Category: Corporate And Other Laws

But there is one catch in fulfilling this intent. Can we become an economy that comes in the first five in GDP rankings (although due to our large population, per capita we may still be very low) if we do not really ‘own’ our businesses in financial structures and do not supposedly pay our due share of taxes?

How can there be an entrepreneurial push to an economy when so much of quality time is spent not on expanding business and exploiting opportunities, but on creating ‘suitable business, financial and tax structures’?

Why are Indians considered a model minority culturally overseas when within the country we see examples of businesses defaulting on loans and interest payments with the term ‘wilful defaulter’ being specially coined for them and being accused of ‘tax evasion’?

[Please refer link (as example) – https://wap.business-standard.com/article/companies/around-rs-10-52-trn-corporate-debt-may-default-over-3-years-india-ratings-120030200388_1.html.]

‘Wilful defaulter’ is someone who has the ability to pay but is organising his business with the intent not to pay.

There are two macro-economic and financial problems that India is facing today:
(I) High debt capital gearing, and
(II) Intent of tax evasion (direct and indirect).

(I) High debt capital gearing
A classic case of high capital gearing and borrowings to fund business outcome comes from a major
telecom service provider (source – ‘moneycontrol.com’, standalone financials).

Between the years 2016-17 and 2020-21, this telecom company had these important events:
i)    Increase in equity capital – Rs. 25,130.07 crores;
ii)    Increase in tangible & intangible assets – Rs. 86,637.52 crores;
iii)    Increase in long-term borrowings – Rs. 105,777.67 crores;
iv)    Increase in short-term borrowings – Rs. 39.35 crores;
v)    Losses incurred in this period – Rs. 86,561.43 crores.

One can see that the increase in share capital to fund losses and increase in tangible and intangible assets is much lower than the increase in borrowings. The company has also used operating creditors to fund its business.

In the case of a large Indian entity whose major business is in oil and gas, between the years 2016-17 and 2020-21, the increase in reserves and surplus due to undistributed profits is Rs. 182,980 crores, while the increase in long-term and short-term borrowings is Rs. 92,447 crores. Clearly, there is a good match between increased borrowings and increased profits after tax for the period under review.

‘High Capital Gearing’ in Indian corporates is resulting in a skewed debt to equity ratio. This high debt when not serviced by payments on due dates of interest and principal instalment due, results in the corporate being ultimately called a ‘Non-Performing Asset’ (by bankers as lenders) and the process of recovery of dues starts.

NPAs pose a serious problem for the financial viability of India’s financial lending sector.

(Please see link – https://www.business-standard.com/article/finance/banks-gross-npas-may-rise-to-13-5-by-sept-financial-stability-report-121011200076_1.html.)

NPAs are unfair to the savings class of citizens because they destroy the net worth of banks – very unfairly, the insurance for the individual saving and keeping money in banks is restricted to Rs. 5 lakhs per bank. How this figure of Rs. 5 lakhs has come about is not known. Anybody who has studied Indian middle class savings patterns knows that a very large part of their savings corpus is in bank deposits. More than the borrower being impacted by action against him, the bank customer is hit hard, again very unfairly. Why has the RBI as regulator not thought of protecting the bank depositor by insisting that all deposits should be fully insured for bank default is not known. If the DICGC (Credit Insurance and Credit Guarantee Corporation) which is a 100% subsidiary of RBI does not have the financial muscle to carry the entire risk liability, one can always bring in Indian and overseas insurers for providing the default risk cover.

The issue that needs attention is why do corporates accumulate such high debt (mainly from the banking sector)? The reality is that once the banking sector was opened to private players and long-term funding got opened in foreign exchanges, both the then Development Finance Institutions, ICICI Ltd. and IDBI Ltd., chose to become commercial / retail banks.

As the push for infrastructure came from the Government of India, commercial bankers became financiers of long-term debt (instead of just working capital funding). Bankers who were working capital funding entities started moving into long-term capital funding without truly understanding the implications. The intent of this article is not to comment on fraudulent behaviour or political intervention in sanctioning of loans. That is a different matter and proving of criminal conduct and punishment thereof is outside the scope of this article.

Corporate promoter groups in multiple business types saw an opportunity to draw large debt (facilitated by the financial markets meltdown in 2008 and 2009) and exploited the situation. The absence of the ‘skin in the game’ philosophy resulted in debt being incurred on unmerited and unviable business expansion / extension or new business proposals. In the hope of keeping the engines of growth firing, the banking sector funding went into undependable and unviable projects. Why did banks and financial institutions continue their funding despite ‘High Capital Gearing’ being visible is the question to be asked. The ease of getting borrowings has compounded the problem. Ultimately, the borrower is facilitated and the depositor is ruined!

