Category: Article

Applicability
One of the most distressing features of section 186 is that it even applies to private limited companies which are not subsidiaries of public limited companies. Section 372/372A had a blanket exemption for private limited companies. A similar exemption is not found u/s. 186. Thus, all private companies would now have to comply with the provisions of this section.

Limit on Investments
The overall limit for a company to invest in the securities of another body corporate u/s. 186(2) is the higher of the following two limits:
(a) 60% of paid-up share capital + free reserves + securities premium; or
(b) 100% of free reserves + securities premium

This limit applies to investment by way of fresh acquisition or purchase or otherwise of securities of another body corporate.

The term ‘Securities’ has been defined u/s. 2(81) of the Act to mean securities as defined u/s. 2(h) of the Securities Contract (Regulation) Act, 1956. Thus, they would include shares (equity, preference, convertible preference, non-voting rights shares), debentures, bonds, derivatives in securities, warrants, other marketable securities of a body corporate. The limit would apply to investment by a company in the securities of both listed as well as unlisted companies.

Next let us examine the definition of the term ‘body corporate’. Section 2(11) of the Act defines it as including a company incorporated outside India. However, it does not include a corporate sole, a co-operative society and any other body corporate so notified by the Government. The most important aspect of a body corporate is that it is an independent legal entity with a distinct identity which is separate from its partners/shareholders/members and has a perpetual succession. It can own property on its own accord and in its own name. Hence, investing in the securities of a foreign subsidiary/joint venture would also fall within the purview of these limits. However, a mutual fund structured as a trust is not a body corporate and hence, investment in the units issued by a mutual fund (structured as a trust) would not be within the purview of section 186.

Let us next look at the composition of the limits for considering the 100% or 60%:

(a) Section 2(64) of the Act defines the phrase ‘paid-up share capital’ to mean such aggregate amount of money credited as paid-up as is equivalent to the amount received as paid-up in respect of shares issued and also includes any amount credited as paidup in respect of shares of the company but does not include any other amount received in respect of such shares, by whatever name called.

(b) The phrase ‘free reserves’ is defined by section 2(43) to mean such reserves which are available for distribution as dividend. These reserves are to be reckoned as per the last audited balance sheet of a company. The following are however, not treated as free reserves:

(i) any amount representing unrealised gains, notional gains or revaluation reserve, or
(ii) any change in carrying amount of an asset or of a liability recognised in equity, including surplus in profit and loss account on measurement of the asset or the liability at fair value.

(c) T he last component of the limits is ‘securities premium’ which is governed by section 52 of the Act and it states that where shares are issued at a premium, the amount of the premium received on those shares shall be transferred to a “securities premium account”.

What if Limits are to be exceeded?

In addition, the requirements of the Companies (Management and Administration) Rules, 2014 as well as the revised Clause 35B of the Listing Agreement should be complied with by all listed companies. This requires that for all resolutions to be passed at General Meetings, evoting facility must be provided by the listed company.

Layers of Investment Companies

The restriction is on routing any investment through more than 2 vertical layers of investment companies as illustrated by the following diagram (illustration-1) which violates section 186:

It may be noted that the prohibition is on having more than 2 layers of investment companies and hence, we need to ascertain what constitutes an investment company? the section defines an ‘investment company’ to mean a com- pany whose principal business is acquisition of shares, debentures or securities. at the outset, it is very clear that the definition only applies to a company and not to any other body corporate or entity. A company is defined to mean a company incorporated under the act or under any previous company law. Hence, if an LLP is used as an investment vehicle then this prohibition u/s. 186 would not apply. Whether you can incorporate an investment LLP is another story altogether.

Secondly, it must be a company whose principal business is acquisition of securities. What is principal business has not been defined. In this context, the principal business tests  laid  down  by  the  reserve  Bank  of  india  to  determine what constitutes an nBfC (non-banking financial Company) may be helpful. according to these tests, a company will be treated as an NBFC if it satisfies both the following conditions as per its audited accounts:

(i)    Its financial assets as per the last audited Balance Sheet should be more than 50% of its total assets (netted off by intangible assets) and

(ii)    Its income from financial assets as per the last audited Profit & Loss Account should be more than 50% of its gross income.

It should be noted that both these tests should be sat- isfied in order to treat a company as an NBFC. A company whose principal business is acquisition of securities may generally also qualify as an NBFC unless it can be treated as a Core investment Company or a CiC or if it is a company exempted from nBfC provisions, e.g., stock brokers. in this respect, the decision of the madras high Court u/s. 372 of the Companies Act,1956 in HC Kothari, 75 Comp. Cases 688 (mad) may be referred to. this decision held that it is clear that the income derived from the business is not the criteria. the test would rather be, as to what is the principal business of the company? a balance- sheet should show as to what is the principal business of the company.

The  department  of  Company  affairs’  views  (dated  1st July, 1963) under the erstwhile section 372 may also be considered:

“In the Department’s opinion whether a company is or is not an investment company and the business which it should or should not transact to fall within the provision of the definition of an “Investment company” within the meaning of section 372(10) is actually a question of fact. The words used in the section are “whose principal business is the acquisition of shares.  ” These words imply that the company concerned is expected to hold the shares, etc., acquired by it for a reasonable time.”

The Department’s views (dated 23rd February, 1961 and 4th October, 1961) under the erstwhile section 372, in relation to a share trading company, were as follows:

“The question as to whether a particular share trading company which deploys its funds for short-term transaction in buying and selling shares is an investment company or not, is one of fact which has to be determined in relation to the actual business transacted by it. The Department is inclined to the opinion that a company should be treated as an investment company if the whole or substantially the whole of its business relates to shares, securities, stock and debentures, etc. A share trading company may take advantage of these provisions of section 372 if it can be classed as an investment company.”

The act expressly provides that the restriction on two layers of investment companies even applies to an NBFC whose principal business is acquisition of securities. CiCs are a class of NBFCs which invest 90% of their net assets in group companies’ securities and at least 60% of 90% of their net assets in group companies’ equity shares. thus, even NBFCs and CiCs are restricted from having only two layers of investment companies.

The investor company could be an investment or an operating company but it cannot route its investment via more than 2 layers of investment companies. if the investment is routed through an operating company or one whose principal business is not acquisition of securities, then the restriction u/s. 186 on 2 layers would not apply. The following diagram (illustration-2) would amplify this statement:

Exemption:
The  prohibition  on  making  investments  only  through   a maximum of two layers of investment companies will not affect the following two cases:
(i)    a company from acquiring any other company incorporated in a country outside india if such other company has investment subsidiaries beyond two layers as per the laws of such country; or
(ii)    a subsidiary company from having any investment subsidiary for the purposes of meeting the requirements under any law or under any rule or regulation framed under any law for the time being in force.

Further, section 186(1) gives power to the Government to prescribe such companies which can invest via more than 2 layers of investment companies.

Thus, exceptions presently available are if the indian in- vestor company has acquired a foreign company which, in turn, has more than two layers as per the laws of its country or if the subsidiary of an investor company, in turn, has any investment subsidiary for meeting the requirements of any law.

When indian companies make overseas investments, several times they consider routing such overseas investments through an intermediate holding Company (IHC), regional holding Company (RHC), etc. it is a moot point whether the prohibition u/s. 186 can apply to an investment made in a foreign company via more than 2 layers of IHCs/RHCs? This is because a company is defined under the act to mean a company incorporated under the act or under any previous company law and an ihC or a RHC incorporated abroad is a body corporate but not a company within the meaning of the act. interestingly, under the fema regulations, the RBI is also known to frown upon the use of multi-layered SPVs for making an overseas direct investment.

