreign origin of a citizen of India or spouse of foreign origin of an OCI card holder registered and whose marriage has been registered and subsisted for a continuous period of not less than two years immediately preceding the application’s presentation would be eligible to obtain registration as an OCI.

For eligibility for registration as OCI, such spouse shall be subjected to prior security clearance from a competent authority in India.

**Any person who, or whose parents or grandparents were born in India as defined in the Government of India Act, 1935 (as originally enacted), and who was ordinarily residing in any country outside India was eligible to become a citizen of India on 26th January, 1950. AnOCI card holder is eligible to visit India without obtaining a VISA.

PERSON OF INDIAN ORIGIN (PIO)

A PIO means a foreign citizen (except a national of Pakistan, Afghanistan, Bangladesh, China, Iran, Bhutan, Sri Lanka, and Nepal):

  • who at any time held an Indian passport; Or
  • who or either of their parents / grandparents/great grandparents were born and permanently resident in India as defined in the Government of India Act, 1935 and other territories that became part of India thereafter, provided neither was at any time a citizen of any of the countries above (as referred above); Or
  • who is a spouse of a citizen of India or a PIO.

A TRANSITION FROM PIO CARD TO OCI CARD

Earlier, the “PIO Card Scheme” was in place. The PIO card scheme has been withdrawn vide Gazette Notification No. 25024/9/2014 F. I dated 9th January, 2015. Further, vide Gazette Notification No 26011/01/2014IC. I dated 9th January, 2015; all existing PIO card holders are deemed OCI card holders. Therefore, no separate authentication of the existing PIO card as an OCI card is necessary. Henceforth, applicants may only apply for an OCI Card, as the PIO Card scheme no longer exists. Current PIO cardholders may apply for OCI cards instead of their PIO cards.

CONCLUSION

The residential status under FEMA is often misconstrued due to the insertion of a number of days’ conditions, similar to the definition under the Income-tax Act. However, it is essential to note that the impact of residential status under FEMA is from the regulatory perspective, not the revenue perspective. Some situations lead to different residential statuses as explained in the article above; however, from the perspective of FEMA, the person’s intention is of utmost importance. It is also noteworthy that intentions need to be justifiable / verifiable from the documentary evidence such as type of visa, employment letter, hiring of an apartment, etc., and it should not be merely a thought by a person that he intends to stay in or out of the country. If the intention, coupled with the number of days of stay, is examined correctly, the residential status can be obtained for a particular person for a given period. As stated earlier, applying the criteria of stay vs. intentions will be relevant in the context in which one seeks to apply the provisions.

Related Party Transactions and Minority Rights – Part 3

Related Party Transactions and Minority Rights – Part 2

Loan From Promoters: An Insight

This is a less-covered area—the words directors and promoters are used synonymously but this may not be always true and the consequence of these two on loans and deposits under the Companies Act, 2013 (CA 2013) and the Companies (Acceptance of Deposits) Rules, 2014 (AODR) are discussed hereunder:

The term “deposit” is defined in clause (31) of section 2 of the CA 2013 that states that ‘a deposit includes any receipt of money by way of deposit or loan or in any other form by a company, but does not include such categories of amount as may be prescribed in consultation with the Reserve Bank of India’.

Rule 2(1)(c) of AODR prescribes categories of amounts which shall not be termed as ‘deposits’ subject to meeting the prescribed conditions. It should be noted that receipt of money in a different form is also covered under the term “Deposit”.

LOAN AND DEPOSIT

Quite often, these two terms are used synonymously and interchangeably but these terms are different. A loan is repayable when it is contracted / incurred. But this is not so with a deposit. Either the repayment will depend upon the maturity date fixed therefore or the terms of the agreement relating to the demand, on making of which the deposit will become repayable. In other words, unlike a loan, there is no immediate obligation to repay in the case of a deposit. That is the essence of the distinction between a loan and a deposit. The loan is usually at the instance of the borrower whereas in the case of a deposit, it is at the instance of the person placing a deposit.

Thus, to simplify: I want a loan. I am a borrower. I approach the bank which is a lender for a loan. I am taking a premises on rent. I place a deposit with the landlord.

Section 143(1)(d) of CA 2013 [Section 227(1A)(d) of the Companies Act, 1956] provides that the auditor shall
inquire “whether loans and advances made by the company have been shown as deposits”. These provisions indicate that it may not be possible to interchange the terms loan and deposit under the Companies Act.

In a transaction of a deposit of money or a loan, a relationship of a debtor and a creditor must come into existence. The term deposit and loan may not be mutually exclusive, but in each case, one needs to consider the intention of the parties and the circumstances. What is required to be noted further is that under the limitation act, the period when limitation begins in the case of deposit and in the case of loan are different. The limitation period in case of a loan starts on a date on which the amount was repayable as per the agreement. As regards deposit, the limitation period starts from the date the depositor claimed repayment of money. In the case of a deposit, the accrual of interest ceases upon maturity, whereas in a loan, interest is payable up to the date of repayment of the loan itself. However, this does not mean that a loan or deposit necessarily will carry an interest. Thus, we come across interest-free loans and deposits. The onus of repayment of loan vests with the person taking the loan. In the case of a deposit, the depositor has to claim the deposit amount.

DEPOSIT

However, for the purpose of CA 2013, the definition of the term ‘Deposit’ clearly states that it includes ‘any receipt of money by way of deposit or loan or in any other form by a company’. Any loan has to fall within the exclusion from the definition of ‘deposit’ if it were to qualify as loan simpliciter.

Rule 2(1)(c) of the AODR prescribes receipts of money that shall not be treated as a deposit. For the purposes of this article, we shall be discussing only 2 such amounts namely:

AMOUNT RECEIVED FROM THE DIRECTOR

Clause (viii) of Rule 2(1)(c) reads as:

(viii) Any amount received from a person who, at the time of the receipt of the amount, was a director of the company or a relative of the director of the Private company:

Provided that the director of the company or relative of the director of the private company, as the case may be, from whom money is received, furnishes to the company at the time of giving the money, a declaration in writing to the effect that the amount is not being given out of funds acquired by him by borrowing or accepting loans or deposits from others and the company shall disclose the details of money so accepted in the Board’s report;

As per Notification dated 15th September, 2015, which amended the rule, any amount received from a director of a company or in the case of a private company, from the relative of the director, shall also be exempt, provided that such person furnishes a written declaration that the amount is not given out of any borrowing or accepting loans or deposits from others …. The reporting in the Board’s report is a condition imposed by the Amendment Rules which are effective from 15th September, 2015. Hence, all reports of the Board of Directors, signed after this date need to give this disclosure.

It is pertinent to note here that a Hindu Undivided Family shall not be regarded as a relative of the director. Rule 16A of ADOR mandates that every company, other than a private company, shall disclose in its financial statement, by way of notes, about the money received from the director.

Thus, the essential conditions for this exemption are as under:

  • Amount is received from a person who was a director of the company (whether Private or Public) at the time of the receipt of the amount (so subsequent cessation does not affect this exemption) or
  • In the case of a private company, from the relative of the director.

Such person furnishes a written declaration that the amount is not given out of any borrowing or accepting loans or deposits from others and the same is disclosed in the Board’s Report. (One needs to look into the exemption notification dated 5th June, 2015 and applicable conditions)

AMOUNTS FROM PROMOTERS

Let us now see Clause (xiii) of Rule 2(1)(c) that deals with the amount brought in by promoters.

Unsecured loans received from the promoters (as defined in clause (69) of section 2) or their relatives (as defined in clause (77) of section 2) or both as per the stipulation of any lending financial institution or a bank shall not be treated as deposits.

Hence, when the loan is brought in without any stipulation imposed by the lending institution or the loan brought in beyond the amount stipulated by lending institutions, the same will amount to a ‘Deposit’. This exemption is available only till the loan from the lending institution subsists and not after the same is repaid.

As the exemption is available only till the subsistence of the loan, the amount brought in by promoters needs to be repaid along with the loans from lending institutions.

The rule reads as:

(xiii) Any amount brought in by the promoters of the company by way of unsecured loan in pursuance of the stipulation of any lending financial institution or a bank subject to fulfillment of the following conditions, namely: –

(a) The loan is brought in pursuance of the stipulation imposed by the lending institutions on the promoters to contribute such finance;

(b) The loan is provided by the promoters themselves or by their relatives or by both; and

(c) The exemption under this sub-clause shall be available only till the loans of financial institution or bank are repaid and not thereafter;

One thus notes that conditions are cumulative. Condition (b) in my view implies that a loan cannot be given by third parties as compliance of the stipulation.

This clause and definition of the word promoter needs little elaboration:

As per section 2 (69) of CA 2013, “promoter” means a person—

(a) Who has been named as such in a prospectus or is identified by the company in the annual return referred to in section 92; or

(b) Who has control over the affairs of the company, directly or indirectly whether as a shareholder, director or otherwise; or

(c) In accordance with whose advice, directions or instructions the Board of Directors of the company is accustomed to act,

Provided that nothing in sub-clause (c) shall apply to a person who is acting merely in a professional capacity.

Before we deal with this definition, we may note that this definition is newly introduced in CA 2013. The term promoter was defined in the Companies Act 1956 only for the limited purpose of fixing liability for a misstatement in the prospectus. So, the definition of promoters under CA 2013 can be analysed in three parts. All the parts are separated by ‘or’ and are thus independent of each other, or mutually exclusive, meaning thereby that for being a promoter, a person may fall within any part of S. 2(69). Suffice it to state as an introduction that the promoter in sub clause (a) covers a factual aspect whereas to identify a person as a promoter in sub clause (b) and sub clause (c), the same has to be established with adequate material.

The first part [contained in sub-clause (a) of sub-section 69 of Section 2] lacks legal certainty in as much as instead of explaining the concept, it appears that it upholds as correct, what is mentioned in the documents referred to in the said sub clause. Without elaborating the essentials of the concept, it merely states that a person is a promoter if the name of that person is mentioned as a ‘promoter’ in the Prospectus or in the Annual Return filed under S. 92 of the Act.

In the second independent clause of the definition of ‘promoter’, we find a little objectivity in the definition, as it talks about the presence of one’s control over the affairs of the company as a prerequisite for being classified as a promoter. Such control may arise out of the position of that person as a shareholder, or a director or otherwise. The control envisaged can be direct or indirect. Undoubtedly, the definition also contemplates a person who may neither be a shareholder nor a director, and yet be a promoter if he has control over the affairs of the company. Thus at the same time, every shareholder or director need not be treated as promoter of the company if he does not exercise any control over the affairs of the company.

In this context, it is notable to look into the definition of ‘control’ given under S. 2(27) of the Act. As per section 2 (27), “control” shall include the right to appoint a majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders’ agreements or voting agreements or in any other manner.

Thus we are told that if a person has a right to appoint the majority of directors or to control the management or policy decisions of a company, then he/she would be considered to be a promoter. But again, what may be classified as control over management and policy decisions is still ambiguous, uncertain, vague & definitely a matter of academic debate and interpretation and thus may lead to two views.

The last part of the definition states that a promoter is a person “(c) in accordance with whose advice, directions or instructions the Board of Directors of the company is accustomed to act”.

This is again vague and from the perspective of a person who is an outsider to the management of the company and this fact may not be evident very easily. So, applying the rules of literal interpretation on S. 2(69) of the Act, and reading all the parts of the definition together, a person may be a promoter of the company even without being a director or a shareholder, if he / she has been named so in the Prospectus or Annual Return of the Company.

Similarly, a person who has been stated to be a promoter in the prospectus of the company or the Annual Return of the Company, would be treated as a promoter even if he / she does not exercise any control over the affairs of the company or even if doesn’t have any right of appointment of a majority of the directors.

Thus, it can be seen that in the formation of a company, people who initially take an active part to give it a concrete shape are known as promoters in the commercial world. The term “promoters” is more familiar with the business than with law. It “involves the idea of exertion for the purpose of forming and starting a company.”

The individuals who not only conduct the task of promotion but also are responsible for all the affairs of the business are the promoters of a company. A promoter of a company is a person or a group of persons who came together with the objective of setting up a business. The promoter can be an individual, a firm or an association of artificial legal persons. To be a promoter, it is not necessary to be a founder of a business; the person who arranges capital and assists in other important works can be equally regarded as a “promoter of a company”. In another sense, the promoters may be called as the Parents of a company on the ideation of whom a company is born.

A person cannot become a promoter merely because he signed the memorandum as a subscriber for one or more shares. The proviso further carves out an exception as to the professionals such as counsels, solicitors, accountants, engineers or other technicians who will not become promoters by reason of acting unless they exceed their professional function and do something more in promoting the company.

TREATMENT OF LOAN RECEIVED FROM MEMBERS / DIRECTORS / PROMOTERS WHEN THEY ARE THE SAME

Let us consider a small Private limited company that has 2 members / shareholders who are directors of the Company. Consider a situation in which these directors lend money to the company for its operations. Since the loan is from the directors, it shall be considered as exempt only if a declaration is obtained from the directors. It is the duty of the concerned director to give the declaration, but it is equally the duty of the company to obtain the declaration. The sub clause granting exemption nowhere says that the director giving loan should not be a shareholder of the company. It similarly does not say that such a director should not be a Managing Director / Whole Time Director / Independent Director / Non-Executive Director / Employee of the Company. Reading any of these things or anything else will amount to inserting words in a statutory provision which we are not allowed to do. So, when a loan is accepted from a director who is a shareholder too, one needs to look into the exemption from the perspective of a loan from the director and one should not travel to other provisions regarding loan from members. If the intention of the rule-making authorities was to debar a company from accepting deposits/loan from their directors who happen to be shareholders of the company, there would have been a clear and explicit provision to that effect in clause (viii). But in the absence of such a provision, we cannot read it in the clause (viii) on our own. Thus loans from directors subject to compliance of conditions shall be treated as exempt deposit under rule 2(1)(c) (viii) of AODR.

Consider further a situation that this company decides to borrow from the financial institution (FI) a term loan of ₹100 crores and FI imposes a condition that promoters of the Company (in this case same 2 directors) bring in ₹10 Crores and such loan from the promoters shall not be repaid till term loan or part thereof continues. It is interesting to see here that such directors / promoters when they bring in a loan pursuant to a condition stipulated, there is no declaration required, and promoters (directors) in such cases, can place the funds with the company out of borrowed funds.

Thus, it is quite logical that with regards to the loans from promoters (who can be even non-individuals) to the company, there cannot be a condition similar to loan from directors or their relatives that they need to be out of their own funds.

Based on the logic explained in the paragraph on loan from directors, not to be treated as loan from members etc, one can conclude that loan from promoters pursuant to a stipulation cannot be considered as a loan from directors even though such promoters are directors and one need not take a declaration from such promoters since this is not prescribed when loan is from promoters.

Rule 2(1)(c) of AODR provides for certain situations in which the receipt of money shall become a deposit:

Any unsecured loans received from the promoters or their relatives or both as per the stipulation of any lending financial institution or a bank which continues beyond the subsistence of such loan from lending financial institution or a bank, shall become deposit.

Other compliances that need to be looked into in the case of loans and / or deposits:

I. CARO 2020 Clause (v) in Para 3 requires reporting in respect of the following:

in respect of deposits accepted by the company or amounts which are deemed to be deposits, whether the directives issued by the Reserve Bank of India and the provisions of sections 73 to 76 or any other relevant provisions of the Companies Act and the rules made thereunder, where applicable, have been complied with, if not, the nature of such contraventions be stated; if an order has been passed by Company Law Board or National Company Law Tribunal or Reserve Bank of India or any court or any other tribunal, whether the same has been complied with or not;

Thus, if loan from promoters does not fall in the four corners of exception, it needs to be reported in CARO.

II. Pursuant to amendments in Schedule III to the Companies Act, companies are required to give certain ratios which includes a ratio related to debts and equity namely Debt Equity ratio. The notification further mentions that the company shall explain the items included in numerator and denominator for computing the above ratios. Guidance note from ICAI further clarifies that the Debt-to-equity ratio compares a Company’s total debt to shareholders’ equity. Both of these numbers can be found in a Company’s balance sheet. Debt-Equity Ratio is defined to mean Total Debt / Shareholder’s Equity.

Is it possible to hold a view that the loan from promoters can be included in Equity for the purposes of this ratio?

CRISIL in its recent publication titled “CRISIL Ratings approach to financial ratios” mentions as under:

RELEVANT EXTRACTS ARE REPRODUCED

Computation of debt and equity has its nuances, especially in the context of promoter / family-owned unlisted entities where a sizeable portion of promoter funds deployed in the business could be in the form of unsecured loans.

These loans are infused either by promoters or family members and are usually subordinated to external debt. Over the years, CRISIL Ratings has observed that this source of funds has demonstrated a high degree of permanence in times of distress, with promoters deferring interest payments on these loans in order to prioritize the servicing of external debt. Furthermore, unsecured loans from promoters in case of promoter owned, unlisted entities are largely viewed as promoter source of funding by lenders and considered subordinate to all other forms of external debt.

Hence, even though as per accounting conventions, unsecured loans are considered part of debt, the aforementioned factors render some equity-like characteristics to these instruments.

CRISIL Ratings, as part of its analytical treatment of unsecured loans, classifies them into one of the following:

  • Part of overall debt,
  • May exclude unsecured loans from computation of debt,
  • In some circumstances, CRISIL Ratings accords partial equity treatment to around 75% of the unsecured loans, while considering the remaining as debt.

In view of the above, it is possible for a company to calculate the ratio treating unsecured loans from promoters as part of Equity.

CONCLUSION

The loans from Directors and Promoters and conditions related to exemptions from AODR are tabulated below:

Particulars Loan from Directors Loan from Promoters
Whether loan from Individuals Only Yes Not necessarily
Whether loan can be out of borrowed funds No Can be permitted
Whether any declaration required that loan is not out of the borrowed funds Yes No
Any Limit on the loan No Yes, subject to limits from Financial Institutions / Banks
Can the loan continue after director ceases to be a director of the Company Yes Not Applicable
Whether loan from relatives is permitted Yes (Only in case of private Limited Company) Yes. Not necessarily in the case of Private Limited Company.
How long loan can continue No such requirement and can be at the instance of the Company Loan can continue till Parent loan from FI continues
Reporting in the Board’s report Yes No such mandatory requirement

Navigating the Landscape: The Integration of ESG Factors Into Business Valuation

In the dynamic world of finance and investment, the integration of Environmental, Social, and Governance (ESG) factors into business valuation has become a paramount consideration. As the global business community grapples with the requirements of sustainability and responsible corporate practices, investors are increasingly recognizing the need to go beyond traditional financial metrics. This article explores the multifaceted realm of ESG, delving into its significance, the process of integrating these factors into business valuation, challenges encountered in this endeavour, and the highlights of Business Responsibility and Sustainability Reporting (“BRSR”) Core which has been introduced recently.

UNDERSTANDING ESG & ITS IMPORTANCE

ESG encompasses a triad of critical factors that collectively shape a company’s approach to sustainability, ethical practices, and corporate governance. Environmental criteria evaluate a company’s impact on the planet, social criteria gauge its relationships with stakeholders, and governance criteria assess the internal structures guiding decision-making. The importance of ESG lies in its ability to provide a holistic view of a company, reflecting its commitment to long-term resilience, ethical conduct, and positive societal impact. Investors are increasingly recognizing that companies with robust ESG practices are not only better equipped to manage risks but are also likely to be more resilient in the face of evolving market dynamics.

INTEGRATION OF ESG INTO VALUATION

The integration of ESG factors into business valuation marks a paradigm shift in how companies are assessed and valued for investment. Traditional valuation methods are being augmented with ESG considerations, as investors seek a more comprehensive understanding of a company’s performance and its ability to create long-term value. ESG integration involves analyzing a company’s ESG practices and assigning a quantitative value to these tangible and intangible factors. These factors become important for the valuation of a business as their impact can be considerable when taken for long periods of time including on its competitive advantages. Below are ways to incorporate the ESG impact under the market and income approach:

  • The Market Approach:

To account for ESG considerations, valuation under the market approach should:

1) Identify and assess ESG practices for comparable companies and industries, then

2) Assess the performance of the subject company for such criteria, and

3) Calibrate the market inputs to the subject entity to take into account the relevant performance as compared to the comparable companies.

An example for adjusting the ESG factor under market approach is as follows:

Relevant ESG Factors GHG Emissions (Co2e) Workplace Accidents
Competitor 1 0.60  65
Competitor 2 0.70 55
Industry Average (a) 0.65 60
ESF factor for Target Company (b) 0.75 70
Premium/(Discount) for ESG factor in comparision to Industry(c) (15%) (17%)
Weights (d) 50% 50%
Industry Average EV/Revenue Multiple (e)*   2.0
Calibrated EV/ Revenue multiple for the Target Company

Considering the ESG Factor (e*d*(1+c))

  1.7

A significant limitation of this method is that ESG data, disclosures, and rating systems are currently in their early stages of development, particularly for entities that are often private companies. Consequently, the scoring process is subjective, as different practitioners may assign varying weightings or scores to distinct ESG factors and practices implemented by companies.

  • The Income Approach:

To account for ESG considerations, valuation under the income approach should consider its impact on the discount rate or cash flows itself.

While discount rate adjustments can be used to incorporate ESG into the Discounted Cashflow approach (DCF), adjusting the discount rate may lead to double counting if beta values have reflected the market’s perspectives on ESG risks. A better way of integrating ESG factors in the DCF can be to adjust future cash flows. This helps the investor to integrate the company’s ESG factors into future cash flows and thus to focus on the relevant material issues. Depending on different industries and company performances, the translation of ESG factors to cash flow adjustments varies. Hence industry to industry lens is very critical since there is no standardized benchmark in ESG integration and adopting industry and company-specific value drivers could help avoid the ambiguity of the cash flow adjustments. Some of the adjustments to be considered include:

– The “E” factor can be incorporated by adjusting the cash flows with additional costs and Capex investments in carbon reduction initiatives and cost savings from the adoption of energy/water saving technology.

– The “S” factor can be incorporated through adjusting costs related to employee training programs, hiring contractual employees on a permanent basis, workplace safety measures and research and development investments to ensure quality and safe products among others.

– The “G” factor can be incorporated through adjusting for fines or penalties imposed by regulatory authorities due to weak governance policies of companies.

An example of adjusting the ESG factor under the income approach is as follows:

Cash Flow Items Amount (INR Mn) ESG Factor Explination of Adjustment
Revenue 1,500    
Revenue Adjustment (300) Social Reduced sales due to consumer boycott pf its products for unethical labour practises such as child labour, poor working conditions or low wages
Adjusted Revenue 1200    
Operating costs and expenses (250)    
Tax Expense (100)    
Tax Adjustment (40) Governance Additional tax payments due to fines imposed by regulatory authorities
Adjusted Net Profits 810    
Depreciation and Amortization 80    
Changes in Net Working Capital 50    
Necessary Capex (200)    
Capex Adjustment (80) Environmental Purchase of machineries necessary to reduce water resource waste
Free cash flow considering ESG Factors 660    

ISSUES IN INTEGRATING ESG FACTORS IN VALUATION

While the integration of ESG factors into business valuation is gaining momentum, it is not without its challenges. One key issue is the lack of standardized metrics and reporting frameworks, making it difficult for investors to compare ESG performance across companies. Additionally, there are concerns about “greenwashing,” where companies may overstate their ESG credentials to appear more attractive to investors. Striking a balance between qualitative and quantitative assessment poses another challenge, as some ESG factors are inherently subjective and context-dependent. Overcoming these challenges requires the development of standardized reporting practices, increased transparency, and ongoing dialogue between investors and companies.

BRSR CORE FRAMEWORK

Recent developments in the ESG landscape include the introduction of the BRSR Core Framework by SEBI, an extension of the existing BRSR framework that delves deeper into ESG integration by providing specific requirements for reporting and assurance. This framework aims to enhance transparency and accountability for companies and further elevate the role of ESG in business valuation.

  • Key Features of BRSR Core:

– Specificity: The framework defines a specific set of ESG indicators that companies must report on, — covering environmental, social, and governance aspects. This specificity ensures consistency and comparability across companies, facilitating easier analysis and assessment for investors.

– Assurance: BRSR Core introduces mandatory assurance requirements for a subset of reported ESG information. This independent verification enhances the credibility and reliability of ESG data, reducing the risk of greenwashing and building investor confidence.

– Value Chain Focus: The framework extends beyond a company’s own operations to include its value chain, requiring reporting on the sustainability practices of its suppliers and partners. This broader scope provides a more comprehensive picture of a company’s overall impact and promotes responsible sourcing practices.

– Phased Implementation: BRSR Core’s implementation is phased, starting with the top 1000 listed entities by market capitalization. This gradual approach allows companies to adapt and implement the framework while minimizing disruption.

Impact on Business Valuation:

– Enhanced Data for Valuation Models: The BRSR Core’s specific and assured ESG data provides valuable input for valuation models, enabling a more comprehensive assessment of a company’s long-term value and risk profile.

– Better Risk Assessment: Deeper insights into a company’s ESG performance through the value chain help identify potential environmental, social, and governance risks that could impact financial performance.

– Improved Comparability: The standardized reporting and assurance requirements facilitate easier comparison of ESG performance across companies, enabling investors to make more informed investment decisions based on ESG considerations.

BRSR Core represents a significant step towards a more integrated and transparent ESG landscape. The BRSR Core framework is still evolving, and its impact on business valuation is likely to grow as companies adapt and investors refine their assessment methods. Ongoing collaboration between regulators, investors, companies, and valuation professionals is crucial to ensure the effectiveness and continued improvement of the framework. Addressing data availability and accessibility, particularly for smaller companies, remains a challenge that needs to be tackled to ensure fair and equitable application of the framework.

CONCLUSION

The integration of ESG factors into business valuation is a transformative trend that reflects the evolving priorities of investors and the broader business ecosystem. ESG considerations are no longer peripheral but integral to evaluating a company’s overall performance and potential for sustained success. While challenges persist, the ongoing evolution of reporting frameworks like BRSR signals a commitment to addressing these issues and advancing the integration of ESG into mainstream financial practices. As businesses navigate this new landscape, embracing ESG not only contributes to a more sustainable future but also positions companies as leaders in an era where responsible practices are synonymous with long-term value creation.

Navigating the “CA (E)Volution”: Balancing Responsibility and Compliance in the Fight Against Money Laundering

“The Expanded Role of Chartered Accountants: Implications, Obligations, and Considerations under the New PMLA Rule in India”

The regulatory landscape in India has undergone a significant change with the new rule incorporating Chartered Accountants (CAs), along with Company Secretaries (CSs) and CMAs, as reporting entities under the Prevention of Money Laundering Act (PMLA). CAs, considered the warriors of the national economy, are expected to take the role of reporting entities as a vital role-upgradation for safeguarding the financial system and countering financial crimes. This expansion of reporting requirements places the role of CAs in the spotlight in combating money laundering and terrorism financing. As trusted professionals and gatekeepers of financial information, CAs now have the responsibility of detecting and reporting suspicious transactions linked to illicit activities or money laundering.

This article examines the concerns and considerations faced by CAs, compares approaches in other countries and provides insights on effective ways for CAs to equip themselves in light of the new rule. While there are already sources available for professionals to understand the notification and rules under the PMLA, this article primarily focuses on examining the specific implications and effects on CAs as reporting entities, providing insights and guidance relevant to their role in combating money laundering and terrorist financing.

BACKGROUND

In the context of combating money laundering and terrorist financing, the Financial Action Task Force (FATF), established by the G-7 countries as a global money-laundering watchdog headquartered in Paris under the OECD Secretariat, assumes great significance. This organisation sets global standards to combat money laundering, terrorist financing and other threats to the international financial system. FATF has developed 40 recommendations on legal, financial regulatory, and international cooperation that serve as a framework for countries to collectively address the challenges of money laundering, terrorist financing, and the financing of proliferation. These recommendations are meant to guide countries in effectively implementing measures within their national systems. The accounting profession plays a vital role in supporting the FATF 40 Recommendations in two key methods. Firstly, the “General Framework” recommendations align with the profession’s mission of promoting transparency and facilitating multilateral cooperation. Secondly, the “Financial System” recommendations emphasise the importance of record-keeping, reporting and promoting transparency, which directly aligns with the core competencies of the accounting profession, such as implementing controls and systems and maintaining audit trails.

One such recommendation is Recommendation 29, which requires the establishment of a Financial Intelligence Unit (FIU) in each country. The FIU serves as a central authority responsible for receiving, analysing and disseminating information related to suspicious transactions and financial intelligence. Reporting entities (RE), such as banks, financial institutions and other relevant businesses, are obligated to submit reports to the FIU in accordance with national laws and regulations.

In India, the FIU is known as FIU-IND and operates under the provisions of the PMLA. FIU-IND serves as the national centre for receiving, analysing and disseminating reports on suspicious transactions, money laundering activities, associated predicate offences and terrorist financing. This includes Suspicious Transaction Reports (STRs), Cash Transaction Reports (CTRs) and reports on cross-border wire transfers. The FIU utilises advanced analytics and intelligence tools to analyse the data received from these reports and shares actionable intelligence with law enforcement agencies.

With the recent rule, CAs have also been included as RE under the PMLA, expanding the concept to include them as well. This brings an important understanding of the differentiation between ‘reporting entities (RE)’ and ‘relevant persons.’ Relevant persons, including practising CAs, CSs and Cost and Works Accountants, become RE when they engage in specified financial transactions, thereby requiring them to comply with the necessary regulatory obligations. As relevant persons, CAs are included in the category of professionals who carry out specified financial transactions on behalf of their clients. These financial transactions fall within the ambit of RE, which means that CAs have reporting obligations under the PMLA. Hence, CAs can be referred to as both relevant persons and RE in the context of the PMLA.

As mentioned earlier, the PMLA encompasses a broad range of entities and individuals involved in designated businesses or professions. To specify the scope of RE, the Ministry of Finance, empowered by the PMLA, has outlined certain financial transactions conducted by relevant persons. These transactions pertain to diverse areas such as property dealings, management of client assets and establishment or administration of companies. The Ministry has further clarified that relevant persons encompass practising individuals or firms who hold certificates of practice under the Chartered Accountants Act, 1949, Company Secretaries Act, 1980 or Cost and Works Accountants Act, 1959. This inclusion aligns with the definition of a “person carrying on designated business or profession” and encompasses these professionals undertaking financial transactions on behalf of their clients. Consequently, these professionals assume the role of RE and are obligated to fulfil the requisite compliance obligations stipulated by the PMLA.

Recommendation 22

The above inclusion by PMLA aligns with Recommendation 22 of the FATF on Designated Non-Financial Businesses and Professions (DNFBPs). Recommendation 22 outlines the customer due diligence and record-keeping requirements that apply to DNFBPs in specific situations. These situations include activities carried out by lawyers, notaries, other independent legal professionals and accountants on behalf of their clients.

Recommendation 22(d): “The CDD and record-keeping requirements set out in Recommendations 10, 11, 12, 15, and 17 apply to designated non-financial businesses and professions (DNFBPs) in the following situations: Lawyers, notaries, other independent legal professionals, and accountants – when they prepare for or carry out transactions for their client concerning the following activities:

  • buying and selling of real estate;
  • managing of client money, securities, or other assets;
  • management of bank, savings, or securities accounts;
  • organisation of contributions for the creation, operation, or management of companies;
  • creation, operation or management of legal persons or arrangements, and buying and selling of business entities.”

By including CAs as RE and imposing compliance obligations on them, the PMLA takes reference from and assumes importance with the customer due diligence and record-keeping requirements outlined by the FATF for DNFBPs. While legal professionals like lawyers are excluded from this rule, unlike in other countries, the inclusion of CAs highlights their crucial role as relevant persons engaged in financial transactions, actively contributing to the fight against money laundering and other illicit activities. Consequently, this ensures that valuable information is gathered as part of the reports collected by FIU-IND, enhancing overall efforts to combat financial crimes.

ACCOUNTANTS AS RE IN OTHER COUNTRIES

In several countries, accountants have been included as RE under their respective Anti-Money Laundering (AML) acts or regimes.

The International Federation of Accountants (IFAC) highlights that while national AML regulations may not explicitly assign accountants specific responsibilities, practitioners are still obligated to adhere to the standards and guidelines set by local accounting bodies. Money laundering is generally not as directly impactful on financial statements as other forms of fraud, like misappropriation. Therefore, detecting money laundering through a financial statement audit is unlikely. However, the indirect consequences of money laundering can still affect an entity’s financial statements, which make it an area of concern for external auditors.

This leads us to the important question of the specific obligations imposed on CAs under this new rule.

THE TRANSITION OF OBLIGATIONS

When interpreting the notification, it is crucial to consider the purpose of the PMLA, which is to combat money laundering and terrorist activities. Suppose a transaction involves the client’s use or sourcing of funds and raises suspicions regarding money laundering or terrorism financing. In that case, the professional cannot claim ignorance of the client’s credentials, as due diligence on the client is a requirement. Additionally, if the professional identifies transactions that require reporting to the FIU-IND, they are obligated to report such transactions.

Comprehensively, below are the factors to be considered or that are expected by the CA to be performed.

1. Enhanced Customer Due Diligence (CDD): There is a need to implement robust CDD measures when establishing a business relationship with a client or when conducting occasional transactions above a certain threshold. Further, the professionals need to gather and verify information about the client’s identity, beneficial ownership and the purpose of the transaction.

2. Transaction Monitoring: The professionals ought to enhance their transaction monitoring systems to detect and report any suspicious transactions. They need to develop an understanding of the typical transaction patterns for each client and be alert to any anomalies or red flags.

3. Suspicious Transaction Reporting: If the professional identifies any suspicious transactions during their audit or through their transaction monitoring systems, they have a legal obligation to report these to the FIU-IND in a timely manner. This involves preparing an STR and submitting it as per the prescribed format and timelines.

4. Record Keeping: The professional must maintain detailed records of their clients, transactions and the measures taken to comply with the reporting obligations. These records should be readily accessible for review by regulatory authorities.

5. Compliance Training and Policies: There is a need for practising professionals to provide appropriate training to their staff on AML / CFT compliance, including recognising and reporting suspicious transactions. They should also update their internal policies and procedures to reflect the new reporting requirements and ensure adherence across the organisation.

As a result, CAs, in addition to the traditional roles in financial auditing, now need to be proactive in identifying and reporting suspicious transactions as per the new PMLA rule. This transition requires them to enhance their knowledge, implement new procedures and stay vigilant in their efforts to combat money laundering.

In practical terms, it is beneficial for CAs to consider the following points, drawing inspiration from a money laundering guide for lawyers. These recommendations encompass similar activities and requirements that can be relevant for CA professionals.

FATF Recommendation Key Consideration Relevance Recommended Actions
10 Customer due diligence Identifying clients and their ownership – Identify the client and their beneficial owner.
– Use reliable, independent source documents or information.
– Request a structure map and details of beneficial ownership for corporate clients.
– Understand the business relationship and the purpose of the transaction.
– Conduct ongoing due diligence to align with your knowledge of the client’s profile and source of funds.
– Refrain from establishing or continuing the business relationship if satisfactory due diligence cannot be carried out.

– Consider reporting suspicious transactions.

11 Record-keeping requirements Maintaining records – Keep copies or originals of documents obtained during CDD measures.
– Maintain files and business correspondence for a specified period or as per the recommended period by the PMLA.
– Include electronic and physical communications and documentation.
– Ensure records are sufficient to reconstruct individual transactions as potential evidence in suits.
12 Enhanced CDD for politically exposed persons (PEPs) Dealing with high-risk clients – Obtain senior partner approval for establishing or continuing a business relationship with PEPs, their families or close associates.
– Take reasonable steps to determine the source of wealth and funds.
– Conduct enhanced ongoing monitoring of the business relationship.
15 New technologies Keeping pace with emerging risks – Identify, assess and manage risks associated with new products, business practices and technologies used by lawyers.
17 Reliance on third parties and group-wide compliance Partnering with reliable entities – Ensure third parties have a good reputation and are regulated, supervised and monitored.
– Confirm that third parties have measures in place to comply with CDD and record-keeping requirements.
– Obtain necessary CDD information from third parties and ensure availability of identification data and documentation upon request.
20 Suspicious transaction reporting Identifying and reporting suspicious activity – Familiarise yourself with the requirements for reporting suspicious transactions in the relevant jurisdiction.
– Report suspicions of criminal or terrorist activity to the FIU-IND as per requirements.

These guidelines, based on the specific recommendations, provide suggested actions for CA professionals to follow in order to comply with the new PMLA rules and effectively prevent money laundering activities. Each recommendation highlights the key consideration, its relevance and the suggested actions to be taken by CAs to fulfil their obligations under the new rule.

ETHICAL CONSIDERATIONS AND CONCERNS

As with any new rule, the implementation of the amended PMLA raises several ethical considerations and concerns that the CA professionals need to navigate. One such consideration is the delicate balance between client confidentiality and reporting obligations. Professionals often face the challenge of deciding when and how to disclose information while upholding the privacy and trust of their clients. One may come across a suspicious transaction involving a client but revealing that information could potentially breach the client’s confidentiality. Striking the right balance requires a deep understanding of the legal framework and clear guidelines. Not to mention the significant effort and investment in conducting thorough due diligence on clients, monitoring transactions and maintaining records.

The enhanced requirements and extensive documentation can be time-consuming and resource-intensive, which requires professionals to allocate sufficient resources to meet these obligations while also ensuring the smooth functioning of their practice.

Importantly, the potential for bias and subjective interpretation in identifying suspicious transactions is also a valid concern. Professionals must ensure they approach their work with objectivity and avoid unintended biases. This can be particularly challenging in cases where transactions may appear suspicious based on subjective criteria. For instance, two professionals may have different interpretations of a transaction’s suspicious nature, leading to inconsistent reporting. Clear guidelines, regular training and collaboration with industry peers can help address this concern.

In light of the new obligations, the CA professionals should equip themselves in the following ways and prepare for the coming days:

The inclusion of professionals like CAs under the PMLA is a significant and welcome development in the fight against money laundering. This expansion of their role emphasises the critical responsibility they hold as warriors safeguarding the financial integrity of the nation. Despite the criticisms surrounding the lower contribution of accountants in terms of STRs compared to other contributors in the global scenario, it remains crucial to strike a balance between compliance efforts and conviction rates in India as the regulatory landscape evolves to combat financial crimes. For instance, although all DNFBPs are required to report suspicious activity reports (SARs), there is underreporting from higher-risk sectors such as trust and company service providers, lawyers and accountants in the UK. It is key to achieving the objective of ensuring that heightened compliance measures effectively translate into successful convictions without imposing an excessive burden on professionals.

The upcoming FATF assessment in 2023 will shed light on the effectiveness of the new notification in addressing financial crimes in India. It is imperative for CA professionals to step up their game by staying updated on compliance regulations, embracing technology and fostering a strong ethical framework. This expanded role signifies a crucial step towards curbing money laundering in India, reinforcing the collective effort to preserve the integrity of our financial system and protecting the interests of our nation.

REFERENCES

1. A Lawyer’s Guide to Detecting and Preventing Money Laundering October 2014, A collaborative publication of the International Bar Association, the American Bar Association, and the Council of Bars and Law Societies of Europe.

2. https://www.nortonrosefulbright.com/en-au/knowledge/publications/bae065f5/tranche-2

3. Anti-money laundering, 2nd edition by IFAC.

4. Extending the Reach: CAs, CMAs and CSs brought under the ambit of PMLA reporting entities by Dr (CA) Durgesh Pandey.

5. https://legal.thomsonreuters.com/en/insights/articles/what-is-a-suspicious-activity-report

6. Requiring Lawyers to Submit Suspicious Transaction Reports: Implementation Issues and Current International Trends by George V. Carmona, Chief of Party, ROLE – USAID

7. Guideline: Accountants Complying with the Anti-Money Laundering and Countering Financing of Terrorism Act 2009, March 2018, published by New Zealand Government

8. https://fintrac-canafe.canada.ca/re-ed/accts-eng

9. https://ec.europa.eu/commission/presscorner/detail/en/MEMO_13_64

10. https://alessa.com/blog/compliance-with-bank-secrecy-act-aml-requirements/

11. https://cfatf-gafic.org/index.php/documents/fatf-40r/388-fatf-recommendation-22-dnfbps-customer-due-diligence

12. https://www.cfatf-gafic.org/index.php/documents/fatf-40r/395-fatf-recommendation-29-financial-intelligence-units

13. https://www.rupanjanade.com/post/the-role-of-professionals-under-the-redefined-pmla

Reporting Under PMLA by Professionals – Deciphering ‘On Behalf Of’

INTRODUCTION

Notifications dated 3rd May, 2023 and 9th May, 2023 issued by the Ministry of Finance have the effect of making relevant persons ‘reporting entities’ as more particularly defined by Section 2(1)(sa)(vi) read with Section 2(1)(wa) of the Prevention of Money Laundering Act, 2002 (PMLA).

The 3rd May, 2023 Notification purports to cover within the definition of ‘reporting entities’ those ‘relevant persons’ who carry out ‘financial transactions’ on behalf of his / her client, in the course of one’s profession in relation to certain activities. If the certain activities listed in the Notification are carried out by the ‘relevant person’, then the professional would find himself/herself as a reporting entity under the PMLA. Explanation 1 in the Notification states that a ‘relevant person’ would include:

•    an individual who obtained a certificate of practice under section 6 of the Chartered Accountants Act, 1949 (38 of 1949) and practicing individually or through a firm, in whatever manner it has been constituted;

•    an individual who obtained a certificate of practice under section 6 of the Company Secretaries Act, 1980 (56 of 1980) and practicing individually or through a firm, in whatever manner it has been constituted;

•    an individual who has obtained a certificate of practice under section 6 of the Cost and Works Accountants Act, 1959 (23 of 1959) and practicing individually or through a firm, in whatever manner it has been constituted.

On the other hand, the 9th May Notification purports to cover within the definition of ‘reporting entities’ those ‘persons’ who carry out certain activities in the course of business on behalf of or for another person as the case may be. This Notification does not seek to restrict the applicability of the Notification to a specific business or profession and therefore, can also act as a trigger for professionals to become reporting entities under the PMLA.

India is a member of the Financial Action Task Force (FATF). The FATF has a set of 40 recommendations that the member countries seek to implement in order to combat the menace of money laundering. Trying to comply with the FATF recommendations on money laundering is one of our country’s international commitments. In fact, the PMLA Act itself is a result of India’s international commitments. The preamble to the Act reads as follows:

“An Act to prevent money-laundering and to provide for confiscation of property derived from, or involved in, money-laundering and for matters connected therewith or incidental thereto.

WHEREAS the Political Declaration and Global Programme of Action, annexed to the resolution S-17/2 was adopted by the General Assembly of the United Nations at its seventeenth special session on the twenty-third day of February, 1990;

AND WHEREAS the Political Declaration adopted by the Special Session of the United Nations General Assembly held on 8th to 10th June, 1998 calls upon the Member States to adopt national money-laundering legislation and programme;

AND WHEREAS it is considered necessary to implement the aforesaid resolution and the Declaration.”

While much has already been discussed regarding these two notifications, there is still uncertainty around the phrase ‘on behalf of’ as used in them. Though perhaps we may have to wait for an authoritative judicial pronouncement on the exact interpretation to be given to this commonly used phrase, today we seek to lay down broad contours of what ‘on behalf of’ could mean with regard to these two notifications.

THE FATF FACTOR

The FATF recommendations also use the phrase ‘on behalf of’ quite often. In fact, the phrase ‘on behalf of’ when used in the Recommendations, seems to signify a fiduciary relationship and is broader than what is given in Indian law. Recommendation 23 (a) reads as follows:

Lawyers, notaries, other independent legal professionals and accountants should be required to report suspicious transactions when, on behalf of or for a client, they engage in a financial transaction in relation to the activities described in paragraph (d) of Recommendation 22. Countries are strongly encouraged to extend the reporting requirement to the rest of the professional activities of accountants, including auditing.

Recommendation 22 (d) in turn reads as follows:

Lawyers, notaries, other independent legal professionals and accountants – when they prepare for or carry out transactions for their client concerning the following activities:

•    buying and selling of real estate;

•    managing of client money, securities or other assets;

•    management of bank, savings or securities accounts;

•    organisation of contributions for the creation, operation or management of companies;

•    creation, operation or management of legal persons or arrangements, and buying and selling of business entities.

The above two recommendations read together therefore are the genesis of the 3rd May, 2023 Circular. This is in line with the commitment that our country is showing to combat money laundering.

LAYING THE GROUNDWORK – USING ‘FOR ANOTHER PERSON’ TO HELP IN INTERPRETING ‘ON BEHALF OF’

In order to narrow down on the meaning of ‘on behalf of’, it would be perhaps instructive to hazard a guess as to what would constitute ‘for another person’. The 3rd May, 2023 notification does not include ‘for another person’. This language is used in the 9th May, 2023 Notification, the relevant portion of which reads –

“the following activities when carried out in the course of business on behalf of or for another person, as the case may be, as an activity for the purposes of said sub-clause”

Therefore, the Notification itself draws a distinction between ‘on behalf of another person’ and ‘for another person’ by making them alternative to each other through the use of the conjunction ‘or’. The list of activities covered in the 9th May notification is also instructive:

a)    “acting as a formation agent of companies and limited liability partnerships;

b)    acting as (or arranging for another person to act as) a director or secretary of a company, a partner of a firm or a similar position in relation to other companies and limited liability partnerships;

c)    providing a registered office, business address or accommodation, correspondence or administrative address for a company or a limited liability partnership or a trust;

d)    acting as (or arranging for another person to act as) a trustee of an express trust or performing the equivalent function for another type of trust; and

e)    acting as (or arranging for another person to act as) a nominee shareholder for another person”.

Though the Explanation to the Notification provides for a list of exclusions, the only relevant part for our discussion would perhaps be restricted to Explanation ‘b’ which reads as follows:

“any activity that is carried out by an employee on behalf of his employer in the course of or in relation to his employment;”

The list of activities enumerated from ‘(a) to (e)’ above is telling. These activities do not need to be necessarily carried out in a representative capacity. They may also be carried out in a personal capacity for the benefit of someone else. A hypothesis can thus be drawn that ‘on behalf of another person’ would denote a person acting in a ‘representative capacity’ for another person, but ‘for another person’ would denote a person acting in a personal capacity for another person. Therefore, based on this premise, the 9th May, 2023 notification would make a professional a ‘reporting entity’, whether he carried out those activities in his individual capacity or in a representative capacity.