To be fair, there is no doubt that in many over-leveraged business segments like the realty sector during Covid-19, the business entities have worked towards reducing debt by sale of business, liquidation of assets, etc.

SOLUTION
One part of the solution to avoid ‘High Capital Gearing’ and funding thereof is to have a much better overview of lending proposals and their appraisal at the lenders’ end (banks and financial institutions).

The other part which is systemic in nature is to remove the Income tax shield advantage of interest cost. Any entity has two sources of funds:
1) Shareholders capital – This funding is less popular because returns to shareholders come after corporate or business Income tax.
2) Borrowings – This funding is more popular because interest paid on debt funds is an eligible item of deductible expense, thereby reducing their cost impact for the business.

If a business wishes to give a shareholder dividend of Rs. 1,000 at a corporate income tax rate of 30%, it needs to earn Rs. 1,400+. However, Rs. 1,000 paid as interest on borrowings being eligible for income tax deduction as expense, actually costs Rs. 700 to the business (tax shield Rs. 300).

This business structuring and Income tax differential treatment of interest payment and returns to shareholders post tax, has moved the pendulum unswervingly towards debt from shareholders’ funds. Also, Indian corporate and business management is still very much dependent on family-based promoter groups who clearly would like to keep their exposure to risk at the lowest level. The principle of ‘as little skin in the game’ is followed.

Owing to this family / promoter development in Indian corporates, and maybe because the law is not facilitative enough, we do not have aggressive ‘business control’ wars and that has closed off the option of takeover by a rival if the business is languishing or going down. The IBC comes in much later at the point where insolvency is declared.

This is why in India the promoters’ exposure when business goes down is very low, thanks further to low capital invested. The high risk exposure is taken by the unsecured creditors and debt holders who are the ones taking the ‘haircut’. Hence, we are seeing the way the existing promoter is fighting to retain control of the entity in the Insolvency and Bankruptcy proceedings. Companies languish but don’t die.

(Please see link – https://m.economictimes.com/news/company/corporate-trends/view-india-is-no-country-for-dying-companies/articleshow/85552085.cms.)

Our laws and our infrastructure to ensure timely implementation of laws are often not in sync with one another. This is fully exploited by a defaulting promoter. As the late Mr. Arun Jaitley said, ‘There are sick defaulting companies, but no poor promoters’!

Business Income tax should be based on profit before interest and tax, thereby removing the tax shield that is provided by interest. To compensate for this additional tax outgo, the rate on business income tax should be brought down by about 300 to 500 basis points (3 to 5%). By putting both sources of funds, at the same tax treatment level, the incentive to move towards debt and reduce equity contribution should diminish.

(II) Intent of tax evasion (direct and indirect)
There is no point in repeating ad nauseam that as per Finance Ministry Officials Indians evade both direct and indirect tax. Of course, nobody talks of the fact that agricultural income does not come under Income tax and therefore all international comparisons of percentage of direct taxpayers and percentage of total direct tax collection to total tax collected from individual assessees gets terribly vitiated.

GST has tightened indirect tax compliance to a great extent, but it could still do better on compliance matters. It is one thing to keep saying that Indians are tax-evaders and another to create an environment where tax evasion is not contemplated because it gives very marginal advantage.

SOLUTION
The solution is evident from the problem. There is a need to break the Chinese wall separating the Direct Tax Administration from the Indirect Tax Administration. GST has an issue because it is borne by the end customer who gets no credit on tax and it becomes a cost to him. That is why we have the sales without invoice, the unverified composition dealer sales, etc. Where the income tax payer can take GST credit (CGST, SGST, IGST) totally, he will be quite pleased.

The author is not aware whether fungibility between direct and indirect tax is available in other economies. All economies do have direct and indirect tax payment by the ultimate consumer. However, the Indian situation is different. We need to incentivise the ultimate taxpayer so that tax revenues are buoyant.

Amend the tax laws such that a direct tax payer is permitted GST paid on his personal purchases funded by income (taxable) as a credit. The moment this is done, the customer will insist on getting a proper ‘GST Invoice’. Of course, this GST invoice must have the assessee’s name and PAN #or Aadhaar #. Once the GST invoice is made, the details of a GST dealer will be available. A direct tax payer for the sake of taking GST credits on direct tax liability payable, will file his income tax return, thereby increasing the numbers of income tax returns filers.

Increased GST Returns filings will benefit state governments also in SGST and share of IGST.

It is preferred that agriculture income also comes within the income tax net, although this may have serious political consequences and may need to wait for implementation. Farmers buying agriculture equipment, seeds, fertilisers will be benefited.

In fact, if after full GST deduction the income tax assessee has a tax refund, 40% of that should be given / paid to him as incentive and the other 60% stand cancelled.

Our tax authorities (both direct and indirect) will need to do some original tax thinking. Just stating that Indians evade tax is insulting and does not improve tax compliance. Let them think of a solution that is not very convoluted and cumbersome.