   Other compliances
in addition to the above substantive provisions, section 186 also lays down several compliances for the investor company, such as, holding investments in its own name, board resolution to be passed by unanimous consent of all directors present at the meeting, maintaining a register of investments, obtaining prior approval of financial institutions in certain cases, etc.

except the provisions relating to two layers of investment companies, none of the other provisions of section 186 are applicable to the following cases of investments:

(a)    to any acquisition made by a registered NBFC whose principal business is acquisition of securities in respect of its investment activities. it may be noted that the exemption is only available to an nBfC which is registered with the rBi. under the CIC directions, a CiC is also a class of nBfCs. hence, this exemption should be available even to registered CICs. however, only CIC-nd-Si, i.e., those which have an aggregate asset size in excess of rs.100 crore need to be registered with the rBi. other CiCs are exempted from  registration  both  as  a  CiC  and  as  an  nBfC. hence, will such exempted CiCs be eligible for the exemption u/s. 186 is a moot point?
(b)    to  any  acquisition  made  by  a  company  whose  principal business is the acquisition of securities. Such companies could be NBFCs, CICs, stock/subbroking companies, Venture Capital Companies, alternative investment funds structured as companies, etc.
(c)    to any acquisition of shares allotted in pursuance of clause (a) of s/s. (1) of section 62, i.e., allotment under a rights issue.

A related compliance is laid down u/s. 187 of the Act which requires all investments made or held by a company to be held in its own name. however, it may hold shares in its subsidiary company in the name of its nominees if it’s required to ensure minimum number of members. unlike the earlier section 49 of the 1956 act, section 187 even applies to a company whose principal business consists of buying and selling of securities.

An  additional  compliance  is  incorporated  in  the  report of the Board of directors. it requires to give particulars   of investments u/s. 186. Further, the Audit Committee’s terms of reference includes scrutiny of intercorporate investments.

Further, section 179(3) states that the power to invest the funds of the company can be exercised by the Board of directors only at a meeting of the Board. hence, a Circu- lar resolution is not possible.

    Exemptions u/s. 372a Dropped

    Penalty
Section 186 imposes a heavy penalty for the violation of the provisions of this section. if a company contravenes the provisions of this section, the company shall be pun- ishable with fine which ranging from Rs. 25,000 to Rs. 5 lakh. Every officer who is in default shall be punishable with a term which may extend to 2 years and with fine ranging from rs. 25,000 to rs. 1 lakh.

  Layers of Subsidiaries
in addition to the restriction on layers of investment companies u/s. 186, there is also a restriction u/s. 2(87) of the act on the number of layers of subsidiaries which certain prescribed class of holding companies can have. a subsidiary includes a company as well as a body corporate, such as an LLP. Thus, in respect of prescribed holding companies they cannot have more than certain number of layers of subsidiaries. it may be noted that unlike the restriction on layers of investment companies, this restriction applies both to operating as well as investment subsidiaries and to subsidiaries which are companies or body corporates. Currently, no class of holding companies or number of layers have been prescribed.

one may compare the restrictions contained in section 186 vs. section 2(87) as follows:

 Compilance for The Investee company
The  investee  company  needs  to  pay  special  attention as to whether the issue of fresh securities to the investor company would constitute a private placement u/s. 42 read with the Rules notified thereunder and/or a preferential issue u/s. 62(1)(c) read with the Rules notified thereunder? Several substantive and procedural conditions have been laid down in this respect for the investee company.

Conclusion
The  law  relating  to  intercorporate  investments  is  one area which has witnessed a sea change under the Companies Act, 2013 as compared to the Companies Act, 1956! Corporate india is going to have to grapple with several intended and unintended consequences of these new  provisions  but  then,  who  said  law  and  logic  go together?

Background:
In India since 2001, issue of DVR shares has been allowed. These can be used to thwart hostile takeovers, as for all practical purposes, they decouple economic interest and voting rights. Shares with DVR are mainly targeted at passive investors. In most cases, small or retail investors hardly exercise their voting rights, nor do they have an understanding of corporate affairs to an extent that they can influence corporate actions. They invest in shares only for economic returns. Therefore, they give away their voting rights in favour of those investors who run the company and have management control. Thus, this mode offers investors an avenue to acquire shares at lower prices with prospects of higher dividends in return for surrendering their voting rights.

Importance:
DVR shares offer investors an opportunity to earn better returns in lieu of surrendering their voting rights and also allow a company to dilute its equity without matching dilution in the promoters’ stake. At times companies issue DVR shares to fund new large projects. This also helps strategic investors who do not want control but are looking at a reasonably big investment in a company.

Legal requirement:
Section 86 of the Companies Act permits the issue of equity shares with DVRs, subject to conditions prescribed under the Companies (Issue of Share Capital with Differential Voting Rights) Rules, 2002.

Conditions:
Rule 3 provides that every company limited by shares may issue shares with differential rights as to dividend, voting or otherwise, if apart from specified procedural compliances, it conforms to the following:

• It has distributable profits in terms of section 205 of the Companies Act, 1956 for three financial years preceding the year in which it was decided to issue such shares.
• It has not defaulted in filing annual accounts and annual returns for three financial years immediately preceding the financial year in which it was decided to issue such shares.
• The issue of such shares cannot exceed 25% of the total issued share capital of the company.

Global perspective:
A large number of global giants have raised funds through DVR issues, prominent among them are Google, NewsCorp and Berkshire Hathaway.

Indian scenario:
While DVR is a well-accepted instrument used by blue-chip companies in international markets to raise funds, even after a decade of the government’s Notification, the concept is yet to gain wide currency in India.

Pantaloons Retail India Ltd. Bonus Issue:
In July 2008, PRIL, India’s leading retailer, was the first to issue bonus shares with a DVR option. The company made a bonus issue of 1: 10 shares with differential voting rights and 5% additional dividends as well. Although there is no fund-raising involved in a bonus issue of shares, the idea was to get the markets familiar with such instruments and create another alternative to raise funds in the future. “Differential voting rights (DVR) has become a widely used innovative instrument in global markets and by coupling a bonus issue with a DVR, we believe in enhancing alternatives for our shareholders,” Kishore Biyani, MD of PRIL had stated in a press release.

Gujarat NRE Coke Ltd. DVR:
In September 2009, the company issued B Equity Shares of the Company with Differential Voting Rights (DVR Shares) with lower voting rights (1/100th of the voting right of ordinary equity share). The same were issued as bonus shares in the ratio of 1 B equity shares for every 10 equity shares held.

The above illustrates the past one year relative performance of the ordinary equity share (512579) vis-à-vis the DVR share (GUJNREDVR) and the broader markets (BSE Sensex). We find that while both the ordinary as well as the DVR share have moved in a direction opposite to the BSE and have witnessed reduced share prices; the magnitude of the fall for DVR (29%) is less than that of the ordinary share (39%).

Tata Motors DVR:

In October 2008, Tata Motors became the first Indian company to make a rights issue of shares carrying differential voting rights (DVR) (issue size: Rs.1960.42 crores). DVR shares have 1/10th of voting rights of ordinary shares and offer a 5% higher rate of dividend over the normal shares. It issued these shares at Rs.305 i.e., about 10% lower than the issue of normal rights at Rs.340.