However, the absence of ‘for another person’ in the 3rd May, 2023 notification is telling. Firstly, the notification restricts itself to ‘financial transactions’, to be carried out specifically ‘on behalf of a client’, ‘in the course of the profession’ and in ‘relation to the following activities’–

1.    “buying and selling of any immovable property;

2.    managing of client money, securities or other assets;

3.    management of bank, savings or securities accounts;

4.    organisation of contributions for the creation, operation or management of companies;

5.    creation, operation or management of companies, limited liability partnerships or trusts, and buying and selling of business entities.”

It may be of particular interest to note that the transactions covered in ‘1 to 5’ as enumerated above can possibly be conducted both ‘on behalf of a client’ as well as ‘for a client’. As the notification omits using the phrase ‘for the client’, the interpretation of ‘on behalf of a client’ gains a greater relevance. Significantly, distinguishing ‘on behalf of a client’ and ‘for a client’ also gains greater relevance as, while the former would make the professional a ‘reporting entity’, the latter would not.

DECIPHERING THE ENIGMA OF ‘ON BEHALF OF’

While embarking upon a journey to find the meaning of a phrase in law, the Black’s Law Dictionary has often served as a good starting point. The Black’s law dictionary, while defining ‘behalf’, includes the definition of ‘on behalf of’. The definition in the dictionary supports our hypothesis that ‘on behalf of’ would denote representative capacity. The dictionary states as follows:

behalf.[fr. Anglo-Saxon half “unit, side”] (14c) Side, part, advantage, or interest. • The phrase in behalf of traditionally means “in the interest, support, or defense of”; on behalf of means “in the name of, on the part of, as the agent or representative of.”

In fact, the Income-tax Act, 1961, also leads credence to this hypothesis of ‘on behalf of’ being used in a representative capacity. The phrase ‘on behalf of’ is used in the very definition of ‘Authorised Representative in Section 288(2) of the Act. It is reproduced below as follows:

Section 288 (2) For the purposes of this section, “authorised representative” means a person authorised by the assessee in writing to appear on his behalf, being—

(i)    a person related to the assessee in any manner, or a person regularly employed by the  assessee; or

(ii)    any officer of a Scheduled Bank with which the assessee maintains a current account or has other regular dealings; or

(iii)    any legal practitioner who is entitled to practise in any civil court in India; or

(iv)    an accountant; or

(v)    any person who has passed any accountancy examination recognised in this behalf by the Board; or

(vi)    any person who has acquired such educational qualifications as the Board may prescribe for this purpose; or

(via)    any person who, before the coming into force of this Act in the Union territory of Dadra and Nagar Haveli, Goa†, Daman and Diu, or Pondicherry, attended before an income-tax authority in the said territory on behalf of any assessee otherwise than in the capacity of an employee or relative of that assessee; or

(vii)    any other person who, immediately before the commencement of this Act, was an income-tax practitioner within the meaning of clause (iv) of sub-section (2) of section 61 of the Indian Income-tax Act, 1922 (11 of 1922), and was actually practising as such;

[(viii)    any other person as may be prescribed.]

Thus, the phrase ‘on behalf of’ in the Income-tax Act, 1961, is clearly in a representative capacity. It may be noted that for a professional to appear before the tax authorities, a ‘vakalatnama’ or a ‘power of attorney’ is required. This allows the person so authorised to appear ‘on behalf of a person’ before various authorities and make pleadings and submissions on their behalf. These pleadings and submissions are binding upon the person so represented. A cursory glance at umpteen Judgements of various courts will show that the Courts observe that Advocates have appeared ‘on behalf of’ a client. This introduces an additional point of distinction between ‘on behalf of’ and ‘for’. We may add this to our original hypothesis – For a transaction or activity to be carried out ‘on behalf of’ another person, there should be authorisation to that effect and the intention to be bound by the action of the person so authorised acting on one’s behalf.

In fact, inspiration can be drawn from the Judgment of the Constitution Bench of the Supreme Court in M. Siddiq (Ram Janmabhumi Temple-5 J.) vs. Suresh Das, (2020) 1 SCC 1The Judgment, more famously known as the ‘Ayodhya Judgment’ or the ‘Ram Janmabhoomi Temple Judgment’ discussed the right of a ‘Shebait’ and the ‘next friend’ of the idol to institute a suit. The following extracts of the Judgment may prove to be instructive:

“Courts recognise a Hindu idol as the material embodiment of a testator’s pious purpose. Juristic personality can also be conferred on a Swayambhu deity which is a self-manifestation in nature. An idol is a juristic person in which title to the endowed property vests. The idol does not enjoy possession of the property in the same manner as do natural persons. The property vests in the idol only in an ideal sense. The idol must act through some human agency which will manage its properties, arrange for the performance of ceremonies associated with worship and take steps to protect the endowment, inter alia by bringing proceedings on behalf of the idol. The shebait is the human person who discharges this role..

..The dedicated property legally vests in the idol in an ideal sense and not in the shebait. A shebait does not bring an action for the recovery of the property in a personal capacity but on behalf of the idol for the protection of the idol’s dedicated property. Ordinarily, a deed of dedication will not contain a provision for the duties of the shebait. However, an express stipulation or even its absence does not mean that the property of the idol vests in the shebait. Though the property does not legally vest in the shebait, the shebait may have some interest in the usufruct generated from it. Appurtenant to the duties of a shebait, this interest is reflected in the nature of the office of a shebait..

..Ordinarily, the right to sue on behalf of the idol vests in the shebait. This does not however mean that the idol is deprived of its inherent and independent right to sue in its own name in certain situations. The property vests in the idol. A right to sue for the recovery of property is an inherent component of the rights that flow from the ownership of property. The shebait is merely the human actor through which the right to sue is exercised. As the immediate protector of the idols and the exclusive manager of its properties, a suit on behalf of the idol must be brought by the shebait alone. Where there exists a lawfully appointed shebait who is able and willing to take all actions necessary to protect the deity’s interests and to ensure its continued protection and providence, the right of the deity to sue cannot be separated from the right of the shebait to sue on behalf ofthe deity. In such situations, the idol’s right to sue stands merged with the right of the shebait to sue on behalf of the idol..

..A suit by a shebait on behalf of an idol binds the idol.For this reason, the question of who can sue on behalf of an idol is a question of substantive law. Vesting any stranger with the right to institute proceedings on behalf of the idol and bind it would leave the idol and its properties at the mercy of numerous individuals claiming to be “next friend”. Therefore, the interests of the idol are protected by restricting and scrutinising actions brought on behalf of the idol. For this reason, ordinarily, only a lawful shebait can sue on behalf of the idol. When a lawful shebait sues on behalf of the deity, the question whether the deity is a party to the proceedings is merely a matter of procedure. As long as the suit is filed in the capacity of a shebait, it is implicit that such a suit is on behalf of and for the benefit of the idol..”

Therefore, the shebait acts in a representative capacity on behalf of the idol in instituting a suit and by the virtue of being the shebait, has the authorisation by the virtue of appointment and consequently the authority to bind the idol through a suit. In short, as the Supreme Court observed, the shebait can file a suit on behalf of the idol.

In fact, the expression ‘on behalf of’ also finds use in the relationship of ‘agency’. A recent Judgment of the Supreme Court inRajasthan Art Emporium vs. Kuwait Airways & Onr. 2023 SCC OnLine SC 1461,examining Section 237 of the Indian Contract Act considered if the agent had the authority to act ‘on behalf of’ the Principal.

Section 237 of the Contract Act provides that:

“237. Liability of principal inducing belief that agent’s unauthorised acts were authorised – When an agent has, without authority, done acts or incurred obligations to third persons on behalf of his principal, the principal is bound by such acts or obligations if he has by his words or conduct induced such third persons to believe that such acts and obligations were within the scope of the agent’s authority.”

The Court observed that: “There is no gainsaying that onus to show that the act done by an agent was within the scope of his authority or ostensible authority held or exercised by him is on the person claiming against the principal. This, of course, can be shown by practice as well as by a written instrument. Thus, the question for consideration is whether on the evidence obtaining in the instant case, can it be said that Respondent 3 had an express or implied authority to act on behalf of Respondent 1 as their agent? If Respondent 3 had such an authority, then obviously Respondent 1 was bound by the commitment Respondent 3 had made to the appellant.”

This Judgment would also support our hypothesis that in order to act ‘on behalf of’ someone, the person must be authorised, and act in a representative capacity and such act must have the power to bind the person to the act committed.

In State of W.B. vs. O.P. Lodha (1997) 5 SCC 93 where an agent was selling goods both in his individual capacity and in his capacity as an agent, the Supreme Court observed: “In my judgement, the scheme of the Act leaves no room for doubt that an agent who sells goods on behalf of somebody else cannot escape the liability to pay sales tax on the sales made by him for and on behalf of others merely because, he was selling goods on behalf of others.”

The importance of the ‘on behalf of’ being in the course of business or profession to trigger the reporting obligations.

Therefore, a relationship akin to an agency would see an agent act ‘on behalf of the principal’. A perusal of the list of the activities and finance transactions covered by both the 3rd May as well as the 9th May, 2023 Notifications would seem to suggest that an agency relationship and the relationship of a constituted attorney / power of attorney holder for carrying out the listed activities / transactions would trigger the definition of reporting entity. After all, a constituted attorney also acts in a representative capacity, is specifically authorised and can bind the Donor (the person who grants the power of attorney) by his / her Acts.

For professionals, it is important to note that both Notifications carry an important safeguard. The activity / transactions must be carried out in the course of business / profession. If this safeguard did not exist, then personal transactions / activities of the nature listed in the notifications would also have been covered. After all, it is quite common for a parent / guardian / family member / spouse to act ‘on behalf of’ the minor child / ward / other members of the family or spouse. For example, for a minor to be admitted into a partnership, a parent / guardian needs to enter into the contract on the minor’s behalf.

In CIT vs. Shah Mohandas Sadhuram [1965] 57 ITR 415 (SC) the Supreme Court observed “Before we discuss these questions it is necessary to consider what are the incidents and true nature of “benefits of partnership” and what is a guardian of a minor competent to do on behalf of a minor to secure the full benefits of partnership to a minor. First it is clear from sub-section (2) of section 30 of the Partnership Act that a minor cannot be made liable for losses. Secondly, section 30, sub-section (4), enables a minor to sever his connection with the firm and if he does so, the amount of his share has to be determined by evaluation made, as far as possible, in accordance with the rules contained in section 48, which section visualises capital having been contributed by partners. There is no difficulty in holding that this severance may be effected on behalf of a minor by his guardian. Therefore, sub-section (4) contemplates that capital may have been contributed on behalf of a minor and that a guardian may on behalf of a minor sever his connection with the firm. If the guardian is entitled to sever the minor’s connection with the firm, he must also be held to be entitled to refuse to accept the benefits of partnership or agree to accept the benefits of partnership for a further period on terms which are in accordance with law. Subsection (5) proceeds on the basis that the minor may or may not know that he has been admitted to the benefits of partnership. This sub-section enables him to elect, on attaining majority, either to remain a partner or not to become a partner in the firm. Thus it contemplates that a guardian may have accepted the benefits of a partnershipon behalf ofa minor without his knowledge. If a guardian can accept benefits of partnership on behalf ofa minor, he must have the power to scrutinise the terms on which such benefits are received by the minor. He must also have the power to accept the conditions on which the benefits of partnership are being conferred. It appears to us that the guardian can do all that is necessary to effectuate the conferment and receipt of the benefits of partnership.”

In fact, ‘on behalf of is often used between a minor and a guardian. If we look at the Indian Trusts Act, 1882, it uses the phrase ‘on behalf of’, statutorily allows a trust to be created by or on behalf of a minor subject to the law contained in Section 7(b) of the Act. In the Definitions included in the FATF 40 recommendations, the phrase ‘on behalf of’ is also used in the definition of trustee to denote a family member which reads as follows:

Trustee: The terms trust and trustee should be understood as described in and consistent with Article 2 of the Hague Convention on the law applicable to trusts and their recognition. Trustees may be professional (e.g. depending on the jurisdiction, a lawyer or trust company) if they are paid to act as a trustee in the course of their business, or a non-professional who is not in the business of being a trustee (e.g. a person acting on behalf of the family).

Normally, this activity of the Guardian would have triggered the definition of ‘reporting entity’ qua the 9th May, 2023 Notification by acting as a partner of a firm on behalf of the minor or through the other activities / transactions listed in the notifications e.g. buying and selling of immovable property and management of bank, savings of securities account. The same activities can also be carried out for family members as well as major children through an express Power of Attorney etc. Therefore, the transaction / activity needing to be in the course of profession / business in addition to being carried out on behalf of another person or (in the case of the 9th May, 2023 Notification) for another person is an important safeguard to one’s privacy.

CONCLUSION

This discussion, rather than trying to be the last word on the interpretation of the phrase ‘on behalf of’seeks to be a ‘starting point’.  The phrase ‘on behalf of’ is generic and is often used in a broad sense. Whether an activity or a transaction is conducted on behalf ofanother person or not would be greatly influenced by fact. The image would change as one peers through the kaleidoscope of facts. In law, the interpretation given to this phrase will undoubtedly affect both, the professionals as well as the general public with regard to the reporting and compliance requirements imposed by Chapter IV of the PMLA.

If one goes through the FATF recommendations which are available on the website, one would see  that the scheme is putting the onus on Lawyers, Notaries, Independent Legal Professionals and Accountants to carry out KYC and report suspicious transactions as a  part of the 40 recommendations. Therefore, putting the onus on professionals is not a decision that has been taken by the Government of India in an arbitrary manner or as a ‘vendetta’ but is a part of our international commitments to adhere to global practices. These obligations will be implemented in FATF member countries across the globe at some point in time, if not already implemented. The relationships that have been indicated for the purposes of reporting are mainly fiduciary in nature. Professionals can avoid being reporting entities by not rendering the services that have been listed in the Notifications. Most of these services are generally not a part of professional services rendered and are more ‘personal’ in nature and may be seen as being fiduciary relationships.

It is important to note that the penalty for not complying with Chapter IV of the PMLA is a monetary one under Section 13 and no prosecution is contemplated. The fine may be steep, as a separate fine may be levied (maximum of One lakh), but the fine shall be for each individual infraction and may add up quite quickly.  However, a word of caution: Some of these activities may also be in violation of the professional code of ethics and may give rise to disciplinary proceedings against the professional concerned. It would perhaps be better for most professionals to avoid carrying out the activities that are contemplated by the 3rd and 9th May, 2023 Notifications in the course of carrying on their professions.

Alternative Investment Funds (AIFs) — Examining the Application of PARI-PASSU and PRO-RATA Concepts

Alternative Investment Funds (AIFs) play a vital role in India’s economy. They provide risk capital in the form of equity/quasi-equity capital for pre-revenue stage companies, early and late-stage ventures, growth companies that wish to scale their operations, and even companies facing distress.

The size of AIFs has grown to a significant amount over the years. There are around 1,100 AIFs registered with SEBI with over 8.44 trillion INR in commitments (as of 30th June, 2023), witnessing an annual growth rate of over 30 per cent.

Considering the need of the economy for such funds, its growth and the huge amount committed, SEBI, aptly supported by its policy advisory committee, is continuously making sincere attempts to ensure transparency and good governance. Recently in May 2023 SEBI, in its consultation paper titled Consultation paper on proposal with respect to pro-rata and pari-passu rights of investors in Alternative Investment Funds (AIFs)”, has empathetically asserted:

“Considering that fair treatment of investors is a core and inherent principle for a pooled investment vehicle, as also evident from global references given above it is essential to expressly provide that AIFs shall not provide any differential treatment to investors which affects economic rights of other investors. Therefore, it is necessary to explicitly provide for fair treatment of all investors as a principle under the AIF Regulations, from the perspective of investor protection.” (para 31 — emphasis supplied)

The objective of this article is to critically examine the extant regulations on pari-passu and pro-rata rights of investors in AIF and the fair treatment of all investors as regards investors joining a fund at different points in time.

What is pari-passu?

Pari-passu is a Latin term that means “ranking equally and without preference.” Applied in the context of investments, pari-passu means that multiple parties to an investment joining an investment scheme at different points of time with varying amounts are treated the same, “ranking equally and without preference — in the sense that the assets or securities would be managed with equal preference or a preference weighted on the value or amount invested and when invested in either the asset or securities.”

Fundraising by an AIF scheme/ fund:

SEBI Regulations governing AIFs viz. SEBI (Alternative Investment Funds) Regulations, 2012, contemplate that a fund approved by SEBI may be able to attract investors to such a fund at different points of time, committing varying amounts (subject to the minimum prescribed). The terms used for investors joining at different points of time are (i) investors joining at the time of First Closing, (ii) investors joining at Subsequent Closing(s), and (iii) investors joining at the time of Final Closing. The Private Placement Memorandum (PPM — explained later) (in section VII) requires each scheme to specify indicative timelines for Initial closing, Subsequent closing(s), Final closing, Commitment Period and Term of the Fund/Scheme.

Considering the above, there is a need to place all these investors joining at different points of time with varying amounts on equal footing.

In mutual fund equity schemes where daily NAV based on the market prices is readily available, all subsequent investors join based on this daily NAV at the time of joining.

However, the investments by most AIFs are in private equity/ quasi equity. These investments have certain time frame depending on the period of nurturing required and success and growth of the ventures. They are illiquid investments and can’t have daily market value. Considering this limitation, the best way to put these investors joining at different points of time with varying amounts is by ensuring equal IRR (Internal Rate of Return) or equal RoI (Return on Investment) for all investors. The implementation of this system may be practically cumbersome and, therefore, in order to simplify the process, in cases of AIFs, this is ensured by what is popularly known as equalization method. In this method, there are three different types of contributions which investors joining during subsequent closing(s) and final closing have to pay — Catch-up Contribution, Compensatory Contribution and Management Fees Additional Contribution. The first two viz. Catch-up Contribution and Compensatory Contributions are meant to place subsequent investors on equal footing vis-à-vis earlier investors and therefore, are distributed by the fund amongst earlier investors on pro-rata basis.

In this article, I am making an attempt to specifically focus on the following:

• The precise nature of Catch-up Contribution and Compensatory Contribution.

• How they are quantified, collected from subsequent contributors (investors) and distributed pro-rata amongst original/ prior contributors.

In Annexure 1, I have brought out the key concepts and the regulatory framework that guides the functioning of AIFs.

The subject of the economic rights of investors during fundraising by AIF — specifically in the context of Category II AIF is very significant.

MODEL CONTRIBUTION AGREEMENT:

Every investor investing in an AIF has to enter into an agreement which is called a Contribution / Subscription Agreement.

The format of PPM provided by SEBI in Part A in Section VII titled ‘Principal Terms of the Fund/Scheme’ requires the Investment Manager to specify the indicative timeline for various closings, the payments unitholders participating in subsequent closings have to make (like catch-up contribution, compensatory contribution).

SIDBI, which manages Fund of Funds, on its website, provides a model contribution agreement.

https://www.sidbivcf.in/files/new_announcement/Model per cent20Contrubution per cent20Agreement per cent20for per cent20AIFs.pdf

The relevant definitions for the present subject are:

• “Catch-up Contribution”

• “Compensatory Contribution”

• “Final Closing”

• “First Closing”

• “Subsequent Closing”

• “Subsequent Contributor”

Clause 3 of this model agreement deals with the “Induction of new contributors and the issue of Units.”

For brevity, the same are not reproduced here.

On reading the above definitions and clause 3 of the model agreement and requirements of PPM, it conveys:

1. At every subsequent closing up to the Final Closing, subsequent contributors shall pay Catch-up Contribution as well as Compensatory Contribution.

2. Both these amounts collected by the Fund shall be distributed amongst the contributors who were admitted prior to such subsequent closing pro rata in proportion to their respective capital contributions.

Considering the above-stated provisions usually contained in all contribution/ subscription agreements and similar provisions contained in PPMs, it is evident that AIFs have to collect catch-up and compensatory contributions from subsequent investors and distribute the same pro-rata amongst prior/ earlier investors.

The next step is to understand how these two contributions are quantified, collected and distributed.

The methodology of quantifying, collecting and distributing Catch-up Contributions and Compensatory Contributions are explained using case studies.

CATCH-UP CONTRIBUTION:

Before a private equity fund is launched, the IM solicits commitments to invest from potential investors. These soft commitments are not legally binding and do not represent future subscriptions. They, however, indicate as to how much capital might be raised.

Once the IM decides to launch the fund, the PPM is published and circulated amongst potential/prospective investors. Thereafter, hard commitments are made by investors with whom contribution/subscription agreements are signed.

The IM can seek to raise additional commitments and capital at any time between the First Closing and the Final Closing.

The above is illustrated below by a hypothetical case of Rahul Fund as at First Closing on 30th November, 2018 (Table no. 1):

 

Investor

COMMITMENT(INR)

OWNERSHIP

The IM 5,00,00,000 10 per cent
Investor1 15,00,00,000 30 per cent
Investor 2 15,00,00,000 30 per cent
Investor 3 15,00,00,000 30 per cent
TOTAL 50,00,00,000 100 per cent

The Fund issues a drawdown notice dated 1st December, 2018 calling upon the investors to contribute 10 per cent aggregating to Rs. 5,00,00,000 and all investors send their contributions by 31st December, 2018. Accordingly, the above data will appear as under (Table no. 2):

INVESTOR COMMITMENT OWNERSHIP DRAWDOWN 1
The IM 5,00,00,000 10 per cent 50,00,000
Investor1 15,00,00,000 30 per cent 1,50,00,000
Investor 2 15,00,00,000 30 per cent 1,50,00,000
Investor 3 15,00,00,000 30 per cent 1,50,00,000
TOTAL 50,00,00,000 100 per cent 5,00,00,000

One year after the Initial Closing, the IM decides to seek additional capital commitments and finds an investor (Investor 4 in the table below). Rahul Fund’s investor allocation will now be as under (Table no. 3):

 

INVESTOR COMMITMENT OWNERSHIP DRAWDOWN 1
The IM 5,00,00,000 8.33 per cent 50,00,000
Investor1 15,00,00,000 25 per cent 1,50,00,000
Investor 2 15,00,00,000 25 per cent 1,50,00,000
Investor 3 15,00,00,000 25 per cent 1,50,00,000
Investor 4 10,00,00,000 16.67 per cent NIL
TOTAL 60,00,00,000 100 per cent 5,00,00,000

 

With this additional investor’s commitment, the initial investors’ ownership has been diluted, yet the new investor hasn’t paid anything into the fund. Investor 4 could simply make the initial drawdown payment to balance things out, but this wouldn’t accurately compensate the initial investors and would eat into Fund’s IRRs.

Instead, an equalisation needs to be completed.

What is equalisation — catch-up contribution?

Equalisation is the process of truing up all investors as if they had all joined a fund on its initial closing date. The process of doing so is multi-pronged. This is called catch-up contribution.

First, Investor 4 pays in drawdown 1 on 31st December, 2019. But rather than making the payment to the fund, the payment is allocated across the initial investors, according to their percentage of ownership of the fund (Table no. 4).

 

INVESTOR COMMITMENT OWNERSHIP DRAWDOWN 1 Returned/called Adj.Drawdown1 Per cent drawdown
The IM 5,00,00,000 8.33% 50,00,000 (8,35,000) 41,65,000 8.33
Investor1 15,00,00,000 25% 1,50,00,000 (25,00,000) 1,25,00,000 25
Investor 2 15,00,00,000 25% 1,50,00,000 (25,00,000) 1,25,00,000 25
Investor 3 15,00,00,000 25% 1,50,00,000 (25,00,000) 1,25,00,000 25
Investor 4 10,00,00,000 16.67% NIL 83,35,000 83,35,000 16.67
TOTAL 60,00,00,000 100% 5,00,00,000 NIL 5,00,00,00 100

The magic of equalisation is putting Investor 4 as if Investor 4 had joined the Fund at the time of initial closing — at par with the IM and other three Investors 1, 2 & 3.
Clause 3.1.of the model agreement also states:

“The Investment Manager shall promptly distribute Catch-up Contributions amongst the Contributors who were admitted prior to such Subsequent Closing pro rata in proportion to their respective Capital Contributions and such amounts distributed to the Contributors shall be added back to their Unpaid Capital Commitments, ……….”

This provision is illustrated as under (Table no. 5):

INVESTOR COMMITMENT DRAWDOWN 1 Unpaid capital commitment Returned/called Adj.Drawdown1 Adjusted unpaid capital
The IM 5,00,00,000 50,00,000 4,50,00,000 (8,35,000) 41,65,000 4,58,35,000
Investor1 15,00,00,000 1,50,00,000 13,50,00,000 (25,00,000) 1,25,00,000 13,75,00,000
Investor 2 15,00,00,000 1,50,00,000 13,50,00,000 (25,00,000) 1,25,00,000 13,75,00,000
Investor 3 15,00,00,000 1,50,00,000 13,50,00,000 (25,00,000) 1,25,00,000 13,75,00,000
Investor 4 10,00,00,000 NIL nil 83,35,000 83,35,000 9,16,65,000
TOTAL 60,00,00,000 5,00,00,000 45,00,00,000 NIL 5,00,00,00 55,00,00,000

From this Table No. 5, it is evident that the share in catch-up contribution received by The IM and Investors 1, 2 and 3 adds up to unpaid capital commitment by all four of them. This, in essence, means that the share in the catch-up contribution received is part refund of the amount they had already paid. This is relevant in deciding the taxability, if any, of this share in catch-up contribution received by original/ prior investors.

The cardinal principle of an AIF is — All investors have to be treated at par — equally treated (barring a few issues like set-up fees, and management fee structure). This ‘catch-up contribution’ has the effect of putting all investors on an equal footing. The outcome should be that, having re-balanced contributed capital, the amount of uncalled capital for each partner is consistent with the percentage ownership of each partner after this subsequent closing.

A basic premise in the treatment of subsequent closings is that subsequent investors should be treated as if they had invested at the beginning.

Following this principle, the new/subsequent investors who join at a later date are put at par with original/ prior investors following this system of catch-up contribution and its pro rata distribution amongst prior/ original investors.

Note that, so far, it appears that the fund does not receive cash on 31st December, 2019; the net effect of the cash flows shown is zero as the flows simply re-balance the investor’s capital

COMPENSATORY CONTRIBUTION:

However, there is one more area where also, both these types of investors need to be put at par — time value of money.

In the given case, the original three investors and the IM had put their money by December, 2018. Whereas the new investor 4 puts his pro rata contribution in December, 2019 — after a lapse of a year. This issue is addressed by what is called Compensatory Contribution in India and Equalisation Interest abroad. The same is amplified as under.

What is Equalisation Interest — called Compensatory Contribution in India?

In the given case, the IM and 3 original investors paid their first drawdown on 31st December, 2018. Whereas, Investor 4 pays Rs. 83,35,000 only on 31st December, 2019 — after a time lapse of 1 year. To compensate for this, Investor 4 also pays compensatory contribution at a specified rate per annum. Normally, this rate is the Hurdle Rate provided in the Contribution/ Subscription Agreement. This compensatory contribution is also distributed amongst original/ prior investors pro-rata.

The collection of Compensatory Contribution from the new investor and distribution of the same amongst the IM and original three investors will put all investors at par vis-à-vis each other. Any drawdown(s) thereafter will be paid by all the 5 investors as per their respective shares of unpaid capital commitments.

The impact of Compensatory Contribution is illustrated on the following page:

INVESTORS DATE AMOUNT Per cent HOLDING Equalisation Interest
Original Investors:
Investment Manager 31-12-2018  2,00,00,000 7.41 per cent  1,95,09,000
Investor 1 31-12-2018  20,00,00,000 74.07 per cent  19,50,11,000
Investor 2 31-12-2018  5,00,00,000 18.52  per cent  4,87,60,000
Final Closing:
Investor 3 30-06-2021  94,00,00,000 -26,32,80,000

Investor 3 pays interest at 10 per cent p.a. (compounded quarterly), being hurdle rate, from 31st December, 2018 to 30th June, 2021.

The readers will notice the loss original investors would suffer (almost close to 100 per cent of the invested amount) if an investment manager decides to waive this equalisation interest.

These calculations look relatively easy and straightforward, but it is easy to imagine how they quickly become increasingly complex as factors multiply. Funds might have multiple capital calls that they need to track between the initial and subsequent closing, as well as multiple closings with different investors on-boarding at different times.

Whether Investment Manager has the right to waive Catch-up and/or Compensatory Contributions?

Clause 3 of the Model Contribution Agreement deals with the Induction of new contributors and issue of Units). This clause states — “The Investment Manager shall however, have the power to waive or increase/reduce, subject to the consent of the Advisory Committee, the Compensatory Contribution on Catch-up Contributions to be received and accepted at such Subsequent Closings.”

In this context, readers’ attention is invited to SEBI’s Consultation paper with respect to pro-rata and pari-passu rights of investors issued in May 20231. In this paper, inter alia, it is stated, “While the above principle is not explicitly stated in AIF Regulations, maintaining pro-rata rights of investors in each investment of the scheme of AIF, including while making distribution of investment proceeds, is an essential characteristic of the AIF structure.”


1. https://www.sebi.gov.in/reports-and-statistics/reports/may-2023/consultation-paper-on-proposal-with-respect-to-pro-rata-and-pari-passu-rights-of-investors-of-alternative-investment-funds-aifs-_71540.html

Considering the above, the right, if any, of the investment manager to waive catch-up and/ or compensatory contribution has to be subject to conditions, and the fund and the trustee are responsible for ensuring pari-passu rights of all investors — initial as well as subsequent — at all times.

As mentioned earlier, accounts of each fund have to be audited each year and the auditor may consider examining, during the course of audit, whether the fund has collected and distributed catch-up as well as compensatory contributions from subsequent investors or not. And, if not, the auditor needs to examine whether such an act affects the pro-rata and pari-passu rights of investors or not. If the auditor finds that it affects this essential characteristic of the AIF structure, it may be his responsibility to suitably report the same.

Taxation of Catch-Up Contribution & Compensatory Contribution:

Also, considering that category II AIF enjoys pass-through status, it is important to understand the income-tax implications of the catch-up contribution and compensatory contribution collected from subsequent contributors and distributed by the Fund amongst prior/ original contributors.

No attempt is made here to analyse income tax implications of these two amounts either in the hands of the Fund or in the hands of contributors (both original as well as subsequent contributors).

However, the potential tax issues are listed as under:

1. The Fund:

• Whether it is a business income and therefore liable to be taxed in the hands of the Fund,

• If not, whether, while passing on both these amounts to original/ prior investors, whether the Fund is required to deduct tax at source? If yes, whether on both the amounts or only on equalisation interest (compensatory contribution)?

2. Subsequent contributors (new investors):

• Whether catch-up contribution as well as compensatory contribution will be treated as ‘cost’ while computing their taxable capital gain? If not, does it mean that same will not give any tax relief in respect thereof to such subsequent investors?

• Whether compensatory contribution which is in the nature of equalization interest (and not actual interest) can be claimed as deduction while computing gross taxable income of such a subsequent contributor in the year of payment?

3. Original / prior contributors:

• Whether these amounts are ‘capital receipts’ or ‘revenue receipts’?

• Whether catch-up contribution received can be adjusted against the amounts paid against earlier drawdown(s) to reduce that amount?

• If not, whether the catch-up contribution is liable to be taxed as capital gain or as income from other sources?

• Whether compensatory contribution (which is in the nature of equalisation interest) liable to be taxed as ‘interest income’? Or, whether the same too will go to reduce the cost already incurred? [NOTE: It is important to note that these so called ‘subsequent investors’ too will qualify to receive both ‘catch-up contribution’ as well as ‘compensatory contribution’ whenever there is any fresh round of fund-raising post their investment.]

CONCLUSION

Considering the above, I submit that it is the responsibility of the Investment Managers, PPM Auditors and Investors to assess if the true principles of catch up and compensatory contributions have been followed.

i. The investment managers have to decide whether to adopt equalisation method at the times of each subsequent closing(s) and final closing.

ii. The AIF PPM Auditors (who can be internal/external auditors or legal professionals), while conducing audits of PPM and annual accounts, have the responsibility to examine the actions and decisions of the IM and, if required, to report on the same.

iii. The investors too need to be vigilant as to their rights to receive catch-up and compensatory contributions whenever they notice that the fund in which they have invested has raised fresh commitments.

The writer has come across an instance where the IM, using its discretionary power, waived these contributions even though such a waiver negatively impacted the investor’s economic rights in his regard.

The annual audit of PPM compliance is mandated in the interests of investors. Considering this, SEBI regulations must provide that this annual audit report should also be shared with each investor along with corrective action(s) taken by AIFs. Considering the automation in back-office systems, the time allowed for conducting such an audit too needs to be reduced to maximum 90 days. SEBI also needs to take initiative to form an investors forum which can, on an on-going basis, disseminate information to investors in the matter of their economic rights and representatives of such a forum are included in alternative investment policy advisory committee.

ANNEXURE 1

The background on AIFs is briefly stated for readers’ quick references and understanding.

What is an Alternative Investment Fund (“AIF”)?

Alternative Investment Fund or AIF means any fund established or incorporated in India which is a privately pooled investment vehicle which collects funds from sophisticated investors, whether Indian or foreign, for investing it in accordance with a defined investment policy (stated in PPM) for the benefit of its investors.

AIF does not include funds covered under the SEBI (Mutual Funds) Regulations, 1996, SEBI (Collective Investment Schemes) Regulations, 1999 or any other regulations of the Board to regulate fund management activities. Further, certain exemptions from registration are provided under the AIF Regulations to family trusts set up for the benefit of ‘relatives‘, employee welfare trusts or gratuity trusts set up for the benefit of employees, ‘holding companies‘ etc. [Ref. Regulation 2(1)(b)]

(source – SEBI FAQs)
https://www.sebi.gov.in/sebi_data/attachdocs/1471519155273.pdf

AIFs are regulated by the capital market regulator’s SEBI (Alternative Investment Funds) Regulations, 2012 as amended from time to time and circulars issued by SEBI.

https://www.sebi.gov.in/legal/regulations/apr-2017/sebi-alternative-investment-funds-regulations-2012-last-amended-on-march-6-2017-_34694.html

SEBI’s Master Circular dated 31st July, 2023 on AIFs:
https://www.sebi.gov.in/legal/master-circulars/jul-2023/master-circular-for-alternative-investment-funds-aifs-_74796.html

SEBI circulars on AIFs:
https://www.sebi.gov.in/sebiweb/home/HomeAction.do?doListingAll=yes&cid=25

SEBI also has formed Alternative Investment Policy Advisory Committee under the chairmanship of Mr N R. Narayana Murthy. This committee has published three reports which are available on SEBI’s website.

Report dated 31st December, 2015:

https://www.sebi.gov.in/sebi_data/attachdocs/1453278327759.pdf

Report dated 26th November, 2017:
https://www.sebi.gov.in/sebi_data/attachdocs/jan-2018/1516356419898.pdf

In terms of SEBI AIF Regulations it is mandatory to obtain certificate of registration from SEBI for enabling AIFs to operate under one of the following 3 categories:

• Category I — AIFs which invest in start-up or early stage ventures or social ventures or SMEs or infrastructure. Includes venture capital funds, SME funds, social venture funds, infrastructure funds, angel funds, etc.

• Category II — AIFs, which do not fall in Category I or Category III and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements. Includes private equity funds or debt funds for which no specific incentives or concessions are given by the government or any other regulator.

• Category III — AIFs, which employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. Includes hedge funds or funds, which trade for short term returns, or open-ended funds, for which no specific incentives or concessions are given by the government or any other regulator.

Private Placement Memorandum (PPM):

The PPM is a risk disclosure document (akin to a prospectus issued by a company making public issue) used for marketing a fund to its potential/ prospective investors.

In terms of Regulation 12, AIF has to, at least 30 days prior to the launch of a scheme, submit Placement Memorandum with the Board and the Board may communicate its comments which will have to be incorporated in the placement memorandum before it can be released to prospective investors. Circular dated 5th February, 2020 issued by SEBI has prescribed format for PPM.

The PPM is divided into two parts — Part A requiring minimum disclosures in respect of 15 sections listed in annexure I to the circular and Part B where any additional information in relation to the Fund/Scheme, Manager, investment team which does not form part of the standard disclosures and the section-wise supplementary section under the earlier sections, can be indicated. Considering a sizable amount invested by each investor and high risks associated with such investments, investors should read the PPM and understand the precise nature of the fund where the amount is being invested, particularly provisions which directly or indirectly affect investors’ economic and legal rights.

http://www.aibi.org.in/Circulars/Disclosure per cent20Standards per cent20for per cent20Alternative per cent20Investment per cent20Funds per cent20(AIFs).pdf

https://www.sebi.gov.in/sebi_data/commondocs/feb-2020/an_1_p.pdf

Economic rights:

The parity of economic rights between investors of AIFs is necessary as well as critical. It is observed that at times, the PPMs adopt different practices which provide differential benefits/rights to certain investors over others. Few such terms on which differential economic rights are provided by AIFs are Drawdown timeline, Hurdle rate of return/performance linked fee, Transfer rights, Information rights, Compensatory contribution for investors on-boarded in subsequent closings including catch-up contribution for maintaining pro-rata rights of investors, and Co-investment rights.

Even though PPMs may provide equal rights to investors in these matters, the IMs may, using their discretion, give such preferential rights to a select group of investors or waive catch-up as well as compensatory contributions. As the minimum investment amount prescribed is rupees one crore, general perception is that the investors are sophisticated and capable of taking decision to invest after properly studying PPM and understanding its contents. However, this perception in reality may not be correct.

AIFs and AUDIT REQUIREMENTS:

To complement the measures prescribed by SEBI, chartered accountants as auditors and consultants, also have an important role to play to ensure orderly growth of AIFs and protection of investors’ economic rights.

The accounts of each fund managed by a registered AIF have to be audited annually by a qualified auditor. Each AIF has to provide Annual Report to all its investors including financial information of investee companies and detailed risk profiles. The auditor’s report along with audited accounts are shared with the investors in each such fund along with the annual report. In order to further protect investors’ interests, SEBI circular has introduced a specific requirement that the terms of a contribution or subscription agreement (by any name it may be called) signed with each investor must be aligned with the terms of the Private Placement Memorandum (PPM — what is PPM is explained earlier) and contribution agreement cannot go beyond the terms of the PPM. The Investment Managers are required to ensure that they carry out all activities of the AIF in accordance with the PPM and that they should maintain fairness in ensuring that investors economic and legal rights are of paramount importance.
Also, with a view to ensure that the management team has complied with the terms of PPM, SEBI has introduced a requirement for annual audits of PPM. The results of the audit and any necessary corrective action must be shared with (i) the Trustee, Board, or Designated Partners of the AIF; (ii) the Board of the Manager; and (iii) SEBI within six months of the financial year’s end.

AIFs that have not received any funding from investors are exempt from the requirement of audit compliance. However, within six months of the end of the financial year, a Certificate from a Chartered Accountant declaring that no money has been raised must be provided to support this claim.

Considering SEBI’s persistent attempts to increase good governance and risks management in the management of AIFs through compliances and disclosures, management teams face number of challenges in their functioning and time is not far when large sized funds will need external audit firms to conduct internal audits to assist the management.
Considering the above, such high risk non-traditional investments present number of challenges to chartered accountants as auditors, tax experts & consultants to ensure that they discharge their expected obligations with due care and caution.

Considering the huge amount generated by AIFs, the responsibilities cast on auditors are enormous and, therefore, the auditors need to be familiar with various special features of AIFs, particularly economic rights of investors. One such important feature is — investors joining a fund at different points of time and ensuring they all stand in equal footing — paripassu.

In May 2023, SEBI had come out with several proposals for stricter regulations of AIFs. SEBI issued four consultation papers.

AIF Taxation:

Category I and Category II AIFs enjoy pass-through status. This subject is known to most tax practitioners.
Government’s role in AIF Funding:

Fund of Funds:

Government of India (GoI) created access to a large capital of funds for startups in India, through the scheme “Fund of Funds for Start-ups” to create a nation of job creators than job seekers. This Fund is operated by SIDBI. https://www.sidbivcf.in/en

Self-Reliant India (SRI) Fund — Mother-Daughters Fund:

MSME Sector is very important for the Indian economy in terms of contribution to GDP and employment generation. Considering that the GoI has set-up SRI Fund (Mother Fund) to assist MSME sector through Daughters Fund in the form of Category II Alternative Investment Fund (AIF) who are oriented towards providing funding support to MSMEs as growth capital, in the form of equity or quasi-equity. The details are available at https://dcmsme.gov.in/Final per cent20SRI per cent20Operating per cent20Guidelines per cent20 per cent20approved per cent20by per cent20Minister per cent20 per cent2017 per cent2008 per cent202021.pdf

The SRI Fund is managed by NSIC Venture Capital Fund. The details are available at http://www.nvcfl.co.in/AboutUs

The Retroactive Application of Special Criminal Laws – Recent Supreme Court Decisions

“The entire Community is aggrieved if the economic offenders who ruin the economy of the State are not brought to books. A murder may be committed in the heat of moment upon passions being aroused. An economic offence is committed with cool calculation and deliberate design with an eye on personal profit regardless of the consequence to the Community. A disregard for the interest of the Community can be manifested only at the cost of forfeiting the trust and faith of the Community in the system to administer justice in an even handed manner without fear of criticism from the quarters which view white collar crimes with a permissive eye unmindful of the damage done to the National Economy and National Interest.”

– State of Gujarat v. Mohanlal Jitamalji Porwal & Ors. (1987) 2 SCC 364

The above quote of the Supreme Court (SC) may seem general – but it puts the importance given to economic offenses in context. In the never-ending game of cat and mouse, it is always the law enforcement that seems to play catch up with the offenders. The last decade has seen an increased focus on special laws with the aim of curbing economic offenses. These laws are special – they have special agencies with special powers for investigation, special courts for prosecution and special procedures – for specific offenses, all justified to prevent economic offenders from escaping punishment. However, some of the amendments brought about to these Acts have raised a peculiar problem that gives the public a cause for concern. Can I be punished for an act that was not an offence at the time of its commission? Can criminal liability be fastened upon me by a retrospective amendment? What repercussions does this have for the concept of mens rea?

The SC has examined two different Acts in two different judgments, both in 2022. Both these judgments are considered a landmark in their own field and the legislations that they consider are of particular interest to Chartered Accountants – The Prohibition of Benami Transactions Act,  1988 (the Benami Act) and the Prevention of Money Laundering Act, 2002 (the PMLA). The issue, however, is still live – very recently, the Bombay High Court issued notice on a petition that challenges what it considers the retrospective application of the Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015 and contends that this Act should not penalize transactions that were entered into before it came into force.

The words “retrospective” and “retroactive” have different meanings in law. However, often these terms work in tandem like in the two SC judgments covered in this article. The SC in the case of Vineeta Sharma v. Rakesh Sharma, 2020 (9) SCC 1, described the nature of prospective, retrospective, and retroactive laws as follows: “The prospective statute operates from the date of its enactment conferring new rights. The retrospective statute operates backwards and takes away or impairs vested rights acquired under existing laws. A retroactive statute is the one that does not operate retrospectively. It operates in futuro. However, its operation is based upon the character or status that arose earlier. Characteristic or event which happened in the past or requisites which had been drawn from antecedent events.”

Readers may read this article and interpret these terms accordingly.

A. THE PROHIBITION OF BENAMI TRANSACTIONS ACT, 1988

The Benami Act was one of those Acts that stood quietly on the sidelines waiting to fulfill its avowed objectives. In 2016, sweeping changes were made to the Act in line with the government’s objective to crack down on economic offences and undesirable practices. The Benami Act has been the subject of much debate and discussion especially as benami transactions in India are neither new nor rare. Traditional civil remedies were often exercised in those transactions that were benami in nature. The courts had dealt with various civil disputes with regard to benami properties. Though the Benami Act was brought out in order to prohibit benami transactions, it was widely considered toothless and was rarely invoked.

Post-2016 amendments, however, the Benami Act is looked upon as having the colour of being criminal legislation. This is primarily because though entering a benami transaction was prohibited even prior to 2016, the criminal provisions lacked teeth. In recent years a variety of legislations have been enacted for special purposes and these are an amalgam of both civil and criminal provisions. The name of the Benami Act is self-explanatory, it seeks prohibition of benami transactions. This is a clear indication that the Act does not exist merely to punish, its raison d’être is to prohibit them altogether. It cannot, however, be doubted that the amending Act brought in wide-ranging changes to the original Act.

The judgment of the SC in UOI v. Ganpati Dealcom Pvt. Ltd. (2023) 3 SCC 315 is a watershed moment for many reasons. The judgment reaffirms the basic principle of the criminal law of not imposing criminality retroactively. How can it be that an act that is not an offence at the time of its commission be considered an offence subsequently? While this may seem like common sense, the manner in which the SC  arrives at this conclusion while considering Sections 3 and 5 of the Benami Act warrants consideration.

What is a Benami Transaction?

Post the 2016 amendment, the definition of ‘benami transaction’ given in section 2(9) of the Benami Act is as follows:

“benami transaction” means,—

(A)    a transaction or an arrangement—

(a)    where a property is transferred to, or is held by, a person, and the consideration for such property has been provided, or paid by, another person; and

(b)    the property is held for the immediate or future benefit, direct or indirect, of the person who has provided the consideration,

except when the property is held by—

(i)    a Karta, or a member of a Hindu undivided family, as the case may be, and the property is held for his benefit or benefit of other members in the family and the consideration for such property has been provided or paid out of the known sources of the Hindu undivided family;

(ii)    a person standing in a fiduciary capacity for the benefit of another person towards whom he stands in such capacity and includes a trustee, executor, partner, director of a company, a depository or a participant as an agent of a depository under the Depositories Act, 1996 (22 of 1996) and any other person as may be notified by the Central Government for this purpose;

(iii)    any person being an individual in the name of his spouse or in the name of any child of such individual and the consideration for such property has been provided or paid out of the known sources of the individual;

(iv)    any person in the name of his brother or sister or lineal ascendant or descendant, where the names of brother or sister or lineal ascendant or descendent and the individual appear as joint-owners in any document, and the consideration for such property has been provided or paid out of the known sources of the individual; or

(B)    a transaction or an arrangement in respect of a property carried out or made in a fictitious name; or

(C)    a transaction or an arrangement in respect of a property where the owner of the property is not aware of, or, denies knowledge of, such ownership;

(D)    a transaction or an arrangement in respect of a property where the person providing the consideration is not traceable or is fictitious.