The taxpayer must feel advantaged in filing the direct tax return, The authorities have to integrate direct and indirect tax, since the end customer is paying for the same and is the same person.

The answer to both the above serious problems lies in making the final individual taxpayer the centre of Government and regulatory authorities’ policies. The solution is available, it has to be accepted and implemented.

Of course, there will be serious resistance to the above proposals from the Revenue Ministry and from businesses, for being ‘impractical and unviable’. However, both proposals are of benefit to the individual – whether as bank depositor, shareholder of over-leveraged entities or as taxpayer (direct and indirect tax). The time has come to be different in thinking and implementing policies.

(The author is grateful for the usage of news links which have collaborated his point of view)

Standards on Auditing (SA) 250, Consideration of Laws and Regulations in an Audit of Financial Statements, deals with the auditor’s responsibility to consider laws and regulations when performing an audit of financial statements. The provisions of some laws or regulations have a direct effect on the financial statements in that they determine the reported amounts and disclosures in an entity’s financial statements, e.g., the Companies Act, 2013 (‘2013 Act’). Other laws and regulations that do not have a direct effect on the determination of the amounts and disclosures in the financial statements, but compliance with which may be fundamental to the operating aspects of the business, to an entity’s ability to continue its business, or to avoid material penalties (e.g., compliance with the terms of an operating license, compliance with regulatory solvency requirements, or compliance with environmental regulations), non-compliance with such laws and regulations may therefore have a material effect on the financial statements. The Code of Ethics issued by the ICAI also includes specific sections on Responding to Non-Compliance of Laws and Regulations (NOCLAR)1 for listed companies. However, the auditor is not responsible for preventing non-compliance and cannot be expected to detect non-compliance with all laws and regulations.

The MCA has issued various amendments to the Companies Act, 2013, including an amendment to Schedule III of the Companies Act, 2013 to increase transparency and to provide additional disclosures in the financial statements, and CARO 2020 to enhance the reporting requirements for auditors. The MCA has also amended the provisions of Rule 11 of the Companies (Audit and Auditors) Rules, 2014 to include additional matters in the Auditor’s Report w.e.f. 1st April, 2021 (except the requirement related to audit trail which is applicable w.e.f. 1st April, 2022).

This article attempts to provide an overview of the key amendments relating to the definition of listed company, Corporate Social Responsibility and managerial remuneration and related challenges emanating from these amendments and the enhanced role of management and auditors.

I. AMENDMENT TO DEFINITION OF LISTED COMPANY
Section 2(52) of the 2013 Act provides the definition of a listed company. Listed companies under this Act are required to adhere to stricter compliance norms when it comes to filing of annual returns, maintenance of records, appointment of auditors, appointment of independent directors and woman directors, constitution of board committees, etc. This may dis-incentivise (or demotivate) private companies / unlisted public companies from seeking listing of their debt securities even though doing so might be in the interest of the company. Effective 1st April, 20212, the MCA amended section 2(52) of the 2013 Act and Companies (Specification of Definitions Details) Rules, 2014 to exclude the following class of companies from the definition of a listed company:

•  Public companies which have not listed their equity shares on a recognised stock exchange but have listed:

– Non-convertible debt securities, or
– Non-convertible redeemable preference shares, or
– Both the above categories
issued on private placement basis in terms of the SEBI (Issue and Listing of Debt Securities) Regulations, 2008 / SEBI (Issue and Listing of Non-Convertible Redeemable Preference Shares) Regulations, 2013, respectively.

• Private companies which have listed their non-convertible debt securities on private placement basis on a recognised stock exchange in terms of the SEBI (Issue and Listing of Debt Securities) Regulations, 2008.

• Public companies which have not listed their equity shares on a recognised stock exchange but whose equity shares are listed on a stock exchange in a permissible foreign jurisdiction as specified in the sub-section of section 23(3)3 of the 2013 Act.

It may be noted that SEBI has not modified the definition of a listed company. Accordingly, the implications are limited to the provisions prescribed under the 2013 Act. Some of these considerations are discussed below:

Relaxation for companies from compliances under 2013 Act
Listed companies are required to comply with additional stringent requirements under the 2013 Act, e.g., at least 1/3rd of the total number of directors to be independent directors, appointment of one woman director on the board, appointment of an internal auditor and compliance with auditor’s rotation norms. Companies which no longer qualify as listed companies pursuant to the above amendment would not be required to comply with such stringent requirements.