The diagram shown alongside illustrates the past one year relative performance of the ordinary equity share (500570) vis-à-vis the DVR share (TATAMTRDVR) and the broader markets (BSE Sensex). We find that while both the ordinary as well as the DVR

share have outperformed the BSE; the magnitude of the gain for DVR (39%) is less than that of the ordinary share (48%).

Conclusion:
For an investor, who believes in being a part of the company’s decision processes, DVR shares are not attractive due to limited voting rights.

However, if one is a minority investor and isn’t concerned much with voting rights per se, then investing in the DVR would certainly be an attractive proposition. DVRs mostly trade at a discount, largely due to the fewer voting rights they enjoy. However, at times, the gap between DVR and ordinary shares is large, providing good opportunity to investors. (Globally, the discount between shares with DVRs and ordinary shares is about 10%.) Not only does an investor stand to gain from capital appreciation in a scenario where the price difference between the ordinary and the DVR share reduces over a period as a result of rising awareness about the product, he will also be entitled to higher dividends. Furthermore, he can always invest back in ordinary shares by exiting DVRs once the differential narrows. Thus, the riskreward ratio of investing in DVRs looks somewhat skewed towards the latter. The only caveat is that before investing in a DVR, investors need comfort about the company’s fundamentals and prospects, and more importantly, its management.

• There is a lot of controversy on ‘governance’ in public sector companies. The Children’s Investment Fund of the U.K. — TCI — is an investor in Coal India and has raised issues regarding the role of government and independent directors on the Board of Coal India. TCI has threatened legal action against independent directors and if I am not wrong has retained a leading legal firm of Delhi to question the decisions and directives of the Government of India and the decisions of the Board. The controversy is regarding pricing of coal and long-term supply agreements with power plants. The issue was resolved by the Government by issuing a ‘Presidential Directive’ to the Board of Coal India Limited to sign the supply agreements. However, since the controversy has arisen it appears from newspaper reports that the independent directors of Coal India have been active and have been adding safety clauses in the supply agreements. View defending the action of the Government is based on that: President holds the shares on behalf of the people of India.

•  Government represents the people of India.

• Presidential directive is in the interest of the people of India.

• TCI was aware of the risk of government control on Coal India’s policy at the time of investing.

Hence, there exists no reason for TCI to object to the decisions and directions of the Government. This controversy raises three issues:

• Firstly, can this concept be extended to the decisions of the majority shareholder in a non-public sector company? The answer is an emphatic: no. This is so because the promoters once having accepted outside shareholders are accountable to the minority shareholders. The whole concept of ‘independent directors’ is to protect the interest of minority shareholders. Even otherwise the promoters or majority shareholders and the Board are accountable to stakeholders other than shareholders. Further the argument of decision in the interest of ‘people of India’ does not apply.

• Secondly, should there be different guidelines for governance of public sector units? The answer is: yes. This would avoid confusion and clearly define the role and responsibilities of the socalled independent directors who are in effect nominated directors.

• Thirdly, should foreign institutions and individuals be barred from investing in public sector units and only Indian nationals, Indian institutions and persons of Indian origin should be allowed to invest in public sector units? The answer is again: yes. Because this would avoid all controversy as whether through the President of India or directly or indirectly it is ‘People of India’ who are shareholders. In conclusion I would repeat: Governance — nay — good governance is a difficult issue and it can and must be resolved. Besides the solutions suggested I am sure there would be other alternatives. These need to be explored — explained and implemented to bring in clarity both in the interest of governance and the investors.

The second limb of governance is being ‘fair’. This is based on the commandment ‘Do unto others as you wish them do unto you’. Let us test the retrospective amendment by the Finance Bill, 2012 of taxing gain arising on transfer of Indian assets held indirectly by a non-resident individual or a legal entity through a corporation in a tax haven. Newspapers report Vodafone has already sent a notice to the Government of India seeking a legal solution. The Finance Minister of the U.K., though not apparently, has met the Indian Prime Minister and the Finance Minister on this issue. The newspapers report that there exists an assurance of our Prime Minister that ‘law will prevail’. This retrospective amendment has also been criticised by many leading foreign investors.

The issues of ‘governance’ are: Is retrospective amendment fair? Does it represent ‘good governance’?

Let me at the outset mention that the Parliament is supreme and laws can be amended retrospectively. Retrospective amendments are welcome where they are made to clarify and/or implement ‘legislative intent’ — but retrospective amendment should not be used to fasten a liability which did not exist or the issue has been the subject-matter of public knowledge and debate and judicial interpretation. The use of ‘tax havens’ to legally avoid or reduce tax liability is public knowledge. The Government of India for the last many years has been unsuccessfully negotiating with the Government of Mauritius for amending the tax treaty for taxing capital gains without success. I repeat the issue is: To achieve the objective of taxing gain on transfer of Indian assets indirectly held through an legal entity in a tax haven — does retrospective amendment represent ‘good governance’ and is it fair? The answer is: No. Amend it but amend it prospectively. Those in-charge of governance have to realise the import of the age-old command of:

‘Yatha raja tatha praja’.

The tax gatherer has to realise that so far as business is concerned, ‘tax’ is a ‘cost’ and it is duty of every business man to reduce ‘cost’ and thereby increase profit. However, the reduction in cost has to be achieved within the framework of law. This right has been recognised by judicial pronouncements and is known as the ‘Westminster Principle’. As a matter of fact, many multinational and large corporations have a dedicated department — personnel — for seeking and devising means of legally reducing tax liability under national and international tax laws. Treaty shopping — a means of reducing tax liability in international operations has been practised for decades. Further, sometime back, business newspapers had reported that a public sector company — desiring to invest abroad or acquire assets abroad was exploring the possibility of making the investment through a subsidiary in a tax haven. This is certainly against the principle of fairness ‘Do unto others as you wish them do unto you’. It is judicially recognised that there is a difference between ‘tax evasion’ and ‘tax avoidance’. Tax evasion is a crime, whereas tax avoidance is a right and negating this right by a retrospective amendment is neither fair, nor does it represent ‘good governance’.

The second issue under ‘fairness’ which is disturbing is cancellation of telecom licences because of corruption. Cancellation is justified where both the giver and taker are involved in the act. Even where the investor is indirectly involved in corruption, cancellation is justified.

The issue is: Is it fair to cancel the licence where an investor has acquired interest in the licence holder after he had obtained the licence and was not involved in the act of bribing. The author is of the view that under such circumstances the licence holder should be punished — the gain the licence holder made be confiscated and the government should acquire the licence holder’s interest in the joint venture without any compensation. An investor who was not involved in corruption should not be penalised. The principle should be and is: ‘Penalise the guilty’.

Above all there is no logic in penalising an investor who is not part of the management group. Let the Government nationalise the corporation without compensation to the promoter, but not penalise you and me who are just investors.

The third limb of governance is ‘transparency’. The issue I would like to discuss is: Life Insurance Corporation acquiring 84% of shares of ONGC offered by the Government in auction. The issue failed as investors perceived that the share of ONGC was probably over -priced. The Government directed LIC to acquire the shares. It is reported that the investment by LIC in ONGC probably exceeded the limit prescribed by the Regulator. I am aware that LIC carries a ‘sovereign guarantee’. Did the Government at the time of announcing the auction declare that if the auction failed or the issue is not fully subscribed, LIC would acquire the unsubscribed shares? The issues are: can — should the ‘sovereign guarantor’ dictate investment policy of LIC and does LIC’s action or gov-ernments’ directive meet the test of transparency.

Let us not forget the old instance of LIC investing in Mundra companies. Chagla Committee was appointed to investigate the investment. The fall out of the findings of the committee was that both the Finance Minister and the Finance Secretary resigned.