Explanation.—For the removal of doubts, it is hereby declared that benami transaction shall not include any transaction involving the allowing of possession of any property to be taken or retained in part performance of a contract referred to in section 53A of the Transfer of Property Act, 1882 (4 of 1882), if, under any law for the time being in force,—

(i)    consideration for such property has been provided by the person to whom possession of property has been allowed but the person who has granted possession thereof continues to hold ownership of such property;

(ii)    stamp duty on such transaction or arrangement has been paid; and

(iii)    the contract has been registered;”

What are the broad repercussions of entering into a Benami Transaction?

Chapter II of the Benami Act deals with the prohibitions of benami transactions. Section 3 and Section 5 deal with the repercussions of entering into a benami transaction as amended in 2016 while Sections 4 and 6 deal with certain consequences with regard to civil remedies. Section 5 is punitive in nature while Section 3(2) and 3(3) make entering into a benami transaction a criminal offense.

Sections 3 and 5 are reproduced below:

“Section 3 – Prohibition of benami transactions.

3. (1) No person shall enter into any benami transaction.

(2)    Whoever enters into any benami transaction shall be punishable with imprisonment for a term which may extend to three years or with fine or with both.

(3)    Whoever enters into any benami transaction on and after the date of commencement of the Benami Transactions (Prohibition) Amendment Act, 2016, shall, notwithstanding anything contained in sub-section (2), be punishable in accordance with the provisions contained in Chapter VII.

“Section 5 – Property held benami liable to confiscation.

5.    Any property, which is subject matter of benami transaction, shall be liable to be confiscated by the Central Government.”

The case for Retroactive Application

Though the amendments were carried out in 2016, the effect of the 2016 amendment Act to the Benami Act (amending Act) was that transactions that could be captured under the definition of ‘Benami Transaction’ entered into before the year 2016 were also liable for prosecution. The stand of the Union of India, in this case, was clear – the 2016 amendments, according to the Union of India, only clarified the unamended 1988 Act (unamended Act) and were made to give effect to the older Act. It was in a sense enacted to fill up certain lacunae in the unamended Act and therefore could be given a retroactive application. It was the case of the Union of India that the 1988 Act had already created substantial law for criminalising the offence of entering into a benami transaction and therefore the 2016 amendments were merely clarificatory and procedural.

The SC’s Judgement with regard to retroactive Application

As the basic argument advanced on behalf of the Union of India was that the amending Act was merely clarificatory in nature, the SC decided to first consider the provisions of Section 3 of the Benami Act as it stood prior to its amendment. It is reproduced for ready reference as hereunder –

“3. Prohibition of benami transactions.—

(1)    No person shall enter into any benami transaction.

(2)    Nothing in sub-section (1) shall apply to—

(a)    the purchase of property by any person in the name of his wife or unmarried daughter and it shall be presumed, unless the contrary is proved, that the said property had been purchased for the benefit of the wife or the unmarried daughter;

(b)    the securities held by a—

(i)    depository as registered owner under sub-section (1) of section 10 of the Depositories Act, 1996

(ii)    participant as an agent of a depository.

Explanation.—The expressions “depository” and “Participants shall have the meanings respectively assigned to them in clauses (e) and (g) of sub-section (1) of section 2 of the Depositories Act, 1996.

(3)    Whoever enters into any benami transaction shall be punishable with imprisonment for a term which may extend to three years or with fine or with both.

(4)    Notwithstanding anything contained in the Code of Criminal Procedure, 1973 (2 of 1974), an offence under this section shall be non-cognizable and bailable.”

The SC observed that the criminal provisions envisaged under the unamended Section 3(2)(a) along with Section 3(3) did not expressly contemplate mens rea and that mens rea is an essential ingredient of a criminal offense.

This observation is interesting because it was the cornerstone for the SC to strike down the retrospective criminality put in place by this act. The importance of the existence of the ‘mental intention’ to be convicted in criminal proceedings is the fundamental cornerstone of criminal law. An individual cannot be said to commit a crime without intent, and where the requirement of intent is whittled down, without knowledge (As in the cases of the second part of Section 304 of the Indian Penal Code – culpable homicide not amounting to murder).

The SC found that the absence of mens rea creates the harsh result of imposing strict liability. The Court further found that ignoring the essential ingredient of beneficial ownership exercised by the real owner also contributes to making the law stringent and disproportionate with respect to benami transactions that are tri-partite in nature and that Section 3 as it stood prior to the amendment was susceptible to arbitrariness. The Court alluded to Article 20(1) of the Constitution of India to emphasise that a law needs to be clear, not vague and should not have incurable gaps that were “yet to be legislated/ filled in by judicial process”. The SC also held that a reading of Section 3(1) with Section 2(a) of the unamended Act would have created overly broad laws susceptible to being challenged as manifestly arbitrary.

It was also considered by the Court that the Union of India fairly conceded that the criminal provision had never been utilised as there was a significant hiatus in enabling the function of the provision.

Having considered the above four broad factors – the SC concluded that Section 3 which contained the criminal proceedings with regard to the unamended benami Act was unconstitutional. The Court held that the criminal provisions in the unamended Act had serious lacunae which could not have been cured by judicial forums, even through harmonious forms of interpretation. Regarding Section 5 of the unamended Act, the Court observed that the acquisition proceedings contemplated therein were in rem against the property itself – and that such rem proceedings transfer the guilt from the person who utilised a property which is a general harm to the society on to the property itself.

The SC held that Section 3 (and Section 5) of the unamended Act did not suffer from gaps that were merely procedural but that the gaps were essential and substantive. In absence of such substantive positions, the omissions in the unamended Act created a law which was both fanciful and oppressive at the same time and that such an overly broad structure would be ‘manifestly arbitrary’ as it did not incorporate sufficient safeguards. The Court held that as the Sections were stillborn (never utilised) in the first place, the said Section 3 was unconstitutional right from the inception.

As a natural corollary to Section 3 (and 5) of the unamended Act being held to be unconstitutional, the SC held that the 2016 amendments are in effect, creating new provisions and offences. The Court held that the law cannot retroactively reinvigorate a still-born criminal offence and therefore, “There was no question of retroactive application of the 2016 Act.”

The Fundamental take away from Ganpati Dealcom

The fundamental takeaway from the judgment of the SC in the case of Ganpati Dealcom with regard to the retroactive application of criminal statutes is that the retroactive application of the amended Section 3 of the Act was struck down not merely on the broadly accepted principles that criminal statutes cannot operate retroactively, but the reasoning was deeper. The primary reason of why the statute could not operate retroactively was that the provisions of the Act prior to the 2016 amendments were held to be unconstitutional and void ab initio. This automatically meant that the 2016 amendment could not claim to be merely ‘procedural or clarificatory’ but gave rise to substantial new offences – for the first time. Given the peculiar nature of the factual matrix of this statute, the retroactive operation of the amended Section 3 was held to be bad in law.

However, the Ganpati Dealcom Judgement is significant for another important reason – the SC had just a few months earlier passed another landmark Judgement in the case of Vijay Madanlal Choudhary & Ors. v. Union of India & Ors. 2022 SCC OnLine SC 92.

The Indian SC does not sit en banc – as a whole, but as a combination of various ‘divisions’ and benches of various strengths. That is the reason why it’s often been called ‘Many Supreme Courts in one.’ Within a few months of the Vijay Choudhary Judgment, some apprehensions were already being cast upon its veracity – one such apprehension has been explicitly mentioned in Ganpati Dealcom.

B. THE PREVENTION OF MONEY LAUNDERING ACT, 2002

The PMLA also seemed to wait in the wings for fulfilling its objectives until post-2014, when it started being invoked in earnest to curb the menace of money laundering. The PMLA, its provisions and its applications have all been criticised in the recent past for their draconian nature. A preventive law rather than a prohibitive one like the Benami Act, it was not ‘still born’. It had been amended from time to time in line with India’s global commitments. The Scheme of the PMLA clearly shows that it does not seek only to punish the offence of money laundering but also to prevent it. A substantive part of the legislation is dedicated to compliance and preventive powers given to the authorities under the PMLA.

While benami transactions were primarily a problem in India (and perhaps in the Indian sub-continent), PMLA is global in its outreach.  Primarily set up to combat some of the greatest evils in the form of drug trade, arms trade and flesh trade, today the framework covers a very wide variety of subjects, each perhaps not as dire as the other. The  PMLA, however, has the most motley assortment of legislations included in its Schedule. Various offences under the Indian Penal Code, Narcotic Drugs and Psychotropic Substances Act, Explosive Substances Act, Unlawful Activities Prevention Act, Arms Act, Companies Act, Wildlife Protection Act, Immoral Traffic (Prevention) Act, Prevention of Corruption Act, Explosives Act, Antiques and Art Treasures Act, Customs Act, Bonded Labour Law, Child Labour Law, Juvenile Justice Law, Emigration, Passports, Foreigners, Copyrights, Trademarks, Biological Diversity, Protection of plant varieties and farmer’s rights, Environment Protection Act, Water / Air Pollution Control law, Unlawful Acts against safety of Maritime Navigation and fixed platforms on Continental Shelf, etc.

What is Money Laundering according to the PMLA?

Section 3 of the PMLA defines the offence of money laundering –

“3.     Whosoever directly or indirectly attempts to indulge or knowingly assists or knowingly is a party or is actually involved in any process or activity connected with the [proceeds of crime including its concealment, possession, acquisition or use and projecting or claiming] it as untainted property shall be guilty of offence of money-laundering.

Explanation.—For the removal of doubts, it is hereby clarified that,—

(i)    a person shall be guilty of offence of money-laundering if such person is found to have directly or indirectly attempted to indulge or knowingly assisted or knowingly is a party or is actually involved in one or more of the following processes or activities connected with proceeds of crime, namely:—

(a)    concealment; or

(b)    possession; or

(c)    acquisition; or

(d)    use; or

(e)    projecting as untainted property; or

(f)    claiming as untainted property,
    in any manner whatsoever,

(ii)    the process or activity connected with proceeds of crime is a continuing activity and continues till such time a person is directly or indirectly enjoying the proceeds of crime by its concealment or possession or acquisition or use or projecting it as untainted property or claiming it as untainted property in any manner whatsoever.”

But this definition is incomplete without considering the definition of proceeds of crime as laid out in Section 2(1)(u) of the PMLA:

Proceeds of crime is defined u/s 2(1)(u) of  PMLA as under:

“(u) “proceeds of crime” means any property derived or obtained, directly or indirectly, by any person as a result of criminal activity relating to a scheduled offence or the value of any such property [or where such property is taken or held outside the country, then the property equivalent in value held within the country or abroad.

Explanation. —For the removal of doubts, it is hereby clarified that “proceeds of crime” include property not only derived or obtained from the scheduled offence but also any property which may directly or indirectly be derived or obtained as a result of any criminal activity relatable to the scheduled offence;”

It would be incorrect to assume that the offence of money laundering would be triggered upon the laundering of money. In fact, Section 3 of the PMLA makes even the possession of proceeds of crime a part of the offence of money laundering. If the section as reproduced above are read, it can be observed that both of them contain ‘explanations’. The retrospective application of these explanations were some of the issues that were brought up before the SC.

What are the broad repercussions of the offence of money laundering?

The broad repercussions of money laundering activity are laid down in Section 4 of the PMLA.

What is the most troublesome though is that the maximum punishment for money laundering that may arise out of all the above-assorted activities is the same – up to seven years (not less than three years) and a fine of five lakh rupees, with a single exception of Narcotic Drugs and Psychotropic Substances Act – the money laundering relating to which attracts a sentence of up to ten years (not less than three years) and a fine of up to five lakh rupees. This punishment is not graded based upon the severity of the scheduled offense.

The case for Retroactive/Retrospective Application

The landmark case on the PMLA is Vijay Madanlal Choudhary & Ors. v. Union of India & Ors. 2022 SCC OnLine SC 92. In this, the case for retrospective/retroactive application of the amendments made in 2019 made to Sections 3 and 2(1)(u) was fairly simple – what was inserted were merely explanations as a part of the statute. It was contended, inter alia, that these explanations were clarificatory in nature and did not increase the width of the definition itself.

What is important is that the constitutional validity of the provisions of Section 3 prior to the insertion of the explanation was not in doubt. What contended was that this amendment was merely clarificatory. It is trite law that the parliament is empowered to make laws that operate retroactively and retrospectively, and such action cannot be challenged especially if the changes are merely clarificatory and/or procedural in nature.

The Supreme Court’s Judgement with regard to Retroactive Application

In Vijay Madanlal Choudhary the SC held that the Explanation as inserted in 2019 in Section 3 of the PMLA (making the offence of money laundering a continuous one) did not entail expanding its purport as it stood prior to 2019. It held that the amendment is only clarificatory in nature in as much as Section 3 is widely worded with a view to not only investigate the offence of money laundering but also to prevent and regulate that offence. This provision (even de hors explanation) plainly indicates that any (every) process or activity connected with the proceeds of crime results in offence of money laundering. The Court held that projecting or claiming the proceeds of crime as untainted property is in itself an attempt to indulge in or being involved in money laundering, just as knowingly concealing, possessing, acquiring, or using of proceeds of crime, directly or indirectly. The Court held the inclusion of Clause (ii) in the Explanation inserted in 2019 was of no consequence as it does not alter or enlarge the scope of Section 3 at all as the existing provisions of Section 3 of the PMLA  as amended until 2013 which were in force till 31.7.2019, have been merely explained and clarified by it.

Similarly, for the changes in the definition of ‘proceeds of crime’ and ‘property’ it was held that the Explanation added in 2019, did not travel beyond that intent of tracking and reaching upto the property derived or obtained directly or indirectly as a result of criminal activity relating to a scheduled offence. Therefore, the Explanation was in the nature of a clarification and not to increase the width of the main definition of “proceeds of crime”. The Court held that the Explanation inserted in 2019 was merely clarificatory and restatement of the position emerging from the principal provision i.e., Section 2(1)(u) of the PMLA.

There is a stark difference in the approach of the SC in both cases. However, it cannot be challenged that the statutory matrix and the circumstances of the application of both laws were also very different. The PMLA was hardly in a state of stasis before the 2019 amendment. The constitutional validity of the sections sought to be amended was not in doubt, the challenge was limited to the amendment itself. However, it would be curious to see if the ‘continuing nature’ of the offence of PMLA will stand up to judicial scrutiny if dissected in a manner similar to the way it has been done in Ganpati Dealcom.

The Fundamental take-away from Vijay Madanlal Choudhary

The key take-away from the Vijay Madanlal Choudhary Judgment with regards to retrospective/retroactive application of criminal statutes is that the manner in which such amendments are brought about in the statute book does matter. Though the law as interpreted by the apex court now states that the explanations are merely clarificatory, the repercussion of making the offence of money laundering a continuing activity is far more sinister.

Though money laundering is an offence by itself, it is what can be termed as a predicate offence, it does not exist in the absence of a primary offence. That primary offence may be any of the offences that have been included in the schedule to the PMLA. By making the offence of money laundering a continuing one, however, the statute has empowered itself to virtually prosecute those accused of offences that may have been committed not only before their insertion into the schedule to the PMLA, but also before the PMLA ever came into force. It is possible that someone may be prosecuted for the offence of money laundering decades after the primary offence is committed, even though such an accused may not have been involved in the commission of the primary offence. This aspect of the retroactive application of the PMLA has been the subject of much litigation before various High Courts. The Vijay Madanlal Choudhary Judgment paves the way for such prosecutions at will, by upholding the explanation that states that the offence of money laundering never ends and also by upholding the explanation that makes proceeds of crime include any property ‘directly or indirectly’ obtained as a result of any criminal activity related to the scheduled offence.

It is not that the concept of manifest arbitrariness of various provisions of the PMLA has not been considered. Those claims however, have been dismissed.

C. CONCLUSION

The retrospective/retroactive application of criminal provisions of special laws cannot be countered by a broad sweeping observation that ‘Criminal legislation does not have retrospective application’. The approach of the Courts is always nuanced. Though certain amendments to the criminal provisions of the Benami Act were held to be prospective and certain amendments to the criminal provisions of the PMLA were considered retroactive/retrospective, this was done given due weightage to the type of amendment contemplated in the amending Act and the sort of lacunae that were sought to be filled by the amendments. The two judgments are harmonious in law, but a view can be taken that there is a difference in the approach and the jurisprudential philosophy between the both of them. It’s telling that just a few months after the Vijay Madanlal Choudhary judgment, in Ganpati Dealcom with regard to the principles regarding confiscation / forfeiture provisions the SC observed:

“In Vijay Madanlal Choudhary v. Union of India 2022 SCC OnLine SC 929, this Court dealt with confiscation proceedings under Section 8 of the Prevention of Money Laundering Act, 2002 (“PMLA”) and limited the application of Section 8(4) of PMLA concerning interim possession by the authority before conclusion of final trial to exceptional cases. The Court distinguished the earlier cases in view of the unique scheme under the impugned legislation therein. Having perused the said judgment, we are of the opinion that the aforesaid ratio requires further expounding in an appropriate case, without which, much scope is left for arbitrary application”.

Justice YK Sabharwal (the then Chief Justice of India) is said to have said in 2006 “We are final not necessarily because we are always right – no institution is infallible – but because we are final.”

The Supreme Court may be final – but that may not hold necessarily true for its judgments. Both these Judgments have come out in 2022. Review Petitions by aggrieved parties were filed against them and the Apex Court has already agreed (albeit separately) to consider the review of both of them, though such a review may take place well into the future.

 

Liberalised Remittance Scheme – How Liberal It Is? (An Overview And The Recent Amendments)

This article looks at recent amendments in the
Liberalised Remittance Scheme (LRS) under Foreign Exchange Management
Act (FEMA) and in the provisions of Tax Collection at Source (TCS) on
remittances under LRS under the Income-tax Act. The changes are
significant and people should be aware of these issues. Along with the
recent amendments, we have dealt with some important & practical
issues also.

A. FOREIGN EXCHANGE MANAGEMENT ACT:

1. Background:

1.1 In February 2004, RBI introduced the LRS with a small limit (vide A.P.
Circular No. 64 dated 4.2.2004). Any Indian individual resident could
remit up to US$ 25,000 or its equivalent abroad per year from his own
funds. It was introduced to provide exposure to individuals to foreign
exchange markets. Dr. Y. V. Reddy, ex-Governor of RBI in his book titled
“Advice & Dissent” on Page 352 mentions that the funds could be
used for almost any purpose. It was supposed to be a “No questions asked” window and was in addition to all existing facilities. Late Finance Minister Mr. Jaswant Singh in a gathering said “Go conquer the world, we will be your supporters”. That was the underlying theme of the LRS.

1.2 There was a small negative list of purposes for which remittance could
not be made. The negative list included payments prescribed under
Schedule I and restricted under Schedule II of Current Account
Transaction Rules such as lotteries and sweepstakes; and payments to
persons engaged in acts of terrorism. Remittances also could not be made
to some countries. Later in 2007 remittance under LRS for margin
trading was also prohibited.

1.3 Over the years, the scheme has been modified. The limits have been increased periodically
(except for a brief period from 2013 to 2015). Today the limit is US$
2,50,000 per year per person. Thus, every individual Indian resident can
remit US$ 2,50,000 per year for any permitted purpose. At the same
time, restrictions have been introduced on current account transactions
and investments under LRS and such restrictions have kept on increasing.
The spirit of the original theme has been diluted to a significant extent. Let us see the current provisions of LRS including its main issues.

2. The present LRS:

2.1 The present LRS is dealt with by the following rules, regulations and circulars. FAQs provide some more clarifications.

i) Foreign Exchange Management (Permissible Capital Account Transactions) Regulations, 2000 (FEMA Notification no. 1).

ii) Foreign Exchange Management (Permissible Current Account Transactions) Rules, 2000.

iii) Foreign Exchange Management (Overseas Investment) Rules, 2022 (hereinafter referred to as “OI Rules”).

iv) Foreign Exchange Management (Overseas Investment) Directions, 2022
vide AP circular no. 12 dated 22.8.2022 (hereinafter referred to as “OI
Directions”).

v) Master Direction No. 7 on LRS updated up to 24.8.2022.

vi) FAQs updated up to 21.10.2021 (these have not been updated with the
rules and regulations of August 2022. However, these contain some
important clarifications.)

The statutory documents are the first
three documents – Rules and Regulations. The fourth and fifth documents
are essentially directions to Authorised Persons – i.e. Banks for
implementation of the rules and regulations. The sixth document – FAQs –
doesn’t have a binding effect. These are clarifications and wherever
helpful, these can be used.

However, if one reads only the
statutory documents, one does not get the full picture. One has to read
all the documents together to understand the entire scheme with its
nuances. At times, A.P. Circulars and Master Directions contain
additional provisions which are nowhere covered in the statutory
documents. Hence it is necessary to consider all the documents.

Also,
as is the case with several rules and regulations under FEMA, one
cannot get the entire picture merely by reading the documents. Some
things go by practice. Many such issues and practical problems will be
dealt with subsequently. Needless to say, it will not be possible to
deal with all issues. The focus is on important issues and issues arising out of amendments to LRS in August 2022 and TCS provisions in Finance Act 2023.

2.2 The present LRS in brief:

2.2.1
Under the present scheme, an Indian resident individual (including a
minor) can remit up to US$ 2,50,000 or its equivalent per financial
year. This limit has been there since May 2015. The remittance can be
made for any “permitted” Current Account Transaction or a “permitted”
Capital Account Transaction. The word “permitted” is a later addition.
As per the 2004 circular, the LRS was overriding all restrictions
(except those stated in the circular itself).

For remittance
under LRS, the simple compliance is the submission of Form A2 with some
basic details. [No form is required for making a rupee gift or a loan.
However, the person must keep a track to see that aggregate of such
rupee payments (discussed later) and foreign exchange remitted during a
year are within the LRS limit.]

Remittances during one year have to be made through one bank only.

2.2.2 Remittance has to be made out of person’s own funds.
In a family, one member can gift (not loan) the funds to another family
member and all the relatives can remit the funds under LRS. This has
been an accepted position.

Source of funds:

Loans: A person cannot borrow funds in India and remit them abroad for capital account transactions.
The restriction on taking loans continues right from the beginning
(i.e., February 2004). One can refer to these provisions in Paragraphs 8
and 10 in Section B of the present Master Direction on LRS.

A person also cannot borrow funds from a non-resident to invest. Thus,
buying a home abroad with a foreign loan is not permitted even if the
loan repayment is within the LRS limit. Foreign builders offer schemes
where the person can get a completed house, but payment can be made over
the next few years after completion. This will clearly be a violation
as the payment option over a few years is a loan.

Primarily a loan also cannot be taken for current account transactions. However, in the FAQs dated 21st October 2021, FAQ 16 clarifies that banks can provide loans or guarantees for current account transactions
only. Here, FAQ is being relied upon. Strictly, FAQs have no legal
authority. In practice, it goes on. Thus, a loan can be taken from a
bank for education and funds can be remitted abroad. However, no loans
can be taken from anyone else even for a current account transaction.

Other prohibited sources:

Remittances out of “lottery winnings, racing, riding or any other
hobby” are prohibited. These are stated in Schedule I of the Current
Account Rules. Hence even if the person has his own funds but earned
from these sources, he cannot remit the same under LRS. This is an issue
that is missed by many people. Further, ‘hobby’ is a broad term. What
seems to be prohibited is income from hobbies which involve gambling and
chance income.

LRS covers both Current and Capital Account Transactions.

2.2.3 Current Account Transactions –

Under clause 1 of Schedule III of Foreign Exchange Management (Current
Account Transactions) Rules, 2000, the following purposes are specified
for which remittance can be made:

i) Private visits to any country (except Nepal and Bhutan).
ii) Gift or donation.
iii) Going abroad for employment.
iv) Emigration.
v) Maintenance of close relatives abroad.
vi) Travel for business or attending a conference or specialised
training or for meeting medical expenses, or check-up abroad, or for accompanying
as an attendant to a patient going abroad for medical treatment/check-up.
vii) Expenses in connection with medical treatment abroad.
viii) Studies abroad.
ix) Any other current account transaction.

Prior to May 2015, there was no limit on remittance for
Current Account transaction. Since May 2015, the limit has been brought
in. Item (ix) above seems to be a misplacement in the Current Account
Transaction rules. This raises some difficulties. Import of goods is a
Current Account transaction. An individual who is doing trading business
in his individual name could import goods worth crores of rupees. Now
can he import above the LRS limit? The view is that for Import, there is
a separate Master Direction laying down procedures and compliances.
Under that Master Direction, there is no limit for imports. Hence
whatever is covered under the Master Direction on Imports, can be
undertaken freely. All other expenses are restricted by the LRS limit.
Thus, expenses for services, travel, etc. will be restricted by the LRS
limit. It would be helpful if Central Government could come out with a
clarification.

We would like to state that India has accepted
Article VIII of the IMF agreement. Under the agreement, a country cannot
impose restrictions on Current Account transactions. However, some
reasonable restrictions can be placed. This is the stand adopted by
India also (refer Section 5 of FEMA). Under this section, a person is
allowed to draw foreign exchange for a Current Account Transaction.
However, the Government can impose some “reasonable restrictions”. This
can mean restrictions on some kinds of transactions or imposition of
some conditions. However, a blanket ban above US$ 2,50,000 on all
current account transactions may not come within the purview of
“reasonable restrictions”. A business entity owned by an individual can
remit any amount for a Current Account Transaction. But the same
individual cannot, if he is doing business in his individual name
(except import of goods and services). In our view, this is not logical.

Specified current account transactions allowed without any limit:

i) Expenses for emigration are permitted without limit. However,
remittances for making an investment or for earning points for the
purpose of an emigration visa are not permitted beyond the LRS limit.

ii)
For medical expenses and studies abroad also, one can incur expenses
more than the LRS limit subject to an estimate given by the hospital/
doctor or the educational institution.

2.2.4 Capital Account Transactions

– The permitted Capital Account transactions can be referred to in
Clause 6 – Part A of the Master Direction on LRS dated 24th August 2022.
Earlier the list was a little more elaborate. Now the list is truncated
after the Overseas Investment Rules have been enacted. The permitted
transactions are:

i) opening of foreign currency account abroad with a bank.
ii) acquisition of immovable property abroad, Overseas Direct
Investment (ODI) and Overseas Portfolio Investment (OPI), in accordance with
the provisions contained in OI Rules, 2022; OI Regulations, 2022 and OI
Directions, 2022.
iii) extending loans including loans in Indian Rupees to
Non-resident Indians (NRIs) who are relatives as defined in the Companies
Act, 2013.

The LRS is primarily used for opening bank accounts, portfolio
investment, acquiring immovable property and giving loans abroad. Prior
to 24th August 2022, the circular referred to specific kinds of
securities – listed and unlisted shares, debt instruments, etc. Now the
reference has been made to Overseas Portfolio Investment (OPI)
and Overseas Direct Investment (ODI) under the New Overseas Investment
regime. This is discussed more in detail in para 2.2.5 below.

It may be noted that a foreign currency account cannot be opened in a bank
in India or an Offshore Banking Unit. The bank account should be outside
India.

2.2.5 Overseas Portfolio Investment (OPI) – OPI has been defined in Rule 2(s) of OI Rules to mean “investment, other than ODI, in foreign securities, but not in any unlisted debt instruments or any security issued by a person resident in India who is not in an IFSC”.
(It has been clarified that even after the delisting of securities, the
investment in such securities shall continue to be treated as OPI until
any further investment is made in the entity.)

Basically, OPI
means investment in foreign securities. Then, there are exclusions to
the same – ODI, unlisted debt instruments and securities issued by a
resident [except by a person in the International Financial Services
Centre (IFSC)].

ODI includes investment in the unlisted equity capital
of a foreign entity. Equity Capital includes equity shares and other
fully convertible instruments as explained under Rule 2(e) of OI Rules.
Thus, now it is clear that investment even in a single unlisted share of
a foreign entity falls under ODI and it requires separate compliance.

Listed foreign securities have not been defined. However, “listed foreign
entity” has been defined in Rule 2(m) of OI Rules to mean “a foreign
entity whose equity shares or any other fully and compulsorily convertible instrument is listed on a recognised stock exchange outside India.”

Para
1(ix)(a) of OI Directions provides further prohibitions under OPI which
are not covered under the OI Rules. It provides that OPI is not
permitted in derivatives and commodities.

This brings out the following:

OPI means Investment in foreign securities. However, investment in the following are not covered under OPI:

i) Investments considered as ODI:

a) Investment in unlisted equity capital;

b) Subscription to Memorandum of Association;

c) Investment in 10% or more of listed equity capital;

d) Investment of less than 10% of listed equity capital but with control in the foreign entity.

ii) Unlisted debt instruments.

iii) Security issued by a person resident in India (excluding a person in an IFSC).

iv) Derivatives unless specifically permitted by RBI.

v) Commodities including Bullion Depository Receipts.

Debt instruments are defined in clause (A) of Rule 5 of OI Rules. These mean:

i) Government bonds.

ii) Corporate bonds.

iii) All tranches of securitisation structure which are not equity tranches.

iv) Borrowings by firms through loans.

v) Depository receipts whose underlying securities are debt securities.

Other investments:
Apart
from listed securities, investment is permitted in units of mutual
funds, venture funds and other funds which can be considered as “foreign
securities”.

Investment in Gold (precious metal) bonds is not permitted as it amounts to a corporate bond.

Buying physical gold or other precious metals outside India is also not permitted under LRS.
Also, see para 2.2.12 for more prohibitions under LRS.

2.2.6 Bank fixed deposits

– Is investment in fixed deposits of banks permitted? Can these be
considered as loans? Extending loans is specifically permitted under
LRS. What is prohibited is borrowing by firms. Banks are not firms.
These are companies.

Bank FDs are also not corporate bonds.
Bonds have a specific meaning. It means a security or an instrument
which can be transferred. A bank FD cannot be transferred.

However,
OPI means investment in foreign securities. A Bank Fixed Deposit is not
a “security”. Hence in our view, keeping funds in Bank FDs is not
considered as OPI.

One view is that bank fixed deposit is like a bank balance. Hence funds remitted under LRS may be kept in bank fixed deposits.
However, funds remitted abroad have to be used within 180 days. (See
para 3 for more discussion). Hence such FDs cannot be held beyond 180
days and should be used for some permitted purpose within 180 days.

2.2.7 Unlisted shares of a foreign company – A background:

From 2004 till 22nd August 2022, the Master Directions were abundantly clear that investment under LRS could be made in unlisted and listed equity shares. However, vide A.P. Circular 57 dated 8th May 2007, the RBI introduced the sentence – “All other transactions which are otherwise not permissible under FEMA …… are not allowed under the Scheme.”
Under this clause, RBI took a view that investment in unlisted shares
was not permitted. According to RBI, investment in unlisted shares was
permitted only as per ODI rules applicable at that time (Old ODI Regime
under FEMA Notification 120 which was in effect before 22nd August
2022). Under those rules, individuals were not permitted to make
business investments outside India. Hence, investments made by resident
individuals in unlisted foreign companies to undertake business were
considered as a violation. With due respect, the stand taken by RBI does
not go in line with the language of the Master Directions – right till
22nd August 2022. All penalties imposed for investment in unlisted
shares by resident individuals – are not in keeping with the law – FEMA.

The phrase “which are otherwise not permissible” applies
to all investments. For example, investment in immovable property
abroad is otherwise not permissible. But under LRS it is permissible.
Loans abroad are otherwise not permissible. But under LRS they are
permissible. The LRS was supposed to apply in addition to all existing facilities.
In Master Circular on Miscellaneous Remittances from India – Facilities
for Residents dated 1st July 2008, the phrase was amended to “The facility under the Scheme is in addition to those already included in Schedule III of Foreign Exchange Management (Current Account Transactions) Rules, 2000”. From May 2015, the Current Account Rules were changed and from Master Circular dated 1st July 2015 onwards, the phrase “in addition to”
has been dropped. However, the fact remains that till 22nd August 2022
investment in unlisted shares was permitted as per Master Direction.
From 23rd August 2022, the phrase “unlisted shares” was dropped in the
Master Direction.

On representation, RBI formally introduced the
scheme of ODI for resident individuals from August 2013 (generally
called “LRS-ODI”). It permitted individuals to invest in unlisted shares
of a foreign company having bonafide business subject to compliances
pertaining to ODI. However, RBI considered investments made prior to
August 2013 as a violation which required compounding. This did leave a
bad taste for Indian investors.

Thus, now the investment in
unlisted securities is covered under the ODI route and has a separate
set of rules and compliances. This was the position since August 2013
under the Old ODI regime as well as under the New OI regime notified on
22nd August 2022. It is not dealt with more in this article as that is a
subject by itself.

2.2.8 Listed securities abroad of Indian companies – Up to Master Circular dated 1st July 2015, the language was that investment could be made under “assets” outside India.
It did not specifically state that investment could be only in
securities of foreign entities. Hence investment made in say GDRs or
securities of Indian companies listed abroad was possible. Later, Master
Circulars were replaced with Master Directions. From Master Direction
dated 1st January 2016, it was provided that investment could be in “shares of overseas company”. Hence, it should be noted that under LRS, an individual can invest in listed securities of a foreign entity.
One cannot invest in securities of an Indian company which are listed
abroad. Some people have invested in bonds of Indian companies listed
abroad. Such investments are not permitted under LRS. One should sell
such investments and apply for compounding of offence. Under the OI
Rules as well, investment in securities issued by a person resident in
India is not permitted under OPI. There is only one exclusion to the
prohibition – investment in securities issued by an entity in IFSC is
allowed.

2.2.9 Investment in permissible security of an entity in IFSC is permitted under LRS. Under the Notification No. 339 dated 2.3.2015, any entity in an IFSC is treated as a non-resident.

OPI as discussed in para 2.2.5 above means investment …. in foreign securities, but not in any unlisted debt instruments or any security issued by a person resident in India who is not in an IFSC.
This language creates some confusion. Investment is not permitted in
any security issued by an Indian resident which is not in IFSC. Does it
mean that investment in any security such as “unlisted debt instrument”
issued by an entity in IFSC is permissible? We would not take such a
view. One has to equate an IFSC entity with a foreign entity. Whatever
security of a foreign entity one can invest in, similar security of an
IFSC entity can be invested in. Thus, investment should be in assets
discussed in paras 2.2.4 and 2.2.5.

2.2.10 Extending Loans:
Under LRS, extending loans to non-residents is allowed. However, this
is allowed in the case of outright loans to third parties. For instance,
Mr. A (an Indian resident) can give a loan to his friend Mr. B (a US
Resident) or to B Inc (a US company).

However, if Mr. A has made
ODI in the USA (whether in his individual capacity or through an Indian
Entity), then a loan by Mr. A to the investee entity in the USA is not
considered under LRS. Mr. A will have to comply with the ODI Rules in
such a case. Under ODI Rules, only equity investment can be made by
individuals. One cannot take a view that investment in equity of a
foreign entity will be under ODI and loan to that entity will be under
LRS. If there is any equity investment in a foreign entity as ODI, then
all conditions of the ODI route shall be fulfilled. Hence, no loan can
be given.

2.2.11 Transactions in Indian rupees – Indian
residents are allowed to give gifts and loans to NRI/ PIO relatives (as
defined under the Companies Act 2013) in rupees in their NRO account.

Para
6(iii) of the Master Direction initially refers to NRIs. Later, it has
been clarified that gifts and loans can be given to PIOs also (i.e.,
foreign citizens but Persons of Indian Origin).

It was represented to RBI that under LRS, foreign exchange can be remitted
outside India to anyone. However, if payment has to be made in rupees in
India, it is not permitted! RBI has since then permitted gifts and
loans in rupees in India but only to NRI/PIO relatives within the
overall LRS limit.

2.2.12 Prohibited transactions – Apart from restrictions discussed in para 2.2.5, the following transactions are prohibited:

i) Transactions specified in Schedule I and Schedule II of Current
Account Transactions Rules. This includes remittances for lottery
tickets, banned magazines, etc.

ii) Remittances to countries identified by FATF as non-co-operative countries.

iii) Remittance for margin trading. Thus, dealing in derivatives and options is not permitted.

iv) Trading in foreign exchange. (This is stated in FAQs updated up to 21.10.2021. No other document states this.)

3. Retaining funds abroad:

3.1 Background: This is the most important change in the LRS.

The individual who has remitted funds under LRS can primarily retain
the same abroad, reinvest the funds and retain the income earned from
such investments abroad. This has now undergone a change with effect
from 24th August 2022. The change has been carried out without any
specific announcement.

The Overseas Investment rules and
regulations were notified on 22nd August 2022. The Master Direction on
LRS was amended on 23rd August 2022 to factor in the changes in capital
account transactions as per the OI Rules as explained in paras 2.2.4 and
2.2.5 above. Paragraph 16 of the Master Direction amended on 23rd
August 2022 stated that – “Investor, who has remitted funds under LRS
can retain, reinvest the income earned on the investments. At present,
the resident individual is not required to repatriate the funds or
income generated out of investments made under the Scheme.” Till
23rd August 2022 funds remitted under LRS and income from the same could
be retained and used abroad without any restrictions.

The Master
Direction on LRS was amended again on 24th August 2022 (just one day
later). This amendment includes an important change in the scheme and
has been dealt with in the next para 3.2.

3.2 Main amendment: Under the LRS Master Direction amended on 24th August 2022, Paragraph 16 provides the following:

“Investor, who has remitted funds under LRS can retain, reinvest the income earned on the investments. The received/realised/unspent/unused foreign exchange, unless reinvested, shall be repatriated and surrendered to an authorised person within a period of 180 days
from the date of such receipt/ realisation/ purchase/ acquisition or
date of return to India, as the case may be, in accordance with
Regulation 7 of Foreign Exchange Management (Realisation, repatriation
and surrender of foreign exchange) Regulations, 2015 [Notification No.
FEMA 9(R)/2015-RB]”.

It is provided that the received or
realised or unspent or unused foreign exchange should be repatriated to
India, unless it is reinvested. The time limit of 180 days is provided.
This condition of repatriating the unused or uninvested funds back to
India within 180 days is a major change. No specific announcement was
made. It was simply brought in the Master Direction on 24th August 2022.

The language is broad. The terms “received” and “realised” can
refer to the amount received on sale of investment, or income on
investment. The terms “unspent” and “unused” can refer to amount
received on sale of investments, or income on investment, or amount remitted from India under the LRS. The amounts have to be reinvested within 180 days from the date of receipt, realisation, acquisition or purchase of foreign exchange.

While the word “reinvested” is used, it cannot be mandatory that the funds
should only be “reinvested”. The intention seems to be that funds should
not be parked idle. They should be “reinvested” or “used” within 180
days. Let us assume a person makes an investment under LRS, then sells
the same and receives the sale proceeds. These proceeds can be used for
any permitted Current Account Transaction (expenditure) or Capital
Account Transaction (investment) within 180 days. That is the purpose of
LRS. Here also it will be helpful if RBI could provide a clarification.

3.3 Retrospective amendment: The requirement to
repatriate the idle funds within 180 days applies not only to fresh
remittances but also to the existing funds lying abroad which were
remitted before 24th August 2022. It is effectively a retrospective amendment. Many people are not aware of this.

Let
us take a case where funds were remitted under LRS since 2018 and funds
were lying idle in the bank account since then. These are unspent funds
and the amendment made on 24th August 2022 applies to such funds as
well. Hence, the person will have 180 days to invest the funds from 24th
August 2022. If it is not done, the funds should be repatriated.

Thus, by 19th Feb 2023 the funds remitted prior to 24th Aug 2022 had to be
utilised, if they were lying unspent or unutilised. If the funds are not
used by then and are still lying abroad, it is a contravention of FEMA.

3.4 Issues: This will cause difficulties for several people. Let us consider some issues.

3.4.1 Small amounts to be tracked and invested: The
income earned on investments abroad should also be invested abroad
within 180 days, or these should be remitted back to India. The income
on LRS funds could be small. Let us take a case where funds are remitted
to a brokerage account in the USA and investment is made in listed
shares. A small amount of income is received and lying in the brokerage
account. Or some funds are kept in the brokerage account to pay an
annual fee. One will have to keep track of all these incomes and
reinvest them. Keeping such a track and investing small funds is
difficult. Further remittance of funds to India also costs money by way
of bank charges, etc.

3.4.2 Time-consuming investments: Let
us consider another case. Let us say the person has purchased a flat
and after few years, he sells the same. He would like to buy another
flat abroad. The sale proceeds of the first flat should be used within
180 days. Either he should buy the flat or invest the funds in permitted
investments. At times, to finalise the transaction for a flat takes lot
of time. Therefore, one will have to plan to invest within 180 days
from the sale of flat.

3.4.3 Consolidation of funds over multiple years for high-value investments:

Some people have sent funds over a few years to buy an immovable property
abroad as one year’s limit under LRS may not be sufficient. However,
with the 180 days’ time limit, the accumulation of funds is not
possible. In such cases, the funds remitted abroad should be invested in
portfolio investment. And when the funds are sufficient to buy the
property, the securities can be sold. This however means that the person
undertakes risks associated with the securities. A fall in prices of
the securities will jeopardise the purchase of property.

3.5 Can the person invest the funds in bank fixed deposits?

See
para 2.2.6 above where it is stated that Bank FDs do not fall within
the definition of OPI. Remitting funds under LRS and keeping them in
Bank FDs for up to 180 days is all right. However, bank fixed deposits
are not securities and can be considered equivalent to funds in a bank
account. Hence, in our view, placing funds in bank fixed deposits will
not be considered an “investment” of funds. It will be ideal if RBI
comes out with a clarification on the same.

3.6 Some cases where the 180-day limit will not apply:

As mentioned in para 2.2.4, Indian residents can give loans and gifts
to NRI relatives. Here, there is no question of utilising foreign
exchange. Hence there is no limit of 180 days or any other time period.
The limit of 180 days applies only for foreign exchange remitted abroad
or lying abroad.

Let us take another illustration. A student
remits funds under LRS for education purposes to his foreign bank
account. Before leaving India, he is an Indian resident. All funds may
not be utilised within 180 days. Some funds may be lying for ongoing and
future expenses. However, when the student leaves India for education
abroad, he becomes a non-resident. In such a case, the 180-day limit
will not apply. Once a person is a non-resident, the funds outside India
are not liable to FEMA restrictions. Hence, the condition of
repatriating the funds within 180 days will not apply.

3.7 Consequences of violation:

What are the consequences of a violation of not using the funds within
180 days? The person concerned has to apply for compounding. Compounding
is a process under which the person concerned admits to the violation.
RBI then levies a penalty for the violation. There is no option to pay
Late Submission Fee (LSF) and regularise the matter. LSF is for delays
in submitting the documents/forms.

There is however, a hitch. Before applying for compounding, the transactions have to be regularised. How does one regularise?

Regularising
means doing something now, which should have been done earlier. In our
view, the violation can be regularised in two manners – one is by
remitting the funds back to India. The other is to invest/use the funds
abroad as permitted – although with a delay. It is however doubtful
whether utilising the funds after the 180-days’ period will be
considered as regularisation. It will be better for the funds to be
repatriated to India. Once the funds are repatriated, a Compounding
Application should be filed with RBI.

3.8 Alternate views:

3.8.1
There is a view that the provision of use of funds within 180 days
applies to an “investor” only (see para 16 of Master Direction). Thus,
if funds are remitted by an investor for investment, one has to use the funds within 180 days. Whereas, if a person has remitted the funds for expenses
such as education, one can use the funds beyond 180 days also. However,
the language does not suggest such an intention. While the provision
starts with the term “investor”, the provision goes on further to add
that the funds have to be surrendered to the bank “in accordance with
Regulation 7 of Foreign Exchange Management (Realisation, repatriation
and surrender of foreign exchange) Regulations, 2015 [Notification No.
FEMA 9(R)/2015-RB]”. Regulation 7 of Notification 9(R) provides as under:

“A person being an individual resident in India shall surrender the
received/realised/unspent/unused foreign exchange whether in the form of
currency notes, coins and travellers cheques, etc. to an authorised
person within a period of 180 days from the date of such
receipt/realisation/purchase/acquisition or date of his return to India,
as the case may be.”

Regulation 7 applies to all individual
Indian residents and for all purposes. Hence even if the funds have been
remitted for expenses, they have to be utilised within 180 days.
Otherwise, the same should be remitted to India.

3.8.2 There is
another view as to when is the amount to be considered as unused/
unspent. The view is that once the amount is remitted abroad, it has to
be used on the first day. If it is not used on the first day, then it is
unused/unspent. If it unused/unspent, it has to be remitted back to
India. The time of 180 days is only to remit the funds back to India.

While
literal reading suggests this – in our view, this is neither the
correct interpretation, nor the intention. One cannot use the funds on
day one. It takes time for the funds to be used. If the funds are not
used within 180 days, then they have to be remitted back to India.

4. Some more issues:

4.1 Purpose Codes: At
the time of remittance, one has to state the purpose code in the form.
For example, one mentions the purpose code as S0023 (remittance for
opening a bank account abroad). After remittance, can the funds be used
for investment in shares? Or the purpose code stated is investment in
real estate (S0005) and one is not able to invest in real estate within
180 days, and hence invested in shares. Can it be done? Technically it
could be considered an incorrect purpose code. However, if one considers
the substance of LRS, remittance for any permitted purpose is allowed.
One may have the original intention for one purpose, but then the
purpose has changed, and it should be all right. After the remittance of
funds, change of use has always been permitted. Assume that a person
has remitted the funds to open a bank account abroad. Under the present
LRS scheme, funds have to be used within 180 days. To comply this
condition, funds are invested. This means the “use of funds” has changed
from keeping funds in bank account to investment. Or the funds are sent
for investment in shares, and then the shares are sold. Does it mean
the sale proceeds have to be reinvested only in shares? No. The funds
have to be used or reinvested for any permissible purpose.

It
will be better that after remitting the funds for the first time, if
there is a change in the use, one should write to the bank and inform
the change of use. This is however out of abundant caution. In substance
after sending the funds, the same can be used for any permitted
purpose. Also see para 3.2 of Part B on TCS provisions.

4.2 Joint holding:

There are people who open bank accounts and make investments in joint
names. Investment is made by one person (say the first holder). Funds
belong to the first holder. That is how it is declared in the income tax
returns. However, to take care of situations where the investor dies or
becomes incapacitated, the account or the investment is held in the
joint name. Otherwise, the funds may be blocked. The process of
producing a Will or succession document is a time-consuming process. So,
the second name is added for the sake of convenience. Hence in our
view, holding an investment or bank account in a joint name is all
right. It is a prudent step. There cannot be any objection to this.

