Startups and funding go hand-in-hand. First-time entrepreneurs are keen to bring angel investors and VC funds on board. That’s when all the documentation and legalities come into the picture. Several entrepreneurs find it difficult to understand legal documents. One such document is the ‘term sheet’. This blog explains the ‘term sheet’ in its entirety and what entrepreneurs must bear in mind before signing this document.

Term Sheet

A term sheet is basically a non-binding document. Apart from two or three clauses – like those relating to exclusivity, confidentiality and governing law – the other provisions in the term sheet do not constitute a binding contract. The idea of a term sheet is to say that the parties – founders and investors – have, after discussions, reached a stage where they have a preliminary level of comfort with each other. It’s a broad, in-principle agreement relating to the key deal terms, including the valuation.

The term sheet codifies the discussions and includes things the parties have agreed to informally, not legally. Subsequent to the term sheet, there will be a due diligence process and the parties will eventually negotiate, agree on, and sign the definitive agreements. The signing of these definitive agreements is when a binding obligation to do the deal is formally created. So, a term sheet creates no contractual obligations on the investor to invest and on the company to issue shares to the investor.

Most terms in a term sheet are pretty standard and have evolved as “market practice” over many years of deal-making. It typically contains the details of who the investor is; name and identities of the investors and founders; the pre-money valuation of the company (as that is what determines how much equity stake the investor gets for certain amount of money); investment amount; whether the investors are going to get a board seat, and then a whole lot of special rights such as veto rights and affirmative rights.

Be careful with affirmative vote, liquidation preference clauses

Below are some the important clauses of a typical angel or VC term sheet that entrepreneurs should pay close attention to:

● Affirmative vote means that unless the investors vote in favour of a particular matter, the company cannot approve such an action. While each VC or angel investor may have its own critical items when it comes to matters requiring the investor’s affirmative vote, the typical rights seen in most such deals include amendment of articles of the company, change in composition of the board of directors, share issuances at lower price than investors’ entry price, and change of statutory auditors. These are matters which can materially affect the rights of the investors.

● Liquidation preference essentially means that in a scenario where either the company gets wound up or sold, the investors will get paid, before everyone else, a certain amount. What this amount should be is a matter of negotiation between the company and the investor, but most investors I know ask for a return of the investment amount along with any accrued and unpaid dividends. This can be seen as a “principal protection” right. In some cases the liquidation preference can get much more complex than a simple 1x return. Some VCs may even ask for 2x plus or 1x plus certain high internal rate of return (IRR). There are various ways one can structure this, but the basic concept behind a liquidation preference is that “the investors should get their money plus some return back, before the founders can get anything”.

These are often referred to in industry parlance as ‘downside protection’ clauses and are meant to protect the investors from the adverse consequences of downside events (like a sale of the company at a valuation lower than investors’ entry valuation, for example) to the investor. But there are times when investor protection becomes almost like a guaranteed IRR and that’s where the debate starts on whether a liquidation preference is really fair. Entrepreneurs, therefore, need to be careful about such clauses.

● Founders’ ownership: In early-stage angel, seed or VC deals, this is a very important issue to be addressed in the term sheet and definitive agreements. In a late-stage company, the ownership of the founders is pretty much cast in stone. But in early-stage startups, the founders’ ownership is very dynamic as the VC is investing at a time when the risk is too high not only of the venture failing but also of the founders losing focus on the venture.

In order to keep the founders focused and committed, investors often put in restrictions on the founders’ ownership. This works somewhat like a stock option plan where the founders start with a certain percentage stake and the remaining stake of the founders will be released to them over a specified period. Investors don’t want a situation where they have funded a company, only to find one or more of the founders quitting or losing commitment soon thereafter, and continuing to sit on a 50 per cent ownership in the company! The idea is to hold the founders accountable.

At the same time, founders should be careful and be comfortable that the founder vesting schedule proposed by the investors is not too harsh on the founders. Investors, too, need to be fair with the founders while still having an effective mechanism to hold them accountable.

● Restrictions on transferability are very common in VC term sheets. Usually, VCs will come in and tell founders not to sell their shares in the company until investors exit. However, founders may want to be able to sell a certain portion of their stock to be able to meet personal expenditure. So, in a term sheet, parties often agree that founders can sell up to a certain percentage of their holding, and there’s a lock-in period agreed to of, say, three to four years for the remaining founder equity.