Besides, it is interesting to note that though the intent of the amendment is to provide relaxations for private / public companies, there might be some unintended consequences as well. One such unintended consequence is the debenture redemption norms. Section 71(4) of the 2013 Act read with Rule 18 of the Companies (Share Capital and Debentures) Rules, 2014 prescribes the quantum of debenture redemption reserve and the investment or deposit of sum in respect of debentures maturing during the year ending on the 31st day of March of the next year, unless specifically exempted. It may be noted that in accordance with Rule 18(7)(b)(iii)(B), debenture redemption reserve is not required to be created by listed companies having privately-placed debentures. Pursuant to the amendment, these exemptions may no longer be available; creation of the debenture redemption reserve and investment of sums in respect of debentures might become applicable for listed companies having privately-placed debentures. However, this will be subject to clarification by the MCA or the ICAI.

Private / public companies listing non-convertible debt securities and / or non-convertible redeemable preference shares on a private placement basis are excluded from the definition of ‘Listed company’ as per the amended definition. One may argue that Ind AS applies to all listed companies. Since these companies are not listed companies as defined under the 2013 Act, such companies would not be required to comply with Ind AS (unless other thresholds are met). A closer look at the aforesaid Rules indicates that Ind AS applies to companies whose ‘equity or debt securities are listed’ – instead of ‘listed company’. Hence, strictly speaking, the other possible view is that private / public companies having listed non-convertible debt securities / non-convertible redeemable preference shares on a private placement basis would need to comply with Ind AS. These companies need to consider GAAP applicable to them and their auditors, while issuing an opinion on true and fair view and compliance with accounting standards u/s 133 of the Act, will need to consider this amendment.

Auditors reporting on Key Audit Matters (KAM)
Auditors are required to report Key Audit Matters in the audit report of a listed entity which has prepared a complete set of general purpose financial statements as required by SA 701, Communicating Key Audit Matters in the Independent Auditor’s Report. KAMs are those matters that, in the auditor’s professional judgement, were of most significance in the audit of the financial statements of the current period. The Standard on Quality Control – 1 and SA 220, Quality Control for an Audit of Financial Statements, define a listed entity as an entity whose shares, stock or debt are quoted or listed on a recognised stock exchange, or are traded under the regulations of a recognised stock exchange or other equivalent body.

Different definitions of ‘Listed company’ under the 2013 Act and SA 220 may raise an applicability issue. One may argue that auditing standards are prescribed u/s 143(10) of the 2013 Act. Accordingly, the question is whether a listed company should be understood uniformly for all purposes under the 2013 Act, including while reporting on KAMs, or the definition of SA 220 be applied while auditing and reporting on the company’s financial statements. The definitions under the 2013 Act are for compliance with the legal requirements under the 2013 Act and do not apply to accounting and auditing matters. Since auditors are responsible to conduct audit in accordance with the SA, the auditor should follow the definition of a listed entity as envisaged in the SAs while reporting on KAMs. Hence, one may argue that auditors of all listed companies (even those not considered as listed companies under the 2013 Act) would continue to report on KAMs as required by SA 701. The MCA and the ICAI may consider clarifying this aspect.

Auditor’s reporting on CARO 2020
The Central Government, in exercise of the powers conferred on it under sub-section (11) of section 143 of the Companies Act, 2013 (hereinafter referred to as ‘the Act’), issued the Companies (Auditor’s Report) Order, 2020 on 25th February, 2020. Called CARO 2020 for short, it is applicable for the financial years commencing on or after 1st April, 2021 to a prescribed class of entities including listed companies, public companies and private companies meeting the prescribed thresholds.

One may take a view that CARO 2020 does not prescribe the listing of securities by any company (including a private company) as a criterion for applicability. Hence the change in definition of a listed company may not impact the applicability of CARO. The MCA and the ICAI may consider clarifying this issue. However, reporting on CARO 2020 would continue to apply to all public companies (listed or unlisted).

II. AMENDMENT TO CORPORATE SOCIAL RESPONSIBILITY (CSR) PROVISIONS
Section 135 of the 2013 Act and the Companies (Corporate Social Responsibility Policy) Rules, 2014 (‘CSR Rules’) prescribe the norms relating to CSR. The MCA has recently overhauled the norms and brought significant changes in implementation of CSR initiatives, introduced new concepts like mandatory impact assessment, and prescribed the manner of dealing with unspent CSR amounts. These amendments were notified on 22nd January, 2021. CARO 2020 has also introduced specific additional reporting requirements for the auditors related to unspent amount under sections 135(5) and 135(6) of the 2013 Act. The revised Schedule III under the 2013 Act has added specific disclosures to be made by companies in respect of CSR spend.

The requirement of audit of CSR activities has not been made mandatory under the 2013 Act. However, various provisions of the Companies (Company Social Responsibilities Policy) Rules, 2014 require the monitoring and reporting mechanism for CSR activities.