The difference between two instances is that in Mundra’s case a private sector entity was involved and in ONGC’s case a public sector entity is involved. It can be argued that in both LIC and ONGC the people of India are involved. The argument in the author’s opinion is fallacious. In case of LIC — it is only the policy-holders who are involved and invest-ments have to be — no must be in the interest of the policy-holders, a class distinct from the rest of people of India. Related issue is: Is this investment in line with the mission statement of LIC which reads as under:

‘Enhancing the quality of life of people through financial security by providing products and services of aspired attributes with competitive returns and by rendering resources for economic development’.

‘Swami Saran Sharma in Outlook Money of 2 May 2012 commented: ‘LIC’s investment in several PSUs is like deliberately chasing bad money.’

The Times of India of 15 May 2012 reports that Mody’s have downgraded LIC. The comment reads as under:

‘LIC’s downgrade comes in the wake of the government dipping into LIC’s resources to recapitalise banks and to bail out the government in its divestment programme.’

The standing Committee on Finance has questioned the Government — regarding LIC’s acquisition of ONGC shares and asked the Insurance Regulatory and Development Authority (IRDA) to inquire if the company had breached investment norms while buying the shares during the Government stake auction. It is reported in Business Standard dated 25-4-2012:

“The committee cannot but conclude that the objec-tive of disinvestments has been reduced to merely deficit-bridging,” goes its rap on one state-run firm’s equity being bought by the other. The report says it regrets the government using central public sector enterprises (CPSEs) as a ‘milching cow’.”

The directive of the Government, on the touchstone of ‘governance’, is not a transparent act. It does not meet both the criterion of ‘fairness’ and ‘transparency’.

As with any new
Legislation, there is a great deal of fascination amongst the business
fraternity and professionals to see whether the Bill is a turbo-charged
version of the old Act or is it merely “Old Wine in a New Bottle”, does
it continue with the “Old Whine with New Throttle”? While there have
been several new concepts which are sought to be introduced by the Bill,
one area which sees a lot of upheaval is that of corporate
restructuring, i.e., mergers, takeovers, slump sales, shareholders’
agreements, etc. Corporate India has always desired a code which
facilitates corporate restructuring. While one can understand the
Regulator’s desire of protecting interest of all stakeholders, it should
not be at the cost of stifling the transaction itself. The words of
Justice D. Y. Chandrachud in the case of Ion Exchange (India) Ltd., 105
Comp. Cases 115 (Bom) in this context are very apt:

“The basic
assumptions which were the foundation of a closely regulated and
controlled economy have altered in the present day society where
corporate enterprise has to gear itself up to a free form of competition
and an open interface with market forces. The fortunes of corporate
enterprise are liable to fluctuate with recessionary cycles. Changes in
economic policy and economic changes affect the fortunes of business as
assumptions and conditions in which corporate enterprises function are
altered. Corporate enterprise must be armed with the ability to be
efficient and to meet the requirements of a rapidly evolving business
reality. Corporate restructuring is one of the means that can be
employed to meet the challenges and problems which confront business.
The law should be slow to retard or impede the discretion of corporate
enterprise to adapt itself to the needs of changing times and to meet
the demands of increasing competition

Let us examine whether the
Bill lives up to the expectations and whether it impedes or expedites
corporate restructuring? We look at some of the key features in this
respect.

Schemes of Arrangement
We may first consider
the provisions which would impact all Schemes of Arrangement, i.e.,
mergers, demergers, reconstruction, etc. Clause 230 of Chapter XV of the
Bill deals with these provisions. Some of the new features of this
Clause as compared to the provisions of the Act are as follows:

(a) Tribunal:
The National Company Law Tribunal (“Tribunal”) would have power to
sanction all Schemes. Thus, instead of the High Court the Tribunal would
be vested with these powers. An Appeal would lie against the order of
the Tribunal to the National Company Law Appellate Tribunal (“NCLAT”)
and against the Order of the NCLAT to the Supreme Court. One important
feature of both the Tribunal and the NCLAT is that Chartered Accountants
can appear before them to plead Schemes of Arrangement. Currently, this
is the exclusive domain of Advocates.

 (b) Corporate Debt Restructuring:
Any scheme of corporate debt restructuring (CDR) which is a part of a
Scheme must be consented to by not less than 75% of the secured
creditors in value. There must be safeguards for the protection of other
secured and unsecured creditors. The auditor must report that the fund
requirements of the company after the CDR shall conform to the liquidity
test based upon the estimates provided to them by the Board of
Directors. Here the auditor would be well advised to remember the CA
Institute’s warning that he should not become a party to preparing
estimates. One important facet of the CDR is that the Scheme should
include, a valuation report in respect of the shares and the property
and all assets, tangible and intangible, movable and immovable, of the company of a Registered Valuer.

(c)
Valuation Report: Every Notice of a meeting for the Scheme of
Arrangement which is sent to creditors and members shall be accompanied
by a copy of the valuation report, if any, and explaining its effect on
creditors, key managerial personnel, promoters and non-promoter members,
and the debenture-holders and the effect of the Scheme on any material
interests of the directors of the company or the debenture trustees.
Currently, the valuation report is only available for inspection at the
company’s office. An overwhelming majority of the shareholders do not go
to the registered office to inspect the valuation report. Now the
valuation report would come home since it needs to be sent to the
members and creditors. The Bill is silent as to whether the valuation
workings also need to be sent to them? In this context the following
decisions would throw some light:

• Hindustan Lever Ltd., 83
Comp. Cases 30 (SC)/ Miheer Mafatlal vs. Mafatlal Industries, 87 Comp.
Cases 792 (SC): Valuation is a specialised subject best left to experts
and Courts would not interfere in the same.

• Asian Coffee Ltd., 103 Comp. Cases 17 (AP): Shareholders need not be given detailed calculations of share exchange ratios.

(d) Notice to Regulators:
Every notice shall also be sent to the Central Government, Income-tax
authorities, the Reserve Bank of India, the Securities and Exchange
Board, the RoC, stock exchanges, Official Liquidator, the Competition
Commission of India (CCI) and such other sectoral regulators or
authorities which are likely to be affected by the compromise or
arrangement (e.g., Telecom Regulatory Authority of India for telecom
companies).

Under the Bill, the authorities, to whom Notice has
been sent, can make representations, within 30 days or else it shall be
presumed that they have no representations to make on the proposals.
However, this period of 30 days should be read subject to the time
allowed under any other Statute for approving such Schemes. For
instance, the Competition Act, 2002 allows the CCI a time period of 210
days for passing an order. Therefore, it stands to reason that the
timeline of 30 days will not be applicable to the CCI.

(e) Objection Threshold:
An objection to the Scheme can now be made only by persons holding at
least 10% of the shareholding or having outstanding debt amounting to at
least 5%. This is a welcome move which would prevent frivolous
challenges which lead to undue delays.

(f) Approval: The
resolution for approving the Scheme requires 3/4th majority in value and
can be passed in person, by proxy or through postal ballot. Postal
Ballot has been made applicable to both listed as well as
unlisted/private companies, unlike s.192A of the Act where it applies
only to listed companies.