● The exit clause is an important and interesting one. This clause requires the founders to commit to deliver an exit – either by an IPO or through an M&A deal – to the investors by a certain date. If that doesn’t happen, this clause would typically require the founders to buy back the shares held by the investors at a price that delivers a guaranteed IRR to the investors. Many entrepreneurs make the mistake of not giving enough importance to this clause either because they feel supremely confident that they would be able to deliver an exit or because “the whole thing is so far away in time anyway”!

As bullish and confident as entrepreneurs need to be to succeed, when it comes to signing up to obligations like this, they need to give it a lot of thought. I have seen term sheets where the founders had agreed to buy back the investor’s shares at a price that would deliver an IRR of 40 per cent, and frankly, I have been shocked at such clauses. One thing for founders to chew on while signing up to these clauses is this – when you commit to an IRR guarantee, remember that it is going to get progressively tougher to deliver that exit the further away in time that an exit event is – it is MUCH TOUGHER to deliver a 25 per cent IRR IPO five years from an investment than to do so three years from the date of the investment.

Types of early-stage financing deals

There are, broadly speaking, two kinds of deals in the early-stage ecosystem. One is a simple preferred/equity deal and the other is what is referred to as a “convertible note deal”. In a simple preferred/equity deal, the valuation (or at least the base case valuation) is locked in upfront and hence, the investor is coming in at a certain value and issued shares on day one. Even in a simple preferred/equity deal, the valuation could be subject to a reset based on certain milestones and contingencies, but there is a valuation agreed upon when the investor invests the money, and the investor is committed to staying invested in the company for a reasonable period.

In an early-stage (pre-Series A) deal, the convertible note structure is common not only in Silicon Valley but also increasingly in India. In such deals, the investor agrees to invest based on the potential in the venture, but is unsure about the valuation that can be ascribed to the startup. Therefore, the investor invests an agreed amount of money into the company and receives “convertible notes” of the company in return (and no shares of the company on day one). The convertible note would, under its terms, convert into equity shares of the company at a valuation that is at a discount to the next round of funding raised by the company. The usual discounts to the next round valuation that the convertible note holders would get could vary from 10 per cent to 20 per cent. Convertible deals are more common in angel and seed rounds, and not so common in Series A rounds.

What makes it all so complicated for entrepreneurs?

It is complicated because these founders are dealing with sophisticated investors. While entrepreneurs can find all this daunting, at the end of the day they will find the term sheet not just protects the rights of the investors but equally protects their own rights as well. Entrepreneurs deal with sophisticated investors who invest based on clear mandates and principles. Most importantly, the investors have a duty to manage other people’s money – which is why they have to be more careful on how they deploy their money. So, investors come up with certain safeguards to protect themselves, and those principles get captured in a term sheet and eventually in the rest of the documents.

Entrepreneurs can often find all this daunting because they have not done this before. Some of them may not even think all this to be important enough in comparison to the more exciting task of building their businesses. However, entrepreneurs must appreciate that high-quality legal documentation is an absolute necessity to ensure that they protect their rights and control over the business that they are working so passionately to grow. Poor or one-sided financing documents can cause operational hardship and even financial leakages to founders even where they have built successful companies.

How to ensure water-tight term sheet

First and foremost, investors as well as founders should get top-notch legal advice. You wouldn’t hesitate to spend good money on getting the best doctors, so why would you not take the same approach when it comes to picking your legal advisors for something that is such an important part of your life – your startup! Most times, founders feel they can draft their own term sheet as there are “open source” type templates available online. May be they can and many of them even have pretty good drafting skills. However, it’s not about the template but about getting top-notch advice. Good counsel doesn’t only mean drafting a document that works, but it’s about having good quality advice at the table for a founder at the time when he is structuring a deal with the investor. Simply put, founders need somebody on the legal side advising and mentoring them.

Suggestions for founders and investors

For founders

● It is, of course, important to guard yourself against signing up to unfair terms. Equally, try to understand what the standard market practice for such deals is, so that you don’t end up baulking at every other term in the term sheet that (wrongly) seems so unreasonable to you at first glance. Founders should understand that while some clauses may, prima facie, appear unfair, they are “standard market practice” for a good reason. Founders must make efforts to understand the intent behind each of these clauses, and seek advice from their legal counsel as to whether specific proposals in the term sheet offered by an investor are standard market practice or not.