5. Co-ownership and Consolidation of funds:

5.1 Co-ownership

– Assume that funds are sent by two or more relatives in one bank
account. From there investment has to be made. It is necessary that the
investment should be made in the proportion in which the funds are
remitted. Assume that Mr. A remits US$ 1,00,000 and Mrs. A remits US$
50,000, and together they invest US$ 1,50,000 in shares. The holding
ratio in the shares should be 2:1 between Mr. A and Mrs. A. If the
investment holding is 50:50, it means Mr. A has given a gift to Mrs. B.
Gift outside India from one resident to another resident is an
impermissible transaction. It will become a violation.

5.2 Consolidation of funds

– Master Direction prior to 23rd August 2022 permitted consolidation of
remittances by the family members. It further provided that clubbing is
not permitted by family members if they are not the co-owners of bank account/ investment/ immovable property. Here, the condition for co-ownership does not mean being just a co-owner. It means that ownership ratio in the asset should be commensurate with the ratio in which payment is made.
This is prima facie in line with the LRS that the owner should remit
the funds. If another person becomes the owner without remitting the
funds it is as good as a gift from the person who has remitted the
funds. This is different from being a joint holder (without remittance
or payment) for the sake of convenience discussed in para 4.2 above.

It may be noted that “family members” have not been explained. It should
be considered as a family comprising relatives under the Companies Act
2013.

5.3 Consolidation of funds for acquiring immovable property

– The amended Master Direction on LRS has retained the above-mentioned
condition of consolidation of funds and co-ownership. However, the
reference to the immovable property has been removed. The Master
Direction has stated that remittances for the immovable property should
be in accordance with OI rules.

Under the OI rules, an Indian
resident can acquire immovable property by remitting funds under LRS.
Further, an Indian resident can acquire property as a gift from another
resident also, subject to the condition that the donor should have
acquired such property in line with FEMA provisions applicable at the
time of acquisition.

Further, proviso to Rule 21(2)(ii)(c) of OI Rules states that “such
remittances under the Liberalised Remittance Scheme may be consolidated
in respect of relatives if such relatives, being persons resident in
India, comply with the terms and conditions of the Scheme”.

Does this mean that relatives can consolidate/ club the remittances, but
property can be owned by one person? As discussed above, an Indian
resident cannot gift funds to another Indian resident outside India.
When consolidated funds are remitted, purchase by one person actually
amounts to a gift of funds – which is not permitted. If the property is
acquired and then later the share in the property is gifted, it is
permissible.

However, if one considers the draft rules on Overseas investment published in 2021 for public consultation, it
provided that if funds were consolidated, the immovable property has to
be co-owned. In the final OI rules notified by Central Government and
the amended Master Direction, the language is different. The condition
of co-ownership is not present for the purchase of immovable property
abroad. While it seems like a specific amendment to relax the condition
for co-ownership, it does not come out clearly that funds can be
remitted by relatives but property can be purchased by one person.

At present, where remittances are consolidated amongst relatives, one
should avoid purchasing immovable property without complying with the
condition of co-ownership. It will be helpful if RBI can provide a
specific clarification.

5.4 In some cases, banks have permitted remittance under LRS from one account of an individual for say
4 different people by obtaining PAN of all 4 people. This is incorrect.
Remittance is not based on PAN. It is per person. One individual
can remit only up to the LRS limit and that too for himself/ herself.
If funds have to be remitted by other Indian resident family members,
then the account holder should first gift the funds to others and then
others may remit the funds from their account. Of course, if the bank
account is a joint account and funds in that account belong to all joint
holders, then each joint holder can remit up to the balance available
under his ownership. Consolidated funds can be remitted subject to what
has been discussed in para 5 above. In such cases, one should keep a
proper account of the funds, ownership and remittances.

Summary:

LRS was started in the year 2004 as the first step towards capital account
convertibility of the rupee. Subsequent amendments have imposed too many
conditions and restrictions. This clearly goes back from
liberalisation.

B. INCOME-TAX ACT – TAX COLLECTION AT SOURCE ON REMITTANCES UNDER LRS:

1. Provisions in force till 30th June 2023:

1.1 Basic provision:

Sub-section (1G) was introduced in Section 206C vide Finance Act, 2020
w.e.f. 1st October 2020. It provides for Tax Collection at Source (TCS)
at the rate of 5% on remittances out of India under LRS. There is
a threshold of INR 7,00,000 for the same, i.e., there is no TCS on
remittances up to INR 7,00,000. The rate of 5% is applicable for amount
in excess of Rs. 7,00,000. It should be noted that TCS is applicable per
person per financial year.

Thus, the bank which sells foreign exchange to the individual for remittance under LRS, will collect tax @
5% over and above the rupee amount required for sale of foreign
exchange. This TCS is like an advance tax. The individual can claim the
TCS as tax paid while filing his income-tax return. Many laymen are
under the impression that this is a straight loss. However, that is not
the case. The issue is that the funds of the person get blocked for some
time.

1.2 Non-applicability of TCS:

1.2.1 Remittance not covered under LRS: TCS applies only where remittance is made under the LRS. For instance – if
an NRI remits funds from his NRO/ NRE Account, TCS will not apply in
such case. It is because this is not a remittance under LRS. Similarly,
TCS is not applicable to remittances by persons other than individuals.

1.2.2 Remitter liable to TDS: It has been provided that if the remitter is liable to deduct tax at
source under any provisions of the Income-tax Act, and has deducted such
tax, then this TCS provision will not apply. The intention seems that
TCS is not applicable only if the remitter is liable to deduct tax at
source on the “concerned LRS remittance” and has deducted the same.

However, the language is not clear whether the remitter should be liable to
deduct tax at source on “the concerned remittance under LRS” or “any
transaction”. The literal reading suggests that it is not necessary that
TDS should be applicable on the concerned LRS remittance. The person
may be liable to deduct tax at source on any payment. Consider some
examples. Some individuals have to deduct tax at source where the
turnover or gross receipts from business/profession exceeds the
prescribed thresholds; or on purchase of immovable property u/s. 194-IA;
or on payment of rent u/s. 194-IB. These transactions on which TDS is
deductible are unrelated to the LRS remittance. The language suggests
that TCS is not applicable where the person has deducted tax at source
under any provisions. In our view, this is not the intention. It would
be better if the Government brings clarity in respect of the provision.

1.3. Concessional rate in case of loan taken for education:

A concessional rate of TCS @ 0.5% is applicable instead of 5% where:

the remittance is for the purpose of pursuing education; and
the amount being remitted is from loan funds obtained from a financial institution as defined u/s 80E.

In other words, if the remittance under LRS is made for the purpose of
education out of own funds then the concessional rate of TCS will not be
applicable and one needs to pay TCS @ 5 per cent.

1.4. Overseas Tour Program Package:

While the threshold of INR 7 Lakhs is prescribed for all purposes, such a
threshold is not applicable where the remittance is for the purpose of
an overseas tour program package. Hence, in such cases, TCS @ 5% is applicable without any threshold.

This is the position of TCS on remittances under LRS as of now. Let us take a look at the amendments proposed in Budget 2023.

2. Amendment vide Finance Act 2023 as passed by the Lok Sabha on 24.3.2023 – TCS rate to be increased to 20%:

2.1 Vide Finance Act 2023, the rate of TCS has been increased from the
existing 5% to 20% for remittances made under LRS w.e.f. 1st July 2023.

2.2 Further, the threshold of INR 7,00,000 has been restricted only to
cases where remittance is for the purpose of education or medical
treatment.

2.3 Consequently, the rate of TCS will now be 20% without any threshold for all purposes except education and medical treatment.

2.4 One more amendment is that the phrase “out of India” has been removed
for the purpose of TCS. Under the original provision, TCS was applicable
only where remittance was done “out of India” under LRS. As discussed
above in Para 2.2.11, LRS can be used for giving gift or loan in rupees
to NRI/ PIO relatives in their NRO account as well. In such case, TCS
was not applicable as per existing provision.

From 1st July 2023, TCS will be applicable on such rupee transfers as well. It is not
required that there is remittance out of India. It should be noted that
for rupee payments discussed in para 2.2.11 of Part A, there is no
mechanism to report to the bank. The remitter has to keep track of rupee
payments and see that all payments in rupees and foreign exchange
should be within the limits of LRS. For remittance abroad, formal
reporting must be made to the bank and thus bank will know that the
funds are being remitted under LRS. In the case of rupee payments, RBI
should work out a mechanism for reporting. Alternatively, the remitter
should himself provide the details to the bank and the bank should
collect TCS.

2.5 The concessional rate of 0.5% where remittance
is out of educational loan (discussed in Para 1.3 above) remains the
same after amendment.

The table below summarises the TCS rate for various transactions before and after the proposed amendment.

Particulars Vide
Finance Act 2020
1st
October 2020 to 30th June 2023
Vide
Finance Act 2023
1st
July 2023 onwards
Remittance out of educational loan taken from
financial institution defined u/s 80E
0.50% on amount exceeding INR
7,00,000
Education & medical treatment 5% on amount exceeding INR
7,00,000
Overseas tour program package 5% without any threshold 20% without any threshold
All other purposes 5% on amount exceeding INR 7,00,000 20% without any threshold

3. Other issues:

3.1 Payment through International Credit Cards:

It should also be noted that payments made by International Credit Card
(ICCs) for foreign tours or any other Current Account Transaction are
not captured within the purview of LRS. The limit of LRS, of course,
applies whether payment is made through bank transfer or through ICC.
There is however no mechanism to collect TCS when payment is made by
ICC.

Finance Minister – Smt. Nirmala Sitharaman, while passing
the Finance Bill in Lok Sabha on 24th March 2023 has made a statement on
this. The Central Government has requested the RBI to develop a
mechanism to capture payment for foreign tours and TCS by ICC.

3.2 Change in use of funds – As mentioned in para 4.1 of Part A, the purpose can be changed after remitting the funds. This can have some issues.

Normally the TCS rate is 20%. If the purpose of remittance is changed to
education, the TCS should have been lower at 5%. As excess tax is
collected, there is no difficulty. In any case, TCS is like advance tax.
It will be claimed as such in the income tax return.

However, let us assume that funds are remitted for education and TCS is 5%. Later
the use is changed to investment, then there is a shortfall in the TCS.
Banks would of course have collected the tax based on declaration and
documents provided by the remitter. The change in use would not cause
any liability on the bank. Will it cause any liability on the remitter?
There should be no implication for a bonafide case. For example, The
original remittance was for education purpose but some funds could not
be used within 180 days. In order to comply with the condition of
investing the funds within 180 days, the funds were invested.
Subsequently the investments were sold and funds were used for
education. This should not be an issue. Even otherwise there is no
specific provision for change of use. Please note that we are discussing
bonafide change in use and not false declarations. Out of abundant
caution, the remitter may inform the bank on change of use and if
necessary, ask the bank to collect additional tax from him and pay the
same to the Government. It may even collect interest. The remitter will
in any case claim the additional TCS in his tax return.

Summary:

20% is a very high rate for TCS. There are no thresholds. The threshold of
INR 7 Lakhs has also been removed. Sometimes, remittances are made for
pure expenses or gift to relatives which do not lead to any potential
incomes. However, with the steep hike in its rate, it appears that the
government does not wish to encourage remittances under LRS. Hence it is
making remittances costlier.

Conclusion:

There are significant changes in the LRS in terms of inserting some
restrictions and disincentives. Before making remittances under the LRS,
one should carefully understand the implications and then go ahead with
the remittance.

(Authors acknowledge contributions from CA Rutvik Sanghvi, Ms. Ishita Sharma and CA Nidhi Shah.)

The Risks Posed to Chartered Accountants by the Prevention of Money Laundering Act, 2002

INTRODUCTION

The role of Chartered Accountants has increased exponentially in the modern-day business environment. Gone are the days when the question of whether a Chartered Accountant conducting an audit was expected to be a watchdog or a bloodhound. The enlarged scope of audit/ compliance and the multifaceted advisory services rendered in today’s complex business environment by Chartered Accountants have opened them up to numerous regulatory and compliance-related challenges. We can see that Chartered Accountants are being called in for questioning by investigating agencies when a client’s affairs are the subject matter of investigation. Much unlike a Lawyer, the communication between a client and a Chartered Accountant does not get covered within the ambit of ‘legal privilege/privileged communication’ even though modern-day Chartered Accountants render a raft of quasi-legal services. With mushrooming of various tribunals before which Chartered Accountants has the right to represent, the risks they are exposed to in dispensing quasi-legal services need to be looked into given the numerous statutory laws that can cause an individual or professional firm to land in hot waters.

The last decade has witnessed sea changes in the regulation of economic activities. A number of legislations have now granted mandates to specialized agencies to detect and prevent economic offences. Much water may have flown under the bridge since the judgment of the Supreme Court in the State of Gujarat v. Mohanlal Jitmalji Porwal (1987) 2 SCC 364 wherein economic offences were compared with even a crime as unforgivable as murder. However, the judiciary still considers economic offences very seriously. It has now been established without a doubt that economic offences are to be regarded as a class unto themselves. The Serious Fraud Investigations Office, the Directorate of Enforcement, and the Income Tax authorities as mandated by the Prohibition of Benami Transaction Law in addition to other investigating agencies including the local police all operate in the field of investigating economic offences. Economic offences do not exist in silos. There is always the possibility of an overlap or an interplay. Investigation of economic offences invariably involves, inter alia, following the trail of money. Consulting and accounting professionals thus suddenly may find themselves in the epicenter of these investigations. No matter what the final verdict is, the taint of being accused of an economic offence often leaves an indelible mark on a person.

While studying for Master’s degree in law, a curious question was posed by a professor: “What can be done about bad advice?” This question was raised over a decade ago, and much water has flown under the bridge since then. Advice no longer needs to be bad to land a professional in hot water. In the Indian context, we have seen auditors hauled onto the coals for mistakes and frauds perpetuated by clients. It may very well be that in some cases professionals are complicit in those crimes due to professional pressure, however, more often than not it is likely that an auditor or a consultant from this august profession has unwittingly and unfortunately been dragged into controversy for no fault of his. This begs the question, “What can be done if good advice has unintended consequences? What can be done if a client does not follow the advice? What is the extent of the advisor’s liability? Chartered Accountants being arrested under the provisions of the Prevention of Money Laundering Act, 2002 (PMLA) (“Act”) are no longer unheard of. Though much has already been discussed about this harsh law with a client-centric focus, today this article shifts the focus onto professionals.

THE RELEVANT PROVISIONS OF THE ACT

One of the most important sections in any Act is the section that contains definitions. More often than not these definitions are contained in section 2 of an Act. The PMLA is no exception and defines proceeds of crime in section 2(1)(u) of the Act while section 3 itself defines the offence of money laundering. Both are reproduced below for clarity.

Section 2(1)(u) – “proceeds of crime means any property derived or obtained, directly or indirectly, by any person as a result of criminal activity relating to a scheduled offence or the value of any such property [or where such property is taken or held outside the country, then the property equivalent in value held within the country [or abroad].

[Explanation – For the removal of doubts, it is hereby clarified that “proceeds of crime” include property not only derived or obtained from the scheduled offence but also any property which may directly or indirectly be derived or obtained as a result of any criminal activity relatable to the scheduled offence.]”

Section 3 reads as follows-

“Whoever directly or indirectly attempts to indulge or knowingly assists or knowingly is a party or is actually involved in any process or activity connected with the [proceeds of crime including its concealment, possession, acquisition or use and projecting or claiming] it as untainted property shall be guilty of offence of money-laundering.

Explanation- For the removal of doubts, it is hereby clarified that, –

(i) a person shall be guilty of offence of money-laundering if such person is found to have directly or indirectly attempted to indulge or knowingly assisted or knowingly is a party or is actually involved in one or more of the following processes or activities connected with proceeds of crime, namely: –

(a) concealment; or

(b) possession; or

(c) acquisition; or

(d) use; or

(e) projecting as untainted property; or

(f) claiming as untainted property,

in any manner whatsoever,

(ii) the process or activity connected with the proceeds of crime is a continuing activity and continues till such time as a person is directly or indirectly enjoying the proceeds of crime by its concealment or possession or acquisition or use or projecting it as untainted property or claiming it as untainted property in any manner whatsoever.]”

ANALYSING THE RISK

A conjoint reading of both sections clearly shows that the Act casts an extremely wide net. This seems to be deliberate and by design. An immediate red flag for Chartered Accountants can be the term ‘knowingly assisted’ which can be easily imported to both, the act of commission as well as an omission by professionals. Some solace therefore can be sought from the inclusion of the word ‘knowingly’ before ‘assisted’, as it establishes the requirement of mens rea for an offence to be made out. The absence of mens rea will certainly be invoked as a defense if any accusations are made under the act, however, mens rea itself is not very easy to prove at the outset and often requires evidence to be lead which equates to one being subject to the rigors of an ignominious criminal trial. It is incredibly difficult to prove the absence of criminal intent before the trial commences unless it is apparent from the face of the record that the accused professional may indeed ex-facie have no criminal intent. A complication that one encounters is the fact that the Economic Case Information Report (ECIR) is not a public document and does not need to be handed over to the accused at the time of the arrest. It may be produced before the special court that shall conduct the trial if required as held in Vijay Madanlal Choudhary v. Union of India 2022 SCC Online SC 929; [2022] 140 Taxmann.com 610 (SC). The Court has held that the ECIR is an internal document of the Directorate and not equivalent to the First Information Report (FIR) which is provided for in the Criminal Procedure Code. This poses a significant increase in the challenge of drafting a bail application. Be that as it may, obtaining bail in PMLA prosecutions is whole together a different challenge by itself, even if the ECIR copy is supplied to the accused. The infamous twin conditions (of the court being satisfied that there are reasonable grounds for believing that the accused is not guilty of the offence and that he is not likely to commit any offence while on bail) fulfill the same role that the mythological Cerberus did when it comes to the grant of bail for those accused under the PMLA. The jurisprudence regarding bail under PMLA has been a roller coaster ride much akin to the plot of a gripping thriller novel, what with the Supreme Court in Nikesh Tarachand Shah v. Union of India (2018) 11 SCC 1 striking down the twin conditions, just for Vijay Madanlal Choudhary v. Union of India (supra) to uphold their revival post the 2018 amendment to the Act. Just like any other movie as of today, the story ends on a cliffhanger with the Supreme Court agreeing to review aspects of the Vijay Madanlal Choudhary judgment. That being said, as of today, the twin conditions are good law.

The red flag is not merely knowingly assisted. The explanation to section 3 lists out the processes or activities which shall constitute the offence of money laundering in wide terms such as ‘concealment, possession, acquisition, use, projecting as untainted property, or claiming as untainted property in any manner whatsoever’. This gamut of activities, despite the standard caveat of mens rea, is enough to cause considerable headaches to Chartered Accountants who are regularly called upon to assist in structuring transactions, helping out in complex business decisions, or auditing books of accounts. To precipitate matters, the definition includes the phrase “actually involved in any process or activity connected with the proceeds of crime.” It is incredibly easy for a Chartered Accountant to be accused of the crime of money laundering. The activity of money laundering, being a continuous activity, also leaves one susceptible to the wrath of the law long after one’s association with the clients concerned may have ceased. Yes, it is true that there are various defenses that may be available to a Chartered Accountant, but a defense is not the same as immunity. I’m sure many will agree that in this particular context, prevention is infinitely better than cure.

The definition of ‘proceeds of crime’ is also amorphous enough to cause sufficient headaches for a Chartered Accountant. Technically, a fee that is received from a client who is involved in the process of money laundering could easily fall within the four corners of the definition of proceeds of crime. This is due to the broad language employed by section 2(1)(u) where property derived even indirectly by a person as a result of criminal activity is to be considered as proceeds of crime, even though it may not by itself be derived or obtained from the scheduled offence. If a client is involved in the commission of a scheduled offence and he pays a fee to a Chartered Accountant, who is unaware of the occurrence of such a scheduled offence, arguably, the fee received could still be claimed to be proceeds of crime even though the offence of money laundering may not be made out. The Supreme Court in Vijay Madanlal Choudhary v. Union of India (supra) has held that the offence of money laundering is an independent offence and that the involvement of a person in any one of the processes or activities provided for in section 3 would constitute the offence of money laundering which would otherwise have nothing to do with the criminal activity relating to a scheduled offence except that the proceeds of crime may be derived or obtained as a result of that crime.

The Appellate Tribunal set up under the PMLA in the case of Vinod Kumar Gupta v. Joint Director, Directorate of Enforcement 2018 SCC On Line ATPMLA 27 has decided an appeal where the Appellant received consultation fees from a party accused of offences under the PMLA and the Appellant took up a defense that he had no way of knowing that he had received consultation fees which may be part of proceeds of crime. The Tribunal observed that all professionals such as Advocates, Solicitors, Consultants, Chartered Accountants, Doctors, and Surgeons receive their professional charges from their respective clients against the service provided. Neither can the presumption under section 5(1)(a) of the PMLA (section 5 deals with provisional attachment of proceeds of crime) be drawn ipso facto that they have the proceeds of crime received as professional charges in their possession nor on the basis of presumption can their movable and immovable properties be attached unless a link and nexus directly or indirectly towards the accused or the crime is established within the meaning of section 2(1)(u) of the Act. In the absence of such a link, the professionals are to be treated as innocent persons as unless a link and nexus of proceed of crime are established under section 2(1)(u), the proceeding under the Act cannot be initiated. A caveat here is advisable, the orders of the Adjudicating Authority and Appellate Tribunal are only with respect to Attachment – these orders are not binding upon the special court that actually tries the offence of money laundering. The Special Court is neither bound, governed nor influenced by any order passed by the Enforcement Authorities and has to act independently on the basis of evidence led before it. Various other High courts have held that the decisions of the Adjudicating Authorities are not binding upon the Special Court where the Special Court has independently applied its mind.

There are various ways in which a professional may be pulled into an investigation under the PMLA by the Directorate of Enforcement some examples that come to mind are:

(i)    Chartered Accountants are privy to sensitive information about their clients and therefore may find themselves receiving summons during an investigation.

Section 50 of the PMLA grants certain authorities of the Directorate the power to summon any person whose attendance they consider necessary to give evidence or to produce any records during the course of any investigation or proceeding under the PMLA. All the persons so summoned shall be bound to attend in person or through authorized agents, as such officer may direct, and shall be bound to state the truth upon any subject respecting which they are examined or make statements and produce such documents as may be required. This would not be a cause of concern for most Chartered Accountants as their role would be confined to assisting the Directorate with their investigation and as such, giving evidence. As mentioned earlier Chartered Accountants do not enjoy the protection of privilege as is enjoyed by lawyers under section 126 of the Indian Evidence Act, 1872. That being said, in Nalini Chidambaram v. Directorate of Enforcement 2018 SCC Online Mad 5924, the Madras High Court, where the concerned Senior Advocate had appeared through an authorized representative before the Directorate of Enforcement, permitted the Directorate to issue fresh summons to the Senior Advocate.

(ii)    Chartered Accountants may find themselves involved in strategizing/planning company structures etc. and may find themselves being entangled in the offence of money laundering.

It would considerably be riskier for a Chartered Accountant if a transaction that he has consulted upon attracts the offence of money laundering. A blanket stand that this was done unknowingly or without mens rea may not be sustainable at the outset, because both commissions and omissions of the Chartered Accountant would need to be considered and the Directorate can always take the stand that this would be a subject matter of evidence to be considered at trial. The directorate may also always take a stand that evidence would need to be led to establish the lack of mens rea or the innocence of the Chartered Accountant. Professionals may need to increase their due diligence with regard to the transactions that they consult upon with their client in order to avoid being unwittingly pulled into this web and ensure proper documentation.

(iii)    Chartered Accountants may find themselves certifying documents or statements and may find themselves being entangled in the offence of money laundering.

In Murali Krishna Chakrala v. The Deputy Director Criminal Revision Case No. 1354 of 2022 and Crl. M. P. No. 14972 of 2022, dated 23rd November 2022, the High Court of Madras held that when issuing certain certificates, a Chartered Accountant is not required to go into the genuineness or otherwise of the documents submitted by his clients and he cannot be prosecuted for granting the certificate based on the documents furnished by the clients.

However, the Madras High Court decision may not come to the aid of Chartered Accountants when they are required to exercise due care while issuing certificates without taking the same at face value. This judgment arguably may not aid auditors who are required to report whether the books of accounts reflect a true and fair view of the financial condition of the audited entity and to what extent an Auditor or a Chartered Accountant certifying a particular document is required to go into the accuracy of the data provided to them (which takes us back to the watchdog versus the bloodhound debate). The risk could always be higher for the internal auditors of an entity. There can be no clear-cut answers as to which commissions and the omissions of a certifying Chartered Accountant would entail scrutiny. It would be advisable to have an iron-fist adherence to the relevant auditing standards and checklists while also ensuring that the client similarly adheres to the relevant accounting standards. It may be tempting to make qualifications when undecided, if for no other reason than to cover one’s own risk. This may be an additional factor in the mind of an auditor or a Chartered Accountant issuing a certificate. It is always preferable to err on the side of caution when risk is involved. One may not need to be actually involved in any dubious activity to incur the wrath of this draconian law.

CONCLUSIONS

This article by itself cannot be considered to be exhaustive. It is meant to be indicative and to inform the Chartered Accountant fraternity that their roles are now under more scrutiny than ever before and so is the risk associated with it. As the business environment and transactions get increasingly complex while some of the scheduled offences remain by and large generic, it may prove impossible for a Chartered Accountant to mitigate all risks. The offences included in the schedule are wide-ranging, spanning from legislation regarding drug trade and human trafficking to offences under certain intellectual property legislations! The most dangerous are the generic offences under the India Penal Code for example -cheating – something that can be invoked easily and is generic enough to include a variety. This takes us back once again to the watchdog and bloodhound conundrum. In today’s modern world perhaps, the bloodhound side shall weigh heavily in the mind of a Chartered Accountant.

The diligence with regard to the documentation needs to start right at the start – from the engagement letter itself. A clearly defined scope of work can help mitigate risk as far as the question of the authorities as to why a specific issue has not been dealt with. Checklists can specify the depth of the scrutiny. An exhaustive and complete audit file for auditors is more important than ever. It may clearly need to be made out and disclaimers may be made out to the effect that the scope of the certification/audit or advice is limited to the commercials involved and that the client must ensure adherence to all relevant local and central laws. The scope of preventive documentation is not exhaustive. It is meant to ensure that the scope of engagement of Chartered Accountants as well as the actual work carried out by them are well defined in order to ensure that no aspersions can be cast upon the role of professionals in any manner. It is not possible for a Chartered Accountant to ensure that the client has not indulged in any of the scheduled offence, indeed, that is not their function unless they come across them while fulfilling the scope of their work. Increased diligence, erring on the side of caution, and extensive documentation are the key to mitigating risk. The margin of discretion in audit qualification has reduced drastically. Going through the schedule of the PMLA is highly recommended, you may be surprised at certain offences that are included therein!

MSME Act, 2006 – 12 Compliance Action Points for Entities Dealing with MSMEs

BACKGROUND OF THE MSME ACT, 2006

The Micro, Small and Medium Enterprises Development Act, 2006 (MSME Act) provides for the registration of micro, small and medium enterprises (MSME) based on the specified criteria. It thereafter provides for a host of measures for the promotion, development and enhancement of the competitiveness of micro, small and medium enterprises. It also casts various obligations on entities dealing with such MSME enterprises. This article explains the extent of obligations cast on entities dealing with such MSME enterprises and the consequences of non-compliance with such obligations.

MEANING OF ENTERPRISE AND APPLICABILITY OF MSME ACT

Section 7 of the MSME Act provides the criteria based on which an enterprise is classified as either a micro-enterprise, small enterprise, or medium enterprise. However, before venturing into the specific criteria for classifying an enterprise into micro, small or medium, it may be important to look at the definition of ‘enterprise’ as provided u/s 2(e) of the Act. The said definition is significant and reproduced below for ready reference:

“enterprise” means an industrial undertaking or a business concern or any other establishment, by whatever name called, engaged in the manufacture or production of goods, in any manner, pertaining to any industry specified in the First Schedule to the Industries (Development and Regulation) Act, 1951 (55 of 1951) or engaged in providing or rendering of any service or services.

On a perusal of the above definition, it is very clear that only establishments engaged in the manufacture of specified goods or rendering any service can be considered an ’enterprise’. Therefore, traders and works contractors are not covered under this definition, and the provisions of the MSME Act do not apply to such traders and works contractors. In fact, in its FAQ dated 24th October, 2016, the Ministry of MSME has clarified vide answer to Q. No. 18 that the policy is meant only for procurement of goods produced or services rendered by MSEs, and traders are excluded from the Policy.

Further, various Court rulings have held that works contractors are not covered under the MSME Act, 2006. Useful reference may be made to the decisions in the cases of Rahul Singh vs. Union of India C 42491 of 2016 (Allahabad High Court), Shreegee Enterprises vs. Union of India 2015 SCC Online Del 13169 (Delhi High Court), Samvit Buildcare Pvt Ltd vs. Ministry of Civil Aviation C/SCA/1094/2018 (Gujarat High Court) and Sterling and Wilson Pvt Ltd. vs. Union of India WP – L1261/2017 (Bombay High Court).

Action points for entities dealing with various vendors

1. Check whether the nature of the contract awarded to the vendor involves  supply of goods, services or works contracts. If the nature of the contract awarded is that of a works contract, then MSME Compliances are not applicable.

2. If the nature of the contract awarded to the vendor is that of the supply of goods, further check whether the goods supplied by the vendor are manufactured or produced by him. If the goods are neither manufactured nor produced by him, but he is merely a trader, then the MSME Compliances are not applicable. For example, a trader of stationery items or supplier of printer consumables would not be eligible for the benefit of the MSME provisions since the said suppliers neither manufacture nor produce the products supplied by them.

3. If the nature of the contract awarded to the vendor is that of supply of services, further check whether the services supplied by the vendor are rendered by him or by some other person. If the services are rendered by some other person and the vendor is merely acting as an intermediary/aggregator, then MSME Compliances are not applicable. For example, an advertising agent might help an enterprise by placing an advertisement in a newspaper. Since the services of advertisement are rendered by the newspaper and not the agent, MSME compliances would not apply to the advertisement amount. However, if the advertising agent charges some amount to the enterprise for either the preparation or placement of the advertisement, then the MSME compliances would become applicable only to the extent of such preparation/placement charges. A similar situation would apply to air travel agents as well.

CLASSIFICATION OF ENTERPRISES

Section 7 of the MSME Act provides for the criteria based on which enterprises can be classified either as micro-enterprise, small enterprise, or medium enterprise. The following table summarises the latest criteria concerning the classification of enterprises as micro, small or medium enterprises:

Classification

Investment Criteria in Plant, Machinery and Equipment do
not exceed

Turnover Criteria do not exceed

Micro

Rs. 1 Crore

Rs. 5 Crore

Small

Rs. 10 Crore

Rs. 50 Crore

Medium

Rs. 50 Crore

Rs. 250 Crore

Further, Section 8 provides for the registration of such enterprises with the MSME and the issuance of a registration certificate. At the time of registration, it is important to mention the specific NIC Codes under which the enterprise intends to supply the goods or the services. The privileges under the law are available only to enterprises which are so registered and bear a Udyog Registration Certificate with the specific NIC Codes listed therein.

Action points for entities dealing with various vendors

4. Check whether the vendor has obtained registration under the MSME Act and if so, obtain a copy of his registration certificate. The correctness of the said certificate can be checked online. If no communication is received from the vendor, it can be presumed that he is not registered under the MSME Act. In case the vendor is not registered under the MSME Act, then MSME Compliances are not applicable even if, factually, he satisfies the conditions for classification as an MSME.

5. Similarly, mere registration under MSME does not automatically entitle the enterprise for blanket benefit of all the privileges under the Act. The privilege to MSME and the obligation cast on the entity dealing with such an enterprise will have to be examined qua each transaction.

MISUSE OF MSME CLASSIFICATION

MSMEs are entitled to various benefits. Some enterprises furnish false information for obtaining Udyam Adhar Memorandum even though they may not be eligible. One of the benefits to MSMEs is procurement preference by public sector enterprises. In this context, to curb fraudulent practices and protect the interests of genuine MSEs, the Ministry of MSME vide Office Memorandum – F.No.5/1(1)/2019-P&G/Policy dated 10th January, 2020 (OM) has provided powers to specified buyers to enquire upon the status of MSEs before awarding any contract. The relevant extract of the said OM is reproduced below“While awarding contract to MSEs under the Public Procurement Policy (PPP), the Government Departments/ CPSEs / Other Organizations shall satisfy themselves about the MSE status of the concerned enterprise. In case of any doubt/ lack of evidence in respect of the MSE status of any enterprise, they may go through due verification process with the help of supporting documents such as CA certificate, details available from the website of Ministry of Corporate Affairs (MCA) etc.”

Action points for entities dealing with various vendors

6. While the above notification may not apply strictly to entities other than the public sector, it may be important to insist on such CA Certificate before taking upon the onus of ensuring the onerous compliance obligations cast in relation to MSMEs.

OBLIGATIONS CAST ON ENTITIES DEALING WITH VARIOUS VENDORS

Section 15 of the MSME Act casts specific obligations on the buyer to make payments to specified suppliers within the prescribed timelines. The provisions are reproduced below for ready reference

Where any supplier supplies any goods or renders any services to any buyer, the buyer shall make payment therefor on or before the date agreed upon between him and the supplier in writing or, where there is no agreement in this behalf, before the appointed day:

Provided that in no case the period agreed upon between the supplier and the buyer in writing shall exceed forty-five days from the day of acceptance or the day of deemed acceptance.

It may be noted that Section 15 uses the word ‘supplier’ and not ‘enterprise’. Therefore, it may be important to understand the definition of the supplier as provided under section 2(n) of the Act and the same is reproduced below:

“supplier” means a micro or small enterprise, which has filed a memorandum with the authority referred to in sub-section (1) of section 8, and includes … (not reproduced as very specific)

On a perusal of the above definition, it is evident that the term ‘supplier’ only covers micro or small enterprises. The MSME Act actually has three classifications – micro , small and medium. While medium-scale enterprises are eligible for various concessions and incentives provided under Chapter IV of the MSME Act, they are not included in the scope of suppliers for Section 15 compliances. Therefore, medium-scale enterprises are not eligible to enjoy the privilege of priority payment under section 15 of the Act.

Action points for entities dealing with various vendors

7. If the vendor is registered under the MSME Act, check the classification of the enterprise. If the enterprise is registered as ‘MEDIUM’, compliance with the provisions of Section 15 is not required. The classification is evident from the registration certificate.

UNDERSTANDING THE PAYMENT OBLIGATION

In cases where the vendors/transactions are eliminated from the purview of MSME Compliance in view of the earlier action points, there is no further cause for worry from the MSME perspective. However, in cases where the vendors/transactions are not eliminated from the purview, it may be important for the entity to examine and ensure compliance with the provisions of Section 15 referred to above. Basically, the said provision requires the entity to make the payment to the MSME vendor within prescribed timelines. Effectively, the provision requires that the payment be made within 15 days from the ‘day of acceptance’ (See detailed analysis later) of the goods or services by the buyer. This time limit can be extended up to a maximum of 45 days from the ‘day of acceptance’ if the date of payment is agreed upon between the supplier and the buyer in writing.Action points for entities dealing with various vendors

8. In order to avail the maximum time limit of 45 days, it is important that the entity enters into written agreements with the vendors and those agreements provide for the credit period to be mentioned as 45 days. In the alternative, if there is no formal agreement entered into with the vendor, the purchase order issued by the entity can specify this term and if no objection is raised to the purchase order, the said purchase order can be considered as the written agreement between the parties.

At this juncture, it may also be important to understand what is meant by ‘day of acceptance’. Explanation (i) to Section 2(b) defines the term ‘day of acceptance’ as under:

‘the day of acceptance’ means,—

(a) the day of the actual delivery of goods or the rendering of services; or

(b) where any objection is made in writing by the buyer regarding acceptance of goods or services within fifteen days from the day of the delivery of goods or the rendering of services, the day on which such objection is removed by the supplier.

Further, Explanation (ii) to the said clause deems the day of the actual delivery of goods or the rendering of services as the day of deemed acceptance where no objection is made in  writing by the buyer regarding the acceptance of goods or services within fifteen days from the day of the delivery of goods or the rendering of services.

The above provisions cast a very important burden on the entities dealing with various vendors to raise commercial or technical objections, if any, in writing within 15 days of the day of the actual delivery of goods or the rendering of services. If such commercial or technical objections are raised in writing, the burden then shifts to the supplier to ensure that such objections are duly resolved and removed. Clause (b) above acts as a protection to the buyer in such cases and the time count does not start till the time of removal of the commercial or technical dispute by the supplier.

Action points for entities dealing with various vendors

9. Immediately after the receipt of goods or services, verify the qualitative and quantitative, and commercial parameters of the goods or services and if there is any variation from the parameters expected under the agreement or the purchase order, raise the objection in writing to the supplier within 15 days of the receipt of the goods or services.

Since the timelines prescribed under the law are anchored around “the day of the actual delivery of goods or the rendering of services“, it may be important to understand what exactly is meant by delivery of goods and rendering of services.

At this juncture, it may be relevant to stress once again the limited applicability of the MSME Act only to the supply of goods manufactured by the vendor or services rendered by the vendor. As stated earlier, the MSME Act does not apply to either traders or to works contractors (where there is a composite supply of goods as well as services).

The Sale of Goods Act, 1930, is an elaborate code dealing with transactions of sale of goods. Section 2(2) of the said Act defines the term “delivery“ to mean a voluntary transfer of possession from one person to another. Section 33 of the Act further specifies that the delivery of goods sold may be made by doing anything which the parties agree shall be treated as delivery or which has the effect of putting the goods in the possession of the buyer or of any person authorised to hold them on his behalf.

The mere change in the place of location of goods from the suppliers’ warehouse to the buyers’ warehouse does not ipso facto mean that the goods have been delivered. Most of the agreements or purchase orders contain clauses which stipulate the timeline when the goods will be deemed to be delivered and the transfer of possession of the goods takes place. Further, it may be important to note the provisions of Section 41 of the Sale of Goods Act, 1930 which specifically mentions that where goods are delivered to the buyer which he has not previously examined, he is not deemed to have accepted them unless and until he has had a reasonable opportunity of examining them for the purpose of ascertaining whether they are in conformity with the contract. Having said so, it is also important to bear in mind the provisions of Section 42 of the Sale of Goods Act, 1930 which specifies that the buyer is deemed to have accepted the goods when he intimates to the seller that he has accepted them, or when the goods have been delivered to him and he does any act in relation to them which is inconsistent  with the ownership of the seller, or when, after the lapse of a  reasonable time, he retains the goods without intimating to the seller that he has rejected them.

Though the Sale of Goods Act, 1930 does not apply to the rendering of services, in my view, in the absence of any authoritative guidance on what could constitute acceptance of the rendering of services, I believe that the above principles would apply in the case of services as well.

Action points for entities dealing with various vendors

10. It is important that the entity enters into a written agreement with the vendors that provides for the time when the delivery will be deemed to be accepted by the buyer. In the alternative, if there is no formal agreement entered into with the vendor, the purchase order issued by the entity can specify this term and if no objection is raised to the purchase order, the said purchase order can be considered as the written agreement between the parties.

IMPACT OF GST NON-COMPLIANCES BY THE VENDOR

The payment due to the vendor would not only include the value of the goods or services supplied but also the GST charged by the vendor for onward payment to the Government. Such GST charged is available as an input tax credit to the buyer enterprise under the GST Law subject to various vendor-specific conditions like payment of tax to the Government and uploading the transaction details on the GST Portal. Many enterprises would wish to withhold the GST component in case of non-compliance in this regard by the vendor. Whether such a withholding of the GST Component would amount to non-payment to the vendor resulting in the consequences under the MSME Act?

A strict reading of Explanation (i) to Section 2(b) defining the term ‘day of acceptance’ may suggest that a buyer can raise an objection regarding the acceptance of goods or services only. However, this would be a very restrictive interpretation of the said provision. One may argue that the acceptance of goods or services is not limited to merely the physical characteristics of the said goods or services but their other financial facets. Eligibility for an input tax credit is a substantial financial facet associated with the supply of the said goods or services and accordingly, if the agreement or the purchase order is suitably worded, the buyer may be entitled to withhold the GST component in case of non-compliance by the vendor.

CONSEQUENCES OF DELAY IN PAYMENT

Section 16 of the Act provides for payment of interest by the buyer to the enterprise in case of delay in payment. The said provision has an overriding effect to anything specifically mentioned in the agreement. The relevant provision is reproduced below for ready reference:

Where any buyer fails to make payment of the amount to the supplier, as required under section 15, the buyer shall, notwithstanding anything contained in any agreement between the buyer and the supplier or in any law for the time being in force, be liable to pay compound interest with monthly rests to the supplier on that amount from the appointed day or, as the case may be, from the date immediately following the date agreed upon, at three times of the bank rate notified by the Reserve Bank.

It may be noted that the provision not only provides for the mandatory payment of interest but also mentions the way the interest is calculated. The same is explained below:

Issue

Provision

Illustration

When is interest payable?

If the buyer fails to make the payment of the
amount to the supplier within the credit period or before the appointed date.

If the goods are received on 15th
April and the agreement provides for a maximum credit period of 45 days, the
outer due date of payment will be 31st  May. If the payment is not made by that
date, the interest liability is triggered.

What is the type of interest?

Compounded interest with monthly rests.

The interest will be payable from 1st  June. The interest will be compounded each month.
So, the interest for the month of July will be calculated by taking the
outstanding principal as well as the interest of June.

What is the rate of interest?

Three times the bank rate notified by the
Reserve Bank

If the Bank Rate notified is 4.25 per cent,
the applicable interest rate will be 12.75 per cent.

 

An associated issue that usually arises is that the RBI keeps
amending the bank rate at various points. Therefore, what is the  bank rate to be taken into account for the
purposes of calculation? In my view, at the end of every month, the interest
needs to be calculated for compounding purposes. The bank rate on the said
date will be applied for the calculation of interest for that particular
month.

Action points for entities dealing with various vendors11. Make sure that the payments to MSMEs are made within the time limits stipulated earlier. If, for any reason, the payments are delayed, also calculate, and provide for interest as per the provisions mentioned above. Make sure that the payments to the MSMEs are made with the applicable interest at the earliest possible opportunity.

HOW DOES ONE DEFINE DELAY IN PAYMENT IN CASE OF MULTIPLE SUPPLIES FROM THE SAME SUPPLIER?

The above provisions require the payment of interest in case of delayed payment. However, a very common issue which may arise includes situations in which the supplier makes multiple supplies and payments are also made on account or in some cases, advances are also given. In such a scenario, the provisions of Sections 59 to 61 of the Indian Contract Act, 1872 become very important. Section 59 of the said Act provides that where a debtor, owing several distinct debts to one person, makes a payment to him, either with express intimation or under circumstances implying, that the payment is to be applied to the discharge of some particular debt, the payment if accepted, must be applied accordingly. Section 60 then provides a similar discretion to the creditor in cases where the debtor has omitted to intimate, and there are no other circumstances indicating to which debt the payment is to be applied. Further, Section 61 specifies that if neither parties make any appropriation, the debts will be discharged in order of time.

Action points for entities dealing with various vendors

12. Make sure that the payments to MSMEs are made with a specific instruction to appropriate the said payments against the outstanding amounts due from them.

FURTHER CONSEQUENCES OF DELAY IN PAYMENT

Section 18 of the Act provides the buyer a mechanism to enforce the payments due under sections 16 and 17 through a reference to MSEFC. The MSEFC would then undertake a conciliation process to settle the dispute between the MSME and the buyer and expedite the payment to the MSME.

Section 22 of the Act also requires the disclosure of the following information in the audited accounts of the enterprise:

(i) the principal amount and the interest due thereon (to be shown separately) remaining unpaid to any supplier as at the end of each accounting year;(ii) the amount of interest paid by the buyer in terms of section 16, along with the amount of the payment made to the supplier beyond the appointed day during each accounting year;(iii)  the  amount  of  interest  due  and  payable  for  the  period  of  delay  in  making  payment  (which have  been  paid  but  beyond  the  appointed  day  during  the  year)  but  without  adding  the  interest specified under this Act;(iv) the amount of interest accrued and remaining unpaid at the end of each accounting year; and (v) the amount of further interest remaining due and payable  even in the succeeding years,  until such date when the interest dues as above are actually paid to the small enterprise, for the purpose of disallowance as a deductible expenditure under section 23.

Section 23 further provides that the interest under the MSME Act will not be allowable as a deduction while computing taxable income.

CONCLUSION

The MSME Act, 2016 casts various obligations on entities dealing with such MSME enterprises. Further, Section 22 requires certain disclosures in the statutory accounts in this regard. Therefore, it is important for a statutory auditor to ensure that the disclosures are correctly made. In determining the correctness of the disclosure, it would be useful for the statutory auditor to understand the scope of the applicability of the law. Further, professionals could also obtain MSME registration for the services rendered by them if they qualify within the turnover and capital criteria listed earlier and avail the benefits of timely payment obligation cast by the Act on the clients serviced by them.

International Trade Settlement in Indian Rupees – New Mechanism

INTRODUCTION

The Reserve Bank of India (RBI) constantly monitors, supervises and regulates the foreign exchange market in India by regulating currency, securing monetary stability, maintaining currency reserves, and overseeing India’s credit and currency system. Due to the recent global events of Russia-Ukrainian conflict resulting in sanctions on major Russian banks by USA, UK and the EU from accessing the SWIFT, the impact of availability of crude oil and fear of global recession, India has been increasingly facing pressure on maintaining the Rupee stability. Further, India’s over dependence on using the US Dollar for trade settlement has its own set of challenges. In fact, dollarization of global trade has given huge advantage to USA at the cost of rest of the world. It’s time for India and other countries to start looking for alternatives to the USD.

In this context, and with an intention to promote international trade, build a healthy forex reserve, support the increasing interest of global trading community in Indian Rupees (INR), and to combat the rupee depreciation, the RBI recently issued a Circular vide A.P. (DIR Series) Circular No.10 dated 11th    July, 2022. Through this circular, RBI has introduced a new mechanism and arrangement for invoicing, payment, and settlement of exports / imports in Indian Rupees (INR). Earlier, under this RBI regulation, international trade (except for those done with Nepal and Bhutan) is only   permitted   to   be   settled   in   specified foreign currencies which are freely convertible. This latest notification paves   the   way   for   international   trade settlement in   INR. The   circular   provides   a   broad framework for implementing the arrangement for cross border transactions in INR.