(g) Accounting Standards: The Scheme shall be sanctioned by the Tribunal only if there is a certificate by the Auditor that the accounting treatment in the Scheme is in conformity with the prescribed accounting standards. Currently, the Listing Agreement contains a similar provision in the case of Listed Companies. The decision in the case of Hindalco Industries Ltd., 94 SCL 1 (Bom) is pertinent in this respect. In this case, the company proposed to write-off the impairment losses and ammortisation loss against the balance standing in the Securities Premium Account by a Scheme of Arrangement. The Scheme was objected to on the grounds that this treatment was in violation of para 58 of AS-28 on “Impairment” since the loss was not routed through the P&L A/c. The High Court over-ruled this objection and held that section 211(3B) of the Act expressly permitted deviation from accounting standards subject to certain disclosures.

The current Accounting Standards are woefully inadequate to address all forms of corporate restructuring, for instance, there are no standards dealing with demergers, reconstruction, reduction of capital, etc. Hence, unless new Accounting Standards are introduced, this would remain an empty formality. In this context Accounting Standard Interpretation (ASI) 11 on AS-14 issued by the ICAI on 1-4-2004 is relevant since it prescribes the stand to be taken in case the accounting treatment specified under the Scheme deviates from the treatment specified from AS-14. Some instances of cases where accounting disputes have been the subject matter of objection to Schemes of Amalgamation/Arrangement, include the following, Gallops Realty, 150 Comp. Cases 596 (Guj); Cairns India Ltd, 101 SCL 435 (Bom); Mphasis Ltd., 102 SCL 411 (Kar); Sutlej Industries Limited, 135 Comp. Cases 394 (Raj),Paramount Centrispun, 150 Comp. Cases 790 (Guj), etc.

(h)    Buy-back: A Scheme in respect of any buy-back of securities shall be sanctioned only if the buy-back is in accordance with the provisions of the Bill. For instance, the decisions in the cases of SEBI vs. Sterlite Industries Ltd., (2004) 6 CLJ 34 (Bom); Gujarat Ambuja Exports Ltd (2004) 6 CLJ 117 (Guj) have held that Schemes of Arrangement need not be in compliance with the buyback provisions of the Act since they operate in different fields. The Court held that the s.77A is merely an enabling provision and the Court’s powers u/ss. 100-104 and 391-394 are not in any way affected. The conditions u/s.77A are applicable only to buyback under that section and the conditions applicable u/ss. 100-104 and 391 cannot be made applicable or imported into a buyback of shares u/s. 77A. There is no reason why a cancellation of shares and consequent reduction cannot be made u/s. 391 read with section 100 merely because a shareholder is given an option to cancel or retain his shares. This position would now be modified by the Bill.

(i)    Takeover: Any Scheme which includes a Takeover Offer in the case of listed companies, shall be as per the SEBI Regulations. In Larsen & Toubro Ltd, 121 Com. Cases 523 (Bom) a takeover of shares by Grasim avoided the provisions of the SEBI Takeover Code since it was done under a Scheme of Arrangement. Grasim acquired around a 30% equity stake in Ultra Tech Cement Company Ltd from the public shareholders under the Scheme of Arrangement, around 4.5% stake from L&T. Further, it also sold its holding in L&T to an Employee Trust of L&T. As a result of the Scheme, Grasim ended up owning a 51.1% stake in Ultra Tech without triggering the open offer provisions under the SEBI Takeover Regulations. The Bill aims to plug this method of acquisition of shares€.

(j)    Minority Squeeze-out: Provisions have been enacted for minority squeeze-out by majority. Majority shareholders (holding 90% of the equity shares capital) who have acquired the majority stake through amalgamation, share exchange, conversion of securities, any other reason, etc., should notify the company of their intention to buy out the remaining shareholders. The purchase price would be ascertained on the basis of the valuation done by a registered valuer.

Merger Schemes

In addition to the above provisions, which are applicable to all Schemes of Arrangement, the following additional requirements which are applicable to a Scheme of amalgamation/ merger are provided in Cl. 232 of the Bill:

(a)    A notice for Merger Schemes must also include a supplementary accounting statement if the last annual accounts of any of the merging companies are more than 6 months old.

(b)    A transferee company should not, as result of the Scheme hold any shares in its own name or under a Trust for the benefit of the transferee company or its subsidiary company or associate company. Such treasury shares shall be cancelled or extinguished. In other words, the Bill prohibits creation of treasury stocks. This supersedes the decision in the case of Himachal Telematics Ltd, 86 Comp. Cases 325 (Del) which upheld the creation of treasury stock arising on a merger. Several mergers, such as, ICICI-ICICI Bank, Reliance Petroleum-Reliance Industries, Mahindra & Mahindra, etc., had followed this route of creating treasury stock. In fact, ICICI Bank sold its treasury stock on the floor of the stock exchange for a handsome amount.

(c)    In case of a merger of a listed company into an unlisted company the transferee company shall remain an unlisted company until it becomes a listed company. If the shareholders of the transferor company decide to opt out of the transferee company, provision shall be made for payment of the value of shares held by them as per a pre-determined price formula or after a valuation is made.

Thus, this provision negates the back-door/reverse merger route of SEBI under which a listed company can merge into an unlisted company and the unlisted company gets automatic listing. This provision is also available for demerger of a listed company into an unlisted company and listing of the shares of the resulting unlisted company. For instance, Cinemax India Ltd, a listed company demerged its theatre exhibition business into an unlisted company. Subsequently, the shares of the unlisted company got listed without an IPO.

The unlisted company gets the gains of listing without the pains of listing. It also bypasses the requirements of Section 72A of the Income-tax Act if the transferee company is a loss-making/sick company. Thus, the unabsorbed depreciation and carried forward losses of the loss-making company are available as a set-off to the healthy company without complying with the requirements of section 72A and Rule 9C since the transferee company is the loss making company. This route is currently available by virtue of Rule 19(2)(b) of Securities Contract (Regulation) Rules, 1957 read with the SEBI’s Circulars CIR/ CFD/DIL/5/2013 and the earlier SEBI/ CFD/SCRR/01/2009/03/09.

Under the Bill, the shareholders of the transferor company have to be provided with a mandatory exit option in the form of a cash payment. It would be interesting to see what happens if more than 25% of the shareholders of the transferor opt out? In such a situation the conditions of Section 2(1B) of the Income-tax Act, 1961 are not met since the section requires that at least 3/4th of the share-holders of the amalgamating company become share-holders of the amalgamated company. How would this condition now be met? As a consequence, the merger would cease to be a tax-neutral amalgamation under the Income-tax Act and as held by the Supreme Court in the case of Grace Collis, 248 ITR 323 (SC), an amalgamation involves a transfer of capital asset. You can join the dots to understand what happens next.

(d)    The Scheme should clearly indicate an Appointed Date from which it shall be effective and the scheme shall be deemed to be effective from such date and not at a date subsequent to the appointed date. Currently, there is no express requirement in the Act but the decision in the case of Marshall Sons & Co. (I) Ltd., 223 ITR 809 (SC) has held that every Scheme of merger must necessarily provide a date with effect from which the transfer will take place and such a date would either be the date specified in the Scheme or the date so specified/modified by the Court while sanctioning the Scheme. An Appointed Date is also relevant from an income-tax perspective. The decisions in the case of Ambalal Sarabhai Enterprises Ltd, 147 ITR 294 (Guj); Amerzinc Products, 105 SCL 682 (Guj), etc. are also relevant in this respect.

(e)    The fee paid by the transferor company on its authorised capital shall be available for set-off against any fees payable by the transferee company on its authorised capital enhanced subsequent to the merger. This express provision sets to rest the constant objection of the Regional Director on this issue. Several decisions have supported clubbing of the authorised capital – Hotline HOL Celdings, 121 Comp. Cases 165 (Del); Cavin Plastics, 129 Comp. Cases 915 (Mad); Areva T&D, 144 Comp. Cases 34 (Cal), etc.