● I find that Indian founders often get too obsessed about their notions of control and ownership of their startup, and this obsession impedes their ability to think optimally when they are raising funds. The point is they have to make a wise choice between excess dilution and under-dilution; they have to make optimal dilution. It is obviously better to own 10 per cent of a unicorn than to own 100 per cent of a $1 million company – and it is usually much easier to create unicorns by diluting more equity and more often.

● Pay special attention to the liquidation preference clause. There are lots of investors who are absolutely fair with entrepreneurs, but there are some who ask for highly unfair liquidation preference clauses. An onerous liquidation preference clause can pretty much wipe out all value for the founders in certain circumstances.

● Keep a pragmatic approach on funding. Keep your focus on closing the deal fast and don’t overdo the posturing and negotiations – there’s your business straining at the leash to grow and you have to go back quick to taking care of it! So, don’t get dogmatic in your approach.

For investors

● Some times, because of their higher position on the food chain, investors can become tempted for “over-protection”. While I think it is fair to provide the investors with multiple layers of protection to address fair risks, it is not fair at all to seek unreasonable or unfair levels of economic and other rights in the garb of “downside protection”. It is my belief that successful investors win more by being fair and balanced in their dealings with founders than do by being too harsh. There should not be patent signs of unfairness in the term sheets that they offer.

● Again, I have realised from my experience advising scores of investors that the consistently successful ones don’t just bulldoze the founders to get their way on deal terms, but make the effort to explain to them why those clauses are important and fair, and get the buy-in of the founders to those clauses.

● Lastly, it is in your interests and the interests of your deal to ensure that the founders get their own legal counsel who is experienced in VC deals. This will save you and your legal counsel the trouble (and cost) of explaining each and every clause in the term sheet to the founders.

The much awaited report of the Companies Law Committee (“Committee”) which proposes a number of changes to the Companies Act, 2013 (“Act”) and rules laid down thereunder (“Rules”) was released in the first week of February (“Report”). The Report in itself is extensive and has covered various chapters and sections of the Act in detail, having received more than 10,000 suggestions from various stakeholders. This blog post seeks to discuss a few recommendations made by the Committee which could have a positive effect on transactions as well as future compliance requirements of companies if they are accepted.

Secretarial Standards

The Report states that the Committee had received a number of questions on the requirement, scope and content of the Secretarial Standards (“SS”) issued by the Institute of Company Secretaries of India (“ICSI”). In an earlier blog on this topic, Codhai had also pointed out that the requirements under the SS seemed to be more stringent and burdensome than the Act itself. The Committee has now recommended that the ICSI re-examine and revise the SS in consultation with all stakeholders and the suggestions received by the Committee on this issue should be taken into account during such re-examination by the ICSI.

Meetings via video-conference

While the Act permits meetings of the board of directors to be held through video-conferencing, the Rules prescribe specific matters which cannot be dealt with in a meeting held through a video conference or using other audio-visual means. Such matters include inter alia, the approval of annual financial statements, the approval of the board’s report, and the approval of matters pertaining to amalgamations, mergers, and takeovers. The Committee was of the view that this requirement completely prohibits the participation of directors through a video conference at board meetings where any of these specified matters are part of the agenda. This prohibition unnecessarily restricts wider participation even if the necessary quorum as specified under the Act is physically present at such a meeting. The Committee, therefore, has now recommended that flexibility be provided to allow participation of directors through video conferencing at meetings were such items are discussed, subject to such participation not being counted for the purpose of calculation of the quorum. The Committee has further recommended that while such directors would be permitted vote, they may also be entitled to sitting fees. If the above recommendation is accepted, a number of Indian companies with a majority of Indian directors but with 1 or 2 foreign directors may have a board meeting to discuss the above matters in India and such foreign directors will also be able to attend and participate in the same through video conferencing.