LEGAL FRAMEWORK

OPENING OF SPECIAL RUPEE VOSTRO ACCOUNTS

The bank of a partner country to approach an Authorised Dealers (AD) bank in India for opening of Special INR Vostro account (nostro and vostro are terms used to describe the same bank account. Nostro, from the Latin, means ours – as in our money that is in deposit in your bank. Vostro again from Latin means yours – as in your money that is in deposit in our bank). The AD bank will seek approval from the RBI for opening and maintaining the special Vostro Account. For example, SBI in India will hold Bank of Russia’s Vostro Account.


TRANSACTION AND SETTLEMENT
An Indian exporter will approach his regular bank, which will send the invoice to the Indian AD bank. The Indian AD Bank will debit the Rupee Vostro account and credit the money to the exporter’s regular bank, which in-turn will credit the money to the exporter’s bank account.

An   Indian   importer   will   transfer   the   payment   into his/her regular bank, which will then transfer that to the AD bank. The AD Bank will credit the Rupee Vostro Account, and the exporter from the other country will be paid through the authorised bank there and in its local currency.


DOCUMENTATION
The export / import undertaken and settled shall be subject to normal documentation process and reporting requirements   as   done   for   regular   export / import transaction namely; LC and related documents etc.


ADVANCE AGAINST EXPORTS
In case of advance payment against exports in INR, the AD Banks will ensure that available funds in these accounts are first used towards payment obligations arising out of already executed export orders / export payments in the pipeline.

SETTING-OFF OF EXPORT RECEIVABLES

‘Set-off’ of export receivables against import payables in respect of the same overseas buyer and supplier with facility to make/receive payment of the balance of export receivables/import payables may be allowed in INR, subject to the conditions as mentioned under the Master Direction on Export of Goods and Services 20161 (as amended from time to time).

BANK GUARANTEE
Issue of Bank Guarantee for trade transactions, undertaken through this arrangement, is permitted subject to adherence to provisions of FEMA Notification No. 82, as amended from time to time and the provisions of Master Circular on Guarantees & Co-acceptances3.


REPORTING REQUIREMENTS
Reporting of cross-border transactions need to be done in terms of the extant guidelines under FEMA 19994.

FAQs

Whether New Mechanism of Settlement in INR is applicable to export / import of goods and services both?

As per the RBI Circular, the new mechanism is applicable to export / import of goods and services.

What is Special Rupee Vostro Account?

It is a bank account held by a foreign bank in India with an Indian bank in INR.

What are prohibited items under the New Mechanism?

As per RBI Circular, the new mechanism of settlement in INR is not available if the correspondent bank is from a country or jurisdiction in the updated FATF Public Statement on High Risk & Non-Co-operative Jurisdictions on which FATF has called for counter measures.

What additional documentation is required by exporters and Importers for settlement of transaction in INR?

As per RBI Notification, there are no additional documents and reports required for settlement of transaction in INR. The export / import undertaken and settled in this manner shall be subject to usual documentation and reporting requirements as per extant FEMA guidelines.

1. Master Direction – Export of Goods and Services (Updated as on 8th January, 2021) – RBI/FED/2015-16/11 FED Master Direction No. 16/2015-16 dated 1st January, 2016 (updated as on 8th January, 2021)
2. Notification No. FEMA 8/2000-RB dated 3rd May, 2000
3. Master Circular – Guarantees, Co-Acceptances & Letters of Credit – UCBs – RBI/2021-22/119 DoR.STR.REC.65/09.27.000/2021-22 dated 2nd November, 2021
4. Master Direction – Import of Goods and Services (Updated as on 31st May, 2022) and Master Direction – Export of Goods and Services (Updated as on 8th January, 2021)

Whether exporters are allowed to set-off export receivables against import payables?
As per RBI Circular, the ‘set-off’ of export receivables against import payables is allowed in respect of the same overseas buyer and supplier with facility to make/ receive payment through the Rupee Payment Mechanism subject to the conditions mentioned relating to set-off of export receivables against import payables under Master Direction on Export of Goods and Services 2016 (as amended from time to time).

Whether the issue of a Bank Guarantee for transaction through the Rupee Payment Mechanism is allowed?

Yes, issue of Bank Guarantee for transaction through the Rupee Payment Mechanism is allowed subject to compliance of provision of FEMA Notification No. 8 as amended from time to time and the provisions of Master Direction on Guarantees & Co-acceptances.


IMPLICATIONS UNDER VARIOUS OTHER LAWS
In case of a Company, to whom Ind-AS is not applicable, Division I of the Schedule III of Companies Act, 2013 requires disclosure and reporting of expenditure in foreign currency and earnings in foreign currency in the Notes to the Financial Statements. Thus, from the audit perspective, one should be careful in reporting and disclosure of expenditure in foreign currency and earnings in foreign currency since all export and imports may not be in foreign currency if the company has opted for trade settlement in INR for import and export in some cases.

Under the Income-tax Act, there are certain exemptions/ deductions relating to export business which are linked to sale proceeds realised in foreign exchange. One should be careful in claiming such exemptions/deductions if exports are settled in INR.

Under GST, the definition of “Export of Services” under clause (iv) states “payment to be received in convertible foreign exchange” whereas in definition of “Export of Goods” such condition is missing. So, one can presume that the benefits of GST can be availed if payment for export of goods is settled and received in INR. Further, in case of Import of Goods and Import of Services, the definition of import of goods and import of services, does not provide for payment in convertible foreign exchange. Thus, GST under reverse charge needs to be paid on import of goods and services settled in INR as provided.

CONCLUSION
The introduction of alternative payment mechanism in INR is not new for India. In the past, India had introduced a similar arrangement with Iran by allowing Rupee-Rial payment mechanism when economic sanctions were imposed on Iran. Further, a similar arrangement was made under Article VI of the 1953 Indo-Soviet trade agreement.

At present, the Indian Rupees (INR) is not considered as a freely convertible currency globally. However, with this effort of RBI, the new mechanism will focus on creating a recognition for the Indian rupee as an international currency by expanding external trade with the rupee- settlement mechanism which will bring down pressure on India’s forex reserves and assist in controlling the rupee depreciation to a certain extent. India’s total imports in F.Y. 2021-22 were $612,608 million5. It is estimated that this arrangement could potentially reduce outflows to the extent of $3 billion per month.

However, one needs to assess the provisions of GST to understand the impact of Rupee settlement on export of goods and services.


5. https://dashboard.commerce.gov.in/commercedashboard.aspx

Hierarchy of FEMA

INTRODUCTION

One of the common questions which a newly qualified CA / Lawyer often asks is “How does one Study FEMA?” The Foreign Exchange Management Act, 1999 (FEMA) has been around since 1999 and before that it existed as the Foreign Exchange Regulation Act, 1973 (FERA). In spite of such a long lineage, this question refuses to die down.

A
possible reason for this confusion could be the multiple sources of
legislations which one comes across when dealing with FEMA. In addition,
there are different agencies which one encounters under this law.
Through this article let us examine the hierarchy of FEMA and the
various types of legislations one encounters when dealing with foreign
exchange transactions in India!

CENTRAL ACT

The
Foreign Exchange Management Act, 1999 is a Central Statute of the
Parliament and is the supreme statute when it comes to regulating all
foreign transactions in India. The Preamble to the Act states that it is
a law relating to foreign exchange with the objective of facilitating
external trade and payments and for promoting the orderly development
and maintenance of the foreign exchange market in India. It applies to
the whole of India and even to an office, branch or agency abroad which
is owned or controlled by a person resident in India.

Three important decisions  have  examined  the  fabric  of FEMA. A two-Judge Bench of the Supreme Court in Dropti Devi vs. Union of India (2012) 7 SCC 499
held that FEMA was quite similar to its predecessor FERA. It held that
insofar as conservation and/or augmentation  of foreign exchange were
concerned, the restrictions in FEMA continued to be as rigorous as they
were in FERA. While its aim was to promote the orderly development and
maintenance of foreign exchange markets in India, the Government’s
control in matters of foreign exchange had not been diluted.

An
offence under FEMA is no longer a criminal offence as it was under FERA.
However, while no arrest can    be made under FEMA, the Supreme Court
in Union of India vs. Venkateshan S., 2002 AIR SCW 1978,
has held that a person who violates the provisions of the FEMA  to a
large extent can be detained under the Preventive Detention Act, namely,
the Conservation of Foreign Exchange and Prevention of Smuggling
Activities Act, 1974 (“COFEPOSA”). It held that the object
of FEMA was also promotion of orderly development and maintenance of
foreign exchange market in India. For violation of foreign exchange
regulations, a penalty can be levied and such activity is certainly an
illegal activity, which is prejudicial to conservation or augmentation
of foreign exchange. The COFEPOSA was enacted to prevent violation of
foreign exchange regulations or smuggling activities which were having
an increasingly deleterious effect on the national economy and thereby
serious effect on the security of the State. It observed that COFEPOSA
empowered the authority to exercise its power of detention with a view
to preventing any person inter alia from acting in any manner
prejudicial to the conservation or augmentation of foreign exchange. If
the activity of any person was prejudicial to the conservation or
augmentation of foreign exchange, the Authority under COFEPOSA was
empowered to make a preventive detention order against such person.
Preventive detention law was for effectively keeping out of circulation
the detenu during a prescribed period as held in Poonam Lata vs. M.L. Wadhawan and Others 1987 (3) SCC 347.

Subsequently, the Delhi High Court in Cruz City 1 Mauritius Holdings vs. Unitech Ltd [2017] 80 taxmann. com 188 (Delhi)
has explained the rationale of FEMA. It held that with the
liberalization of India’s economy, it was felt that FERA must be
repealed and a new legislation must be enacted. FEMA was enacted in view
of significant developments that had taken place ~ there was a
substantial increase in the foreign exchange reserves, growth in foreign
trade, rationalisation of tariffs, current account convertibility,
liberalisation of Indian investments abroad, increased access to
external commercial borrowings by Indian corporates and participation of
foreign institutional investors in India’s stock markets. The focus had
now shifted from prohibiting transactions to a more permissible
environment. The fundamental policy of FEMA no longer prohibited Indian
entities from expanding their business overseas and accepting  risks in
relation to transactions carried out outside India. The policy now was
to manage foreign exchange. Under FEMA, all foreign account transactions
were permissible subject to any reasonable restriction which the
Government may impose in consultation with the RBI.

Subsequently, a three-Judge Bench of the Supreme Court in VijayKaria vs. Prysmian Cavi E Sistemi SRL
[2020] 11 SCC 1, has approved the above Delhi High Court decision and
has again explained the legislative intent and the background behind the
replacement of FERA by FEMA. It held that FEMA, unlike FERA, referred
to the nation’s policy of managing foreign exchange instead of policing
foreign exchange, the policeman being the RBI under FERA. It was
important to remember that Section 47 of FERA no longer existed in FEMA
and hence, transactions that violated FEMA could not be held to be void
ab initio. Also, if a particular act violated any provision of FEMA or
the Rules framed thereunder, permission of the RBI could be obtained
post-facto if such violation could be condoned. The decision also
referred to the above-mentioned two member Bench decision in Dropti Devi (supra)
and held that the observations contained therein as to conservation
and/or augmentation of foreign exchange, so far as FEMA was concerned,
were made in the context of preventive detention of persons who violate
foreign exchange regulations. It concluded that to use those
observations in Dropti Devi to contend that any violation of any FEMA would make such violation an illegal activity did not follow.

The
FEMA consists of 49 sections. While section 2 contains definitions,
sections 3 to 9 are the substantive provisions of the FEMA which lay
down the permissions and prohibitions on a person for matters connected
with foreign exchange in India. All the remaining sections deal with
procedures, penalties, powers, etc.

U/s 46 of  the  FEMA,  the 
Central  Government  has  the power to make Rules to carry out the
provisions of the Act. Further, u/s 47, the RBI has powers to make
Regulations to carry out the provisions of the Act and the Rules.

The
Finance Act, 2015 made certain key amendments to FEMA. The Finance
Minister stated that Capital Account Controls was a policy, rather than a
regulatory matter. Therefore, the Finance Bill amended FEMA to clearly
provide that control on capital flows as equity will be exercised by the
Central Government, in consultation with the RBI. Controls on debt
capital flows continue to be exercised by the RBI. Further, even in the
equity flows, the matter of pricing, reporting and valuation continues
to be determined by the RBI. Moreover, the RBI administers the equity
flows as regulator under the aegis of the Rules enacted by the Central
Government.

RULES

As noted
above, the Central Government has power to frame rules under FEMA.
Accordingly, the Department  of Economic Affairs, Ministry of Finance,
exercises this power. The Government has framed various rules for
permitting Current Account Transactions, Adjudication Procedure under
FEMA, Compounding Procedure for violations under FEMA, etc.

In
2015, the power was shifted from the RBI to the Central Government to
frame laws pertaining to control of equity capital flows both into India
and from India. Pursuant to the same, the Central Government has
notified the Foreign Exchange Management (Non-Debt Instrument) Rules, 2019
which deal with foreign investment (e.g., Foreign Direct Investment,
Foreign Portfolio Investment, Foreign Investment in LLPs, AIF/REITs, NRI
Investment, etc.,) in India by a person resident outside India and
acquisition of immovable property in India by a person resident outside
India. Thus, now the power to make Regulations in respect of these two
important matters vests with the Central Government. However, the RBI
continues to administer these rules.

Recently, the Central Government has notified the Foreign Exchange Management (Overseas Investment) Rules, 2022
which deal with overseas investment (e.g., Overseas Direct Investment,
Overseas Portfolio Investment, Overseas Investment by an individual,
etc.,) by a person resident in India and acquisition of foreign
immovable property by a person resident in India. However, the RBI
continues to administer these rules.

REGULATIONS

The
RBI is the nodal regulatory authority for all matters connected with
foreign exchange transactions in India. It is the authority which has
powers to launch prosecution, levy penalties, allow compounding  of 
offences,  etc.,  as well as the agency which notifies regulations for
various vital foreign exchange transactions such as, borrowing and
lending in foreign exchange and rupees / realisation of foreign exchange
/ export and import provisions / foreign currency accounts / remittance
of assets / valuation / reporting requirements / cross border mergers,
etc.The RBI has been revising old regulations and hence, whenever it
issues a new regulation, it denotes the same with (R) as a suffix along
with the  year of publication. For example, the Foreign Exchange
Management (Remittance of Assets) Regulations, 2016 have superseded the
Foreign Exchange Management (Remittance of Assets) Regulations, 2000 and
the revised regulations are numbered FEMA13(R)/2016-RB dated 1-4-2016.
The regulations are notified by the Government in the Official Gazette.

DIRECTIONS / CIRCULARS

One
unique feature of the FEMA Regulations are the Authorised Person
Directions issued by the RBI u/s 10(4) and 11(1) of FEMA to various
Authorised Persons, popularly known as “A.P.(DIR Series) Circulars”.
Authorised Persons are Authorised Dealers, Money Changers, Banks, etc.,
who are authorised by the RBI  to deal in foreign exchange. These
directions lay down the modalities as to how the foreign exchange
business has to be conducted by the Authorised Persons with their
customers/constituents with a view to implementing the regulations
framed. Thus, these crculars are operational instructions from the RBI
to Banks, etc. The legal validity of these circulars has been upheld by
the Bombay High Court in the case of Prof. Krishnaraj Goswami vs. the RBI, 2007 (6) Bom CR 565.
The Court held the RBI issued the circulars by way of directions as
contemplated under Sections 10(4) and 11(1) of the Act. A bare reading
of these provisions clearly showed that  the  RBI  had the power to
issue directions to the authorised persons and this power was wide
enough to cover any kind of directions so far as it provided for the
regulation of FEMA. The RBI had jurisdiction to issue such circulars.
The Act clearly stipulated that an Authorised Person shall in all his
dealings be bound by these directions, general or special, issued by the
RBI.

MASTER DIRECTIONS
The
RBI has started the practice of issuing Master Directions on various
important subjects. For instance, all instructions issued by the RBI in
respect of External Commercial Borrowings and Trade Credits have been
compiled  in  the  Master  Direction  on  Master Direction – External Commercial Borrowings, Trade Credits and Structured Obligations.
The list of underlying Rules / Regulations /
Notifications/Instructions/  Circulars  on this subject are all compiled
and  consolidated  within this one direction. The Master Directions 
are  issued  u/s 10(4) and 11(1) of FEMA and have the same force  of law
as the AP DIR Circulars. As of date, the RBI has issued Master
Directions on different subjects such as, foreign investment in India,
LRS, import, export, deposits, remittance of assets, etc.

MASTER CIRCULARS
Earlier,
the RBI issued a Master Circular which consolidated all the existing AP
DIR Circulars at one place. Master Circulars were issued with a sunset
clause of one year. They were introduced in accordance with the
recommendations of the Tarapore Committee. This Committee recommended
that every year, the RBI should consolidate all the instructions and
regulations on each subject into a Master Circular for use by the
public. It also recommended that the Master Circulars should be prepared
in an unambiguous language without using jargons. The Master Circulars
did not have the same force of law which the Master Directions have.
However, now with the issuance of Master Directions on all subjects, the
Master Circulars have lost its significance. They could, however, yet
be referred to when there is some interpretation issue or if one wishes
to trace the history of changes to a provision.

FDI POLICY

When
it comes to foreign investment in India, one finds another important
legislation framed by another Ministry within the Government. The
Department for Promotion of Industry and Internal Trade (DPIIT),
Ministry of Commerce and Industry, frames the Foreign Direct Investment Policy
in India which lays down the sectors in which FDI is allowed, the
conditions attached and the sectoral caps.  It also lays down the
sectors in which FDI is Automatic and those in which it requires
approval of the Government of India. The FDI Policy is prepared in the
form of the Consolidated FDI Policy (“CFDIP”).

The
DPIIT, Commerce Ministry makes policy pronouncements on FDI through the
Consolidated FDI Policy Circular/Press Notes/Press Releases which are
notified by the Department of Economic Affairs, Ministry of Finance as
amendments to the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019
under FEMA. These notifications take effect from the date of issue of
press notes/ press releases, unless specified otherwise therein. The
policy also clearly states that in case of any conflict, the relevant
notification under the Foreign Exchange Management (Non-Debt
Instruments) Rules, 2019 will prevail. The policy also explains that the
regulatory framework, thus, consists of FEMA and rules/ regulations
there under, consolidated FDI policy circular, press notes, press
releases, clarifications, etc.

The DPIIT issues a Consolidated
FDI Policy which subsumes all press notes / press releases / circulars
issued by DIPP till date. The latest CFDIP was issued in October
2020.Any amendments to this policy are by way of press notes issued by
the DPIIT.

The power of the Central Government to lay down economic policy has been the subject-matter of great judicial interest. In Balco Employees Union vs. UOI, (2002) 2 SCC 333,
the Supreme Court laid down the prerogative of the Government to frame
economic policy. It held that Courts have consistently refrained from
interfering with economic decisions. In Federation of Railway Officers Association vs. UOI (2003) 4 SCC 289,
the Apex Court laid down that on matters affecting policy and requiring
technical expertise Courts would leave the matter for decision of those
who are qualified to address the issues. Unless the policy or action is
inconsistent with the Constitution and the laws or arbitrary or
irrational or abuse of the power, the Court will not interfere with such
matters.

The validity of the FDI Policy laid down by the Government has come in for review by the Courts. In the decision of Radio House vs. UOI, 2008 (2) Kar. LJ 695 (Kar),
the Court while dealing with the FDI Policy, held, that no directions
can be given to the Government to accept a particular definition. It is
for the Government to evolve    a policy to safeguard the interest of
the retailers. It is  trite position in law that the Court should not
substitute its wisdom for the wisdom of the Government in policy
matters.

A decision of the Delhi High Court in the case of Putzmeister India Pvt Ltd and others vs. UOI, W.P.(C) 5633-35/2006 Order dated 1st July, 2008 (Del)
is also relevant. This case examined the validity of the press notes
issued by the Commerce Ministry. It held that a large number of
decisions have ruled that the wisdom   of an executive policy does not
fall within the domain of judicial review; nor does Article 226 permit
High Courts to sit in appellate judgment over executive decisions, made
in legitimate bounds of exercise of power.

The Supreme Court had an occasion in Manohar Lal Sharma vs. UOI, (2013) 33 taxmann.com 33 (SC)
to examine the Government’s FDI Policy in respect of retail trading. It
held that if the Government of the day after due reflection,
consideration and deliberation felt that by allowing FDI in multi-brand
retail trading, the country’s economy would grow and it would facilitate
better access to the market for the producer of goods and enhance  the
employment potential, then it was not open for the Court to go into the
merits and demerits of such a policy. It further laid down that on
matters affecting policy, the Supreme Court did not interfere unless the
policy was unconstitutional or contrary to the statutory provisions or
arbitrary or irrational or in abuse of power.

Again, the Delhi High Court in Dr. Subramanian Swamy vs. UOI, [2014] 44 taxmann.com 281 (Delhi)
was faced with a Public Interest Litigation over whether the FDI Policy
permitted FDI in existing airlines only and not in proposed or new
airlines. It refused to grant any interim injunction against the policy
and held that a policy of   the Government of India was essentially an
executive function, and not a statute.

FAQs

The
RBI has been issuing FAQs on matters pertaining  to various foreign
exchange transactions, such as, LRS, compounding of contraventions, etc.
The FAQs attempt to put in place the common queries that users have on
the subject in an easy to understand language. The FAQs issued by the
RBI are at best, executive instructions which neither have the statutory
force nor can override the express provisions of the law. The issuance
of FAQs by the RBI is not in pursuance of any power conferred under FEMA
and do not have any statutory force.
PRESS RELEASES
When
the RBI issues some Regulations or Directions, it may also issue a
press release giving a brief idea about the same and annex the main
Notification / Circular. The press release is merely for information
purposes.

NODAL AUTHORITY

As
explained above, the RBI is the nodal authority for   all matters
pertaining to FEMA. The Foreign Exchange Department of the RBI deals
with all foreign exchange matters. The RBI also issues various forms /
returns to be filed by users / banks in respect of foreign exchange
transactions.

ENFORCEMENT OF FEMA

For
adjudicating any offence under FEMA, the Central Government has powers
to appoint Adjudication Officers. The Directorate of Enforcement or ED
has been appointed as the Adjudicating Authority under FEMA. It has also
been vested with powers of search and seizure of assets of an accused.
One of the important powers of the ED in this respect is found u/s 37A
of FEMA. This empowers the ED to seize assets of the accused in India of
a value equal to the offence under FEMA. It may be noted that even
though the agency i.e., ED is same under FEMA and the Prevention of
Money Laundering Act, 2002 (PMLA), an offence under FEMA is not a
Scheduled Offence under PMLA. Thus, an offence under FEMA does not
automatically become an offence under PMLA and vice- versa. These two
Statutes are separate and independent. However, if an offence under FEMA
also falls under any of the scheduled offences under PMLA, then the
accused could be tried under both statutes. For instance, a person
resident in India, with a view to evading taxes, sets up an undisclosed
offshore structure which violates FEMA, and is also in violation of the
Black Money Act, 2015. This constitutes a scheduled offence under PMLA
and hence, could be tried under both FEMA and PMLA and not to mention
also under the Black Money Act! Similarly, a smuggling offence would
violate both the FEMA as well as the PMLA. Hence, whether or not PMLA is
attracted in addition to FEMA needs to be tested based on the facts of
each offence.

APPELLATE MECHANISM

Orders of the Adjudicating Authority can be appealed against before the Special Director (Appeals) constituted under FEMA.

An
appeal against an Order of the Special Director (Appeals) lies before
the Appellate Tribunal constituted under FEMA. The Appellate Tribunal
constituted under the Smugglers and Foreign Exchange Manipulators (Forfeiture of Property) Act, 1976 (SAFEMA)
is empowered to act as the Appellate Tribunal under FEMA. Any person
aggrieved by an Order of the Appellate Tribunal can appeal to the High
Court on any question of law arising from such Order.

COMPOUNDING

As
a parallel route, section 15 of FEMA provides that any contravention
under the Act may, on an application made by the person committing such
contravention, be compounded within 180 days from the date of receipt of
application by the officers of the RBI. Certain compounding powers have
been delegated to the Regional Offices/ Sub- Offices of the RBI but
offences related to Liaison/ Branch/ Project office(LO/ BO/ PO)
division, Non Resident Foreign Account Division (NRFAD) and Immovable 
Property  (IP) Division are compounded out at New Delhi . For all other
contraventions, compounding is handled by the CEFA, Foreign Exchange
Department, RBI Mumbai. The Compounding Authority examines the
application based on the documents and submissions made in the
application and assesses whether contravention is quantifiable, the
amount of contravention and the compounding fee. The Authority
accordingly issues the Compounding Order. In Sterlite Industries (India) Ltd.vs. Special Director of Enforcement, [2022] 140 taxmann.com 615 (Bom),
the Court held that it was clear that no proceeding or further
proceeding could be continued once a Compounding Order is passed by the
RBI in a particular case. A very interesting judgment of the Bombay High
Court on the powers of the RBI to compound an offence as well as the
interplay between FEMA and PMLA is found in New Delhi Television Ltd vs. RBI(2018) 149 SCL 29 (Bom).

HIERARCHY

Thus,
the descending order of hierarchy amongst various pronouncements would
be as follows: FEMA, 1999 -> Rules -> Regulations -> AP Dir
Circulars / Master Directions -> FAQs. While dealing with matters
pertaining to Foreign Investment in India, the Foreign Direct Investment
Policy should also be considered.

Another universe would be the
judgments on FEMA of the Supreme Court and High Court,  the  decisions 
of the FEMA Appellate Tribunal and Compounding Orders issued by the
Compounding Authority, RBI.

ANCILLARY LAWS

Certain allied laws though not directly connected with FEMA could be treated as friends of FEMA! These are the
Prevention of Money Laundering Act, 2002, the Conservation of Foreign
Exchange and Prevention of Smuggling Activities Act, 1974, the Smugglers
and Foreign Exchange Manipulators (Forfeiture of Property) Act, 1976,
the Foreign Contribution (Regulation) Act, 2010, the Foreign Trade
(Development and Regulation) Act, 1992.
One or more of these allied
laws, may or may not be relevant   in a transaction under FEMA. It would
be worthwhile to examine their applicability also when dealing with a
foreign exchange transaction. While foreign investment by Foreign
Portfolio Investors is governed by FEMA, their registration and
operational guidelines are handled by SEBI. Similarly, investments /
operations in the GIFT City are regulated by the International Financial
Services Centres Authority, SEBI and to some extent by the RBI.

EPILOGUE

India’s
laws on foreign exchange management are myriad, complex and ambiguous
at times. Add to this the multiplicity of regulations and you have a
heady cocktail! All the best with practicing FEMA!!

PMLA – Magna Carta – Part 2

Part – I of the article on PMLA – Magna Carta was published in the September 2022 issue of the BCAJ. In this concluding part, the author has answered some interesting and important questions arising from the Supreme Court decision in the case of Vijay Madanlal Choudhary vs. Union of India [2022] 140 taxmann.com 610 (SC). For a detailed analysis of the case, please refer to the September 2022 issue of the BCAJ.

1.    Whether investigation under PMLA can automatically be extended under other Statutes like the Black Money Act or the Fugitive Economic Offenders Act by the authorities under PMLA?
“Investigation” is a crucial term which has a bearing on the interpretation of all substantive aspects of PMLA. It is defined in section 2(1)(na) of PMLA, as under:

(na) “investigation” includes all the proceedings under this Act conducted by the Director or by an authority authorised by the Central Government under this Act for the collection of evidence.

The term “investigation” has been dealt with by the Supreme Court in the above mentioned decision. The Supreme Court has held that:

•    the term “proceedings” [section 2(1)(na) of PMLA] is contextual and is required to be given expansive meaning to include the inquiry procedure followed by the Authorities of Enforcement Directorate (ED), the Adjudicating Authority, and the Special Court.

•    the term “investigation” does not limit itself to the matter of investigation concerning the offence under PMLA, and is interchangeable with the function of “inquiry” to be undertaken by the authorities under PMLA.

It is apparent from the above mentioned interpretation of the term “investigation” by the Supreme Court that the word “proceedings” which is a part of the term “investigation” is contextual and must be given wider meaning to include the inquiry conducted by the Director or by an authority authorised by the Central Government under PMLA for collection of evidence. The “authority” referred to in section 2(1)(na) are all the authorities mentioned under sections 48 and 49 of PMLA.

In exercise of the powers conferred by section 49(1), the Central Government has notified the appointment of the following officers:

•    Director, Financial Intelligence Unit, India under the Ministry of Finance, Department of Revenue, to exercise the exclusive powers conferred under section 49.

•    Director of Enforcement holding office immediately before 1st July, 2005 under FEMA.

The scope of the powers of Director, Financial Intelligence Unit, India and the Director of Enforcement have been specified respectively, in Notification No. GSR 440(E) dated 1st July, 2005 and Notification No. GSR 441(E) dated 1st July, 2005. A review of the powers listed in the said two notifications suggests that the investigation under PMLA may be extended to other statutes.

•    This view is fortified by the powers of section 45 of PMLA authorising the Director of Enforcement or other authorised officer to file a complaint to the Special Court.

•    Reference may also be made to section 66 of PMLA which authorises the Director of Enforcement and other authorities specified by him to disclose information to authorities under “other laws”.

2. Whether fees received by a Chartered Accountant or a lawyer from an offender under PMLA be regarded as proceeds of crime?
The expression “proceeds of crime” is defined in section 2(1)(u), as under:

(u) “proceeds of crime” means any property derived or obtained, directly or indirectly, by any person as a result of criminal activity relating to a scheduled offence or the value of any such property or where such property is taken or held outside the country, then the property equivalent in value held within the country or abroad.

Explanation — For the removal of doubts, it is hereby clarified that “proceeds of crime” include property not only derived or obtained from the scheduled offence but also any property which may directly or indirectly be derived or obtained as a result of any criminal activity relatable to the scheduled offence.

A review of the above mentioned definition would show that it is very widely worded. However, with the passage of time, even such a widely worded definition was found inadequate to cover a number of situations faced by the authorities. Accordingly, the Explanation was added w.e.f. 1st August, 2019 to expand the parameters of “proceeds of crime”. The purpose of adding the Explanation was to bifurcate the definition into the following two types of properties on a stand-alone basis:

•    Property derived or obtained from a scheduled offence.

•    Property which is directly or indirectly derived or obtained as a result of any criminal activity related to a scheduled offence.

The opening words of the Explanation suggest that the Explanation is intended to apply retrospectively.

Wordings of the Explanation leave open a possibility that the Enforcement Directorate may consider the fees received by the Chartered Accountant or lawyer from an offender under PMLA as “proceeds of crime”. In terms of section 24 of PMLA, the burden of proving that the fees received from the offender do not constitute “proceeds of crime” will be on the CA or the lawyer.

It may be noted that the constitutional validity of section 24, which mandates a reverse burden of proof, has been upheld by the Supreme Court in the recent decision.

[However, the matter has been sent by SC for review by a larger Bench].

3. Can a legitimate property acquired by a person be attached or appropriated by the authorities, if later it is found that the said property was acquired by the seller from the proceeds of crime? To what layers the officers can go to attach the property?

Section 8(5) of PMLA deals with confiscation of property on the conclusion of the trial of an offence under PMLA as a result of which the Special Court gives a finding that the offence of money-laundering has been committed. Consequently, the Special Court will pass an order that the following properties stand confiscated to the Central Government:

•    The property involved in money-laundering; or

•    The property which has been used for the commission of the offence of money-laundering.

Accordingly, the property legitimately acquired may be attached and confiscated under PMLA if the Special Court finds that such a property was acquired by the seller through the proceeds of crime. The categorical finding of the Special Court that the property is involved in money- laundering does not leave any doubt that the property described in the captioned issue is liable to confiscation. As regards the second part of the captioned issue, namely; up to what layers the officers can go, a reference may be made to the definition of “offence of money-laundering” in section 3 which is very comprehensive. This definition is clarified and strengthened by the Explanation added w.e.f. 1st August, 2019. Being clarificatory, the Explanation is retrospectively applicable.

Clause (ii) of the Explanation clarifies that the process or activity connected with the proceeds of crime is a continuing activity which continues till such time a person is directly or indirectly enjoying the proceeds of crime.

In the Supreme Court decision, all nuances of the definition of money-laundering were examined and it was categorically held that the said definition has a wider reach so as to capture every process and activity, direct or indirect, connected with the proceeds of crime and is not limited to the happening of the final act of integration of tainted property in the formal economy.

4. In the event it is found that the legitimate property acquired by an innocent person was out of the proceeds of crime what remedies does he have? How can a person or a consultant safeguard his interests from handling proceeds of crime?

Section 24 of PMLA which deals with the reverse burden of proof gives the right of defence to the person charged with the offence to prove to the contrary. In this connection, a similar situation was noticed by PMLA Appellate Tribunal.

In S. Ramesh Pothy vs. Deputy Director, Directorate of Enforcement (2019) 102 taxmann.com 314 (PMLA-AT), the appellant had purchased the property from one ‘D’ for business. Enforcement Directorate alleged that the appellant purchased the property out of proceeds of crime since the father of ‘D’ was facing criminal prosecution for offences committed under provisions of PMLA. On that ground, the provisional attachment of said property was confirmed by the Adjudicating Authority. The appellant produced bank statements and individual tax returns to prove the source of funds for the purchase of property.

It was held by PMLA Tribunal that the appellant was the bonafide purchaser of the property and was not involved in any crime relating to money-laundering. The gist of the Tribunal’s decision is:

•    There was no cogent and clear material on record even prima facie that the appellant had any knowledge of any FIR against the accused vendor. There was no mechanism to know if any FIR was registered against any vendors, or their family members and other relatives.

•    While purchasing the property from any vendor, due diligence does not lead to knowledge about the registration of FIR against the vendor or his family members and other relatives.

•    Under the Transfer of Property Act and the Registration Act, there is no method or process to find out about the existence of any FIR nor is there any provision to mandatorily disclose the existence of any FIR against the vendor or his family members.

•    The “No Encumbrance Certificate,” issued in the State of Tamil Nadu, did not have any clause whereby the FIR against the relatives or family members of vendors is reflected.

The above mentioned decision gives sufficient clues to discharge the reverse burden of proof and the relevant remedies to discharge such burden.

Indeed, the person charged, or his consultant can safeguard his interest by proper study of section 3 and section 24 in light of the minutest facts of the case. Indeed, while presenting a reply to the show-cause notice, the facts have to be properly articulated and succinctly presented in defence.

[Section 24 has been under review by a larger Bench of SC.]

5. What are the beneficial provisions of section 436A of CrPC that can be invoked by the accused arrested for an offence punishable under PMLA?

Section 436A of CrPC deals with the maximum period for which an undertrial prisoner can be detained. To understand the substance of section 436A, it is necessary to refer to its following background.

Prior to June 2006, there were instances where undertrial prisoners were detained in jail for periods beyond the maximum period of imprisonment provided for the alleged offence. Therefore, section 436-A was inserted in the Code to release an undertrial prisoner [other than the one accused of an offence for which death has been prescribed as one of the punishments], who has been under detention for a period extending to one-half of the maximum period of imprisonment specified for the alleged offence, on his personal bond, with or without sureties.

The intention was also to provide that in no case should an undertrial prisoner be detained beyond the maximum period of imprisonment for which he can be convicted for the alleged offence.

Accordingly, w.e.f. 23rd June 2006, section 436-A was inserted in CrPC. The benevolent provisions of section 436-A are clear and evident from its following language.

“436-A. Maximum period for which an undertrial prisoner can be detained –


Where a person has, during the period of investigation, inquiry or trial under this Code of an offence under any law (not being an offence for which the punishment of death has been specified as one of the punishments under that law) undergone detention for a period extending up to one-half of the maximum period of imprisonment specified for that offence under that law, he shall be released by the Court on his personal bond with or without sureties.

Provided that the Court may, after hearing the Public Prosecutor and for reasons to be recorded by it in writing, order the continued detention of such person for a period longer than one-half of the said period or release him on bail instead of the personal bond with or without sureties:

Provided further that no such person shall, in any case, be detained during the period of investigation, inquiry, or trial for more than the maximum period of imprisonment provided for the said offence under that law.

Explanation — In computing the period of detention under this section for granting bail, the period of detention passed due to delay in proceeding caused by the accused shall be excluded.”

Indeed, the language of section 436-A of CrPC is self-explanatory and does not require any interpretation. However, to ensure that the case of the accused falls within the parameters of section 436A of CrPC so as to qualify him for the benefit thereunder, it is advisable for the accused to take the help of a professional having expertise in CrPC.

6. After this SC decision, what defences are still available to the litigants? Are they totally defenceless?

Reference may be made to Question No. 4 which gives a broad guideline for defence that may be formulated after a study of the case laws relevant to sections 3, 5, 8,19 and 24.

It may be noted that the strategy for defence must be formulated in consultation with the Counsel who had dealt with the matter in the High Court or subordinate Court before it was carried to the Supreme Court in various civil and criminal writ petitions, appeals, SLPs, etc. The order of the Supreme Court passed on 27th July, 2022 clarifies that the interim relief granted by the Supreme Court in the petitions/appeals will continue for a period of 4 weeks from 27th July, 2022, with the liberty to the parties to mention for an early listing of the case including for continuation/vacation of the interim relief.

7. What is the final take of this Supreme Court decision?

The final take of the decision may be summarised by a broad review of the following approach of the Supreme Court.

•    The Supreme Court was seized of 241 civil and criminal writ petitions, appeals, special leave petitions, transferred petitions and transferred cases raising various questions of law.

The Government of India, too, had filed appeals and SLPs. There were also few transfer petitions filed before the Supreme Court under Article 139A(1) of the Constitution of India.

Questions in these petitions, appeals, etc. pertained to the constitutional validity and interpretation of certain provisions of PMLA and other statutes including the Customs Act, the Central Goods and Services Tax Act, the Companies Act, the Prevention of Corruption Act, the Indian Penal Code and the Code of Criminal Procedure (CrPC).

However, the Apex Court decided to confine to challenge to the validity of certain important provisions of PMLA and their interpretation.

•    In addition to challenges to Constitutional validity and interpretation of provisions of PMLA, there were also SLPs filed against various orders of High Courts and subordinate Courts all over the country with prayers for grant of bail or quashing or discharge.

All such SLPs were rejected by the Supreme Court.

•    Instead of dealing with facts and issues in each case on merits, the Supreme Court confined itself to examining the challenge to the relevant provisions of PMLA, being a question of law raised by parties.

• The question as to whether some of the amendments to the PMLA could not have been enacted by the Parliament by way of a Finance Act was not examined by the Supreme Court. The same was left open for being examined along with the decision of the Larger Bench (seven Judges) of the Supreme Court in Rojer Mathew vs. South Indian Bank Ltd (2020) 6 SCC 1.


Revised Code of Ethics

INTRODUCTION AND OVERALL STRUCTURE OF THE REVISED CODE OF ETHICS

ICAI recently issued the 12th edition of the Code of Ethics, in convergence with the changes to the International Ethics Standards Board for Accountants (IESBA) Code of Ethics. In this article, we shall discuss certain significant changes in the revised Code of Ethics and their relevance in the contemporary professional world.

For the first time, the Code of Ethics has been segregated into different volumes, i.e. I, II and III. These volumes became applicable with effect from 1st July, 2020.

Volume–I of the Code of Ethics (12th edition) is the revised Counterpart of Part-A of Code of Ethics, 2009. It is based on International Ethics Standards Board for Accountants (IESBA) Code of Ethics, 2018 edition.

Volume–II of the Code of Ethics is the revised counterpart of Part-B of the Code of Ethics, 2009. It is based on domestic provisions.

Volume–III of the Code of Ethics contains Case Laws segregated and updated from the Clauses under Part-B of Code of Ethics, 2009.

The Code of Ethics, 2009, and the revised Code of Ethics are a convergence (and not an adoption) of the provisions of the International Federation of Accountants (IFAC) IESBA Code of Ethics.

It is a well-known maxim that “Ignorance of Law is No Excuse”. The revised Code of Ethics (Volume–I) has been issued as a Guideline of the Council. Further, there is change from “should” to “shall”, and requirements are clearly demarcated. As a result, the non-compliance with provisions of the Code will be deemed as a violation of Clause (1) of Part-II of the Second Schedule of the CA Act, 1949-

A member of the Institute, whether in practice or not, shall be deemed to be guilty of professional misconduct, if he-

(1) contravenes any of the provisions of this Act or the regulations made thereunder or any guidelines issued by the Council.

Thus, the revised Code of Ethics, 2019, is mandatory to be followed.


VOLUME-I – STRUCTURE

Volume-I of the Code of Ethics is based on the IESBA Code of Ethics and is structured as follows:

Part 1- which applies to all Professional Accountants, is Complying with the Code, Fundamental Principles and Conceptual Framework.

Part 2- pertains to provisions applicable to Professional Accountants in Service.

Part 3- pertains to provisions applicable to Professional Accountants in Public Practice.

The Code further contains International Independence Standards (Parts 4A and 4B):

• Part 4A- Independence for Audits & Reviews (Sections 400 to 899)

• Part 4B- Independence for Other Assurance Engagements (Sections 900 to 999).

The Code also contains a Glossary of terms used in the Code of Ethics applicable to all Professional Accountants, whether in practice or service.


DEFERRED PROVISIONS OF VOLUME I

There are certain provisions of Volume-I of the Code of Ethics deferred till further notification:

(a) The provision relating to Non-Compliance of Laws and Regulations, popularly called NOCLAR is the new provision in Volume-I. It was not there in the Code of Ethics, 2009. It has been made applicable to members in practice and service both.

(b)  Fees- Relative Size- These deal with the restriction of fees from any single client.

(c) Taxation Services to Audit Clients- the earlier edition of the Code had no prohibition on Taxation Services to Audit Clients. However, the revised Code has certain restrictions on taxation services provided to audit clients.


CERTAIN SIGNIFICANT CHANGES IN THE REVISED CODE OF ETHICS

(a)  Independence Standards- While the 2009 edition of the Code has Section 290, i.e., “Independence – Assurance Engagements”, Volume–I of the Revised Code, based on the 2018 IESBA Code, has “Independence Standards” in the form of Parts- 4A and 4B as mentioned above.

All members are expected to comply with these Independence Standards while conducting various professional assignments.

The segregation of the existing Section 290 into Parts- 4A and 4B represents the bulkiest change. Most provisions/compliances are common to both Parts 4A and 4B but are given separately in the Code under both parts.

(b)  Breaches of the Code- This is regarding the Accountant’s duty in case of breach of Independence Standards, where nobody, except the member knows that there has been breach on his part. There was no such corresponding provision in the earlier Code of Ethics.

This may be said to be a mechanism of self-correction prescribed in the Code in case the Chartered Accountant on his own discovers an unintentional violation.

Examples

A Chartered Accountant who identifies a breach of any other provision of the Code shall evaluate the significance of the breach and its impact on the chartered accountant’s ability to comply with the fundamental principles. The chartered accountant shall also: (a) take whatever actions might be available, as soon as possible, to address the consequences of the breach satisfactorily; and (b) determine whether to report the breach to the relevant parties.

(c) Firm Rotation Requirements- The 2009 edition of the Code of Ethics contained requirements relating to partner rotation. It does not contain Firm rotation requirements.

However, in line with the Companies Act, 2013, the Code being the immediately subsequent edition after coming into force of Companies Act, 2013, Section 550 on Firm rotation has been incorporated in Volume-I over and above the provisions of partner rotation appearing in the IESBA Code.

Accordingly, it is clarified in the Code that partner rotation will co-exist along with Audit Firm rotation (wherever prescribed by a statute).

The 2019 Code (i.e., Volume-I) incorporates Firm rotation requirements to make the guidance comprehensive for members.

(d) Introduction of Key Audit Partner and changes in Rules of Partner Rotation- Key Audit Partner was not defined in the earlier Code of Ethics. In Volume-I of the revised Code of Ethics, Key Audit Partner has been defined as “The Engagement partner, the individual responsible for the engagement quality control review, and other audit partners, if any, on the engagement team who make key decisions or judgments on significant matters with respect to the audit of the financial statements on which the firm will express an opinion. Depending upon the circumstances and the role of the individuals on the audit, “other audit partners” might include, for example, audit partners responsible for significant subsidiaries or divisions.”

The time or period of partners in the Firm remains the same, i.e., 7 years.

However, there is a change with regard to the difference in cooling-off periods. As against the cooling-off period of 2 years, now there will be a cooling-off period of:

  • 5 years for Engagement Partners;

  • 3 years for Engagement Quality Control Review; and

  • 2 years for all other Key Audit Partners of the Firm.

This change is important, as it makes stricter rules on partner rotation.

Further, there are certain restrictions on Activities During Cooling-off w.r.t partner rotation as contained in Section 540 of Volume-I of the Code of Ethics.

The Chartered Accountant will have to maintain the relevant documentation regarding the Key Audit Partner, Cooling-off provisions etc.

(e) Changes in Professional Appointments- The Council of ICAI approved the KYC Norms, which are mandatory in nature and shall apply in all assignments pertaining to attest functions. These became mandatory with effect from 1st January, 2017.

In the revised Code, in paragraph R320.8, the incoming auditor shall request the retiring auditor to provide known information regarding any facts or other information of which, in the retiring auditor’s opinion, the incoming auditor needs to be aware before deciding whether to accept the engagement. There was no such corresponding duty in the earlier Code.

(f) Periodical Review with respect to Recurring Client Engagements-
As per Volume-I of the Code of Ethics, for a recurring client engagement, a professional accountant shall periodically review whether to continue with the engagement.

In view of the same, potential threats to compliance with the fundamental principles might be created after acceptance which, had they been known earlier, would have caused the professional accountant to decline the engagement.

(g) Introduction of the term “Public Interest Entity”-
The Revised Code 2019 edition contains a new term, “Public Interest Entity” (PIE). It had not been used in the Code of Ethics, 2009.

PIE is defined as-

(i) A listed entity; or

(ii) An entity-

  • Defined by regulation or legislation as a public interest entity; or

  • For which the audit is required by regulation or legislation to be conducted in compliance with the same independence requirements that apply to the audit of listed entities. Such regulation might be promulgated by any relevant regulator, including an audit regulator.

For the purpose of this definition, it may be noted that Banks and Insurance Companies are to be considered Public Interest Entities.

Other entities might also be considered by the Firms to be public interest entities, as set out in paragraph 400.8.

There are enhanced independence requirements for PIE clients in the new Code.

(h) Management Responsibilities- The provisions on Management Responsibilities occur for the first time in the ICAI Code of Ethics and appear in Sections 607 – 608.