(f)    Every company in relation to which the Tribunal makes an Order, shall, until the completion of the
Scheme, file a statement in such form and within such time as may be prescribed with the RoC every year duly certified by a CA/CS/CMA indicating whether or not the Scheme is being complied with in accordance with the Orders of the Tribunal.

Fast-track Mergers

Clause 233 provides a new concept of fast-track mergers:

(a)    A new concept of fast-track mergers has been introduced for mergers between small companies or between a holding company and its wholly owned subsidiary without going through the Tribunal Process.

(b)    A Small Company is defined to mean a ‘private company’ meeting either of the following requirements:

•    Paid up capital does not exceed the sum prescribed which may range from Rs. 50 lakh – Rs. 5 crores.

•    Turnover does not exceed the sum prescribed which may range from Rs. 20 lakh – Rs. 2 crore.

It may be noted that a merger between a holding and a 100% subsidiary could also opt for the fast-track route even though the companies are not small companies.

(c)    This route is optional and if the companies desire to adopt the conventional route i.e., the Tribunal-approved Route, then they may adopt the same.

Cross-Border Mergers

(a)    The Bill provides that a merger of a foreign company incorporated in the jurisdictions of such countries as may be notified from time to time by the Central government into an Indian company is permissible. For instance, Corus Group Plc (now Tata Steel Europe Ltd), UK merging into Tata Steel and Tata Steel issuing its Indian shares to the shareholders of Corus, wherever they may be located. Currently also, mergers of a foreign company into an Indian company is permissible. Any merger involving an Indian Company would be governed by the Companies Act, 1956. Sections 391 to 394 of the Act deal with Mergers of companies. Section 394 of the Act provides for facilitating amalgamation of companies. Section a.394 states that the section only applies to a Transferee Company which is a company within the meaning of the Act, i.e., an Indian Company. However, the Transferor Company is defined to include any Company, whether Indian or Foreign. Hence, the transferor company can be a foreign company. The decisions in the cases of Bombay Gas Co., 89 Comp. Cases 195 (Bom), Moschip Semiconductor Technology Ltd., 120 Comp. Cases 108 (AP), Adani Enterprises Ltd., 103 SCL 135 (Guj); Essar Oil Ltd, Company Petition No. 280 of 2008 (Guj), etc., clearly support this point.

However, Cl. 234 of the Bill now provides that only companies from specified jurisdictions would be permissible. This restriction is not there currently. Probably, the Government wants to limit the scope to those countries which either have a DTAA or a TIEA with India.

(b)    Cl. 234 of the Bill also provides for a merger of an Indian company into a foreign company which is currently not possible. S.394 states that the section only applies to a Transferee Company which is a company within the meaning of the Act, i.e., an Indian Company. However, the Transferor Company is defined to include any Company, whether Indian or Foreign. Thus, currently an Indian company cannot merge into a Foreign Company.

The consideration for the merger may be discharged by the foreign company in the form of cash or its Indian Depository Receipts. Thus, the foreign company cannot issue its shares to the Indian shareholders of the transferor company. For instance, if ACC were to merge into Holcim of Switzerland, Holcim cannot issue its shares to the Indian shareholders of ACC. It must issue IDRs or pay cash. Currently, Standard Chartered Bank Plc, UK, is the only foreign company to have issued IDRs in India. One possible reason for this embargo is that under the FEMA Regulations, Indian residents can acquire shares of a foreign company

only under the Liberalised Remittance Scheme, i.e., by paying consideration in cash. There is no provision for a stock swap in the case of an outbound in-vestment by resident individuals. This is one area which could be liberalised by permitting the consideration to be in the form of shares also.

The Bill provides that the prior approval of the RBI would be required for such a merger of an Indian company with a foreign company.

Registered Valuer

Clause 247 of the Bill introduces a new concept of a Registered Valuer. Where a valuation is required to be made in respect of any property, stocks, shares, debentures, securities or goodwill or any other assets or net worth of a company or its liabilities under the provision of this Act, it must be valued by a Registered Valuer. The qualifications and experience for such a person would be prescribed. It may be recalled that a few years ago, the Shardul Shroff Committee had recommended that valuations should be carried out by independent registered valuers instead of the current practice. Would a CA automatically be registered as a registered valuer or would he have to acquire some additional qualification for the same? What happens in case of a partnership firm or LLP of professionals – would all partners need to obtain qualifications? One wonders whether a CA would be the right person to value property, plant and machinery whereas whether a chartered engineer would be able to value shares and goodwill? Does a one-size fits all approach work or is not the current dual system a better approach?

Some of the valuation areas under the Bill which would require a Registered Valuer include:

•    Further issue of shares
•    Assets involved in Arrangement of Non Cash transactions involving directors
•    Shares, Property and Assets of the company under a CDR
•    Scheme of Arrangement
•    Equity Shares held by Minority Shareholders
•    Assets for submission of report by Liquidator.

Reduction of Capital

Clause 66 of the Bill deals with Reduction of Share Capital of a Company:

(a)    A reduction of share capital cannot be made if the Company is in arrears in the repayment of any deposits accepted by it or interest payable thereon by it.

(b)    Further, an application for the reduction shall not be sanctioned by the Tribunal unless the accounting treatment, proposed by the company for such reduction is in conformity with the prescribed Accounting Standards. This would require framing of Standards on reduction. (c) The Order confirming the reduction shall be published by the company in such manner as the Tribunal may direct. Under the current provision, the Court has discretionary power to order publishing of reasons of reduction and such other information as it thinks fit.

(d)    The current discretionary power of the Court to order the addition of words “and reduced” to the names of the company reducing their capital has been withdrawn. Further, The current power of the Court to dispense with the requirement of the consent of the creditors in case of reduction of capital by way of either diminution in any liability in respect of the unpaid share capital or repayment to any shareholder of any unpaid share capital has been withdrawn.

Slump Sale

Currently, under the Act a public company is required to obtain its members’ consent to sell, lease, etc. of the whole or substantially the whole undertaking of the company. Thus, an ordinary resolution of the members is required u/s. 293(1) for a slump sale. In case of a listed company, this consent is to be obtained by a Postal Ballot.

Under Clause 180 of the Bill this provision of Postal Ballot will now be applicable even to a private limited company. Further, the approval of the members is to be obtained by way of a special resolution instead

of an ordinary resolution. Thus, the regulatory arbitrage available in a slump sale over a demerger is sought to be plugged. This would make it more challenging for listed companies to hive-off their undertakings by way of slump sales.

Specific definition of the terms ‘undertaking’ and ‘substantially the whole undertaking’ have been provided under the Bill as follows:

(i)    “Undertaking” shall mean an undertaking in which the investment of the company exceeds 20% of its net worth as per the audited balance sheet of the preceding financial year or an undertaking which generates 20% of the total income of the company during the previous financial year.

(ii)    “Substantially the whole of the undertaking” in any financial year shall mean 20% or more of the value of the undertaking as per the audited balance sheet of the preceding financial year.

It may be noted that this definition of undertaking is only relevant for the purposes of the Bill. What constitutes an undertaking for determining whether a transaction is a slump sale u/s. 2(42C) of the Income-tax Act, would yet be determined by Explanation-1 to Section 2(19AA) of that Act, which provides as follows:

“For the purposes of this Cl. , “undertaking” shall include any part of an undertaking, or a unit or division of an undertaking or a business activity taken as a whole, but does not include individual assets or liabilities or any combination thereof not constituting a business activity.”