Resident Director

The Act currently requires all companies to compulsorily have at least 1 director on board who has stayed in India for a total period of not less than 182 days in the previous calendar year. Upon receipt of various concerns pertaining to this requirement, the Committee felt that it would be more appropriate to amend the above requirement and make it in relation to the director’s stay in India during the financial year and not the calendar year. Further, it was felt that this requirement should become effective after a period of 6 months from the date of incorporation of the company. The primary reason for this recommendation, as pointed out by the Committee was that the requirements for residency in the previous year compels a new subsidiary of a foreign company to appoint an individual or a professional that may be unconnected with the company, as its director, which does not in any way help the board’s decision making and could lead to unnecessary disputes. The Committee has therefore, now recommended that it would be more appropriate to amend the residence requirement to the current financial year instead of the previous calendar year. This recommendation seems to be in line with the Government’s ‘Make in India’ initiatives, and its plans to ease the compliances pertaining to the setting up of a business in India by a foreign company.

Definition of Related Party

Presently, as per the definition under the Act, a “related party” with reference to a company would include any company which is a holding, a subsidiary, an associate company, or a fellow subsidiary of such a company. The use of the word ‘company’ in this definition signifies that only those entities that are incorporated in India would come under the purview of the definition. This has resulted in the understanding that companies incorporated outside India (such as a holding company, a subsidiary, an associate, or a fellow subsidiary of an Indian company) are excluded from the purview of ‘related party’ of an Indian company. The Committee has noted that this carve out was unintentional and seriously affects the compliance requirements of related parties under the Act. The Committee, therefore, has now recommended that the definition of the term ‘related party’ be amended to substitute the word ‘company’ with ‘body corporate’, thus including companies incorporated outside India. Further, the Committee has also recommended that an ‘investing company’ or the ‘venturer of a company’ be included as related parties under the Act.

Related Party Transactions

The Ministry of Corporate Affairs (“MCA”) had in July 2014, issued a circular clarifying that only members of a company that were related parties to a contract or an arrangement that was the subject matter of a resolution could not vote on such resolution. However, the Committee has noted that this circular had been misinterpreted, and hence, should be withdrawn. Thus, all related parties would be prohibited from voting on any related party transactions irrespective of whether or not they are parties to the transaction in question. The Committee further noted that as all parties in case of joint ventures and closely held public companies may be related parties, not allowing them to vote on resolutions may be impractical and therefore such cases may be specifically excluded from the requirements of the provision. It is pertinent to note that private companies are not bound by this restriction as of July 05, 2015 and only public companies are required to comply with this provision.

While some of the above recommendations if approved by both houses of the parliament, would be welcome changes that would facilitate the ease of doing business in India (for example the recommendations pertaining to resident directors), others would iron out certain ambiguities in the Act and the Rules and companies would have to ensure that additional compliances, if any, are adhered to (for example, the change in the definition of related parties). While the MCA has been pro-active and has taken on record most of the the suggestions received by stakeholders, it has invited further comments from the public based on the recommendations provided in the Report. Let us hope that the parliament too follows suit shortly and implements these recommendations, which would provide much needed clarity and relief to corporates in India.

While going through the recent judgements of the Income Tax Appellate Tribunal (“ITAT”), I came across this interesting decision issued by the Mumbai bench of ITAT in relation to transfer of shares of a company called Century Enka Limited (“CEL”), wherein the ITAT has given certain guiding principles as to what is meant by a reorganization of the business or arrangement which are relevant for claiming the tax benefits under the Double Taxation Avoidance Agreement (“DTAA”) entered between India and the Netherlands.

Facts of the case

This case is between Accordis Beheer BV (“AB”) and Director of Income Tax, Mumbai (“DoIT”). AB held 38.24 % of shares in CEL and had tendered certain portion of its holding through a High Court approved scheme of arrangement under which CEL had bought back the shares resulting in capital gains of INR 58.64 crores to AB.

AB, upon a claim being raised by the income tax authorities cited Article 13(5) of the India-Netherland DTAA and contended that the capital gains is not taxable in India, which was not acceptable to the authorities. Accordingly, the parties went to the ITAT for its ruling. While we shall review the other contentions of the party later, I would like to firstly apprise you as what constitutes Article 13 of the DTAA. This article relates to the capital gains earned by the resident members of either state.