The feature did not find mention in the Code of Ethics, 2009. In Volume-I, there is a new section dealing with ‘Management Responsibilities’. As per the same, the Firm shall not assume management responsibility for an audit client.

Determining whether an activity is a management responsibility depends on the circumstances and requires the exercise of professional judgment. Examples of activities that would be considered management responsibility include:

  • Setting policies and strategic direction.

  • Hiring or dismissing employees.

  • Directing and taking responsibility for the actions of employees in relation to the employees’ work for the entity.

However, providing advice and recommendations to assist the management of an audit client in discharging its responsibilities is not assuming a management responsibility.

  • Providing administrative services to an audit client does not usually create a threat. Examples of administrative services include:

  • Word processing services.

  • Preparing administrative or statutory forms for client approval.

  • Submitting such forms as instructed by the client.

  • Monitoring statutory filing dates and advising an audit client of those dates.

Members may note another term known as “Management Services” as appearing in Section 144 of Companies Act, 2013. These are not defined in the Companies Act or the Rules framed thereunder. Since these will be defined by Government, there is no finality of views on the Management Services being or not being at par with Management Responsibilities as appearing in Volume-I of the Code.

(i) Documentation Requirements- The 2009 Code required Firms to document their conclusions regarding compliance with independence requirements.

In the 2019 Code, the requirements of documentation have been given in greater detail. NOCLAR requires all steps in responding with NOCLAR to be documented.

The Chartered Accountant is encouraged to document:

  • The facts.

  • The accounting principles or other relevant professional standards involved.

  • The communications and parties with whom matters were discussed.

  • The courses of action considered.

  • How the accountant attempted to address the matter(s).

  • Requirements for NOCLAR have to be sufficient to enable an understanding of significant matters arising during the audit, the conclusions reached, and significant professional judgments made in reaching those conclusions. Thus, documentation is of critical importance in manifesting compliance with NOCLAR.

CONCLUSION
The Code of Ethics has been developed to ensure ethical behaviour for members while retaining the long-cherished ideals of ‘excellence, independence, integrity’, protecting the dignity and interests of members and leading our profession to newer heights.

Major Changes in Overseas Investment Regulations under FEMA

INTRODUCTION
A revamp of the Overseas Direct Investment regulations of the Foreign Exchange Management Act, 1999 (FEMA) was under process for quite some time. Draft Overseas Investment Rules and Overseas Investment Regulations were also in the public domain for consultation. The Finance Ministry, in consultation with RBI, has now finalised the Rules and Regulations, overhauling the outward investment provisions substantially. The new rules supersede the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004, and the Foreign Exchange Management (Acquisition and Transfer of Immovable Property Outside India) Regulations, 2015.

This article highlights the significant changes in Overseas Direct Investment provisions in a simplified manner. While there are open issues due to the language adopted in the rules and regulations, such analysis of issues is beyond the scope of this article.

1. WHAT ARE THE MAJOR CHANGES BROUGHT ABOUT BY THE NEW PROVISIONS?

The new provisions have liberalised a few important areas concerning overseas investments and, more importantly, clarified quite a few aspects regarding the older provisions. Some of the significant changes brought about by the new rules and regulations are summarised below:

(i) The new provisions provide enhanced clarity to various terms, including:

  • Bonafide business activity
  • Foreign entity
  • Overseas Direct Investment (ODI)
  • Overseas Portfolio Investment (OPI)
  • Strategic Sector
  • Subsidiary or Step-down subsidiary (SDS),
  • Financial services activity
  • Revised pricing guidelines

(ii) The provisions also dispense with approval for:

  • Deferred payment of consideration.
  • Investment/disinvestment by a person resident in India under investigation by any investigative agency/regulatory body if conditions are met.
  • Issuance of corporate guarantees to or on behalf of Second or subsequent level Step Down Subsidiary (SDS).
  • Write-off on account of disinvestment.
  • Round-tripped investment if conditions are met, etc.

The provisions have also brought in revised set of compliances and ‘Late Submission Fee’ (LSF) for reporting delays.

2. HOW WOULD THE REVISED OVERSEAS INVESTMENT RULES OPERATE?

In line with amendment to Section 6 of FEMA in 2015, the changes are brought about both by the Government and RBI in the following manner on 22nd August, 2022:

Title

Content

Notified by

FEM (Overseas Investment) Rules,
2022

Dealing with Non-Debt
Instruments

Central Government [Notification
No. G.S.R. 646(E).
]

FEM (Overseas Investment) Regulations,
2022

Dealing with Debt
Instruments

RBI [Notification No.
FEMA 400/2022-RB.
]

FEM (Overseas Investment) Directions,
2022

Directions to be
followed by Authorised Dealer-Banks

RBI [Annexed to AP DIR
Circular No. 12.
]

Consequential amendments have also been made to the Master Direction on Reporting under FEMA and the Master Direction on Liberalised Remittance Scheme (LRS).

3. WHAT IS COVERED BY OVERSEAS INVESTMENT?

Overseas Investment (“OI”) means Financial Commitment (“FC”) and Overseas Portfolio Investment (“OPI”) by a person resident in India.

FC, in turn, means the aggregate amount of investment made by a person resident in India by way of:

– Overseas Direct Investment (“ODI”),

– Debt (other than OPI) in a foreign entity or entities in which ODI is made, and

 – Non-fund-based facilities to or on behalf of such foreign entity or entities.

The total FC made by an Indian entity in all the foreign entities taken together at the time of undertaking such commitment cannot exceed 400% of its net worth as on the date of the last audited balance sheet or as directed by RBI.

It should be noted that the erstwhile regulations allowed unexhausted limit of holding as well as subsidiary for reckoning the limit of 400% of the net worth of the ‘Indian Party’. Now, only the net worth of the investor entity (Indian Entity) is to be
considered.

Corporate guarantees by specified group companies are allowed. However, they will be counted towards the utilisation of such group companies’ financial commitment.

4. WHAT DOES ODI COVER?

Rule 2(1)(q) of the OI Rules defines ‘Overseas Direct Investment’. Accordingly, ODI means investment by way of:

a.    Acquisition of unlisted equity capital of a foreign entity, or

b.    Subscription as a part of the Memorandum of Association of a foreign entity, or

c.    Investment in 10% or more of the paid-up equity capital of a listed foreign entity, or

d.    Investment with control, where investment is less than 10% of the paid-up equity capital of a listed foreign entity.

Control and Equity Capital are important terms, explained later in this article.

Further, once an investment is classified as ODI, the investment shall continue to be treated as ODI even if the investment falls below 10% of the paid-up equity capital of the foreign entity or if the investor loses control of the foreign entity.

5. WHAT ARE THE CHANGES IN ODI RULES AS COMPARED TO EARLIER?

The erstwhile regulations referred to ODI as Direct investment outside India by an Indian Party in a Joint Venture (JV) and Wholly Owned Subsidiary (WOS). All these terms have undergone a change.

JV/WOS is substituted under the new regime with the concept of ‘foreign entity’, which means an entity formed or registered or incorporated outside India with limited liability. By implication, investment cannot be made in any foreign entity with unlimited liability. It includes an entity in an International Financial Services Centre (IFSC) in India.

The concept of Indian Party (IP), where all the investors from India in a foreign entity were together considered as IP, has been substituted under the new regime with the concept of ‘Indian entity’, which shall mean a Company or a Limited Liability Partnership or a Partnership Firm or a Body Corporate incorporated under any law for the time being in force. Each investor entity shall be separately considered an Indian entity.

Further, there was lack of clarity between ODI and portfolio investment under the erstwhile regulations. ODI and OPI have now been demarcated into distinct baskets of investments which is explained below.

6. WHAT IS THE CRITERIA TO DETERMINE AN ODI INVESTMENT VIS-À-VIS LISTED AND UNLISTED ENTITIES?

One of the major clarifications emerging in the new rules is that any investment (even one share) in an unlisted entity would be considered as ODI. This was not clear in the erstwhile regime, and each AD Bank was applying different criteria for the same.

Further, an investment in a listed entity of over 10% will now be considered as ODI even if there is no control, while an investment of any limit in a listed entity which provides control would be considered as ODI.

The following flow-chart depicts the difference between ODI and OPI in the case of investment in equity capital:

Control has become a key factor in determining whether an investment is ODI. ‘Control’ has been defined to mean:

– the right to appoint a majority of the directors, or

– to control management or policy decisions exercisable by a person or persons, acting individually or in concert, directly or indirectly,

– including by virtue of their shareholding or management rights or shareholders’ agreements or voting agreements that entitle them to 10% or more of voting rights or in any other manner in the entity.

The above wording makes it clear that ‘Control’ should be looked at in substance and not on a technical basis.

As per the new rules, ODI covers investment in ‘Equity Capital’ which is defined to mean equity shares or perpetual capital; or instruments that are irredeemable; or contribution to non-debt capital of a foreign entity in the nature of fully and compulsorily convertible instruments. What is meant by perpetual capital is not clarified – but it seems to suggest that equity capital would be capital which is for the long term and not a specific period as it would be in the case of redeemable instruments.

7. WHAT ARE THE IMPORTANT CHANGES AS FAR AS STRUCTURING OF OVERSEAS INVESTMENTS GO?

One of the important changes brought about relates to subsidiary or step-down subsidiary (SDS) of the foreign entity. Subsidiary means a first-level subsidiary of a foreign entity. SDS means second and further level subsidiaries beneath the first level subsidiary. Subsidiary or SDS of a foreign entity is defined as an entity in which the foreign entity has ‘Control’. It should be noted that ‘Control’ is the only criterion for determining whether an entity is a subsidiary/ SDS of the foreign entity. Hence, where the foreign entity does not have ‘Control’, it will not be treated as SDS. The rules provide that in such a case, even no reporting is required.

However, it has been provided that the subsidiary and SDS shall comply with the structural requirements of the foreign entity, i.e., it should have limited liability. At the same time, it has been provided that only ‘subsidiaries and SDS’ are required to comply with the structural requirements of the foreign entity. Hence, it can be inferred that the foreign entity may invest in an entity with unlimited liability if the entity does not fall within the definition of subsidiary/ SDS, i.e., the foreign entity does not have control over such underlying entity.

Another important change is the introduction of ‘strategic sector’. The above requirement of limited liability for a subsidiary / SDS has been exempted for a foreign entity hiving its core activity in a ‘strategic sector’ which shall include energy and natural resources sectors such as Oil, Gas, Coal, Mineral Ores, submarine cable system and start-ups and any other sector or sub-sector as deemed fit by the Central Government. ODI in these sectors can also be made in unincorporated entities as well as part of consortiums (in the case of the submarine cable systems sector).

As can be noticed above, strategic sectors include startup sector. However, any ODI in startups shall not be made out of funds borrowed from others in accordance with Rule 19(2) of OI Rules.

8. WHAT DOES OPI MEAN?

OPI means investment in foreign securities other than ODI. It does not include investment in any unlisted debt instruments, or any security issued by a person resident in India (except for those in an IFSC).

More importantly, FC does not include OPI investment; hence the overall limit of 400% of net worth does not apply to OPI investments.

Thus, any investment less than 10% in a listed entity without control would be outside the ambit of FC and its limits. However, there are caps on OPI investments which are given below:

An Indian entity can invest only 50% of its net worth as on the date of its last audited balance sheet under the OPI route. A resident individual can invest up to the limit as per LRS, i.e., $ 250,000 per financial year.

OPI by a resident in India in the equity capital of a listed entity, even after its delisting, shall continue to be treated as OPI until any further investment is made in the entity.

Minimum qualifications shares, or shares or interest acquired by resident individuals by way of sweat equity shares or under Employee Stock Ownership Plan or Employee Benefits Scheme up to 10% of the equity capital of a foreign entity, whether listed or unlisted and without control shall be considered as OPI.

Any investment made overseas under Schedule IV of the OI Rules in securities as stipulated by SEBI, Mutual Funds (MFs), Venture Capital Funds (VCFs) and Alternative Investment Funds (AIFs) registered with SEBI shall also be considered as OPI.

9. WHAT CHANGES HAVE COME IN FOR INVESTMENTS THAT CAN BE MADE IN FOREIGN ENTITIES UNDERTAKING FINANCIAL SERVICES ACTIVITIES?

For an Indian entity engaged in financial services activity in India, there are no significant changes. Such an entity can make ODI in a foreign entity which is directly or indirectly engaged in financial services activity subject to the erstwhile conditions of a) a 3-year profit track record; b) being registered or regulated by a financial services regulator in India and c) having obtained the required approval for the activity from the regulators both in India and the host country. However, as per the new rules, in the case of an ODI made in an IFSC, such approval would have to be provided within 45 days from the date of application; else, it would be considered that such approval has been granted. Banks and NBFIs regulated by RBI are not included in these regulations and would need to follow the conditions laid down by RBI in this regard.

Further, until now, only Indian entities in the financial services sector were allowed to invest in foreign entities engaged in financial services. As per new ODI Rules, Indian entities which are not involved in financial services activities are also permitted to invest in foreign entities engaged in financial services (except banking and insurance) subject to only one condition – that such entities have earned net profits during the last three financial years.

This single condition also has been removed for Indian entities that invest in an entity in an IFSC engaged in financial services activity.

Even Resident Individuals (RI) are allowed to make ODI in a foreign entity in an IFSC, including in an entity engaged in financial services activity (except for banking and insurance). However, in such a case, where the RI controls the foreign entity, such entity cannot have a subsidiary or SDS outside the IFSC.

Further, what activities would constitute ‘Financial services activity’ was not clear in the erstwhile regulations as the term was not defined. However, the new rules provide that a foreign entity shall be considered to be engaged in the business of financial services activity if it undertakes an activity which, if it were carried out by an entity in India, would require registration with or is regulated by a financial sector regulator in India.

10. CAN A GIFT OF OVERSEAS SHARES BE RECEIVED OR MADE BY A RESIDENT INDIVIDUAL?

Foreign securities can be acquired by a Resident Individual (RI) as a gift from another person resident in India who is a relative as per clause (77) of section 2 of the Companies Act. Gift of shares can also be received from a person resident outside India, but only in accordance with provisions of the Foreign Contribution (Regulation) Act, 2010 (FCRA) and the rules and regulations made thereunder.

At the same time, RIs are not allowed to gift an overseas investment to a person resident outside India.

11. WHAT ARE THE CHANGES FOR OVERSEAS INVESTMENT BY A RESIDENT INDIVIDUAL?

Apart from changes in acquiring shares by way of gift and in a foreign entity in an IFSC as explained above, the following are the other main changes for overseas investment by a RI:

a. Step-down subsidiary (SDS) in case of ODI

Under FEMA 120, individuals investing under the ODI Route were not allowed to invest in a structure which would have a subsidiary or an SDS. Under the new regulations, a subsidiary or SDS of a foreign entity is allowed where RI does not have control of the foreign entity.

Moreover, in case of acquisition by way of inheritance or sweat equity shares or qualification shares or shares or interest under ESOP or Employee Benefits Scheme, ODI can be in a foreign entity engaged in financial services activity or can also have a subsidiary or SDS even if RI has control in such foreign entity.

b. Certain investments deemed to be OPI

Acquisition of sweat equity shares or qualification shares or shares or interest under ESOP or Employee Benefits Scheme, amounting to less than 10% of equity capital of a foreign entity without control, will be classified as OPI even if such entity is unlisted.

Similarly, a contribution by an RI to an investment fund or vehicle set up in an IFSC would be considered an OPI.

c. Inheritance of foreign securities under the ODI route is also now expressly provided.

12. IS ROUND TRIPPING ALLOWED UNDER THE NEW RULES?
Round tripping was not allowed earlier without prior approval of the RBI. It was not considered a bona fide business activity by RBI, which was the prerequisite for an ODI investment. While this condition continues, bona fide business activity has now been exhaustively defined under the new rules. It simply means an activity permissible under any law in force in India and in the host jurisdiction.

Rule 19(3) now prohibits investment back into India in cases where the resultant structure has more than two layers of subsidiaries.

The combined reading of the definition of bona fide business activity and limitation in restriction under Rule 19(3) above suggests that round tripping is now allowed. However, it has not been expressly provided for in the Rules.

13. ARE THERE ANY CHANGES IN THE ACQUISITION OF IMMOVABLE PROPERTY OUTSIDE INDIA?

While the rules for the acquisition of Immovable Property (IP) outside India have remained largely the same, the following changes need to be noted as per Rule 21 of the OI Rules read along with amendments in the LRS Master Direction:

a.    IP can be purchased under the LRS Scheme as earlier. Further, funds can also be consolidated in respect of relatives as earlier. However, the requirement for such relatives to be co-owners has been removed now.

b.    A person resident in India can acquire IP now out of income or sale proceeds of assets (other than ODI) acquired overseas as per the provisions of the FEMA.

c.    Earlier only a company having an office outside India could acquire IP outside India for the business and residential purposes of its staff. This has now been allowed for an Indian Entity which has a wider meaning now, as explained earlier.

d.    In the erstwhile regulations for buying IP outside India, it was permitted to acquire property jointly with a relative who is a PROI, given that there should be no remittance from India. This condition (of no remittance) seems to have now been removed.

14. WHAT ABOUT INVESTMENTS MADE UNDER THE ERSTWHILE REGULATIONS?

Rule 6 prescribes that any investment or financial commitment outside India made in accordance with the Act or the Rules or Regulations made thereunder and held as on the date of publication of these new rules shall be deemed to have been made under the new Rules and Regulations.

Conversely, it has been provided that if any investment was in violation of the earlier regulations it will remain a violation and may attract consequences as if the old rules are still applicable.

15. WHAT ARE THE CHANGES MADE FOR INVESTMENT IN IFSC?

There are several relaxations made under the new OI Rules in respect of investment in an IFSC. Fundamentally a foreign entity is defined to include an entity set up in an IFSC. Thus, investment into an entity in an IFSC would be considered ODI. At the same time, overseas investment by a financial institution in an IFSC is outside the ambit of the OI Rules.

Specific relaxations have also been made for investment by an Indian entity and RI in an entity engaged in financial services activity in an IFSC, as explained in reply to query 9 above. Such an investment is now allowed by an Indian entity not engaged in financial services activity within India without any attendant conditions.

16. ARE THERE ANY CHANGES IN THE PRICING GUIDELINES?

Earlier the pricing guidelines stated that investment in a JV/WOS outside India could happen at the value arrived at as prescribed by FEMA 120 or even at a value lower than that. Also, the transfer of investment in a JV/WOS could happen at the fair valuation as per FEMA 120 or even at a value higher than that. However, the new OI Rules prescribe that the pricing for investment as well as transfer shall be subject to a price arrived at on an arm’s length basis, taking into consideration the valuation as per any internationally accepted pricing methodology. Further, AD Banks are required to put in a board-approved policy with respect to the documents that need to be taken by them with respect to the pricing and also provide for scenarios where such valuation may not be insisted upon.

17. WHAT ARE THE MODES AVAILABLE FOR FINANCIAL COMMITMENT BY AN INDIAN ENTITY OTHER THAN BY WAY OF EQUITY CAPITAL?

Separate Regulations have been issued by RBI (OI Regulations) for investment in Debt Instruments issued by a foreign entity or to extend non-fund-based commitment to or on behalf of a foreign entity, including the overseas step-down subsidiaries of such Indian entity, subject to the following conditions:

i) The Indian entity is eligible to make ODI,

ii) Such an entity has made ODI in the foreign entity,

iii) The Indian entity has acquired control in such a foreign entity at the time of making such FC.

FC by an Indian entity by way of debt, guarantee, pledge or charge and by way of enabling deferred payment are covered in Regulations 4, 5, 6 and 7 of the OI Regulations. Further, FC under all these regulations would be considered part of the overall limit for FC as stipulated by the OI Rules.

18. IS DEFERRED PAYMENT ALLOWED NOW? WILL IT ALSO COVER CONDITIONAL PAYMENT?

Regulation 7 of OI Regulations now allows acquisition or transfer through deferred payment. This was earlier under the approval route. The deferred consideration shall be treated as part of non-fund-based commitment till the final payment is made. It is provided that payment of consideration may be deferred provided:

i)    Deferment is for a definite period,

ii)    Deferment should be provided for in the agreement,

iii)    Equivalent amount of foreign securities shall be transferred or issued upfront, and

iv)    Full consideration shall be paid finally as per applicable pricing guidelines.

Under conditional payment, the amount of payment may vary, or payment may not be made at all. Whereas the above-mentioned conditions for deferred payment require upfront transfer/issue and valuation and also eventual payment of full consideration as per pricing guidelines. Hence, conditional payment may not be allowed as part of deferred payment.

19. OTHER CHANGES

Apart from the above changes, the new OI Rules have also brought in changes with respect to the following:

a. Requirement of a NOC as per Rule 10 of the OI Rules by an Indian entity under investigation or having an account termed as NPA or classified as a willful defaulter.

b. Restructuring of the Balance Sheet of the foreign entity has been allowed subject to conditions as provided in Rule 18 of the OI Rules.

c. Reporting for OI has been changed, and new forms have been issued – ODI has to be reported in Form FC, while OPI has to be reported in Form OPI by a person resident in India other than individuals.

One must keep in mind the above changes before entering into a Financial Commitment in respect of a foreign entity. As mentioned earlier, there are certain issues with regard to the new regulations and an analysis of all such issues is beyond the scope of this article.

PMLA – Magna Carta – Part 1

BACKGROUND
On 27th July, 2022, the Supreme Court of India gave a landmark ruling in the case of Vijay Madanlal Choudhary vs. Union of India [2022] 140 taxmann.com 610 (SC) on various aspects and concepts involving dicey provisions of The Prevention of Money Laundering Act, 2002 (“PMLA”). This decision put to rest raging controversies on various issues agitated in a huge batch of petitions, appeals and cases.

DICEY ISSUES
The issues agitated before and examined by the Supreme Court covered as many as twenty significant aspects of PMLA. Some of these had arisen from decisions of various High Courts rendered a long time ago and were pending the final decision of the Apex Court. Few crucial aspects related to parameters of the concept of money-laundering, punishment for money-laundering, confirmation of provisional attachment, search and seizure, arrest, the burden of proof, bail, powers of authorities regarding summons, production of evidence and Special Courts.

These aspects were agitated before the Supreme Court in as many as over 240 civil and criminal writ petitions, appeals and special leave petitions (SLPs) including transferred petitions and cases.

APPROACH OF THE SUPREME COURT

The Supreme Court was seized of various civil and criminal writ petitions, appeals, SLPs, transferred petitions and transferred cases raising various questions of law. Such questions pertained to constitutional validity and interpretation of certain provisions of the other statutes, including the Customs Act, the Central Goods and Services Tax Act, the Companies Act, the Prevention of Corruption Act, the Indian Penal Code and the Code of Criminal Procedure (CrPC). However, the Apex Court decided to focus primarily on the challenge to the validity of certain important provisions of PMLA and their interpretation.

In addition to ‘challenge to constitutional validity’ and ‘interpretation of provisions of PMLA’, there were SLPs filed against various orders of High Courts and subordinate Courts all over the country. In all such SLPs, prayer for grant of bail or quashing or discharge was rejected by the Supreme Court. The government of India, too, had filed appeals and SLPs. There were also a few transfer petitions filed before the Supreme Court under Article 139A(1) of the Constitution of India.

Instead of dealing with facts and issues in each case, the Supreme Court confined itself to examining the challenge to the relevant provisions of PMLA, being a question of law raised by parties.

The question as to whether some of the amendments to the PMLA could not have been enacted by the Parliament by way of a Finance Act was not examined by the Supreme Court. The same was left open for being examined along with the decision of the Larger Bench (seven Judges) of the Supreme Court in Rojer Mathew (2020) 6 SCC 1.

Consistent with the approach of the Supreme Court, the author, too, has decided merely to give here the gist of the conclusions reached by the Supreme Court on crucial aspects, as follows.

DEFINITIONS
Certain substantive aspects of the following important definitions in PMLA were examined by the Supreme Court.

  • “investigation”
  • “proceeds of crime”

As regards the definition of “investigation”, it was concluded that the term “proceedings” [section 2(1)(na) of PMLA] is contextual and is required to be given expansive meaning to include the inquiry procedure followed by the Authorities of Enforcement Directorate (ED), the Adjudicating Authority, and the Special Court.

Likewise, it has been held that the term “investigation” does not limit itself to the matter of investigation concerning the offence under PMLA and is interchangeable with the function of “inquiry” to be undertaken by the Authorities under PMLA.

As regards the definition of “proceeds of crime”, it was held that the Explanation inserted w.e.f. 1st August, 2019 does not travel beyond the main provision predicating tracking and reaching up to the property derived or obtained directly or indirectly as a result of criminal activity relating to a scheduled offence.

OFFENCE OF MONEY-LAUNDERING

The concept of “money-laundering” is pivotal to all other provisions of PMLA. This concept was rationalised by inserting an Explanation w.e.f. 1st August, 2019. The Supreme Court examined all nuances of “money-laundering” and held that “money-laundering” has a wider reach so as to capture every process and activity, direct or indirect, in dealing with the proceeds of crime and is not limited to the happening of the final act of integration of tainted property in the formal economy. The Supreme Court opined that the Explanation does not expand the purport of Section 3 (Offence of money-laundering) but is only clarificatory in nature.

The Supreme Court clarified that the word “and” preceding the expression “projecting or claiming” occurring in Section 3 must be construed as “or”, to give full play to the said provision so as to include “every” process or activity indulged into by anyone. According to the Supreme Court, “projecting or claiming the property as untainted property” would constitute an offence of money-laundering on a stand-alone basis, being an independent process or activity. Being a clarificatory amendment, it would make no difference even if the Explanation was introduced by Finance Act or otherwise.

The Supreme Court very aptly rejected the interpretation suggested by the petitioners, that only upon projecting or claiming the property in question as untainted property that the offence of money-laundering would be complete. According to the Supreme Court, after insertion of the Explanation to section 3, this suggestion was not tenable. Indeed, it was explained that the offence of money-laundering is dependent on the illegal gain of property as a result of criminal activity relating to a scheduled offence. This proposition was elaborated by the Supreme Court with the observation that the Authorities under PMLA cannot prosecute any person on a notional basis or on the assumption that a scheduled offence has been committed unless it is so registered with the jurisdictional police and/or pending enquiry/trial including by way of criminal complaint before the competent forum. In view of the Supreme Court, if the person is finally discharged/acquitted of the scheduled offence or where the criminal case against him is quashed by the Court of competent jurisdiction, there can be no offence of money-laundering against him or anyone claiming such property being the property linked to the stated scheduled offence through him.

CONFIRMATION OF PROVISIONAL ATTACHMENT
In various appeals and petitions, the constitutional validity of section 5 of PMLA authorising provisional attachment was challenged. After examining the relevant legal position, it was held by the Supreme Court that section 5 is constitutionally valid. According to the Supreme Court, provisional attachment provides for a balancing arrangement to secure the interests of the person and also ensures that the proceeds of crime remain available to be dealt with in the manner provided by PMLA. Elaborating this, it was observed by the Supreme Court that the procedural safeguards as envisaged by law are effective measures to protect the interests of the person concerned.

The challenge to the validity of section 8(4) of PMLA authorising seizure of property attachment which is confirmed, was also rejected by the Supreme Court subject to Section 8 being invoked and operated in accordance with the meaning assigned to it.

SEARCH AND SEIZURE
In several petitions, PMLA authorities’ powers of search and seizure were challenged as unconstitutional to the extent of deletion of the Proviso to section 17 which dispensed with report or complaint to the Magistrate. This challenge was also rejected by the Supreme Court on the ground that there are stringent safeguards provided in section 17 and the rules framed thereunder.

A similar challenge to the deletion of Proviso to section 18(1) dealing with the search of persons was also rejected on the ground that there are similar safeguards provided in section 18. Accordingly, it was held that the amended provision does not suffer from the vice of arbitrariness.

ARREST
The challenge to the constitutional validity of section 19 providing powers to arrest was rejected on the ground that there are stringent safeguards provided in section 19. Accordingly, the Supreme Court held that section 19 does not suffer from the vice of arbitrariness.

BURDEN OF PROOF
Section 24 of PMLA mandates a reverse burden of proof. In respect to the challenge to the validity of this provision, the Supreme Court held that section 24 has reasonable nexus with the purposes and objects sought to be achieved by PMLA and cannot be regarded as manifestly arbitrary or unconstitutional.

SPECIAL COURTS TO TRY OFFENCE OF MONEY-LAUNDERING
Section 44 of PMLA provides for trial of the offence of money-laundering and scheduled offence by Special Courts.

As regards the challenge to the validity of section 44, the Supreme Court did not find merit in such a challenge (that was based on the premise that section 44 was arbitrary or unconstitutional). However, it observed that the eventualities referred to in section 44 shall be dealt with by the Court concerned and by the Authority concerned in accordance with the interpretation given in this judgement.

OFFENCES TO BE COGNISABLE AND NON-BAILABLE
Section 45 of PMLA deals with this aspect. Earlier, in Nikesh Tarachand Shah vs. UoI (2018) 11SCC 1, the Supreme Court had declared the twin conditions in section 45(1) of PMLA, as it stood at the relevant time, as unconstitutional. However, now the Supreme Court has held that the said decision did not obliterate section 45 from the statute book; and that it was open to the Parliament to cure the defect noted by the Supreme Court in the earlier decision to revive the same provision in the existing form.

To elaborate this, the Supreme Court observed that it does not agree with the observations in Nikesh Tarachand Shah distinguishing the ratio of the Constitution Bench decision in Kartar Singh, and other observations suggestive of doubting the perception of Parliament in regard to the seriousness of the offence of money-laundering including about it posing a serious threat to the sovereignty and integrity of the country. It was further elaborated by the Supreme Court that section 45, as applicable post-2019 amendment, is reasonable and has direct nexus with the purposes and objects to be achieved by PMLA and does not suffer from the vice of arbitrariness or unreasonableness.

As regards the prayer for grant of bail, it was explained by the Supreme Court that irrespective of the nature of proceedings, including those under section 438 of CrPC or even upon invoking the jurisdiction of Constitutional Courts, the underlying principles and rigours of section 45 may apply.

It was also explained that the beneficial provision of section 436A of CrPC (which provides a maximum period for which an undertrial can be detained) could be invoked by the accused arrested for an offence punishable under PMLA.

POWERS OF AUTHORITIES REGARDING SUMMONS AND PRODUCTION OF DOCUMENTS AND EVIDENCE

Section 50 of PMLA deals with the powers of authorities regarding summons, compelling production of records, etc.

In this connection, the Supreme Court held that the process envisaged by section 50 is in the nature of an inquiry against the proceeds of crime and is not an “investigation” in the strict sense of the term for initiating prosecution; and the authorities under PMLA referred to in section 48 are not police officers as such.

It was explained by the Supreme Court that the statements recorded by the Authorities under PMLA are not hit by Article 20(3) (no person accused of any offence shall be compelled to be a witness against himself) or Article 21 of the Constitution of India (Protection of life and personal liberty).

ENFORCEMENT CASE INFORMATION REPORT (ECIR)

In respect of the plea that a copy of ECIR should be supplied to the arrested person, the Supreme Court held that in view of the special mechanism envisaged by PMLA, ECIR cannot be equated with an FIR under CrPC. It was explained that ECIR is an internal document of the ED and the fact that an FIR in respect of a a scheduled offence has not been recorded does not come in the way of the authorities referred to in section 48 to commence inquiry/investigation for initiating “civil action” of provisional attachment of property being proceeds of crime.

It was held that the supply of a copy of ECIR in every case to the arrested person is not mandatory and it is sufficient that at the time of arrest, ED discloses the grounds of such arrest.

Indeed, the Supreme Court observed that, when the arrested person is produced before the Special Court, it is open to the Special Court to look into the relevant records presented by the authorised representative of ED for answering the issue of the need for his/her continued detention in connection with the offence of money-laundering.

On this issue, it was suggested by the Supreme Court that even though the ED manual is not to be published, being an internal departmental document issued for the guidance of the ED officials, the department ought to explore the desirability of placing information on its website which may broadly outline the scope of the authority of the functionaries under the Act and measures to be adopted by them as also the options and remedies available to the person concerned before the Authority and the Special Court.

PUNISHMENT
As regards the plea about the proportionality of punishment with reference to the nature of the scheduled offence, it was held by the Supreme Court that such plea is wholly unfounded and stands rejected.

WAY FORWARD
What next after the pronouncement of the Supreme Court ruling?

Indeed, in terms of Article 141 of the Constitution, the propositions affirmed by the Supreme Court are now binding on all courts in India.

That calls for clear direction for the way forward. The way forward post 27th July, 2022 is outlined by the Supreme Court by way of following interim measures for four weeks from 27th July, 2022.

  • The private parties in the transferred petitions are at liberty to pursue the proceedings pending before the High Court. The contentions other than those dealt with in this judgement, regarding validity and interpretation of the concerned PMLA provision, are kept open, to be decided in those proceedings on their own merits.

  • Writ petitions which involve issues relating to Finance Bill/Money Bill are to be heard along with the Rojer Mathew case.

  • In the writ petitions in which further relief of bail, discharge or quashing was prayed, the private parties are at liberty to pursue further reliefs before the appropriate forums, leaving all contentions in that regard open, to be decided on its own merits.

  • The writ petitions in which validity and interpretation of other statutes (such as Indian Penal Code, CrPC, Customs Act, Prevention of Corruption Act, Companies Act, 2013, CGST Act) were challenged, were directed to be placed before appropriate Bench “group-wise or Act-wise”.

  • The parties are at liberty to mention for early listing of the concerned case including for continuation/vacation of the interim relief.

[Some of the interesting questions and answers arising from reading of this judgment will be dealt with by the Author in the next issue of the BCAJ]

References:

[Readers are advised to read the following two articles published in the BCAJ in 2021 written by Dr. Dilip K. Sheth about PMLA for more insight. The said articles can be accessed on bcajonline.org]

1.    OFFENCE OF MONEY-LAUNDERING: FAR-EACHING IMPLICATIONS OF RECENT AMENDMENT – Published in January, 2021.

2. ‘PROCEEDS OF CRIME’ – PMLA DEFINITION UNDERGOES RETROSPECTIVE SEA CHANGE – Published in February, 2021.  

Editor’s Note: At the time of going to press, the Supreme Court, on 26th August 2022, stated that two aspects of its 27th July 2022 judgement required reconsideration (i.e. (i) the finding that ECIR is not FIR and hence no mandatory need to provide it to the accused; and (ii) the negation of the cardinal principle of “presumption of innocence”).

NSE’S HIGH-TECH STOCK MARKET SCANDAL: WILL THE MASTERMINDS GO SCOT FREE?

NSE was hit by a co-location trading scandal sometime in 2015 when a whistle-blower first complained to the Securities and Exchange Board of India (SEBI). Author and Journalist Palak Shah has done a deep dive investigation into the NSE co-location scam. His book The Market Mafia, published in November 2020, is a full-scale exposé of the deep rot in India’s financial market ecosystem. As a journalist working with some of the leading Business newspapers in Mumbai, Palak has much insight into the working of markets, exchanges, SEBI and regulations. Considering certain constraints, BCAJ sent him questions and carried this e-interview to throw light on how the NSE scam has unfolded and the delay in investigating it. Hope you enjoy reading it!

Q.1. Can you briefly explain the matter relating to the Colo scam and corporate governance issues at NSE?
Co-location (Colo) is nothing but proximity hosting of broker servers with NSE’s master order matching engine in the exchange premises at Bandra-Kurla Complex (BKC). It gives a superior trading speed and advanced information on price moves and order books. As I have detailed in my book, The Market Mafia, the Colo scandal goes back to 2010. When NSE started co-location trading, it lacked the necessary study from the market regulator SEBI and hence safeguards. There were flaws in the system, which investigations post 2015 revealed were deliberate. The flaws gave a few an advantage in connecting first and hence faster data and so on. Had SEBI made a proper study of NSE trading systems in 2010 or carried out a thorough audit and then given its go-ahead after a public consultation, the scenario would have been different. The deliberate flaws in the system were a result of corporate governance lapses at NSE, for which the accountability has to be fixed.   

Q.2. How was the matter unearthed?

In January 2015, an unknown whistle-blower first informed SEBI about the co-location scandal and certain flaws in the system. The then SEBI whole time-member Rajeev Agarwal pushed his officials into action, and the probe started in the weeks following the whistle-blower complaints. But even after Agarwal set the ball rolling, SEBI was slow in its approach and investigations since NSE’s top bosses enjoyed high patronage in New Delhi, and the regulators were scared to take them head-on. Multiple forensic and system audits by IIT Mumbai were carried out under SEBI’s instructions. NSE’s top management was hostile towards these investigations since they would not share the data and other inputs with the investigators. Yet certain facts on governance lapses and flaws in the system emerged. CBI registered an FIR in 2018 on the basis of a complaint but for four years the Co-location file kept gathering dust since no major investigation was done by the agency. It was believed by many that key players in the scam were difficult to identify. In November 2020, I published my book The Market Mafia – Chronicle of India’s High Tech Stock Market Scandal & The Cabal That Went Scot Free. The book detailed the nuts and bolts of NSE’s trading system and, for the first time, gave an inside into the working of a Co-location scam and other aspects that most of the market investors were unaware about. The book also gave vital details of the key characters in the co-location scam and brought into the public domain several hidden communication between NSE officials and SEBI with regard to the ongoing probe. The book laid bare how NSE flouted norms with relative ease and impunity, and even senior SEBI officials looked the other way. The Market Mafia carries a detailed account of brokers, NSE officials, financial market experts and policymakers who benefited from the Co-location scam and the happening within NSE. For the first time in 30 years after the Harshad Mehta scam, a book has revealed true events to show how India’s stock markets are rigged by those very people who are supposed to protect the system.

In February 2022, SEBI released an order against former NSE MD and CEO Chitra Ramkrishna, who was among the key managerial persons when the co-location scam was taking place and was later in charge of NSE between 2013 and 2016. The SEBI order stated that Ramkrishna was taking instructions from an unknown person to run the exchange, whom she called a Yogi dwelling in the Himalayas. All this attracted public attention to the NSE scandal, which I say is several times bigger than the Harshad Mehta scam.

Q.3. As the first line of oversight, has NSE performed its obligation when the matter came to light?


From the beginning, NSE has been lax in diving deep into the scandal, which came to light in 2015. It has shielded and protected its officials who could have turned a blind eye to the various lapse or who could have engineered the flaws in the trading system. Simple instance of NSE shielding its officials can be gauged from the fact that Ramkrishna was allowed to exit NSE with dignity and was also paid Rs 44 crore in dues in 2016. Instead, the exchange was required to conduct investigations into her bad governance practices and slap some serious charges. Several other instances, like sharing data illegally with Ajay Shah and Susan Thomas, the two well-known market researchers by NSE, show that the officials within the exchange were complacent with the scamsters.

Q.4. Was SEBI aware of the irregularities at NSE, and for how long?

SEBI officials can be charged with ‘Omission and Commission of Duty’ which implies complacency in the scandal. It is one of the directions in which the CBI is now probing SEBI officials. The regulator is alleged to have hidden facts from the public, investigators and government about the scam. This is clear from the various arguments of CBI in the court.

Q.5. As a regulator, has SEBI been fair in investigating the matter and discharging its obligation in terms of timeliness of action, quality of investigation, quantum of punitive action taken and taking corrective action?

SEBI failed to conduct due diligence of NSE co-location trading systems from the day it started in January 2010. SEBI has been very slow in ordering proper investigations and even conducting its own probe. It left the probe to NSE to investigate itself. SEBI’s orders are childish and loosely knit. It has broken down the scam into various instances of small violations and not imposed charges of fraud and other stringent provisions laid down in the SEBI Act. The regulator has wide-ranging powers to probe such scandals, which it has not used at all. The list of SEBI’s inaction is long. All this points to SEBI’s lack of willingness in bringing the real culprits to book.

Q.6. Was a similar matter also detected at any other exchanges, and has SEBI dealt with other exchanges differently?

Yes, a forensic audit by TR Chaddha and Co. points out a scandal in sharing data by MCX with Susan Thomas and one New Delhi based algo trading Chirag Anand in an unauthorised manner. But SEBI and MCX have buried this scandal. NSE data, which was illegally obtained by Ajay Shah and Susan Thomas was going into algo trading work. Similarly, data obtained from MCX without following proper checks and balances were also going into algo trading work. SEBI has failed to take the MCX probe further and bring the actual culprits to book.

Q.7. How, in your view, will these irregularities impact the credibility of the Indian securities market, especially when one out of two exchanges and its regulator is found inactive or even complicit?

Both foreign investors and domestic institutions strongly believe that India follows the rule of law. Retail investors believe that Indian markets are most efficient and scam free. All the investors have placed their faith in SEBI and exchanges like NSE, BSE and MCX who are the larger players. They invest and trade billions of dollars at the blink of an eye. But the scandal at NSE and data sharing at MCX in a dubious manner, both of which show SEBI in poor light, can erode the trust of these investors. The credibility of the market has already been impacted but would be in ruins till the time the culprits are not found and brought to book by the government.

Q.8. You have been covering the colo and corporate governance matter at NSE in detail at various forums for quite a long time and have also covered these irregularities in detail in your book – ‘The Market Mafia’ – What is the whole idea behind this book?

You will find that The Market Mafia is a unique book since it gives all the real names of those behind the scandal at NSE and dubious happenings at MCX. The book exposes SEBI and the government’s lack of will for the past few years to investigate the scandal. It also reveals the conflict of interest that prevails in the governing structures of the stock markets and, above all, the bureaucratic rut that has exposed SEBI as a lame paper tiger.

JURISDICTION OF SEBI IN TAKING ACTION AGAINST PRACTISING CHARTERED ACCOUNTANTS

BACKGROUND
With the onset of the infamous Satyam scam of 2008-2009, where major accounting frauds were exposed, SEBI initiated a detailed investigation in the books of accounts of Satyam. Post investigation, SEBI issued a Show Cause Notice to the statutory auditor of Satyam, namely Price Waterhouse Co. (PWC). The power of SEBI to issue such a Show Cause Notice to a Chartered Accountant (firm) was challenged by PWC before the Hon’ble Bombay High Court (Writ Petition No. 5249 of 2010) under Article 226 of the Constitution. The Hon’ble Bombay High Court (vide its order of 13th August, 2010) put the controversy to rest by allowing SEBI to initiate action and bring Chartered Accountants within its fold – subject to not encroaching on the ICAI’s powers under the Chartered Accountants Act, 1949 (CA Act).

The Hon’ble Bombay High Court emphasized the fact that only if the Chartered Accountant was involved in falsification and fabrication of books of a listed company, then SEBI could invoke its powers under Section 11(4) r.w.s. 11B of the SEBI Act, which reads as under:

Section 11B.

(1)    Save as otherwise provided in section 11, if after making or causing to be made an enquiry, the Board is satisfied that it is necessary:

(i)    in the interest of investors, or orderly development of securities market; or

(ii)    to prevent the affairs of any intermediary or other persons referred to in section 12 being conducted in a manner detrimental to the interest of investors or securities market; or to secure the proper management of any such intermediary or person

it may issue such directions:

(a)    to any person or class of persons referred to in section, or associated with the securities market; or

(b)    to any company in respect of matters specified in section 11A, as may be appropriate in the interests of investors in securities and the securities market.

An important facet of the aforesaid definition is whether an auditor of listed companies (and registered intermediaries) can be considered to be a ‘person associated with the securities market’ and thereby under the jurisdiction of SEBI. The Hon’ble Bombay High Court clarified that if SEBI concludes that there was no ‘mens rea or connivance’ to fabricate and fudge the books of accounts, then SEBI ought not to issue any direction(s) against the auditor.

Within the aforesaid contours, the proceedings (qua PWC) continued at the SEBI level and finally concluded with an Order against PWC (on 10th January, 2018), inter-alia, imposing a restraint on PWC on issuing a certificate to a listed company for two years, amongst other directions. PWC challenged the SEBI Order before the Hon’ble Securities Appellate Tribunal (SAT). In the said case (decided on 9th September, 2019), the Hon’ble SAT went into the question as to whether SEBI could have proceeded against an auditor in connection with the work which they have undertaken for a listed company in respect of maintaining its books of accounts. After deliberation, the Hon’ble SAT ruled that SEBI’s enquiry ought to be only restricted to the charge of conspiracy and involvement in ‘fraud’. SEBI cannot take action against the auditing firm on the charge of professional negligence – since the CA firm was under the jurisdiction of ICAI. The said SAT Order has been challenged by SEBI before the Hon’ble Supreme Court – in which the regulator obtained a limited stay in its favour (Supreme Court Order dated 18th November, 2019 in Civil Appeal No(s). 8567-8570/ 2019). Until the Hon’ble Supreme Court finally adjudicates the matter – the question of SEBI’s jurisdiction of taking action against the Chartered Accountant(s) remains an open-ended one.

However, in the recent past, SEBI has been penalizing auditors of listed companies and registered intermediaries in respect of their auditing functions by alleging that the concerned auditor had violated Sections 12A(a), 12A(b) and 12A(c) of the SEBI Act, which reads as under:

12A. No person shall directly or indirectly:

(a)    use or employ, in connection with the issue, purchase or sale of any securities listed or proposed to be listed on a recognized stock exchange, any manipulative or deceptive device or contrivance in contravention of the provisions of this Act or the rules or the regulations made thereunder;

(b)    employ any device, scheme or artifice to defraud in connection with issue or dealing in securities which are listed or proposed to be listed on a recognised stock exchange;

(c)    engage in any act, practice, course of business which operates or would operate as fraud or deceit upon any person, in connection with the issue, dealing in securities which are listed or proposed to be listed on a recognised stock exchange, in contravention of the provisions of this Act or the rules or the regulations made thereunder.

RECENT RULING BY HON’BLE SAT

Through recent decisions in the M. V. Damania case (Appeal No. 335 of 2020 decided on 17th January, 2022) and Mani Oommen case (Appeal No. 183 of 2020 decided on 18th February, 2022); the Hon’ble SAT has set aside the SEBI orders penalising the auditors:

I.    In the M. V. Damania case, the concerned auditor had certified the expenditure incurred by Paramount Printpackaging Ltd (PPL) towards Initial Public Offering (IPO) expenses out of the IPO proceeds. The crux of SEBI’s allegation was that auditor negligently certified that an amount of Rs. 36.60 crores was utilized towards objects of the IPO. SEBI had alleged that:

(i)    PPL made payment to the various vendors in crore of rupees without having any invoices;

(ii)    in some cases, bills from the vendors were issued at a later date, post remittance by PPL; and

(iii)    the auditor did not raise any red flag against doubtful payments made by PPL.