Thus, what may be an undertaking under the Bill may not satisfy the conditions laid down under the Income-tax Act. Distinctions between the two definitions are given in the Table:

Inter-Company Loans and Investments
Clause 186 of the Bill is at par with the current Section  372A of the Act. However, en masse changes have been carried out in this very important provision. Some of the key features of Clause 186 are as follows:

(a) A Company cannot make investment through more than 2 layers of investment companies. The restriction is on 2 layers of investment companies and not operating companies. An Investment Company means a company whose principal business is acquisition of shares, debentures or other securities. This is one of the most important restrictions under the Bill. This prohibition does not apply in two situations:

A company can acquire any foreign company if such foreign company has investment subsidiaries beyond two layers as per the foreign laws. However, the RBI is known to frown upon such multi-layer structures for outbound investment.

•  A subsidiary company can have any investment subsidiary for the purposes of meeting the requirements under any Law.

This prohibition is even applicable to NBFCs and Core Investment Companies (CICs) registered with the RBI and to private companies. One would have expected private companies and CICs to be exempted from this restriction.

(b) The main provision of Clause 186 is the same as Section 372A, i.e., a company cannot make a loan/investment/guarantee exceeding 60% of its paid-up capital + free reserves + securities premium or 100% of its free reserves + securities premium, without the prior approval by way of a special resolution. However, the current embargo on a loan/guarantee to any body corporate has been modified to a loan to any person. Thus, loans to individuals/HUF/firm/AOP/Trust, etc., would also be covered.

An NBFC whose principal business is acquisition of shares and securities, shall be exempt from the provision of this clause in respect of subscription and acquisition of securities.

(d) The loan must be given at a minimum rate of interest equal to the prevailing yield of 1/3/5/ 10 years’ Government Security closest to the tenor of the loan. Presently, the minimum rate is the Bank Rate of the RBI, which currently is 8.50%. The 2011 draft of the Companies Bill also pegged the minimum rate at the Bank Rate but the 2012 version has changed it to its current form.

(c) The current exemptions given u/s. 372A of the Act have been done away with. Consequentially:

•    Private limited companies will have to comply with this section.

•    Loans by a holding company to its 100% subsidiary would have to comply with this section. Thus, interest free loans to a 100% subsidiary will not be possible even for a private company.

•    Acquisition by a holding company by way of subscription, purchase or otherwise the securities of its wholly owned subsidiary would have to comply with this section.

•    Any guarantee given or security provided by a holding company in respect of any loan made to its WOS would have to comply with this section.

(d) A company shall disclose to the members in the financial statement the full particulars of the loans given, investment made or guarantee given or security provided and the purpose for which the loan or guarantee or security is proposed to be utilised by the recipient of the loan or guarantee or security.

(e)    A company which is in default in the repayment of any deposits/interest thereon, shall not give any loan or give any guarantee or provide any security or make an acquisition till such default continues.

(f)    Restrictions have been put on SEBI intermediaries, such as, brokers, merchant bankers, underwriters, etc., from accepting inter-corporate deposits exceeding prescribed limits. One fails to see the logic for this provision when the SEBI Regulations do no prescribe any limits.

Shareholders’ Covenants

Currently, Restrictive Covenants forming part of Shareholders’ Agreement, such as, Tag Along, Drag Along, First Refusal, Russian Roulette, Texas Shoot-out, Dutch auction rights, etc., are the subject-matter of great dispute in the case of public companies.

The Supreme Court has held that they are valid against a company only if they are a part of the Articles of Association or else they remain a private contract between shareholders – V.B. Rangarajan vs. V. Gopalkrishnan, 73 Comp. Cases 201 (SC). A Single Judge of the Bombay High Court in the case of Western Maharashtra Development Corporation vs. Bajaj Auto Ltd., (2010) 154 Comp Cases 593 (Bom), had ruled that a Shareholders’ Agreement containing restrictive Clauses was invalid, since the Articles of a public company could not contain Clauses restricting the transfer of shares and it was contrary to Section 108 of the Act. Subsequently, a two-member Bench of the Bombay High Court, in the case of Messer Holdings Ltd vs. Shyam Ruia and Others (2010) 159 Comp Cases 29 (Bom) has overruled this decision of the Single Judge of the Bombay High Court.

The Bill provides that securities in a public company are freely trans-ferrable but a contract in respect of transfer of securities in a public company shall be enforceable. It is

submitted that this express provision sets at rest once and for all whether public companies can contain pre-emptive rights. This would be a big boost for Private Equity/FDI/Private Investment in Public Equity (PIPE) transactions since they usually come with pre-emptive rights.

Other Important Changes

Some other important changes in the sphere of restructuring include the following:

(a)    Infrastructure companies can issue redeemable preference shares having a tenure of more than 20 years provided they give the holders an option to ask for a redemption of a specified percentage every year. Real estate development has been defined as an infrastructure sector along with, air/road/water/rail transport, power generation, telecom, etc.

(b)    Prescribed class of companies which comply with accounting standards cannot utilise their securities premium account for paying premium on redemption of preference shares. They must use their profits alone. This is a very important restriction and it would be interesting to see the class which is prescribed. One fails to understand the logic behind this embargo.

(c)    Companies which are unable to redeem preference shares can, with the Tribunal’s approval, issue fresh preference shares in lieu of the same and that would constitute a deemed redemption of preference shares.

(d)    Prescribed class of companies which comply with accounting standards cannot utilise their securities premium account for buying back shares or for writing-off preliminary expenditure of the company. They must use their profits alone. Again, it would be interesting to see the class which is prescribed.

(e)    The time limit between two or more buy-back of securities, whether board approved or shareholder approved, has been made one year. The odd-lot buy-back provision has been dropped as a method of buy-back.

Conclusion

It would be interesting to see what the Rules provide since a bulk of the provisions would be prescribed in the Rules. Hence, the “Devil would lie in the Details (Rules)”. To sum up, there are some laudable amendments, some not so good and some quite serious ones. The Bill is a cocktail of surprises and shocks and corporate India would have to accept both. As Arnold Bennett, the English Author, once said:

“Any Change, even a Change for the Better, is always accompanied by Drawbacks and Discomforts”.

In order to abolish this cadaverous practice, the Government of Maharashtra (GoM) decided to replace it with a tax supposed to be more robust and tax payer friendly. As most of us are aware, the GoM finally acted upon its long standing promise of doing away with Octroi and introduce an account based system of tax ‘The Local Body Tax (LBT)’. The tax being based on the philosophy of selfassessment, shall definitely reduce the hassles and inefficiencies caused due to stoppage of vehicles at Octroi check posts.

While most of us are must have become aware of the broad scheme of the Act by way of newspaper and media reports, we need to familiarise ourselves with the legal framework.

The basis of the levy is the Maharashtra Municipal Corporation Act, 1949 (‘Act’). Section 152P of the Act empowers the Municipalities to levy LBT on items imported into their territory. However, while there is no separate Act, there are a whole new set of rules which essentially govern the levy. All the important provisions are contained in the rules thereby making them more relevant than the Act.

However, the new tax has been welcomed with one of the largest mass movements by the business community in recent times, and the government has been forced to postpone the levy. The reason for the stiff opposition seems to be certain draconian provisions. However, before welcoming or opposing this Act, we need to objectively analyse the provisions of LBT.