The said article from the DTAA is given below for ready reference:

“5. Gains from the alienation of any property other than that referred to in paragraphs 1, 2, 3 and 4 shall be taxable only in the State of which the alienator is a resident. However, gains from the alienation of shares issued by a company resident in the other State which shares form part of at least a 10 per cent interest in the capital stock of that company, may be taxed in that other State if the alienation takes place to a resident of that other State. However, such gains shall remain taxable only in the State of which the alienator is a resident if such gains are realised in the course of a corporate organisation, reorganization, amalgamation, division or similar transaction, and the buyer or the seller owns at least 10 per cent of the capital of the other…”

The income tax authorities (referring to the bold section above) held that since the company in question, i.e. CEL, is based in India, the shares tendered under the buyback were more than 10% of the capital stock and the shares were transferred to an Indian resident, again CEL, the transaction was taxable in India.

However, AB in its contentions held the non-applicability of the said provisions referring to the same article (the one underlined above) contended that the capital gains had arisen due to the corporate reorganization scheme under the approval of the High Court and hence the taxability of the transaction is in Netherland, the state of its residency.

ITAT’s decision

The decision of the ITAT in the said case depended primarily on two factors a) would the transaction of buyback of CEL constitute “reorganization”, and b) would it also be a scheme of “arrangement” qualifying for the DTAA.

As there is no definition of the term reorganization, the ITAT has relied on the definition as provided in the Dictionary of Accountants which defines reorganization as a major change in the financial structure of a corporation or a group of associated corporations resulting in alterations in the rights and interests of security holders; a recapitalization, merger or consolidation. Based on the facts, ITAT held that in the current scenario there has been no major change in the financial structure of CEL which have resulted in the alteration of the rights of AB. AB still enjoys the same rights as the shareholders and of course the share capital of CEL has come down marginally due to the buyback of shares.

Further, the ITAT referring to section 390 of the Companies Act, 1956 held that the term arrangement would refer to a reorganization of the share capital of the company caused due to consolidation of shares of different classes, or by the division of shares into shares of different classes or by both those methods, which clearly was not the case in the current matter.

The ITAT also held that the entire scheme as approved by the High Court was clearly an exit route provided to AB as the buyback of shares by CEL was provided only to non-residents and the cancelation of shares post buy back didn’t result in a significant change in the financials of CEL and hence AB’s transfer of shares in the present fact pattern did not amount to “reorganization” under Article 13(5) of the DTAA. It further said that AB is not eligible to the exception provided for in the DTAA and, hence, is taxable on the buyback transaction.

Conclusion

While we are aware that any decision of the Appellate Tribunal is binding only on the parties and the Income tax authorities concerned to the said matter, we should note that this is an important decision wherein reliance has been placed on the terms reorganization and arrangement and ITAT has been very strict with AB even though it has agreed that a buy back under the court approved route is not a colorable device. While this ruling would be a guiding principle for residents doing business in either of the States, it should be kept in mind that any further amendments to the Income Tax laws would change the scenario, till then all transactions need to keep this ruling in mind.

The Startup India Event organized by the Government last month was extremely well received by the entrepreneurial community. The event culminated in the unveiling of the Startup India Action Plan (“SAP”) by the Prime Minister. As expected, there were several interesting proposals aimed at promoting the growth and development of startups in India. This blog looks into some of the proposals that garnered much attention and analyses whether these are adequate to make the startups to “stand up”.

Definition

The Government has rightly sought to clearly outline the beneficiaries of the SAP by defining the term “startup”. The SAP has defined a startup as an Indian entity that is not more than 5 years old and having an annual turnover of not more than INR 250 million in the preceding financial year. Further, such entity should be working towards innovation, development, deployment or commercialization of new products, processes or services (“Objectives”); and must be driven by technology or intellectual property. In addition, such entity should not have been formed by the restructuring of a business already in existence.

Defining a startup is not an easy task and for many entrepreneurs, startup is merely “a state of mind” which cannot be defined. The Government should be complimented for its efforts in outlining the contours of a startup well. While the definition adequately captures most characteristics of a startup, the condition of it being driven by technology or intellectual property could exclude certain enterprises from being classified as a startup. The idea of the SAP should be to incentivize ventures that benefit the nation by working towards the stated Objectives, and it being driven by technology or intellectual property need not be the determining factors. Accordingly, it would be beneficial if the final policy drops this requirement from the definition so that businesses achieving the stated Objectives, for instance rural health and education, are not kept out of the policy for them not being driven technology or intellectual property.