In view of the aforesaid, SEBI imposed a monetary penalty of Rs. 15 lakhs on the auditor firm (and its partner), jointly and severally, for alleged violation of provisions of Section 12A(a), 12A(b) and 12A(c) of the SEBI Act r.w. Regulations 3 and 4 of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 (PFUTP Regulations).

In Appeal, the concerned auditor contended the following, amongst other arguments:

(i)    audit of the financial statements of PPL was based on the information provided by the management;

(ii)    in the process of the audit, the endeavour was to obtain audit evidence that is sufficient and appropriate to provide a basis for forming an independent opinion;

(iii)    all the payments made by PPL were supported by bank statements; and

(iv)    in any case, SEBI had no jurisdiction to proceed against Chartered Accountants, who are members of the ICAI.

The Hon’ble SAT ruled that the provisions of Section 12A(a) and 12A(b) of the SEBI Act do not apply to Chartered Accountants since ‘they are not dealing in the securities’. Similarly, the provisions of Section 12A(c) cannot be made applicable because the concerned auditor has carried out no ‘fraud’. Most importantly, the Hon’ble SAT ruled that in the absence of connivance, deceit, or manipulation by the auditor, the provisions of Regulation 3 and 4 of the PFUTP Regulations cannot be made applicable. Consequently, the SEBI Order was set aside.

II.    In the Mani Oommen case, SEBI alleged that DCHL (a listed company) had understated its outstanding loans to the tune of Rs. 1,339.17 crores in 2008-09 and wrongly disclosed the difference between the actual and reported outstanding loans for 2009-10 and 2010-11. Also, its promoters, the owner of the Deccan Chronicle Marketers (DCM) had wrongly transferred loans on the last day of the financial year and reversed on the first day of the next financial year. SEBI had alleged that:

(i)    As per Sections 224 and 227 of the Companies Act, 1956, an auditor owes an obligation to the shareholders to report true and correct facts about the company’s financials, and the auditor was duty bound to report correct facts under Section 227 of the Companies Act.

(ii)    SEBI opined that the concerned auditor overlooked the reporting of the outstanding loans, and he was not diligent in his obligation to check outstanding loans details from the bank and other independent sources.

In view of the aforesaid, SEBI held that the auditor did not adhere to the Auditing and Assurance Standard – 5 (AAS) prescribed by ICAI. SEBI alleged that the concerned auditor had violated the provisions of Section 12A(a) and 12A(b) of the SEBI Act r.w. Regulations 3 and 4 of the PFUTP Regulations. Consequently, SEBI penalized the said auditor and prohibited him from issuing any certificate of audit and rendering any auditing services to any listed companies and registered intermediaries for one year. Additionally, SEBI directed listed companies and intermediaries registered with SEBI not to engage any audit firm associated with the said auditor in any capacity for issuing any certificate w.r.t compliance of statutory obligations, which SEBI is competent to administer and enforce.

In Appeal, the concerned auditor contended the following, amongst other arguments:

(i)    as a statutory auditor, the responsibility was to express an opinion on the financial statement based on the internal audit;

(ii)    the auditor was not involved in the preparation of the books of accounts of the company; and

(iii)    the accounting adjustment, namely non-disclosure of the loans by transferring the same to the another entity was brought to his notice for the first time during audit of the books of accounts of DCHL in October-2012 (at a later point in time).

The Hon’ble SAT ruled that,
in the entire SEBI Order, there is no finding that the concerned auditor was instrumental in preparing false and fabricated accounts or has connived in the falsification of the books of account. The only finding by SEBI was that due diligence was not carried out by the said auditor. There was no finding (by SEBI) that the auditor had manipulated the books of accounts with knowledge and intention, in the absence of which, there is no deceit or inducement by the auditor. In the absence of any inducement, the question of fraud committed by the auditor does not arise. Consequently, the SEBI Order was set aside.

FRAUD VIS-À-VIS NEGLIGENCE

It is clear from the aforesaid rulings of the Hon’ble SAT that lack of due diligence can only lead to professional negligence, which would amount to misconduct – which could be under the purview of other regulators (like ICAI / NFRA). While the much-needed clarity on the jurisdiction of the SEBI vis-à-vis auditors is being awaited from the Hon’ble Supreme Court, the Chartered Accountant(s) must bear in mind that presently SEBI can act against them – if found that there was an element of ‘fraud’ while auditing listed companies and regulated intermediaries.

The Regulation 2 (c) of PFUTP Regulations define the term ‘fraud’ in two parts:

(i)    First part includes any act, expression, omission, or concealment committed whether in a deceitful manner or not by a person or by any other person with his connivance or by his agent while dealing in securities in order to induce another person or his agent to deal in securities, whether or not there is any wrongful gain or avoidance of any loss; and

(ii)    The second part includes specific instances which may tantamount to be fraudulent.

In the Kanaiyalal Baldevbhai Patel case (2017 15 SCC 1 – decided on 20th September, 2017), the Hon’ble Supreme Court has ruled that the term ‘fraud’ under the PFUTP Regulations is an act or an omission (even without deceit) if such an act or omission had the effect of ‘inducing’ another person to ‘deal in securities’.

The term ‘negligence’ as quoted in the PWC Order (SAT Appeal No. 6 of 2018) means the failure to use such care as a reasonably prudent and careful person would use under similar circumstances; it is the doing of some act which a person of ordinary prudence would not have done under similar circumstances or failure to do of a person of ordinary prudence would have done under similar circumstances (Black’s Law Dictionary, 6th edition).

RISK OF REGULATORY OVERREACH

The regulatory overlaps between SEBI and other regulators in the financial service space has been an ongoing issue. With SEBI having powers under the Securities and Exchange Board of India Act, 1992 (SEBI Act), there arises a situation where SEBI exercises jurisdiction against all persons on the ground that they are ‘associated with the securities market’. Consequently, the casualty is usually the regulated entities and professionals who advise them on lawfully navigating this complex regulatory space. In the past, there have been instances of such regulatory overlaps of SEBI with Insolvency and Bankruptcy Board of India (IBBI), Competition Commission of India (CCI), Reserve Bank of India (RBI), Central Electricity Regulatory Commission (CERC), etc.

One cannot deny that the SEBI is an apex regulator when it comes to protecting the sanctity of the securities market and, in fact, has been armed with powers to protect the interest of investors. If the regulator demonstrates that an auditor was involved in fabricating and fudging the financial statements or had ‘colluded’ with the listed company / promoters, a charge of fraud can be fastened. However, the question is whether SEBI ought to adjudicate on issues pertaining to professional conduct of practising Chartered Accountant(s). At the end of the day, the bible for Chartered Accountants is the auditing standards – which are prepared and deliberated upon by the ICAI. The hazard of over-regulation may result in moving away from a solution-oriented regime and create a situation where every audit report will carry more caveats than it already carries. There being a thin line between a ‘fraudulent’ and ‘negligent’ act, to avoid anomaly, inter-agency coordination is desirable.

THE WAY FORWARD

In October 2010, the central government constituted Financial Stability and Development Council (FSDC) – an apex regulatory Council to resolve regulatory overlaps. FSDC’s role is to enhance inter-regulatory coordination and promote financial sector development. The Chairman of the Council is the Finance Minister, and its members include the heads of financial sector Regulators (RBI, SEBI, PFRDA, IRDA, etc.), Finance Secretary and/or Secretary, Department of Economic Affairs, Secretary, Department of Financial Services, and Chief Economic Adviser. The Council is empowered to invite experts to its meetings as and when required. FSDC may consider inviting representatives from the ICAI and NFRA for inter-regulatory coordination to resolve the regulatory overlap.

THE ESG AGENDA AND IMPLICATIONS FOR C-SUITE AND CORPORATE INDIA

INTRODUCTION
The topic of Environmental, Social and Governance (‘ESG’) aspects of a business has been extensively covered across the global media in the past couple of years. The focus on ESG has been particularly expedited by the Covid-19 pandemic. There is mounting pressure on businesses from all stakeholders – shareholders, investors, regulators, suppliers, customers and communities – to start thinking about their sustainability and wider ESG journey.

ESG – DEVELOPMENTS IN INDIA

The business landscape in India is catching up on the ESG agenda. There is a significant growth in ESG-linked capital markets in India, with assets under management of the top 10 ESG mutual funds growing to INR 12,000 crore during 2019-2021 – representing almost a 5x increase in just two years1. From F.Y. 2022-23, SEBI has mandated the top 1,000 listed companies by market capitalisation to disclose ESG data through Business Responsibility and Sustainability Report (BRSR). At the COP26 summit in November 2021, India announced its goal to be net-zero by 2070. It will be businesses – large and small – which will eventually have to work towards achieving the net-zero goal and key targets around the country’s energy mix and carbon emissions intensity.     

In addition to this business and regulatory imperative, environmental factors are also at play. According to Germanwatch, India is one of the top countries which will be impacted by climate change2. Chennai almost ran out of water in 2019. The year 2021 saw droughts, floods, and landslides in various states in India. The start of the year 2022 was one of the coldest winters in India. The frequency and scale of such events are predicted to only increase in the future. Combining the impacts of such natural disasters with India’s goal to be net-zero by 2070 means that businesses across industry sectors will have to start considering sustainability and ESG parameters to make their operations more resilient for a climate-informed landscape of the future.

 

1   https://economictimes.indiatimes.com/mf/mf-news/esg-fund-assets-jump-4-7-times-in-2-years-may-grow-further/articleshow/88380627.cms

2   https://www.business-standard.com/article/current-affairs/india-among-top-10-countries-most-affected-by-climate-change-germanwatch-121012500313_1.html

So, what does this ESG agenda mean for Indian companies?

I have identified three key themes and focus areas for the C-suite to consider while trying to embed ESG parameters into business operations: a) Sustainable/ESG financing, b) Operating model, and c) Stakeholder engagement.

SUSTAINABLE/ESG FINANCING

Sustainability is not an overnight success. Embarking on a sustainability journey involves potential changes to how businesses have operated historically. This requires long-term planning and resources, with capital often being the most important. Organisations that lack enough capital or need additional funds can look at Sustainable/ESG financing. There are growing sustainability-focused capital markets – in India and overseas – that Indian companies can tap into to finance their sustainable business transformations. Depending on the business needs, the funding can take the form of either of the following two mechanisms: 1) ‘Use of proceeds’ instruments (e.g., Green/sustainability bonds/loans), where funds are used to finance specific projects/initiatives with environmental or social benefits. The 2022 Finance Budget has laid out various policies, including launching Sovereign Green Bonds and other initiatives on a private-public partnership model, in order to boost the climate finance ecosystem in India. In September 2021, Adani Green Energy Limited issued green bonds worth $750 million to fund the Capex of its ongoing renewable projects3. 2) ‘ESG-linked’ instruments (e.g., ESG/sustainability-linked loans), where repayment terms are pegged to certain environmental or social performance indicators. Ultratech Cement is already linking its financial commitments with sustainable targets4.

 

3   https://www.adanigreenenergy.com/newsroom/media-releases/Adani-Green-Energy-Continues-to-Ramp-Up-Focus-On-ESG

4   https://www.business-standard.com/article/current-affairs/glasgow-cop26-how-india-inc-plans-to-meet-net-zero-targets-by-2070-121110300058_1.html

Financial institutions are increasingly moving away from funding traditional environmentally damaging assets and industry sectors. Sustainable/ESG financing can help CFOs access necessary capital as well as a greater capital pool. Additionally, such funding can potentially be at a lower cost, in turn positively impacting the bottom line. ESG/sustainability-linked loans usually involve a reduced interest rate when underlying ESG goals are met. Similarly, organisations can issue Green/sustainability bonds at lower coupon rates to investors who are willing to accept lower returns alongside achieving positive environmental and social outcomes. For organisations, sourcing cheaper Sustainable/ESG financing can help reduce the cost of capital and improve margins whilst advancing their sustainability/ESG agenda. Additionally, through embedding ESG metrics within their strategic decision-making process, an organisation can ensure that funds are utilised in activities/initiatives which can generate maximum environmental and social impact.

OPERATING MODEL – VALUE CREATION FROM ESG
Secondly, from an operating model perspective, there are opportunities for value creation as well as risk mitigation from incorporating ESG parameters into business operations. Organisations can look at value creation by assessing their product/service mix. Companies can consider launching new sustainable products to take advantage of shifting consumer trends and preferences. E.g., the plant-based protein market in India is expected to grow to $650-700 million by 20255. Similarly, the market for vegan food, recycled raw materials, electric vehicles, alternative raw materials to single-use plastics, etc., is on the rise. A global BCG research suggests that within the consumer goods sector, 70% of consumers are willing to pay a 5% price premium for more sustainably manufactured products6. India’s net-zero goals and transition to zero-carbon economy present multiple business opportunities in the areas of green hydrogen, biofuels, electric vehicles and related infrastructure, waste management, etc. Organisations can therefore achieve top-line growth through a combination of ESG/sustainability-focused new product and service launches, entering into new markets, and premium pricing. For SMEs and start-ups, it is a great opportunity to be disruptors in the sustainability domain. Through sustainable products and services, SMEs/start-ups can achieve a competitive advantage vis-à-vis large corporates which lack ESG credentials.

 

5   https://www.cnbctv18.com/environment/global-surge-in-plant-based-cultivated-meat-indian-market-sees-substantial-growth-11012762.htm

6   https://www.bcg.com/publications/2020/supply-chain-needs-sustainability-strategy

A strong focus on environmental parameters can help organisations achieve significant resource efficiencies. Through embedding circular economy principles, companies can look at reducing the usage of raw materials and resources, including reusing and recycling them, in turn driving cost savings. A global paper company managed to achieve a 10% increase in EBITDA margins through a combination of emissions costs reductions, resource efficiencies and revenue growth7. By 2030, Ambuja Cement is targeting to save 77 litres of water/tonne of cement produced8. While these ESG-focused efforts require initial investments and often involve a longer payback period, it is not always the case. A private Indian mining company that invested in a water treatment facility on their site was able to recover the investment in just under three years. Reducing greenhouse gas emissions by shifting to renewable sources of energy and less carbon-intensive methods can also drive energy savings. Ultimately, such cost savings translate to higher business valuations. The BCG research cited earlier9 also suggests that by being leaders in the ESG domain, companies across industry sectors are able to achieve significant valuation premiums (between 11-14% across consumer goods, steel and chemical sectors) over peers. Businesses can therefore look at significant value creation through a combination of multiple ESG-focused initiatives across their end-to-end value chains.

OPERATING MODEL – RISK MITIGATION BY FOCUSING ON ESG

From a risk mitigation perspective, companies need to start assessing and adapting their supply chains to account for negative impacts from climate change. Almost 5 million hectares of crop in India was affected in 2021 due to climate crisis10.  A negative impact on the agricultural sector can have a knock-on implication on multiple other industry sectors that directly or indirectly rely on agricultural produce for their raw material needs. WWF research predicts that almost 30 cities in India will face acute water crises by 205011. In addition to traditional industry sectors like agriculture, manufacturing, mining, chemicals, this can be a cause of concern for the growing technology sector in India, whose demand for water to cool their data centres will continue to rise. There is a growing sense of urgency for businesses across industry sectors to look at sustainable options and plan for raw material shortages (in India and globally) to avoid potential supply chain disruptions.

Indian companies might also face risks from regulatory changes and/or increased scrutiny. While an earlier blanket ban imposed in 2019 on single-use plastics was held off by the central government, it is now going to come into force from 1st July, 2022. New EPR rules in relation to plastic recycling and use are also coming into effect from 1st July, 202212. Corporates will have to reassess their supply chains to comply with these upcoming regulations. In November 2021, a local municipal corporation in western India, imposed a crackdown on major textile companies discharging trade effluents into the city sewage network citing environmental concerns, leading to factory closures. Proactively implementing sustainable supply chain measures can help organisations mitigate any potential disruptions (and consequential financial loss) from such regulatory changes and/or scrutiny.

 

7   https://www.bain.com/client-results/a-paper-company-takes-bold-steps-to-become-a-sustainability-leader/

8   https://www.business-standard.com/article/current-affairs/glasgow-cop26-how-india-inc-plans-to-meet-net-zero-targets-by-2070-121110300058_1.html

9   https://www.bcg.com/publications/2020/supply-chain-needs-sustainability-strategy

10 https://www.downtoearth.org.in/news/climate-change/climate-crisis-has-cost-india-5-million-hectares-of-crop-in-2021-80809

Focusing on social aspects like health and safety, employee wellbeing, impact on communities and indigenous populations is also becoming increasing important. Any instances of corruption, bribery, child-labour, human rights abuses, etc. can lead to a negative impact on brand reputation. This might also entail financial risk in the form of a decline in stock prices or reduced valuations, regulatory penalties and fines. Ensuring the right social and governance policies for increased transparency and accountability is becoming critical.

Leading Indian multinationals have already committed to various climate change and sustainability and ESG goals. The likes of the Tata group have put compliance with ESG standards as a top business priority, and more business will follow. For SMEs as well, it will be a business imperative to consider the ESG agenda – particularly where they are suppliers or customers of large Indian and global multinationals which have their own sustainability goals and targets to achieve.

 

11 https://www.downtoearth.org.in/news/water/wwf-identifies-100-cities-including-30-in-india-facing-severe-water-risk-by-2050-74058

12           https://indianexpress.com/article/india/centre-notifies-epr-norms-for-plastic-packaging-waste-7780632/

ESG AND STAKEHOLDER ENGAGEMENT
Lastly, from a stakeholder engagement perspective, the C-suite can place high importance on ESG reporting and sustainability-related disclosures. For listed companies not within the remit of the current SEBI mandate, as well as for private companies, a voluntary disclosure can help achieve a competitive advantage through improved brand credentials. Such a voluntary disclosure can be based on existing domestic requirements in India (SEBI’s BRSR) or any global frameworks (like GRI, UN SDGs, etc.) or a customised basis depending on the commercial priorities. Voluntary disclosures can also help C-suite pre-empt any potential disclosure requests and/or pressure from customers, communities, activists and investors and build more transparent and better working relationship with these stakeholders. Mandatory or voluntary disclosures that show improved performance and results on ESG metrics can help enhance ESG ratings for organisations, which can in-turn enable them to access a larger capital pool and at more favourable terms. The government of India is also looking at obtaining an ESG ranking for the upcoming Initial Public Offering of the Life Insurance Corporation of India, with the aim of attracting a larger and responsible pool of capital13.

Impact investment has gained a lot of traction in India in the past couple of years. According to data from Impact Investors Council, almost $1.2 billion were invested just in the first five months of 202114. Private equity and venture capital groups in India are also increasingly focusing on ESG parameters as part of their investments as well as launching dedicated ESG funds15. Consequently, for SMEs and start-ups, focusing on ESG can be a great catalyst for raising funds to fuel their expansion and growth journey.

CONCLUSION

All of the above three themes – Sustainable/ESG financing, Value Creation and Risk Mitigation from ESG from an Operating Model perspective and Stakeholder Engagement – are in a way interrelated. In practice, it will be difficult to isolate one theme from the other. Progress in one aspect will have a compounding impact on others. Similarly, a negative outcome in one will also mean potential revisions across other ESG initiatives. Therefore, organisations will have to undertake a robust scenario-planning analysis in choosing ESG initiatives to be implemented and engage in continuous monitoring to maximise their ESG impact.

Irrespective of the industry sector, ownership status (public vs. private), the scale of operations (start-up vs. large multinational), it is becoming clear that there are multiple business reasons for organisations to look at ESG.

Climate change is already here (the latest evidence is the unseasonal rain on 6th January, 2022 in my home city of Ahmedabad – for a minute not considering its unintended consequences for the agricultural sector). The time for the C-suite of Indian organisations to act is now. The more proactive they are, the bigger will be the benefits and opportunities for future generations in India.

 

13             https://economictimes.indiatimes.com/markets/ipos/fpos/govt-working-on-esg-ranking-for-lic-ahead-of-public-offer/articleshow/88744950.cms

14 https://www.freepressjournal.in/business/impact-investors-infused-around-12-bn-in-india-amid-the-second-wave-of-covid

15           https://www.livemint.com/companies/news/aavishkaar-capital-launches-250-mn-esg-first-fund-11643022266115.html

UNDERSTANDING PREPACK RESOLUTION

BACKGROUND OF IBC AND NECESSITY OF PREPACKING THE RESOLUTION
The Insolvency and Bankruptcy Code, 2016 (IBC) was passed four years ago with the objective ‘to consolidate and amend the laws relating to reorganisation and insolvency resolution in a time-bound manner for maximisation of value of assets of such persons, to promote entrepreneurship, availability of credit and balance the interests of all the stakeholders including alteration in the order of priority of payment of Government dues and to establish an Insolvency and Bankruptcy Board of India, and for matters connected therewith and incidental thereto.’ The NCLAT in Binani Industries Limited vs. Bank of Baroda & Anr. laid down the objective of the code as ‘reorganisation and insolvency resolution of Corporate Debtor (CD), maximising value of assets of the company and promoting entrepreneurship, availability of credit and balancing the interests of all stakeholders’.

Since then, the IBC has moved on and benefited with the help of the rich source of knowledge as provided by jurisprudence. After all, it was time for Government to take steps that would further improve the ease of doing business. Especially with the impact of the pandemic, there is every possibility that businesses will suffer from greater stress due to external reasons beyond their control. This could also put many businesses into greater trouble, making them go through the stress of insolvency through the Courts.

The IMF, through its ‘Special Series on Covid’, identifies three potential phases of the crisis, viz., a first phase where there is a need for interim measures to halt insolvency and debt enforcement activity; a second phase, in cases of severe crisis, where transitional measures may be required to respond to the wave of insolvency cases, including special out-of-court restructuring mechanisms; and a third phase in which countries strengthen their regular debt resolution tools to address the remaining debt overhang and support economic growth.

While the harsh truth of such turmoil is flailing and failing businesses, the pressing need is to allow genuine businesses to sustain themselves and provide options for them to recoup and bounce back. Legislative options may create a lucrative, conducive environment to rescue those affected in these challenging times. ‘Prepack’ emerges in the midst of all this as a decoction which combines the formal and informal option to lessen the burden. Addressing this necessity, the Ministry of Corporate Affairs constituted a sub-committee on 24th June, 2020 to propose a detailed scheme for implementation of prepacked and prearranged resolution processes.

As of today a company in stress in India has four options: the Compromise and Arrangement scheme under the Companies Act, 2013; the Corporate Insolvency Resolution Process (CIRP) under the IBC; RBI’s prudential framework for early recognition, reporting and time-bound resolution of stressed assets; and fourth, the out-of-court settlement framework. The then Finance and Corporate Affairs Minister, the Late Mr. Arun Jaitley, once said, ‘I think today may not be the right time to go in for this discussion (informal option) because of the huge rush of companies coming to the insolvency process, but once this rush is over over the next couple of years, and business comes back to usual, honest creditor-debtor relationship is restored on account of IBC, a situation may arise when we may then have to consider a need to marry the two processes together so they may well exist simultaneously’. Thus, the necessity to introduce an ecosystem of informal options was foreseen at the time of legislation of the IBC and prepack has emerged as an innovative corporate rescue method that incorporates the virtues of both informal (out-of-court) and formal (judicial) insolvency proceedings1.

GETTING TO KNOW ABOUT PREPACK
Prepack is a process to conclude in advance an agreement by a company which is stressed before moving for statutory administration of the same. This provides it an opportunity to continue its business as a going concern and enables the promoter to rationally decide the options, and to save the time and money cost, along with erosion of goodwill, had this been routed through the CIRP channel.

The United Nations Commission on International Trade Law (UNCITRAL) in its ‘Legislative Guide on Insolvency’ uses the word ‘Expedited reorganisation proceedings’ and Paragraph 76 defines prepack as ‘to involve all creditors of the debtor and a reorganisation plan formulated and approved by creditors and other parties in interest after commencement of the proceedings. Reorganisation may also include, however, proceedings commenced to give effect to a plan negotiated and agreed by affected creditors in voluntary restructuring negotiations that take place prior to commencement, where the insolvency law permits the court to expedite the conduct of those proceedings’.

The USA was the first to introduce prepack in the Bankruptcy Reform Act of 1978. It soon gained momentum with more than 20% of the bankruptcies going through prepack2.The plan ‘is negotiated, circulated to creditors and voted on before the case is filed’3.

With a slight variation, the United Kingdom requires an administrator to conclude the sale. The Insolvency Practitioners Association issued a Statement of Insolvency Practice which defines prepack sale as ‘an arrangement under which the sale of all or part of a company’s business or assets is negotiated with a purchaser prior to the appointment of an Administrator and the Administrator effects the sale immediately on, or shortly after, appointment.’

In Singapore, the Insolvency, Restructuring, and Dissolution (Amendment) Bill, 2020 proposes to introduce a new prepack scheme for micro and small companies in the Covid-19 environment. An automatic moratorium would come into play when a company is accepted into the scheme. There would be no requirement to convene a meeting of the company’s creditors. Instead, the Court can approve the scheme, provided that the company can satisfy it that if a meeting had been called a majority representing at least two-thirds in value of the creditors would have approved the proposed scheme.

BENEFITS OF PREPACK

Faster resolution and cost effective: The greatest advantage of prepack lies in early disposal of the case. A majority of the terms are negotiated at the stage before the same are administered by the courts, which allows sufficient time for the debtor to fructify the negotiations. The time taken in courts reduces substantially, together with an increase in the possibility of a resolution. This eventually reduces the cost of administrator / Insolvent Professional (IP) consultant. On the other hand, increase in the time involved in the process of resolution would mean that the CD may have to sustain the stress until the resolution, which in turn reduces the value of the business and also the overall chances of resolution. After introduction of the IBC, the time for resolving insolvency also came down significantly from 4.3 years to 1.6 years. Now, prepack intends to bring it down even further. In countries which are in advanced stages of implementation of the insolvency law, such as the UK and the USA, the time of resolution in prepack can be as low as a few hours!

Goodwill retention and value maximisation: The threat to any business during the resolution process is the disruption that it causes on its normal business, which eventually threatens and hampers its goodwill. Even the Act tries to resolve this concern by introducing a moratorium on admission of CIRP, but the concern is that of loss of goodwill which would otherwise impact the right resolution options. Prepack as an option would enable the CD to safeguard the goodwill which otherwise would be impacted in the formal process.

Increases the possibility of resolution: Once a debtor opts for CIRP, he loses control of the decision-making process which goes to the creditors. It is believed that the defaulting debtor must not be in control of the decision-making process, but then this reduces the possibility of resolution and leads to liquidation. The incidental option for a defaulting debtor in CIRP is that of liquidation, but the statistics reveal that debtors that stay long at CIRP are more prone to end in liquidation. Liquidation is a consequence of failed resolution and a non-desirable situation for the debtor, the creditors, the employees, etc. With prepack invoking informal methods, the chances of resolution increase with intent to move with commercial wisdom, which the debtor can assist and resolve.

Less reliance on courts: The report of the sub-committee of the Insolvency Law Committee on prepacked Insolvency Resolution process mentions withdrawal of applications filed for initiation of CIRP in respect of 14,510 Corporate Debtors at pre-admission stage, closure of CIRPs of 218 CDs u/s 12A of the Code, 27 terminations of CIRPs by the Adjudicating Authority (AA), closure of CIRPs on taking note of settlement recorded by the mediator, and even settlements at the level of the Apex Court. The volume of cases is testimony to the success of out-of-court settlements which if nurtured and guided can enable courts to decide and resolve.

CONCERNS IN PREPACK
Transparency: In the existing CIRP, section 29A of the IBC, 2016 imbibes the importance of transparency and concern of involvement of the related party in the process. Over the concerns of serial prepacking or phoenix companies hangs the fear of failure of prepack. This may also necessitate the Government to work the whole process in a controlled environment to ensure that any unscrupulous elements do not fail the process.

Defaulting debtor in decision-making: The process of CIRP shifts the decision-making power from the CD to professionals who are independent and work for the common commercial good of all. This ensures that the CD is not in control of but only a part of the decision-making process. The RP and the COC decide the course of action which is further supervised by the Courts. Prepack in contract empowers the defaulting corporate to decide on the course of resolution, whereas administrator / RP / IP have a limited role in the resolution process, that of overseeing and approval. This ensures that the CD does not hijack the resolution in his favour if left unchecked.

Framework on prepackaged Insolvency Resolution Process as suggested by the sub-committee
Different jurisdictions have legislated prepack under insolvency with various options; but it is necessary to make a law which is country-specific because one size may not fit all. The three principles that the sub-committee suggested to guide the design of the prepack framework are,
(i)    the basic structure of the Code should be retained;
(ii)  there should be no compromise of the rights of any party; and
(iii) the framework should have adequate checks and balances to prevent any abuse.

The report mentions the following as the main features of prepack:

  •  Prepack as an option must be part of the same law which governs IBC and also part of the same legislation.
  •  Prepack as an option must be available to all CDs for any stress, pre-default and post-default.
  •  The CD shall initiate prepack with consent of simple majority of (a) unrelated FCs and (b) its shareholders. No two proceedings – prepack and CIRP – shall run in parallel.
  •  Promoters and management of the CD to be in control of the decision-making process, except for decisions on matters enumerated u/s 28 of the Code, including interim finance, which shall be taken by the CD with the approval of the CoC.
  •  List of documents and reports like outstanding claims, including contingent and future claims, and a draft Information Memorandum, etc., shall be prepared by the CD and certified by the MD.
  •  The moratorium u/s 14 shall be available from the Prepack Commencement Date (PCD) till closure or termination of the process.
  •  IP shall be appointed by unrelated FC’s who shall not run the business like in CIRP but only administer / conduct the process of prepack.
  •  Similar to CIRP, RP shall make public announcements but on electronic platform, he shall verify the claim, constitute CoC (Committee of Creditors), get valuation report, conduct due diligence, make application to AA (Adjudication Authority) in case of avoidance transaction, etc.
  •  As in CIRP, the CoC shall take decisions with regard to approval by majority of votes except that of liquidation which requires 75% vote.
  • ? Section 29A related to persons not eligible to be resolution applicants to remain sacrosanct even in the prepack process.
  •  Prepack to have the Swiss challenge method to counter the first offer to ensure better proposals. Two-option approach: (i) without Swiss challenge but no impairment to Operational Creditors (OCs), and (ii) with Swiss challenge with rights of OCs and dissenting FCs subject to minimum provided u/s 30(2)(b). Prepack should allow 90 days for market participants to submit the resolution plan to the AA and 30 days thereafter for the AA to approve or reject it.

BRIEF ABOUT THE PREPACK INSOLVENCY RESOLUTION PROCESS (PIRP) PASSED BY ORDINANCE DATED 4TH APRIL, 2021


The Government, aware of the urgent need for prepack, has inserted a Prepackaged Insolvency Resolution Process (PIRP) under Chapter III-A in Part II of the IBC through the ordinance route. The following is a brief, along with some highlights, about the process:

  •  An application for initiating a PIRP may be made in respect of a CD classified as a micro, small or medium enterprise under sub-section (1) of section 7 of the Micro, Small and Medium Enterprises Development Act, 2006.
  •  Restrictions have been placed on the CDs who have recently concluded CIRP / PIRP within three years or are undergoing CIRP, or those against whom liquidation order is passed u/s 33.
  •  An FC, not being a related party of more than 66% in value, has to propose an IP to be appointed as the Resolution Professional (RP). The CD shall also obtain approval for filing the PIRP from its FC not being its related parties representing not less than 66% in value of the financial debt due to such creditors.
  •  The majority of directors / partners have to declare that the CD shall file an application for PIRP within the timeframe not exceeding 90 days along with other declarations as required u/s 54A(2)(f).
  •   The special resolution in case of companies should have three-fourths of the total number of partners approving for filing the PIRP.
  •  The IP to be appointed as RP in PIRP is duty-bound to confirm whether the CD confirms the eligibility requirement for application under PIRP.
  •  Fees paid to the IP to perform his duties shall form part of the PIRP costs.
  •  The AA shall, within a period of 14 days of the receipt of the application under PIRP, either accept or reject it after providing seven days’ time to rectify the defects, if any.
  •  The PIRP shall commence from the date of admission of the application by the AA. The PIRP shall be completed within 120 days from its commencement and the RP shall submit the resolution plan within 90 days from the prepackaged insolvency commencement date. If the resolution plan is not approved by the CoC within the stipulated time, then the RP shall file for termination of the PIRP.
  •  Moratorium as provided in sub-section (1) read with sub-section (3) of section 14 shall be applicable and shall cease to exist upon termination of PIRP.
  •  CD shall submit within two days of commencement of PIRP a list of claims and preliminary information memorandum relevant to formulate the Resolution Plan.
  •  Unlike in CIRP, the management of affairs shall vest with the Board of Directors. However, the management may be handed over to the RP if the Committee by a vote of not less than 66% of the voting share in value decides to do so, or the AA is of the opinion that the affairs had been conducted in a fraudulent manner or there has been gross mismanagement.
  •  The CoC shall be constituted within seven days of the prepackaged insolvency commencement date and its first meeting shall be held within seven days of its constitution.
  •  The CD shall submit the base resolution plan, referred to in clause (c) of sub-section (4) of section 54A, to the RP within two days of the prepackaged insolvency commencement date and the RP shall present it to the CoC.
  •  The CoC may approve the base resolution plan for submission to the AA if it does not impair any claims owed by the CD to the operational creditors.
  •  The RP shall invite prospective resolution applicants to submit a resolution plan or plans, to compete with the base resolution plan, in such manner as may be specified.
  •  Sub-section (2) section 14, sub-section 2A of 14, section 14(3(c), section 17, section 19(3), section 18 clause g to e, section 19(2), section 21, section 25(1), clauses (a) to (c) and clause (k) of sub-section (2) of section 25, section 28, section 29, sub-sections (1), (2) and (5) of section 30, sub-sections (1), (3) and (4) of section 31, sections 24, 25A, 26, 27, 28, 29A, 32A, 43 to 51, provisions of Chapters VI and VII of Part II have been applied mutatis mutandis to the PIRP.
  •  If the AA is satisfied that the resolution plan as approved by the CoC under sub-section (4) or sub-section (12) of section 54K, as the case may be, subject to the conditions provided therein, meets the requirements as referred to in sub-section (2) of section 30, it shall, within 30 days of the receipt of such resolution plan, by order approve the resolution plan.

Prepack is a great way if India can take a leaf out of the book of countries which have legislated, administered and have learnt from experience. It may also be necessary to implement the law in a controlled environment but with the caution of not excessively restricting the eco-system which the law would promulgate. This law would stretch to the fullest strength when it is allowed to resolve the stress, provided that it is allowed to be experimented with within the framework, with little interference from courts. Excess legislation and restrictions may dilute the intent of faster resolution; this requires that those involved in the process of prepack are sensitive to the consensus-building mechanism of debtors and creditors. This also means that creditor-debtor must also act maturely during this process as they must realise that the success of this process depends on its negotiation and approval of the same. On the point of restriction, such as the one in section 29A, views are divided on transparency and genuine related-party buyer.

References
1 Bo Xie (2016), Comparative Insolvency Law: The Prepack Approach in Corporate Rescue, Edward Elgar Publishing
2 Vanessa Finch, Corporate Insolvency Law Perspectives and Principles (2nd ed., Cambridge University Press, 2009) 454
3 John D. Ayer et al, ‘Out-of-court Workouts Prepacks and Pre-arranged Cases, a Primer’, (April, 2005), ABI Journal <https://www.abi.org/abijournal/out-of-court-workouts-prepacks-and-pre-arranged-cases-a-primer> [2] (2020) 8 Supreme Court Cases 531

COGNIZANCE OF THE OFFENCE OF MONEY-LAUNDERING

INTRODUCTION
.
Newspaper reports show that, on an average, every week in two to three cases a businessman, politician, banker or bureaucrat is booked under the Prevention of Money-Laundering Act (PMLA). Apart from attachment of property and freezing of bank accounts, another action started simultaneously against such a person is initiation of criminal proceedings. On a complaint made u/s 44 of the PMLA, investigation commences and the Special Court may take cognizance of the offence of money-laundering.

However, the terms ‘cognizance of offence’ and ‘cognizable offence’ are not defined in the PMLA. Indeed, section 65 provides that the provisions of the Code of Criminal Procedure, 1973 (CrPC) shall apply insofar as they are not inconsistent with the provisions of the PMLA for arrest, search and seizure, attachment, confiscation, investigation, prosecution and all other proceedings under the PMLA.

Accordingly, in the absence of any provision in the PMLA, one may refer to the provisions of the CrPC on a given aspect such as the definition of ‘cognizable offence’. This
term is defined in section 2(c) of the CrPC as follows:

‘Cognizable offence’ means an offence for which, and ‘cognizable case’ means a case in which, a police officer may, in accordance with the First Schedule or under any other law for the time being in force, arrest without warrant.

From a review of the above-mentioned definition one can see that where the offence is covered under the First Schedule of the CrPC or under any other law for the time being in force, the police officer may arrest without a warrant.

A reference to the First Schedule shows that it provides the following classification of offences:
• cognizable or non-cognizable,
• bailable or non-bailable, and
• the court which will try the offence.

Part II of the First Schedule refers to ‘classification of offences under other laws’. It provides that offences punishable with imprisonment for more than three years would be cognizable and non-bailable.

A reference to section 4 of the PMLA shows that the offence of money-laundering is punishable with rigorous imprisonment for more than three years which may extend up to seven years (ten years in the case of NDPS offences).

Accordingly, on the basis of the criteria specified in the First Schedule of the CrPC, the offence of money-laundering is cognizable.

WHETHER THE OFFENCE OF MONEY-LAUNDERING IS COGNIZABLE?
The issue whether the offence of money-laundering is cognizable had come up for consideration before the Courts in the following cases:
•  Jignesh Kishorebhai Bhajiawala vs. State of Gujarat [2018] 90 taxmann.com 320 (Guj);
• Rakesh Manekchand Kothari vs. UoI (Manu/Guj/0008/2015);

Chhagan Chandrakant Bhujbal vs. UoI [2017] 78 taxmann.com 143 (Bom);
• Vakamulla Chandrashekhar vs. ED [2019] 356 ELT 395 (Del);
• Virbhadra Singh vs. ED (Manu/Del/1813/2015);
• Moin Akhtar Qureshi vs. Union of India [2017] 88 taxmann.com 66 (Del);
• Rajbhushan Omprakash Dixit vs. Union of India [2018] 91 taxmann.com 324 (Del).

The Courts gave views which were divergent and in many cases the matter was carried to the Supreme Court by way of SLPs which are pending.

However, an Explanation to section 45 has now settled the issue. The Explanation was added to section 45 w.e.f. 1st August, 2019 to clarify the meaning of ‘offence to be cognizable and non-bailable’. It reads as follows:

‘Explanation. – For the removal of doubts, it is clarified that the expression “Offences to be cognizable and non-bailable” shall mean and shall be deemed to have always meant that all offences under this Act shall be cognizable offences and non-bailable offences notwithstanding anything to the contrary contained in the Code of Criminal Procedure, 1973 (2 of 1974), and accordingly the officers authorised under this Act are empowered to arrest an accused without warrant, subject to the fulfilment of conditions under section 19 and subject to the conditions enshrined under this section’.

Thanks to this clarification, the controversies faced by the Courts in the above-mentioned decisions have been put to rest.

COGNIZANCE OF THE OFFENCE OF MONEY-LAUNDERING – PRECONDITION

There are two provisions which refer to the precondition to take cognizance of the offence of money-laundering.

Section 44(1)(b) of the Prevention of Money-Laundering Act, 2002 (PMLA) provides that, notwithstanding anything contained in the CrPC, a Special Court may take cognizance of the offence of money-laundering upon a complaint made by an authority authorised in this behalf under the Act, without the accused being committed to it for trial.

The second Proviso to section 45(1) lays down the basic precondition for taking cognizance of an offence punishable u/s 4. It categorically provides that the Special Court cannot take such cognizance except upon a written complaint by the Director or any officer of the Central or State Government authorised by a general or special order.

‘Taking cognizance of’ – connotation of
The expression ‘taking cognizance of’ is not defined or explained in the PMLA. In section 44, too, there is no clarification as regards the meaning of this expression. However, its meaning has been examined by the Supreme Court and the High Courts in various decisions. The propositions laid down by the Courts may be reviewed as follows:

• Whether a Magistrate has taken cognizance of an offence depends on the facts and circumstances of each case and no rule of universal application can be laid down on this issue1.
• Taking cognizance means cognizance of an offence and not of an offender. ‘Cognizance’ indicates the point of time when a Magistrate takes judicial notice of an offence. It is different from initiating a proceeding. Rather, it is a condition for initiating a proceeding2.
• Taking cognizance does not involve any formal action but occurs as soon as a Magistrate applies his mind to the suspected commission of an offence and takes first judicial notice of an offence on a complaint or police report or on his own information.3
• The Magistrate takes cognizance once he makes himself fully conscious and aware of the allegations made in the complaint and decides to examine or test the validity of the said allegation4.
• At the stage of taking cognizance, only the prima facie case is to be seen. It is not open to the Court to appreciate the evidence at this stage with reference to the material5.
• For taking cognizance of an offence, the Court has to merely see whether prima facie there are reasons for issuing process and whether the ingredients of an offence are on record6.
• ‘Taking cognizance of offence’ means taking notice of an offence which would include the intention of initiating judicial proceedings. It is not the same thing as issuance of process. It is entirely different from initiation of judicial proceedings; rather, it is a condition precedent to the initiation of proceedings by the Magistrate7.

Private complainant has no locus standi
Having regard to the provisions of section 44(1)(b) and section 45 of the PMLA dealing with a complaint to the Special Court to take cognizance of an offence punishable under the PMLA, an important question that frequently arises is whether a complaint filed by a private complainant can be entertained by the Special Court.

This question was addressed by the Delhi High Court in the Raman Sharma case8. While answering it in the negative, the High Court made the following observations:

‘The question before the learned Trial Court was whether the Trial Court can entertain a complaint filed by a private party for the offence committed under the Prevention of Money-Laundering Act. On this issue, section 44(b) of the Act clearly stipulates that the Special Court may, upon a complaint made by an authorised person in this behalf under this Act, take cognizance of an offence under section 3. Further, the second Proviso to section 45 makes it clear that the Special Court shall not take cognizance of offence except upon a complaint in writing made by the Director, or any officer of the Central Government or State Government authorised in writing in this behalf by the Central Government.

_________________________________________________________________________________

1   Nupur Talwar vs. CBI [2012] 1 SCC (Cr) 711

2   Ajit Kumar vs. State of WB; AIR 1963 SC 765

3   Anil Sawant vs. State of Bihar (1995) 6 SCC 142; R.R. Chari vs.
State of
UP 1951 CrLJ 775(SC); Darshan Singh Ram Kishan vs. State of Maharashtra 1971
CrLJ 1697 (SC)

4   Narayandas Bhagwandas Madhavdas vs. State of WB; 1959 CrLJ
1368(SC)

5   Kishan Singh vs. State of Bihar 1993 CrLJ 1700 SC

6   Chief Enforcement Officer vs. Videocon International Ltd.
[2008] 2 SCC 492

7   State of Karnataka vs. Pastor P. Raju: AIR 2006 SC 2825; State
of WB vs. Mohd Khalid AIR 1995 SC 785

8   Raman Sharma vs. Director, Directorate of Enforcement (2020)
113
taxmann.com 114 (Del)

Accordingly, the learned Trial Court opined that the aforesaid two provisions make it clear that the Court cannot entertain a complaint filed by a private complainant for the offence committed under the Act’.

Cognizance of supplementary complaint
In the context of a supplementary complaint, a question arises whether cognizance is required to be taken again on the filing of a supplementary complaint? This question has been addressed by the Delhi High Court in Yogesh Mittal vs. Enforcement Directorate (2019) 105 taxmann.com 336 (Del). While answering it in the negative, the Delhi High Court made the following observations:

‘It is thus trite law that cognizance is taken of the offence and not the offender. It is also well settled that cognizance of an offence / offences once taken cannot be taken again for the second time. Since this Court has already taken a view that a supplementary complaint on additional evidence qua the same accused or additional accused who are part of same larger transactions / conspiracy is maintainable, however, with the leave of the Court and cognizance is taken of the offence / offences, not the offender and in case no new offence is made out from the additional material collected during further investigation, supporting an earlier offence on which cognizance has already been taken or additional accused are arrayed, no further cognizance is required to be taken’.

Procedural aspect of the cognizance of the offence of money-laundering
Apart from the above-mentioned substantive aspects of cognizance of the offence of money-laundering, it is equally necessary to be aware of procedural aspects relating to the same. Such procedural aspects are not specified in the PMLA.

Section 65 of the PMLA provides that the provisions of the CrPC shall apply, insofar as they are not inconsistent with the provisions of the PMLA, for search and seizure, attachment, confiscation, investigation, prosecution and all other proceedings under the PMLA.

Hence, a reference may be made to Chapter XII of the CrPC [Information to the Police and their Powers to Investigate]. This Chapter lays down the procedure to be followed for investigation of cognizable or non-cognizable offences.

A reference may be made to the following provisions relating to a cognizable offence:
• Section 154 – Information in case of cognizable offence,
• Section 157 – Procedure for investigation of cognizable offence,
• Section 158 – Report to Magistrate, how submitted,
• Section 159 – Power to hold investigation or preliminary inquiry,
• Section 160 – Police officer’s power to require attendance of witnesses,
• Section 161 – Examination of witnesses by Police,
• Section 167 – Procedure when investigation cannot be completed in twenty-four hours,
• Section 172 – Diary of proceedings in investigation,
• Section 173 – Report of police officer on completion of investigation.

A review of the above-mentioned provisions of the CrPC in the context of certain provisions of the PMLA would show that the PMLA does contain the following provisions which are analogous to corresponding provisions of the CrPC:
• Section 19 of the PMLA empowers the ED to arrest a person u/s 19 if, on the basis of material in its possession, it has reason to believe that a person is guilty of an offence punishable under the PMLA.
• Proviso to section 44(1)(b) of the PMLA (inserted w.e.f. 1st August, 2019) requires that upon completion of investigation where it is found that no offence of money-laundering was committed, just like section 173 of the CrPC, the ED is required to submit a closure report to the Special Court.
• However, in respect of the other provisions of Chapter XII of the CrPC, such as filing of FIR, maintaining a case diary, etc., the PMLA does not contain analogous provisions.

CONCLUSION

Often, clients approach their chartered accountants with the show cause notice received by them from an Enforcement Officer alleging that an offence under the PMLA has been committed. The clients seek advice on the manner of giving a reply. That apart, a number of questions are raised by clients in respect of the consequences of various actions under the PMLA, such as provisional attachment of property, arrest, search and seizure, etc.