Levy: The levy is on import of goods for the purpose of consumption, use or sale. Thus liability to pay LBT generally rests on the person who brings goods within the limits of a municipal corporation. However, when goods are purchased from within the city, it shall be the duty of the purchasing dealer to ensure that the goods are not imported goods. If the goods purchased are imported goods, he shall ensure by way of a declaration in the purchase invoice, that LBT on the same has been paid. In case of lapse of due diligence by the purchasing dealer, he shall become liable to LBT.

It is pertinent to note that, Rule 22 empowers the Commissioner to enquire and satisfy himself that the declaration furnished is true and correct. Thus having regard to this provision, it will not be wrong to extrapolate the verdict of Bombay High Court in the case of Mahalaxmi Cotton Ginning Pressing and Oil Industries ([2012] 051 VST 0001) wherein the Hon’ble High Court has upheld the constitutional validity of Section 48(5) of the MVAT Act, which provides that set-off of Input Tax credit (ITC) shall only be available if tax is actually paid by the supplier into the government treasury. Thus if during the course of assessment proceedings, the officer observes that the selling dealer has not “actually paid” the VAT in full or part, he shall be entitled to deny the claim of ITC made by the purchasing dealer. This is already causing undue hardship to the assessee under VAT.

Lacuna in the definition of LBT: LBT has been defined to mean a tax on the entry of goods into the limits of the city. However, it does not include octroi. This exclusion of octroi from the definition might result in double taxation. As mentioned above, LBT will have to be paid on any goods imported within the city. However, since LBT does not include octroi, those dealers who have imported goods within the city after paying octroi might be asked to pay LBT as well, as payment of octroi shall not tantamount to payment of LBT.

Coverage of one and all: Virtually anyone bringing in goods to the city is proposed to be brought under the ambit of LBT. The definitions of ‘business’ and ‘dealer’ have been kept wide enough to override any decision of the courts granting exclusion to people from VAT. This is because, ‘Business’ has been defined to also include profession and any kind of occasional transaction without regard to its frequency, volume or regularity. The definition of ‘dealer’ includes all kinds of persons including various agents handling goods/documents of title and auctioneers who receive the price for auctioned goods.

Be it small or big traders, professionals, brokers, factors, agents, societies, clubs, etc. or people carrying on temporary business; almost everyone will be covered if he makes purchases of a meagre Rs. 1,00,000/- in a year and brings into the city goods worth Rs. 5,000/-. Even one-time transactions like purchase of car by an individual to render professional services shall be liable to tax.

Registration, returns & maintenance of records: While dealers carrying on regular business within the city are required to obtain make an application for registration within 30 days, dealers carrying on temporary business are required to make an application 15 days prior to commencing a business.

Returns are to be filed at half yearly intervals within 15 days from the end of the period. The first return shall be in Form E1 and shall be for the period of 6 months – April to September. The second return (in form EII) is an annual return i.e. for the full financial year. Thus there is an overlapping of return period. Further, there is also a provision for revision of returns; however the time limit is very short i.e. within a month from due date of filing of the original return.

Payment of tax is to be made on a monthly basis. The Rules also provide for a composition scheme for small dealers having turnover upto Rs. 5 lakh , builders and contractors. The composition scheme provides for a simple way of calculation of taxes irrespective of items imported, which is quite encouraging.

LBT requires issuance of bills in case of any sales amounting to a meagre Rs. 10/- or more and more so preservation of the same for a period of 5 years. Failing to issue an invoice might lead to penalty. However there is a duplicacy in the penalty provisions – Rule 48(1) provides a penalty upto double the tax amount, while Rule 48(7) provides for a penalty of double the invoice amount. Both the provisions provide penalty for not issuing invoice.

Further, the taxability of an item is determined in accordance with rates mentioned in the Schedules. Schedule-A lists the items and rates at which the same shall be taxed. The dealer will need to work out the liability to LBT based on different rates prescribed (ranging from 0% to 7%) and this may become an exercise in itself. Schedule-B lists out the items exempt from tax.

There are very few items which have made it to the coveted Schedule-B and even fruits, vegetables, etc are not covered in the exemption list. Persons dealing in these will have to register as well.

Sweeping powers: Wide powers have been given to the Municipal officers to seize goods, attach any property (and not just bank and debtors as is the case in VAT), stop any vehicle in transit etc. The business community is afraid that these powers will become a cause of harassment. However, it may be mentioned that some of the powers can be exercised only by an officer of the rank of DMC and above.

Further, penalties for most offences are steep and discretionary which might also give an impetus to unsavoury favours sought by officers. For example, (i) Penalty for non-registration may extend upto 10 times of the amount of LBT payable during the period during which the dealer did not have registration; and (ii) Penalty for failing to disclose fully and truly all material facts, claiming an inaccurate deduction or failing to show appropriate liability of LBT in the return may go upto 5 times the amount of LBT payable.

Exemptions & Refunds: Goods sent for job work/ processing outside the city should be received without any change in appearance or condition; failing which LBT will have to be paid afresh on the entire value of goods and not just the value addition on account of processing. What fails to appeal to a rational mind is how processed goods will appear the same as original! The other condition which needs to be complied with is that the goods sent out should be brought back within 6 months.

In case of goods imported into the city for job work, the condition appears a little rational as the words used in the Act are the goods should not change ‘form’, which in my opinion is a little broader than the word ‘appearance’.

Further, LBT shall not be levied on goods exported outside the territory of India.

It is also relevant to note that, in case of goods imported but re-exported to another city, by way of sale or otherwise (i.e. branch transfer), 90% of the LBT paid on import shall be refunded.

Payment of disputed appeal before appeal: The law mandates assessee to deposit the entire amount of the disputed tax before filing an appeal. Considering that the appellate authority is a municipal officer and the despicable disposal rate that Indian judicial system has, in my humble opinion, stay should be granted atleast upto the stage of first appeal.

Appeal against an order passed by an officer below the rank of a Deputy Municipal Commissioner (DMC) shall lie with the DMC while that passed by an officer of the rank of DMC and above shall lie with the Municipal Commissioner. Further, there is no provision for second appeal and hence the only remedy will be approaching the High court.

Interest on delayed payments: The interest rates prescribed for delayed payment of LBT are phenomenally high. Interest rate ranges from 2% p.m. for delay upto 1 year to 3% p.m. (36% p.a.) for delay of more than a year. Interest rates need to be re-visited as no other law requires payment of such high interest rates.

No credit mechanism: No mechanism for input credit of LBT paid has been prescribed in the Rules/ Act, which will lead to a cascading effect on LBT paid. This shall especially affect those dealers who do not directly procure from the manufacturer as more the number of intermediaries, lesser the chances to fix a competitive selling price.

While the law relating to LBT is indeed welcome being more sound in terms of ideology as compared to octroi, it is only apropos that some of the provisions be revisited and watered down so as to inspire confidence within the business community. While all and sundry were under the ambit of octori; the same cannot be the case in LBT in view of administrative difficulties of registration, returns, assessment, etc.

Taking a cue from the above, LBT can be perceived to be akin to VAT. Thus the simpler way for the State could be to collect it alongwith VAT under a separate challan/accounting code.

With the traders demanding abolition of the law, the government has responded by promising to revisit the Act. In principle, the levy is better than octroi – it is accounts based, will avoid delays when goods are in transit. However, the way the Rules have been drafted, it appears to put excessive compliance burden on the trading community. Having to deal with one more authority with potential harassment has made the businesses nervous. It shall not out of context here to remember Benjamin Franklin’s saying “The only things certain in life are death and taxes.” All that one can hope for is, that the law be made simple so that it can be widely and easily adopted!