Auditor’s responsibilities
Wherever an eligible company undertakes CSR activity itself, the key responsibilities of the auditor are summarised below:
• Auditors should check compliance with section 135 of the 2013 Act and check whether the expenditure has been incurred as per the CSR policy formulated by the company;
• The auditor is also required to check whether the activity / project undertaken is within the purview of Schedule VII of the Act;
• If mere contribution / donation is given for a specified purpose, then whether it is specifically allowed as per Schedule VII of the Act;
• The auditor, while opining on the financial statements, will also be required to check whether separate
disclosure of expenditure on CSR activities has been made as per Schedule III applicable for the financial
year ending 31st March, 2021 and additional disclosures as per revised Schedule III have been made by the company for the financial year commencing on or after 1st April 2021;
• The auditor to check whether the company has recorded a provision as at the balance sheet date to the extent considered necessary in accordance with the provisions of AS 29 / Ind AS 37, Provisions, Contingent Liabilities and Contingent Assets, in respect of the unspent amount;
• To check compliance with relevant Standards on Auditing for audit of CSR spend including:
– SA 250 – Consideration of Laws and Regulations in an Audit of Financial Statements;
– SA 720 (Revised) – The Auditor’s Responsibilities Relating to Other Information.

Eligible CSR activities in the context of Covid-19
The MCA has issued a Circular dated 30th July, 2021 clarifying that spending of CSR funds for Covid-19 vaccination for persons other than the employees and their families is an eligible CSR activity under Schedule VII of the Companies Act, 2013. Management would need to establish necessary internal controls to track that the spend is made to benefit persons other than employees and their families.

Increased focus on impact creation
The amendments require every company with an average CSR obligation of INR 10 crores or more (in the three immediately preceding F.Y.s) to undertake an impact assessment of their CSR projects having an outlay of INR 1 crore or more and has been completed not less than one year before undertaking the impact study. The assessment should be carried out through an independent agency and the impact assessment reports should be placed before the board and should be annexed to the annual report on CSR.

Enhanced monitoring mechanism
The amendments significantly enhance the monitoring mechanism and require the CSR committee to formulate and recommend an annual action plan in pursuance of its CSR policy to the board of directors. The action plan should include the prescribed matters such as the manner of execution of such projects or programmes, modalities of utilisation of funds and implementation schedules, and the monitoring and reporting mechanism for the projects or programmes.

The board of the company is required to satisfy itself that the funds disbursed have been utilised for the CSR purposes and in the manner as approved by it. It should be certified by the Chief Financial Officer or the person responsible for the financial management of the company.

The amendments have introduced a new format for the annual report on CSR activities to be included in the board’s report of a company for the F.Y. commencing on or after 1st April, 2020. Some of the new disclosures to be made by companies in the annual report include details of impact assessment of CSR projects (if applicable) along with the report and amount spent on impact assessment, details of the amount available for set-off and details of unspent CSR amount for the preceding three F.Y.s, including amount transferred to unspent CSR account and fund specified in Schedule VII of the 2013 Act. In case of creation or acquisition of a capital asset, additional disclosures are prescribed.

The auditor will also be required to read the information included in the annual report as required by SA 720, The Auditor’s Responsibilities Relating to Other Information.

Unspent CSR amount – Reporting in CARO 2020
Section 135 prescribes a mandatory spending of 2% of the average net profits made by the company during the three immediately preceding financial years on CSR activities. Earlier, section 135 followed a ‘comply or explain approach’, i.e., the board of directors was required to explain in the Board Report the reason for not spending the minimum CSR amount. Accordingly, no provision for unspent amount was required to be made before the amendment.

The MCA observed that a tenable reason does not expel or extinguish the obligation to spend the stipulated CSR amount4. With this objective in mind, section 135 and the CSR Rules were amended and the ‘comply or explain’ approach was replaced with a ‘comply or pay penalty’ approach. The amended provisions now require the following in respect of ‘unspent amounts’:

• On-going CSR projects [Section 135(6)]: In this case, the company should transfer the unspent amount to a special bank account within a period of 30 days from the end of the financial year. The company should spend such amount within a period of three F.Y.s from the date of such transfer as per its obligation towards the CSR policy. In case it fails to do so, it would be required to transfer the same to a fund specified in Schedule VII of the 2013 Act within a period of 30 days from the date of completion of the third financial year.

Other than on-going projects [Section 135(5)]: When there is no on-going project, the unspent amount should be transferred to a fund specified in Schedule VII of the 2013 Act within a period of six months from the end of the financial year.

Additional reporting requirements for CSR have been introduced in CARO 2020 which require the auditor to report on the above two aspects.

Implementation challenges
The following implementation challenges will need to be considered and evaluated by both the company and the auditor in this regard:

• The CSR amendments do not link the applicability of the amendments to any financial year. It may be noted that the applicability of this amendment is prospective and therefore provision may be required for shortfall for the F.Y. 2020-21 and onwards.