To advise clients on the proper course of action it is necessary for us to familiarise ourselves with basic knowledge of the main provisions of the PMLA. This will facilitate proper steps to be taken by the client during adjudication and other proceedings under the PMLA and briefing the arguing Counsel engaged by the client for representation before the Special Court.

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 1st
April, 2022)

II. 10% of the annual consolidated turnover, as
per the last audited financials of the subsidiary (with effect from 1st
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 31st March, 2023) and
on a mandatory basis from 1st 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 1st April, 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.

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.

PERSON IN CONTROL (PIC): NEW MODIFICATION IN THE ENTITY

Cementing the path for a notable modification in the manner that the promoters and more than 5,000 publicly-listed corporate entities operate in India, the Securities and Exchange Board of India (SEBI), in a consultation paper has suggested doing away with the concept of promoters and shifting to ‘person in control.’ It has proposed the change to put an end to the present definition of promoter group with an idea to streamline the disclosure encumbrance. Apart from this, SEBI has announced a few other proposals that include (a) decreasing the minimum lock-in period (tenure an investor can hold on to the securities) after an initial public offer (IPO) for promoters’ portion of a minimum 20% from the current three years to one year, and the lock-in period for holding more than 20% from one year to six months; and (b) decreasing the lock-in period for pre-IPO shareholders (those who invest in the entity even before the public issue) from the current one year to six months.

The notion of the promoter is a heritage from history when a corporate body or a group of companies (say, a business house like Tata, Birla and so on) would establish a business unit; for example, a power or steel or fertilizer plant, by pledging some funds of their own and financing the remainder of the project cost by borrowings from banks or financial institutions, on top of raising funds from the capital market. This business unit would remain linked with the establishment – virtually all through the life-span of the project – having a fundamental interest in safeguarding its constant profitability and progress and consistently work for achieving this goal, thereby obtaining the position of what one may label as ‘once a promoter, always a promoter’.

FIRST LESSONS IN INTERPRETATION OF CONTROL
In order to move with the times, SEBI in its Board meeting on 6th August, 2021 gave in-principle assent to move from the concept of promoter to ‘controlling shareholders’ as was recommended in the Consultation Paper dated 11th May, 2021 which dealt with the evaluation of the structure relating to promoters and the promoter group. Although the Consultation Paper has mentioned many other viewpoints and aspects, restructuring the definition of the promoter group rationalising the disclosure needs for group entities is one of the key changes proposed. This seems to be a branding modification in the configuration of the company law.

The Companies Act, 2013 along with the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 has defined the term promoter ‘as a person who has been named as such in a prospectus or is identified by the company in the annual return in section 92; or a person who has control over the affairs of the company, directly or indirectly, as a shareholder, director or otherwise; or a person with whose advice, directions or instructions the Board of Directors of the company is accustomed to act.’ A person or group of people to be categorised as a ‘promoter group’ should have at least 20% equity share capital.

As per the Consultation Paper issued by SEBI, a controlling shareholder is to be defined as ‘A person who has control over the affairs of the company, directly or indirectly whether as a shareholder, Director or otherwise.’ The concept of controlling shareholders would restructure the tactic followed by controllers while levying any compulsions and transferring the responsibility of obeying statutory compulsions over to the controlling shareholders.

According to Regulation 2(1)(e) of the Takeover Regulations, 2011, the term ‘control’ has been defined as the right to appoint the majority of the Directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner. In an identical manner, the term control has been defined u/s 2(27) of the Companies Act, 2013 as well.

Though the clarification of the term control given by the SEBI has been swinging, in the case of Subhkam Ventures vs. SEBI, the SEBI pronounced that defensive agreements, namely, positive votes extended to the nominee Director of the investor on issues such as amendment of the articles of association, alterations in share capital, consent of the annual business plan, reorganisation of the investee entity, the nomination of significant officers of the entity, etc., all these qualify as gaining of control by the investor.

However, on appeal the Securities Appellate Tribunal (SAT) opined that control is a power by which, on the one hand, an investor can instruct an entity to do what it wants to do. It was also explained by the SAT that the power by which an investor can prohibit an entity from doing what the latter wants to do cannot by itself qualify as ‘control’. SEBI appealed against the SAT order before the Supreme Court. However, the Court could not pronounce its verdict due to the removal of the case owing to the departure of the investor.

The interpretation of the term ‘control’ came up before the Whole-Time Member (WTM) of SEBI for judgment in the case of Kamat Hotels vs. SEBI. The WTM had to resolve, inter alia, whether there had been a takeover of control by the Noticees just by virtue of entering into a contract under which they were allowed a number of privileges that would activate an open offer under the Takeover Code, 1997. The WTM judged that the determination of ‘control’ because of the existence of positive voting rights in light of the realities of the case was inappropriate. The WTM, with regard to the privileges accessible to the Noticees as per the contract specified as above, made an obiter pronouncement in its order: ‘It is apparent that the scope of the covenants, in general, is to enable the Noticees to exercise certain checks and controls on the existing management for the purpose of protecting their interest as investors rather than formulating policies to run the target company.’

However, since the contract ended on 31st July, 2014 and the terms and clauses that allegedly bestowed ‘control’ on the Noticees under the contract were no longer compulsory on the promoters of Kamat Hotels, therefore, the WTM opted that the determination of ‘control’ was no longer appropriate.

On the basis of earlier precedents, it looks like determination of ‘control’ shoots from several ideologies which when applied to a given group of particulars and situations offers scope for various interpretations. In this background, SEBI had proposed a Consultation Paper in March, 2016 in which the definition of ‘control’ under the Takeover Regulations was considered to be
amended as: ‘(a) the right or entitlement to exercise at least 25% of voting rights of a company irrespective of whether such holdings give de facto control, and / or (b) the right to appoint the majority of the non-Independent Directors of a company’. However, the same has not yet been executed.

IS IT THE RIGHT TIME TO MOVE FROM THE WORD ‘PROMOTER’?
Many will give a quick answer to the above question by saying ‘yes’ since the concept of ‘promoter’ has become stagnant. The concept of promoter embraces all types of casual people, blood relatives who have been suing are also treated as promoters. In short, persons who have no control whatsoever of the organisation are treated as promoters. This gives an incorrect feeling to the investors of the organisation.

SEBI should make the concept smarter, fluid and accurate rather than completely abolishing the responsibility of the leading shareholder. This can be done by employing global yardsticks. Expressions like a person acting in concert or persons in control are understood throughout the world and these will surely describe who is overseeing the entity. The minority shareholder will be better off if this modification is implemented. But it is clear that the concept of promoter has not gone away and the only change is in the terminology which has moved on from ‘promoter’ to ‘person in control’. This is a step forward because once a Promoter need not always be a Promoter.

SEBI CHASING CHANGING SCENARIO
During the previous decade, the investor scene in India experienced a radical deviation whereby a new class of shareholders has arisen as leading investors, namely, private equity funds (PEF), alternate investment funds (AIFs), mutual funds, etc. Due to this the shareholding of the promoters has come down and total promoters’ holdings in the prominent 500 listed entities by market value is on a downhill journey since 2009 when it had topped at 58%.

The new class of shareholders invests in new-age and tech businesses (although unlisted) by means of what is termed as ‘control deals’ even prior to these going in for an initial public offer (IPO) and continue to retain shares post-listing, many times being the biggest public shareholders, holding special privileges such as the right to appoint Directors.

Although the actual ‘ownership’ and ‘controlling rights’ of a company have transferred to PEFs or AIFs, the establishment that introduced the business firm continues to possess power (notwithstanding its shareholding having been reduced to a minority) as the current regulation lists it as a promoter. The market watchdog needs to fix this glitch by changing the emphasis from promoters to controlling shareholders, or the so-called ‘person in control’ (PIC). Nonetheless, it also needs to be asked whether the new class is indeed keen to take control?

These organisations signify a collection of tens of thousands of investors. However, in the case of mutual funds these run into lakhs of investors. They gather money from individual investors and many of them are high net-worth individuals and invest in companies with the prime aim of producing handsome returns. In a basic way they are financial investors, would stay invested in an entity as long as the target is achieved, otherwise they will depart; on the other hand, the role of a PIC necessitates that he stay invested over the long term. The question is, does SEBI really expect promoters to play the role of PICs.

From its suggestions on minimum lock-in period, it does not seem to be so. Post an IPO, the SEBI allows the promoter to discard his or her portion of a minimum of 20% within one year against the existing three years. Besides, holding of more than 20% can be discarded in six months instead of one year.

It is even contemplating to entirely get rid of the condition of minimum shareholding for a person to qualify as a promoter. If a unit, for instance, PEF, can dispose of its shareholding obtained before its IPO (even though big enough to give it the position of a promoter) within one year of the public issue or the condition of minimum shareholding itself is relinquished, how can it be imagined to be fair to the role of a ‘person in control’?

Irrationally, the watchdog does not even want the public to recognise the individuality of investors behind the issuer. As per the relaxed disclosure obligations, the issuer need not furnish financial statements of group entities associated with the one being listed; it need not name financial investors as promoters in IPOs; and it need not specify precise corporate entities which are part and parcel of the promoter group. How can an entity whose basis of funding is masked in privacy infuse confidence?

Today, many of the listed companies are professionally administered and much of the activity is positioned around the Board of Directors, including several Independent Directors. It also includes the Chief Executive Officer (CEO) supported by numerous teams, including the audit committee, remuneration committee, etc., for crystal-clear operations. Could the PIC role be delegated to the CEO or the BoD? The answer to this is not in the affirmative.

The members of the Board, including the CEO, are professionals. They are nominated and obtain their power from the shareholders even though by majority vote or any other method approved by them. If the majority shareholders vacate, then it is doubtful that the current CEO or BoD will continue. Further, if the former leaves within a short period, which is highly possible as per the new regulations suggested by the market regulator, then the case for the CEO or BoD serving as PIC becomes less likely. When the person who established the entity is reduced to a minority and the new group of shareholders who have majority share are reluctant to sneak into the former’s shoes, it will be tantamount to impelling the listed entity into a position of a ‘ship without a commander’.

The market watchdog should re-look at its suggestions keeping two essential principles in mind. These are, (i) the voting or controlling power of an investor must be proportional to his investment or the shares held by him, and (ii) solidity of the management. In the present situation, where the majority of shareholding is entrusted in PEFs or AIFs, they should be made accountable to accept the role of a PIC and remain invested in the entity over a reasonably long period. The market regulator must not decrease the lock-in period. It should also not abandon the prerequisite of minimum shareholding for an entity to remain in control of the firm and demand complete clarity on funding bases. Amazingly, the complete workout of the transition from promoters to controlling shareholders will prove to be pointless unless the SEBI effectively tackles the elephant in the room, viz., the definition of ‘control’.

NEW MODIFICATION IN A NUTSHELL

SEBI has recommended decreasing the minimum lock-in periods post a public issue for promoters and pre-IPO shareholders.

The consultation paper suggested a three-year transition period for moving from the promoter to the person in control concept.

If the object of the issue involves an offer for sale or financing other than for capital expenditure for a project, then the minimum promoters’ contribution of 20% should be locked in for one year from the date of allotment in the IPO.

The promoters’ holding in excess of minimum promoters’ contribution shall be locked in for a period of six months as opposed to the existing requirement of one year from the date of allotment in the IPO.

Control Person means any person that holds a sufficient number of any of the securities of an issuer so as to affect materially the control of that issuer, or that holds more than 20% of the outstanding voting securities of an issuer.

Control Person means any individual who has a Control relationship with the Fund or is an investment adviser of the Fund.

Control Person means a Director or executive officer of a licensee or a person who has the authority to participate in the direction, directly or indirectly, through one or more other persons, of the management or policies of a licensee.

The changes in the nature of ownership could lead to situations where the persons with no controlling rights and minority shareholding continue to be classified as promoters.

It will lighten the disclosure burden for firms.

The regulator has proposed to eliminate the present definition of promoter group because it would rationalise the disclosure burden.

It is necessitated by the changing investor landscape in India where concentration of ownership and controlling rights do not vest completely in the hands of the promoters or the promoter group.

This is because of the emergence of new shareholders such as private equity and institutional investors.

The investor focus on the quality of board and management has increased, thereby reducing the relevance of the concept of promoter.

It also suggested doing away with the current definition of promoter group since it focuses on capturing holdings by a common group of individuals.

It often results in capturing unrelated companies with common financial investors.

CSR RULES AMENDMENT – AN ANALYSIS

1. BACKGROUND
Corporate Social Responsibility (CSR) can be defined as a company’s sense of responsibility towards the community and environment (both ecological and social) in which it operates. Companies can fulfil this responsibility through waste and pollution reduction processes, by contributing educational and social programmes, by being environmentally friendly and by undertaking activities of similar nature. CSR is not charity or mere donations. CSR is a way of conducting business by which corporate entities visibly contribute to the social good.

The Companies Act, 2013 has formulated section 135, Companies (Corporate Social Responsibility) Rules, 2014 and Schedule VII which prescribe mandatory provisions for companies to fulfil their CSR. This article aims to analyse these provisions (including all the amendments therein).

Applicability of CSR provisions
o On every company including its holding or subsidiary having:
* Net worth of Rs. 500 crores or more, or
* Turnover of Rs. 1,000 crores or more, or
* Net profit of Rs. 5 crores or more
o during the immediately preceding financial year, and
* A foreign company having its branch office or project office in India, which fulfils the criteria specified above.

However, if a company ceases to meet the above criteria for three consecutive financial years then it is not required to comply with CSR provisions till such time as it meets the specified criteria.

The Ministry of Corporate Affairs, vide Notification dated 22nd January, 2021 in exercise of the powers conferred by section 135 and sub-sections (1) and (2) of section 469 of the Companies Act, 2013 (18 of 2013), notified rules to further amend the Companies (Corporate Social Responsibility Policy) Rules, 2014. These rules are to be called the Companies (Corporate Social Responsibility Policy) Amendment Rules, 2021.

They shall come into force on the date of their publication in the Official Gazette. As per the Notification, section 21 of the Companies (Amendment) Act, 2019 has come into force with effect from 22nd January, 2021.

2. The top ten points relating to changes in CSR rules are as follows
CSR expenditure
(i) Surplus from CSR activities to be ploughed back in same project or transferred to Unspent CSR Account and spent as per policy and annual action plan, or transferred to Fund within 6 months of the end of the financial year.
(ii) Excess amount spent shall be set off within three succeeding financial years subject to conditions (i.e., surplus arising out of CSR activities shall not be considered and the Board of the company shall pass a resolution to that effect).
(iii) CSR amount may be spent for creation / acquisition of capital asset to be held in the manner prescribed.
(iv) Specific exclusion of sponsorship activities for deriving market benefits from the scope of CSR activities.

Governance
(v) Eligible implementing entities through which a company shall undertake CSR activities will be required to register themselves with the Central Government w.e.f. 1st April, 2021.
(vi) Responsibility of the Board to ensure that the funds so disbursed have been utilised for the purposes and in the manner as approved by it and the CFO or the person responsible for financial management shall certify to the effect.
(vii) CSR Committee to formulate Annual Action Plan for CSR activities.
(viii) Companies with average CSR obligation of Rs. 10 crores or more in three preceding years to undertake impact assessment through an independent agency for projects of Rs. 1 crore or more which have been completed not less than one year before the impact study and the report to be placed before the Board and in the Annual Report of CSR.

Reporting
(ix) Earlier, only the contents of the CSR policy were required to be disclosed on the company’s website. Now, composition of CSR Committee, CSR Policy and projects approved by the Board are required to be disclosed.
(x) New format inserted for disclosure to be included in the Board’s Report.

3. The provisions relating to amendment of the Companies Act are tabulated below:

Section

Description

Amendment

Earlier
provision

Implication

135(5)

CSR spending

If the company has not completed 3
years
since incorporation, then 2% of average net profit during such
immediately preceding financial year

The Board to ensure that the company
spends at least 2% of the average net profit made during 3 immediately
preceding financial years

This provision is to rationalise the
method of computation of net profit for the purpose of CSR

In case of newly-incorporated entities,
the amount of CSR expenditure will be increased

135(5)

2nd proviso

Unspent amount not relating to an
ongoing project

The unspent amount not relating to an
ongoing project shall be transferred to a Fund specified in Schedule
VII within 6 months of the end of the financial year

If the company fails to spend the
amount, the Board is required to specify the reasons for not spending

This is a welcome step and the
corporates will be benefited

In case the amount cannot be spent, it
can be transferred to a Fund, avoiding non-compliance

135(6)

Unspent amount relating to an ongoing
project

The company is required to transfer the
amount to a special ‘Unspent CSR Account’ within 30 days from
end of financial year and spend it within 3 financial years from date
of such transfer

No corresponding provision

This is a welcome step and the corporates
will be benefited

This will enable corporates to plan
their cash flows and park the excess amount in ‘Unspent CSR Account’ to be
utilised within next 3 F.Y.s

135(7)

Contravention w.r.t. sections 135(5) and
135(6)

Fine equal to:

In case of company – 2X of the amount required to be
transferred, or Rs. 1 crore, whichever is less

In case of officers – 1/10th of the amount
required to be transferred, or Rs. 2 lakhs, whichever is less

No corresponding provision

Provision for fine introduced

4. The provisions relating to amended CSR Rules as per the Companies (Corporate Social Responsibility Policy) Amendment Rules, 2021 are tabulated below:

Rule

Description

Amendment

Earlier
provision

Implication

4

CSR implementation

Eligible implementing entities through
which a company shall undertake CSR will require to register themselves
with Central Government w.e.f. 1st April, 2021

No corresponding provision

Welcome step from the point of view of
governance

Responsibility of the Board to ensure that the funds so disbursed
have been utilised for the purposes and in the manner as approved by
it and the CFO or the person responsible for financial management shall certify
to the effect

5(2)

CSR Committee

Committee to formulate annual action
plan
for CSR activities

Institute transparent monitoring
mechanism for implementation of projects

This is a new provision

Shall help in formulation of
Board-governed annual plan. This would lead to good governance

Board may alter such plan based
on recommendation of CSR Committee

7

CSR expenditure

Board to ensure administrative overheads
not to exceed 5% of total CSR expenditure for financial year

Contribution to corpus, expenditure on
CSR projects approved by Board on recommendation of CSR Committee, excluding
items not falling under Schedule VII

New provisions and welcome ones

This was required as corporates
necessarily need to incur some administrative expenses

Surplus from CSR activities not to be treated as business profit and
be ploughed back in same project or transferred to Unspent CSR
Account
and spent as per policy and annual action plan or transfer to
Fund
within 6 months from the end of financial year

New provision

Shall benefit the corporates in
smoothening their cash flow and also compliance of the CSR provision

Excess amount spent shall be set off within 3
succeeding financial years subject to conditions (i.e., surplus
arising out of CSR activities shall not be considered and Board of the
company shall pass a resolution to that effect)

New provision

Shall benefit the corporates in
smoothening their cash flow and also compliance of the CSR provision

CSR amount may be spent for creation
/ acquisition of capital asset to be held in the manner prescribed

 

8

CSR reporting

Companies with average CSR
obligation of Rs. 10 crores or more in 3 preceding years to undertake impact
assessment
through an independent agency for projects of Rs. 1 crore or
more which have been completed not less than 1 year before the impact study

No corresponding provision

New provision

Will lead to good governance

The report to be placed before the
Board
and in the Annual Report of CSR

Company may book the expenditure
towards CSR which shall not exceed 5% of total CSR expenditure or Rs. 50
lakhs, whichever is less

9

Display of CSR activities on website

Company to disclose composition of CSR Committee,
CSR Policy and projects approved by the Board

Company to disclose the contents of the
CSR policy

 

10

Format for Annual Report on CSR

New format inserted for disclosure to be included in the Board’s
Report

No corresponding provision

Procedural, to clarify the definitions
and meanings

2(b)

Meaning of administrative overheads

General management and administrative
expenditure, excluding direct expenses towards a particular project

No corresponding provision

2(d)

Meaning of CSR activities

Excludes sponsorship activities for deriving market benefits for its
products

As per Schedule VII

2(f)

Meaning of CSR Policy

Definition amended to widen the scope
of Committee to recommend formulation of annual action plan

2(g)

Meaning of international Org.

As defined u/s 3 of UN (Privileges and
Immunities) Act

No corresponding provision

2(i)

Meaning of ongoing project

Project already commenced, multi-year
project, i.e., not less than 1 year but not exceeding 3 years

No corresponding provision

2(j)

Meaning of public authority

As defined under the RTI Act

No corresponding provision

6

CSR Policy

Omitted

List of CSR projects which a company
plans to undertake and monitoring process

This provision was omitted as the
provision relating to annual plan has been introduced

5. Impact Analysis
(I) The new rules will give the corporates thenecessary flexibility in spending in case of ongoing projects.
(II) Those corporates that are unable to spend for any reason will be able to comply with the rules if they transfer the amount to a special Fund
(III) The new rules will bring in more transparency and will involve experts in impact analysis.
(IV) The quality of governance through the Board will be a notch higher
(V) The reporting and disclosure will improve.

ERRATA
We regret that in the BCAJ issue dated January, 2021 (Vol. 52-B, Part 4), certain inadvertent errors have crept in on three different pages. In all cases, lines / cross-headings that should have been deleted have appeared with a ruling line across them. On Page 5, the lines ‘Since we all try to avoid… feel negative emotions’, have a ruling line across them. Similarly, one line on Page 30 and six lines on Page 31 also have ruling lines across them.
The errors are sincerely regretted

DAUGHTER’S RIGHT IN COPARCENARY – PART VI

I am overwhelmed that my articles on the subject have evinced considerable interest. The amendment to the Hindu Succession Act, 1956 (‘the Act’) by the Hindu Succession Amendment Act, 2005 (‘the Amendment Act’) and the issue of daughters’ right in coparcenary property have now been the subject matter of substantial litigation all over the country. Through my articles published in the BCAJ in January, 2009; May, 2010; November, 2011; February, 2016; and May, 2018, I made an attempt to analyse and explain the legal position as per the various cases decided by several High Courts and by the Supreme Court of India.

It cannot be disputed that the amendments were beneficial to society and a step towards ensuring equality between males and females in an HUF. However, in view of the imprecise language of the Amendment Act and lack of clarity about what exactly was intended by the Legislature, the amendment was the subject matter of a plethora of court cases all over the country and ultimately some cases went up to the Supreme Court.

In view of the cases decided by the Supreme Court till then, my article published in February, 2016 expressed a hope that the legal position then explained was final. Unfortunately, further decisions came from the Supreme Court. I say unfortunately because as explained in my last article published in May, 2018, confusion was created by two different decisions of the Supreme Court and I had to end the article with the fervent hope that the Apex Court would review its decisions to resolve the conflict.

I am glad to note that the Supreme Court has now tried to resolve the conflict in its recent decision in the case of Vineeta Sharma vs. Rakesh Sharma and others, reported in (2020) 9 SCC 1.

The confusion created by the Supreme Court can be explained in brief as under:

‘The Supreme Court in the case of Sheela Devi vs. Lal Chand [(2006), 8 SCC 581] held that the Amendment Act would have no application in a case where succession was opened in 1989, when the father had passed away. In the case of Eramma vs. Veerupana (AIR 1966 SC 1880), the Supreme Court held that the succession is considered to have opened on the death of a person. Following that principle in the case of Sheela Devi (Supra), the father passed away in 1989 and it was held that the Amendment Act which came into force in September, 2005 would have no application’.

Based on this, the Madras High Court applied the decision to other cases.

Even in the case of Prakash vs. Phulavati (2016) 2 SCC 36 which was decided in 2016, the Supreme Court held that ‘the rights under the Amendment Act are applicable to living daughters of living coparceners as on 9th September, 2005 irrespective of when such daughters are born’.

Thus, there is a plethora of cases deciding that the father of the claiming daughter should be alive if the daughter makes a claim in the coparcenary property. Moreover, it is necessary that the male Hindu should have been alive on the date of coming into force of the Amendment Act. Thus, at that stage the legal position was that the rights of a daughter under the Amendment Act are applicable to living daughters of living coparceners as on 9th September, 2005 irrespective of when such daughters are born. Consequently, I closed my February, 2016 article with the hope that this final legal position would prevail without any further complications.

Unfortunately, this did not happen and in the case of Danamma vs. Amar (2018) 3 SCC 342 the Supreme Court held differently. The principle laid down in earlier cases was not followed and (without considering its own decision in the case of Sheela Devi) it was held that a daughter would have a share even if her father was not alive on the date of coming into force of the Amendment Act. This decision caused confusion. In my June, 2018 article I could end only by expressing the fervent hope that the Apex Court would review its decision in the Danamma case so that the apparent conflict is resolved without resulting in further litigation. Both these decisions were re-ordered by a Bench of two judges. Later, it was decided to refer the issue to a larger Bench.

Therefore, it is heartening to note that the larger Bench of the Supreme Court, after considering all previous decisions, including some High Court cases, has now taken a view which possibly settles all the confusion created earlier and lays down the law which is now final and binding on all. In the recent case of Vineeta Sharma (Supra), the Supreme Court has overruled its earlier decision in the cases of Prakash vs. Phulavati and partly overruled the Danamma decision of interpretation of the Amendment Act.

The final legal position as emerging from this decision can be summarised as follows:
(i) A daughter of a coparcener who is living as on9th September, 2005 shall by birth become a coparcener in her own right in the same manner as a son and have the same rights in the coparcenary property as she would have had if she would have been a son;
(ii) This position applies regardless of when such daughter is born;
(iii) It is not necessary that the father on account of whom a daughter gets a right should be alive.

Hopefully, this closes the chapter of controversies regarding the interpretation of the Amendment Act. I can only express the wish that the legal ingenuity of lawyers does not extend to raising any new issues and allows the final legal position to stand.

VALUATION OF CONTINGENT CONSIDERATION

The billion-dollar acquisitions that we read about, especially of early-stage companies, raise the question, how do deal makers arrive at the deal price? There is seldom a transaction wherein the buyer and the seller would agree on the future outcome of certain critical parameters which could be a point of negotiation, or even the cause of some potential deals falling through with the two parties unable to reconcile on the deal price. It is contingent consideration that helps in breaking this deadlock between two parties because it enables the buyer to pay a part of the deal price to the seller only on the achievement of certain pre-agreed critical milestones. While such contingent consideration is commonly observed in M&A deals, there are several complexities when it comes to the valuation aspects of such consideration.

1. INTRODUCTION TO CONTINGENT CONSIDERATION

Ind AS 103, Para 37 requires the consideration transferred in a business combination to be measured at fair value which is to be calculated as the sum of the acquisition-date fair value of assets transferred by the acquirer, the liabilities incurred by the acquirer to the former owners of the said business, and the equity interests issued by the acquirer. In fact, contingent consideration is one of the forms of consideration as described in Ind AS 103 and it has to be recorded at the acquisition-date fair value as a part of the total consideration. Contingent considerations are typically employed in transactions to bridge the valuation gap between the buyers’ and the sellers’ differences of opinion regarding the target entity’s future economic prospects. It helps to get the buyer and the seller on the same page when it comes to the valuation of the target entity. Let us examine this basic concept by way of an example:

Company A intends to acquire Company B. Company B has just introduced a new product line that is expected to generate significant sales. Company B’s owners have projected a significant amount of sales from the proposed product line and are considering the same to influence the deal size. Company A, on the other hand, believes that there is a risk of uncertainty in the achievement of targets contemplated by the seller and hence there is a disagreement on the deal valuation. By incorporating a contingent consideration clause in the purchase agreement, the seller accepts part of the business risk along with the buyer and also participates in any upside post-transaction.

Contingent consideration may be contingent on different events, for example, on the launch of a product, on receiving regulatory approval, or reaching a certain revenue or income milestone. The achievement of such events often spans over more than a year. Thus, it is necessary to understand the acquisition date as well as the post-acquisition treatment of such contingent consideration.

2. CLASSIFICATION AND MEASUREMENT OF CONTINGENT CONSIDERATION

2.1 Liability vs. equity classification
The classification of consideration is essentially driven by the mode of settlement of such consideration. Consideration settled in cash is always classified as a liability. In a scenario where the consideration is to be settled by issue of certain instruments of the buyer, one needs to determine whether the number of instruments to be issued are fixed and determined at the acquisition date. In a scenario where the number of instruments is fixed, then such consideration is classified as equity, and where the number of instruments to be issued is not fixed, then such consideration is to be recognised as a liability. Refer to Figure 2.1.1 for a simplified approach to determining equity vs. liability.

Figure 2.1.1: Classification of contingent consideration

Example: A fixed monetary amount to be settled in a variable number of shares would be classified as a liability.

Contingent consideration classified as a liability is required to be re-measured at its fair value at each reporting period. For example, a consideration depending on revenue achieved over the next three years from acquisition will need to be fair-valued at the end of each year / quarter. Whereas, a consideration classified as equity is not required to be fair-valued post the initial recognition since the consideration has already been determined and locked as at the acquisition date.

3. VALUATION OF CONTINGENT CONSIDERATION / EARN-OUTS

The methods to be followed and the approach will be driven by the way the payment of such contingent consideration or earn-outs is structured. The pay-outs are structured based on a single or more than one metric. The Table below illustrates the various metrics which are commonly observed for contingent consideration:

Financial matrices

Non-financial matrices

Revenue

Gross profits

EBITDA

Profit before tax

Cash flows targets

Stock price

Result of clinical trials

Software development / R&D milestones

Employee retention targets

Customer retention targets

Closing of a future transaction

Number of units sold

Mostly, contingent consideration is paid on achievement of certain revenue or profit targets. Additionally, such payments may be spread over more than just one year. The pay-outs can either be linear pay-outs or non-linear pay-outs.

3.1 Linear pay-outs
Pay-outs which are dependent on a single metric and are expressed in terms of a fixed percentage or the product of a financial or some non-financial parameters, are referred to as linear pay-outs. Considerations that vary based on different levels of revenue or other parameters are non-linear pay-outs. For example:

Target will receive a payment at some future date as follows:

  •  If EBIT < $1 million, the payoff is zero;
  •  If EBIT = $1 million, the payoff is a 10x multiple of EBIT.

The valuation method will be driven by the structure of the contingent consideration pay-outs. There are two broad valuation approaches used to value a contingent consideration.
i) Probably weighted expected return method, more commonly referred to as ‘PWERM’, or scenario-based method (‘SBM’); and
ii) Option pricing method, also referred to as the ‘OPM’.

3.1.1 Probably weighted expected return method (PWERM)
The PWERM assesses the distribution of the underlying matrices based on estimates of the forecasts, scenarios and probabilities. The pay-out computed is then discounted to present value using a discount rate corresponding to the risk inherent in the inputs considered while computing the compensation. The following are the steps followed:
i) Estimate scenarios of outcomes and associated probabilities.
ii) Compute the expected payoffs using the scenario probabilities.
iii) Discount expected payoffs to present value using risk-adjusted discount rates.

Illustration 3.1.1.1

• INR 100 crores payment contingent upon obtaining FDA approval.
• Approval expected in one year.

Solution:

Particulars

Payment

Probability

Prob.-weighted payment

Approval
obtained

Approval
obtained

INR
100

INR
0

75%

25%

INR
75

INR
0

Total

Discount
rate

Present
value factor

 

100%

10%

INR
75 crores

 

0.91

Fair
value of contingent consideration

INR
68 crores

Advantages:
i)    Management controls scenarios and probabilities: The scenarios and probabilities are generally prepared by the management because they would be the best source for such data points.
ii)    Understandable: The computation and the flow are understandable to a reader with basic financial knowledge.
iii)    Flexible: The model can be structured to fit most pay-out scenarios.

Disadvantages:
i)    Management controls scenarios and probabilities: While this has been discussed under advantages, management control over these inputs is also counter-intuitive since management tends to be overly optimistic or pessimistic in its assumptions.
ii)    Lots of subjective assumptions: Most of the methods / inputs are subjective and involve judgement, which at times is not the most ideal approach to value such pay-outs.
iii)    Discount rate: Since the methods involve multiple scenarios, it is challenging to estimate the appropriate discount rate.
iv)    Path dependencies: Pay-out scenarios which are path dependent, i.e., the result of one scenario is related to one or more dependent scenarios, are difficult to model in the PWERM. It can lead to multiple nodes and is prone to errors.

3.2 Non-linear pay-outs
Non-linear contingent considerations are either not strictly linear, or they pay a fixed amount based on a milestone correlated with the broader economy; thus, they require an OPM as their complexity and discounting cannot be adequately captured in a PWERM; for example, if the buyer pays INR 50 crores if EBITDA is at least INR 75 crores in the first three years, or if the buyer pays 40% of revenues above INR 50 crores in year two, subject to a maximum of INR 40 crores. Another, more complicated, example: The buyer pays 40% of revenues in years one to three, subject to a minimum of INR 10 crores and a cap of INR 40 crores. In such an arrangement, a PWERM will not work since it’s impossible to adjust the discount rate to align with the risk of such a complex pay-out structure. An option-pricing model is generally used to value such arrangements.

3.2.1 Option-pricing methods
The payoff structures for contingent consideration arrangements that have a non-linear structure are similar to those of options in that payments are triggered when certain thresholds are met. Accordingly, some option-pricing methods may be appropriate for valuing contingent consideration that have a non-linear payoff structure and are based on metrics that are financial in nature (or, more generally, for which the underlying risk is systematic or non-diversifiable). The OPM is implemented by modelling the underlying metrics based on a log-normal distribution that requires two parameters:

* The expected value: The management expectation of the matrices over the term of the arrangement. This is generally provided by the management.

* The volatility (standard deviation) of the metric: The volatility of the metric measures the potential variability from the expected value. This is generally determined by using market-based data. However, volatility for financial metrics like revenue and EBITDA cannot simply be computed using the movement in stock prices of the comparable companies. It needs to be appropriately levered and unlevered to capture the variability in achievement of the metrics.

There are two widely used option-pricing methods, viz., the Black-Scholes Model (‘BSM’) and the Monte Carlo simulation model.

3.2.1.1 Option-pricing method – Black-Scholes Model
BSM treats a pay-out arrangement just like an ordinary option which enables use of the standardised Black Scholes – Merton formula. This approach can work for simpler pay-out structures, for example, if the selling shareholder earns the pay-out only if the target metric hits a threshold, or for linear pay-outs with caps or floors. The consideration is assumed to represent a call option on the future performance of the seller.

Illustration for BSM
Earn-outs are contingent upon the target of achieving a benchmark EBIT of INR 11,25,000 within three years. The EBIT is currently INR 10,00,000. At the end, the acquirer will pay additional consideration equal to the excess EBIT over the benchmark.

The discount rate is 10% and the risk-free rate is 3%. Volatility of earnings is 14% based on historical EBIT.

The inputs to the Black-Scholes Model for this example are:

i)    The current INR 10,00,000 level of earnings is the value of the underlying,
ii)    the benchmark of INR 11,25,000 serves as the exercise price,
iii)    the term is three years,
iv)    the volatility is 14%,
v)    the risk-free rate is 3%, and
vi)    the dividend rate is 0%.

Based on the above inputs, calculations for the Black-Scholes Model can be incorporated into an Excel spreadsheet. The resulting call option value of INR 84,413 will be the value of the contingent consideration.

3.2.1.2 Option-pricing method – Monte Carlo Simulation Model
For more complex structures, a Monte Carlo simulation is preferred. Arrangements that pay over multiple periods or multiple metrics are subject to combined caps or a floor. A Monte Carlo simulation considers the correlation between matrices and pay-outs over multiple periods. The Monte Carlo simulation repeats a process many times attempting to predict all the possible future outcomes. At the end of the simulation, several random trials produce a distribution of outcomes that can be analysed. Random numbers are used to measure possible outcomes and the likelihood of their occurrence. Generally, simulation software are used to generate random numbers. These random numbers are generated based on the applicable distribution driven by the metric triggering the pay-outs.

The following are the important considerations of key inputs for valuing contingent considerations using an option-pricing model:

Discount rate applied based on risk of target metric
For earn-outs that require this kind of discount rate, either the top-down or bottom-up approach may be used to develop the rate. These approaches are well known in the valuation field. They rely on the concept of beta (ß), which reflects the level of market risk reflected in an instrument.

In the top-down approach, ß is based on the deal’s rate of return adjusted for the difference in market risk between the target metric and the overall enterprise value. Adjustments can reflect many relevant factors, such as the general risk in the target metric, leverage, term, size premium and entity-specific risk. In the bottom-up approach, ß is the target metric adjusted for term, size, entity-specific risk and other relevant valuation factors. The bottom-up approach may rely on statistical analysis of the target metric from the entity or its peers.

Volatility
Valuation techniques that rely on options modelling or Monte Carlo simulation require a volatility of the target metric. There are four ways in which such volatility can be computed:

i)    Historical changes in the target metric for the acquired entity and public comparable companies,
ii)    Entity volatility based on the relationship between the target metric and the enterprise value,
iii)    The difference between analyst forecasts and actual results for peer companies, and
iv)    Fitting a distribution to management’s estimates.

With any of these methods, a discussion with management is recommended since a derived volatility may fail to accurately incorporate the economics of the entity’s situation.

Both option-pricing models can get complex and difficult to comprehend for a lot of professionals and they have their share of advantages and disadvantages.

Advantages:
i)    Manage complex payoff structures: Can accommodate a wide range of complex payoff structures.
ii)    Objective assumptions: Most inputs are governed by market-related inputs making it less subjective than the PWERM.
iii)    Discount rate: Since the computations are made using random numbers and volatility, generally risk-adjusted discount rates are used, reducing the need of subjectivity inherent in building discount rates for financial matrices.

Disadvantages:


i)    Perceived to be complex and time-consuming.
ii)    Rigid: OPMs are based on a prescribed formula and are perceived as rigid relative to the PWERM.
iii)    Difficulty in converting real-world cash flows into risk-free cash flows: It is challenging at times to convert the pay-out structure into models to be used with the OPMs.

Valuation of contingent consideration and selection of the appropriate methods for doing so can be quite challenging. Such valuations are continuously evolving as new literature on methods and approaches is published around the world. The selection of methods to value these arrangements is driven by the complexity of the pay-outs and the experience and the qualifications of the valuer to be able to appropriately apply these methods.

The complexity of contingent consideration is not limited to its valuation but has several accounting and taxation implications which need to be considered and analysed. The accounting and tax aspects vary, based on the accounting standard being followed as well as the structure of the transactions. A discussion on these aspects would warrant an independent article, which we intend to cover over the next few issues.

INTRODUCTION TO ACCREDITED INVESTORS – THE NEW INVESTOR DIASPORA

Investors and investments have, over the decades, evolved with respect to form, structure, taxation and compliances involved. The constant need to test and re-invent has led to newer market participants exploring the investment universe.

However, one of the foremost principles of investment and investing, that is, investors should invest in financial products after knowing the risks and returns associated with them, and therefore take an informed decision regarding their investments in line with their risk-return profile, continues to prevail.

SEBI Consultation Paper: On 24th February, 2021, SEBI introduced a ‘Consultation Paper on the Introduction of the Concept of Accredited Investors’ (‘Consultation Paper’) in the Indian securities market.

The Consultation Paper made a case for introduction of the concept of Accredited Investors (AI) in the Indian securities market and covered the following aspects:

  •  Benefits to the Indian Securities Market
  •  Proposed AI eligibility criteria for various categories of investors, namely, Individuals, HUFs, Family Trusts, Bodies Corporate and Non-Resident Investors
  •  Process and validity of accreditation
  •  Procedure for implementation

SEBI Press Release (SEBI PR): Subsequently, on 29th June, 2021, SEBI via PR No. 22/2021, inter alia proposed a formal introduction of the framework for AI in the Indian securities markets.

This article covers the following aspects:

(A) CONCEPT OF AI

The AI framework as proposed by SEBI in India and prevalent framework across different economies; impact on the Indian securities markets vis-à-vis Private Equity, Venture Capital, Portfolio Management Services (PMS) and the Startup ecosystem.

AI, or as they are colloquially called Professional or Qualified Investors, amongst others are a class of investors who possess expert understanding of various financial products, the risks and returns associated with them, coupled with the financial capacity to absorb losses, enabling them to take relatively higher risk in their investing endeavours.

Hence, they are classified as a distinct group to recognise their ability to take informed decisions regarding investments and to selectively eliminate the need for extensive regulatory protection. Such investors may also enjoy relaxations with respect to disclosure requirements, filings of offer documents / prospectus, etc., and enhanced flexibility in respect of investor reporting.

Across the globe, other jurisdictions have also similarly demarcated this investor class considering their distinct knowledge and investment experience, alongside financial capacity.

(B) WHY HAVE ACCREDITED INVESTORS

The investment ecosystem in India today restricts investments in various asset classes based on the capacity of the investor to digest risks associated with that investment. This ability to digest risks is determined by minimum investment thresholds and high net worth requirements.

However, over time, investors have gained requisite knowledge to demonstrate an understanding of the asset class along with the ability to take on the risks associated with such investments.

Therefore, identifying this new investor diaspora as an ‘Accredited Investor’ enables achieving the premise of risk-reward balance coupled with the opportunity to allow investors to invest in asset classes that they understand and follow which would fill in the gap in the current investment and securities regulations. This model has also been successfully implemented globally (see ‘Accredited Investor Ecosystem Globally’ below) and has resulted in the creation of this new investor diaspora.

Overall economic boost in the investment universe and promotion of asset classes which hitherto were inaccessible to a large set of investors would be visible.

(C) THE ACCREDITED INVESTOR FRAMEWORK AS PROPOSED BY SEBI IN INDIA1 AND ACROSS DIFFERENT ECONOMIES:

(I) The eligibility criteria for Resident Investors, Non-Resident Indians and Foreign Entities as proposed by SEBI are as detailed below:

Category of investor

Eligibility criteria for Indian
investor to be an Accredited Investor

Eligibility Criteria for Non-Resident
Indians and Foreign Entities to be Accredited Investors

Individuals, HUFs and Family Trusts

Annual income >= INR 2 crores; or

Net worth >= INR 7.5 crores with not
less than INR 3.75 crores of financial assets; or

Annual Income >= INR 1 crore + Net
worth >= INR 5 crores; with not less than INR 2.5 crores of financial
assets;

Annual income >= USD 300,000; or

Net worth >= USD 1,000,000; with not
less than USD 500,000 of financial assets; or

Annual income >= USD 150,000 + Net
worth >= USD 750,000; with not less than USD 375,000 of financial assets

Trusts (other than Family Trusts)

Assets Under Management >= INR 50
crores

Assets Under Management >= USD 7.5
million

Bodies Corporate

Net worth >= INR 50 crores

Net worth >= USD 7,500,000

Others

Central and State Governments,
Developmental agencies such as SIDBI, NABARD, etc., set up under the aegis of
Government(s), funds set up by Government(s) and QIB’s as defined under SEBI
(ICDR) Regulations, 2018

Multilateral agencies, Sovereign Wealth
Funds, International Financial Institutions and Category – I FPIs

 

1   SEBI Consultation Paper dated 24th
February, 2021

Manner of determination of annual income, net worth and value of real estate assets
(i) The income and asset details which need to be considered for assessment of eligibility criteria shall be as per the data furnished in the Income-tax Returns filed for the immediately preceding financial year and the financial year in which assessment is being made.

(ii) For calculation of net worth, the value of the primary residence of the investor shall not be included.

(iii) In case the assets of the investor accounted for the assessment of eligibility criteria are in the form of real estate, a ‘ready reckoner rate’ as published by the respective local bodies shall be considered.

Manner of determination of annual income and net worth in case of joint accounts

In case of joint accounts held by individuals, the account shall be considered as an AI account only in the following scenarios:

(i) The First holder of the account is an AI;

(ii) The Joint holders are parent(s) and child(ren), where at least one person is independently an AI;

(iii) The Joint holders are spouses and their combined income / net worth meets eligibility criteria.

Manner of determination of financial capacity in case of bodies corporate

For bodies corporate, the latest statutorily audited information as on the date of application shall be considered for assessment of eligibility.

For trusts, the calculation of Assets Under Management shall be based on the valuation data as included in the Statutory Audit Report of the preceding financial year or as on the date of application.

(II) Accredited Investor Ecosystem Globally

Country

Accredited Investor criteria

Regulation

United States of America

Earned income exceeding USD 200,000 (or
USD 300,000 together with a spouse) in each of the prior two years and
reasonable expectation of a similar earning for the current year, or

SEC Reg 501(d)

United States of America




(continued)

has a net worth over USD 1,000,000,
either alone or together with a spouse (excluding the value of the primary
residence

SEC Reg 501(d)

Singapore

Net personal assets exceeding SGD 2
million (or equivalent in foreign currency), or in case of Corporates – Net
Assets exceeding SGD 10 million (or equivalent foreign currency) or

Income in preceding 12 months should be
not less than SGD 300,000 (or equivalent in foreign currency)

Section

4A(1)(a) of the Securities and Futures
Act (SFA)

Australia

Net assets of at least AUD 2.5 million, or

A gross income for each of the last 2
financial years of at least AUD 250,000

Section 708(8) of the Corporations Act,
2001

United Kingdom

‘Experienced Investor’ definition in the
UK:

A body corporate which has net assets in
excess of
€ 1,000,000 or which is part of a group which has net assets in excess of €
1,000,000;

Trustee of a trust where the aggregate
value of the cash and investments which form part of the trust’s assets is in
excess of € 1,000,000;

An individual whose net worth, or joint
net worth with that person’s spouse, is greater than € 1,000,000, excluding
that person’s principal place of residence

Section 3 of Financial Services
(Experienced Investor Funds) Regulations, 2012

When compared to global benchmarks, the financial parameters (vis-à-vis income and net worth) laid down by SEBI are on the higher side and may indicate a sense of conservative caution which is understandably needed in the advent of the sensitivity and adaptability concerns that surround this critical regulation. However, over time SEBI may consider re-evaluating these parameters as soon as AI investment becomes mainstream and with the imminent need to reduce entry barriers (income and net worth) for a seamless functioning of these crucial market participants.

(D) IMPACT ON THE INDIAN SECURITIES MARKETS VIS-À-VIS PRIVATE EQUITY, VENTURE CAPITAL, PMS AND STARTUP ECOSYSTEM

The Indian financial and securities market ecosystem is evolving with the Startups and the alternative investment space is fast maturing.

The proposed regulations as detailed below create a base for a thriving market and a soft regulatory regime. While the market for customised products for elite investors may not be readily available in the Indian securities market at this juncture, putting in place the required enabling framework will propel innovation in and development of the securities market in time to come.