• Assessment of presentation of unspent amount in the CSR bank account in the financial statements may be critical as such amounts would not be available for any other purpose. Ind AS 7 / AS 3 on Cash Flow Statement requires companies to disclose, together with a commentary by management, the amount of significant cash and cash equivalent balances held by the entity that are not available for use by the entity. Thus, the amounts in the unspent CSR bank account should be disclosed as restricted cash with adequate commentary by the management in the financial statements.

• While preparing quarterly financial information, an issue may arise whether provision for CSR obligation for the entire year should be recognised in the first quarter or the provision for unspent amount should be made at the end of the year. In this regard, the ICAI has clarified that for the unspent amount a legal obligation arises to transfer to specified accounts depending upon the fact whether or not such unspent amount relates to on-going projects. Therefore, liability needs to be recognised for such unspent amount as at the end of the financial year. However, the amount spent during the interim period needs to be charged as expense for the same interim period. It cannot be deferred to the remaining interim periods of the financial year.

The amendments have also prescribed significant penalties, e.g., in case of non-compliance with provisions relating to unspent amount a penalty twice the default amount would be imposed on the company subject to a maximum of INR 1 crore. The auditor will need to evaluate the implications on the audit report in case of non-compliance with the mandatory and stringent CSR provisions.

III. MANAGERIAL REMUNERATION
Section 149(9) of the 2013 Act provides that an independent director may receive remuneration by way of profit-related commission as may be approved by the members. In case of no / inadequate profit, section 197 of the 2013 Act permitted payment of remuneration only to its executive directors or managers.

The MCA has extended the model followed for remuneration to executive directors to non-executive directors (including independent directors) by amending section 149 and section 197, and Schedule V to the 2013 Act. Schedule V now prescribes the following limits for payment of remuneration to each non-executive director (including independent directors):

While Schedule V has been amended to include the limits for non-executive directors, Explanation II which provides for computation of effective capital for a managerial person has not been amended. It provides as below:
• Where the appointment of the managerial person is made in the year in which the company has been incorporated, the effective capital shall be calculated as on the date of such appointment;

• In any other case the effective capital shall be calculated as on the last date of the financial year preceding the financial year in which the appointment of the managerial person is made.

In the absence of a specific amendment, one may take the view that similar provisions should be applied for other directors also, i.e., for a non-executive director. The MCA may issue a clarification in this regard.

The above amendment is effective from 18th March, 2021. This means that companies would need to comply with the amended provisions in F.Y. 2020-21 and onwards.

Amendment to remuneration policy
The earlier remuneration policies of the company would not have the flexibility of payment of remuneration in case of no / inadequate profits as payment of remuneration to non-executive directors (including independent directors). Since the amendments now permit payment of remuneration in case of loss / inadequate profits, the remuneration policy of the company would need to be updated so as to comply with these requirements.

Auditor’s reporting
Auditor’s reporting on director’s remuneration in its audit report (under ‘Report on Other Legal and Regulatory Requirement’) will encompass remuneration paid to non-executive directors as well. Since remuneration would be paid to non-executive directors (including independent directors) in case of no / inadequate profits, the auditors would need to verify compliance in this regard.

BOTTOMLINE
The overhaul of the CSR provisions, amendments to the definition of listed company and managerial remuneration highlights the intent of the MCA aimed towards developing a robust and coherent regulatory and policy framework and underlying ecosystem. The primary responsibility of effective implementation of these amendments lies with the management by ensuring their compliance in a timely manner. However, the reporting responsibilities and issuing a true and fair view on the financial statements of the company lies with the auditor. The auditor should keep track of these fast-changing regulations and their consequential implications on the audit report, especially in case there is any non-compliance.

Love what you have. Need what you want. Accept

INTRODUCTION
SPACs. The word does not sound very exciting but it is a phenomenon that is taking stock markets (at least in the USA) by storm. The abbreviation expands as Special Purpose Acquisition Companies but a more street-sounding name is ‘blank cheque companies’. These are companies that are set up with next to nothing and list on the stock exchanges only for the purpose of raising capital for acquisitions. In India, SEBI is planning to come out with a framework on SPACs ostensibly to facilitate Startups to list on the exchanges. SPACs are usually formed by private equity funds or financial institutions, with expertise in a particular industry or business sector, with investment for initial working capital and issue-related expenses.

Private companies would benefit from SPACs as they go on to become listed entities without going through the rigours of an Initial Public Offering (IPO). It is not that SPACs is a new phenomenon – the concept of reverse mergers resembles a SPAC in many respects. SPACs are different from normal companies in that they have only one object – to list on the exchanges with the sole intention of acquiring a target company. One of the main advantages of a SPAC is the fact that it can use forward-looking information in the prospectus – this may not be permitted in a usual IPO.

In case the SPAC is not able to identify and acquire a target company within the set time frame it winds up and the funds are returned to the investors. In case the SPAC identifies a target company and enters into a Business Combination, the shareholders of the SPAC will have the opportunity to redeem their shares and, in many cases, vote on the initial Business Combination transaction. Each SPAC shareholder can either remain a shareholder of the company after the initial Business Combination or redeem and receive its pro rata amount of the funds held in the escrow account.

Investors in a SPAC put in a small amount of money for a stake in the company (usually around 20%). They get allotted shares with a lock-in period of up to a year. They have the option of exiting once the lock-in period is over. SPACs would also have similarities with Cat-1 alternate investment funds (AIF’s) – an angel fund listing on the SME platform.

THREE STAGES
Usually, a SPAC will have three phases with different time frames:

Ind AS accounting standards
Since all SPACs have to list on some stock exchange, they would have to follow Ind AS accounting standards as it is mandatory for all listed entities.

Stage 1
In Stage 1, SPACs normally issue different types of financial instruments to the founders / investors such as equity shares, convertible shares or share warrants. Investors would be keen to invest in these instruments since the warrants give them an opportunity to get some more shares in case a target company has been identified. Usually, the IPO price is fixed at par (say Rs. 10) while the exercise price of the warrants is fixed about 15% higher. SPACs are forced to invest at least 85% of their IPO proceeds in an escrow account. Accounting for these instruments would be driven by Ind AS 32 / Ind AS 109. Since the SPAC would not be undertaking any commercial activities at this stage, very few Ind AS standards other than Ind AS 32/109 would need to be applied. Typically, at this stage SPACs do not own too many assets. The nature of the financial instruments issued to the investors would determine the accounting. These instruments could be equity instruments, share warrants that are exercisable, convertible shares or bonds and other instruments that are entirely equity in nature. The type of the instrument would determine whether it would be accounted for as equity share capital, under other equity, or as a separate line item ‘instruments that are entirely equity in nature’.

Stage 2
Once a target company has been identified and the acquisition is formalised, Ind AS 103 Business Combinations would have to be applied. There are seven steps in Business Combination accounting:

1.    Is it an acquisition
2.    Identify the acquirer
3.    Ascertain acquisition date
4.    Recognising and measuring assets acquired, liabilities assumed, and NCI
5.    Measuring consideration
6.    Recognising and measuring Intangible Assets
7.    Post-acquisition measurement and accounting

First step – Is it an acquisition?
An amendment to Ind AS 103 has made the distinction between an asset acquisition and a Business Combination clearer. The main pointers are:

1.    Business must include inputs and substantive processes applied to those inputs which have ability to create output / contribute to ability to create output.
2.    Change in definition of ‘output’ – it now focuses on goods and services provided to customers.
3.    Omission of ability to substitute the missing inputs and processes by the market participants.
4.    Addition of ‘Optional Concentration Test’.

Remaining steps
Once the transaction meets the definition of a Business Combination, the other six steps would need to be followed. These would invariably be: identifying the acquirer, determining the acquisition date, measuring acquisition date fair values, measuring the consideration to be paid, recognising goodwill and deciding on post-combination accounting. Business Combination Accounting permits the recognition of previously unrecognised Intangible Assets – this clause would be important for SPACs since they would invariably look at technology companies that have some Intangible Assets for an acquisition.

GOING CONCERN?
Most SPACS have a limited shelf-life of about two to three years. One of the fundamental principles on which the Framework to Ind AS Standards has been formulated is the principle of Going Concern. An interesting question that arises is whether the management will need to comment on the going concern concept since it is clear that the SPAC will not be a going concern in a few years from the date of listing. Usually, SPACs provide a disclosure on their status in the financial statements. The disclosure given below is from the Form 10K (annual report) of Churchill Capital Corp IV for the year ended 31st December, 2020:

‘Our amended and restated certificate of incorporation provides that we will have until 3rd August, 2022, the date that is 24 months from the closing of the IPO, to complete our initial business combination (the period from the closing of the IPO until 3rd August, 2022, the “completion window”). If we are unable to complete our initial business combination within such period, we will: (1) cease all operations except for the purpose of winding up; (2) as promptly as reasonably possible, but not more than ten business days thereafter, redeem the public shares at a per share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest (net of permitted withdrawals and up to $100,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), subject to applicable law; and (3) as promptly as reasonably possible following such redemption, subject to the approval of our remaining stockholders and our board of directors, dissolve and liquidate, subject in each case to our obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. There will be no redemption rights or liquidating distributions with respect to our warrants, which will expire worthless if we fail to complete our initial business combination within the completion window.’

It would appear that a disclosure on the above lines would suffice to satisfy the ability of the entity to continue as a going concern during the limited period of its existence.

CONTINGENT CONSIDERATION
A SPAC merger agreement may include a provision for additional consideration to be transferred to the shareholders of the target company in the future if certain events occur or conditions arise. This additional consideration, commonly referred to as an ‘earn-out’ payment, may be in the form of additional equity interests in the combined company, cash or other assets. If the SPAC is identified as the accounting acquirer and the target company is a business, the earn-out payment may represent contingent consideration in connection with a Business Combination. While such payments may be negotiated as part of the merger, the terms of the arrangement need to be evaluated to determine whether the payment is part of or separate from the Business Combination. In making this evaluation, the SPAC should consider the nature of the arrangement, the reasons for entering into the arrangement and which party receives the primary benefits from the transaction.

If the arrangement is entered into primarily for the benefit of the SPAC or the combined company rather than primarily for the benefit of the target or its former shareholders, the arrangement is likely a separate transaction that should be accounted for separately from the Business Combination. For example, payments are sometimes made to shareholders of the target company who will remain as employees of the combined company after the merger. In this case, the SPAC must carefully evaluate whether the substance of the arrangement is to compensate the former shareholders for future services rather than to provide additional consideration in exchange for the acquired business. If the SPAC determines that an earn-out provision represents consideration transferred for the acquired business, the contingent consideration is recognised at acquisition-date fair value under Ind AS 103. However, earn-out arrangements that represent separate transactions are accounted for under other applicable Ind AS. For example, payments made to former shareholders of the target company that are determined to be compensatory are accounted for as compensation expense for services provided in the post-merger period.

TAX IMPACT
Shareholders
At the time of the Business Combination, shares are usually issued. For shareholders under the Indian Income-tax Act, 1961, issue of shares in any form results in a ‘transfer’ of shares held by the existing shareholders of the Indian target entity. The consideration is received in the form of SPAC shares. Capital gains tax may emerge on the sale / swap of shares of the Indian target company against the shares of SPAC. The taxable capital gains would be the excess of the fair market value over the cost of acquisition in the hands of the selling shareholders. Tax rates vary from 10% to 40% under the Indian tax laws, plus applicable surcharge and cess. Tax rates shall primarily depend upon various factors – inter alia, the mode of transfer, i.e., share swap vs. merger, residential status of shareholders, availability of treaty benefits and the period of holding of the shares.

SPAC
A SPAC is required to comply with the applicable withholding tax obligation at the time of discharge of consideration to non-residents, i.e., whether on account of a merger or swap of shares.

If an Indian target company has unabsorbed tax losses and its shareholder voting rights change by more than 49%, then the unabsorbed tax losses would lapse and it shall not be eligible to carry forward its past tax losses.

Once the shares of the SPAC are listed, it is possible that the tax implications of the indirect transfer rules outlined in section 9(1)(i) would need to be considered. However, this would apply only if the SPAC is a foreign company. [Will SPAC be an Indian or a foreign company?] If it is an Indian company, then its shares are actually located in India only. Where is the question of applying indirect transfer rules? For example, a tax liability would arise if a SPAC derives its substantial value from India (more than 50%) under the Indian indirect transfer rules. Shareholders who hold less than 5% of the voting power or the SPAC’s capital are not subject to Indian indirect transfer implications, provided certain conditions are met. For other shareholders, any transfer of SPAC shares results in Indian indirect transfer implications.

SPONSORS
Typically, a SPAC sponsor converts its Class B shares into Class A shares upon successfully acquiring a target company. Depending upon the date and timing of the Business Combination and the conversion of Class B shares into Class A shares, tax implications under the Indian indirect transfer rules need to be evaluated for the SPAC sponsor.

SPACs would also need to consider the implications of Notification No. 77/2021 dated 7th July, 2021 issued by the Central Board of Direct Taxes which clarifies that where the value of net goodwill removed from the block is in excess of the opening written down value as on 1st April, 2020, such excess will now be offered to tax as short-term capital gain.

WOULD SPACs BE A SUCCESS IN INDIA?
The answer to this question would obviously depend on the guidance that SEBI comes up with on SPACs. The Primary Market Advisory Committee of SEBI is deliberating on whether a framework for SPACs should be introduced. The Committee is also looking into any safeguards that should be built into the framework being proposed. From the information available now, SPACs are being set up by hedge funds and private equity investors who plan for a quick exit from their investments in a couple of years. The success of SPACs depends on the existence of companies that are available for a Business Combination. Traditional Indian companies may not be interested in the SPAC route as many would feel that it is too short-term in nature – they are in for the long term. Startups could provide a good source of companies that are SPAC-eligible. India has a large number of Startups but how many of them are worthy of listing remains to be seen. In addition, Indian companies do not have a history of issuing complicated financial instruments which is one of the basic requirements of a SPAC. As things stand today, it would be reasonable to conclude that there will be a few SPAC transactions in India but the concept of SPAC is not going to overly excite everyone at Dalal Street!