Ease of Doing Business

The SAP has proposed the rolling out of a mobile app and portal through which startups could be registered with different agencies of the Government and also make various compliance related filings. This could drastically reduce the time period for registering a startup in India, which at present takes up to 3 weeks. It would also be helpful if a nodal authority is constituted by the Government to streamline the entire process of seeking approvals and registrations by the startups.

Another positive step towards reducing the regulatory burden on startups is the proposal to allow startups to self-certify their compliance with respect to certain specified labour and

environmental laws. Further, no inspections would be conducted on startups with respect to labour laws in the first 3 years unless there is a credible complaint regarding their violation. The above measures, apart from permitting the entrepreneurs to focus on their core business, would shield the startups from corruption, which was pointed out as the biggest grouse of the entrepreneurs in a recent survey. While this is indeed welcome, there is a fear that the lack of threat of prosecution could lead to non-compliance of the labour and environmental norms by startups, and adequate safeguards must be implemented to avoid such a scenario.

The SAP also proposes to simplify the mechanism for winding up of startups by incorporating special provisions in the Insolvency and Bankruptcy Bill, 2015 (“IB Bill”). Given that a large number of startups fail, an easy winding up process would reduce the burden on entrepreneurs, and enable them move on to a new venture without getting bogged down by the long-drawn winding up process. The IB Bill would, however, have to go through the expansive debates in both houses of the Parliament and could take considerable time before it is made into law. Hence, it would be beneficial if a fast track scheme for winding up of startups is announced as part of a special scheme by the Government in the interim.

Tax Benefits

The loudest cheers during the event were reserved for the tax soaps proposed by the Government. With the idea of enhancing the working capital for startups, it was proposed that the profits of startups would not be taxed for a period of 3 years. On further reflection, however, this measure may not alter the landscape for startups too much as most of them may not see taxable profits in their initial years. In addition, the policy does not clearly state whether the exemption is available for the first 3 years from incorporation or for the first 3 years of profitability. Even if one were to assume that it is the latter, an entity ceases to be a startup after 5 years of incorporation, and considering that even some of the poster boys of Indian startup ecosystem are yet to see any profits, the tax exemption may not move the needle much for most startups.

One would feel that the startups would have been better served had the Government provided them with exemption/incentives under indirect taxes during the first 3 years of incorporation. Startups often have to spent considerable amounts towards indirect taxes, such as service tax and customs duties, and any reduction in such tax outgo would definitely augur well for them.

The SAP also proposes to extend the current tax exemption for the consideration received by a startup in excess of the fair market value of shares when its shares are issued to a venture capital fund, in case of issuance to incubators as well. While this step would benefit startups that are backed by incubators, HNIs are the prime source of early stage funding for most startups and the tax exemption should have been extended to them as well.

Attracting Investments

The Government also announced several measures aimed at attracting further capital towards startups. A capital gains tax exemption has been proposed for people who invest such taxable gains in fund of funds recognized by the Government. In addition, the existing exemption for capital gains tax (in relation to gains from transfer of residential property) in case of investment in small and medium enterprises in the manufacturing sector is proposed to be extended to all startups.

Further, to augment the funding channels for startups, the Government has proposed to establish a fund of funds with a corpus of INR 100,000 million. Without getting into the debate of whether the Government is in the right in utilizing tax payers’ money for funding start-ups, one point I would like to make is that the Government should come up with a transparent policy for identifying the startups that would be eligible for such Government funding. Perhaps it would be a good idea for the Government to fund social venture/impact funds that back businesses serving underserved consumers. These social ventures are necessary to address some of the most significant problems of the Indian society. However, they often fail to garner the attention of institutional investors, particularly in their later stages, and the fund of funds of the Government could offer much needed fillip.

The SAP also has several other proposals like easy and fast track registration of intellectual property, enabling startups to participate in Government tenders, offering credit guarantees, creation of incubators, innovation centers, and research parks, etc.

While the SAP addresses several key concerns of the startups, at several instances, it stops short from being a true game changer. Nevertheless, the Government should be lauded for the positive intent showcased through the SAP and it is hoped that the Government is able to translate this intent into real action.

While all of us have raved and ranted in equal measure about booking a cab in today’s time, it may be safely said that most people would, by now, have a ‘preferred choice’ of cab company which they use while trying to make it from point A to point B. However, the minute a ridiculous surge price kicks in, your preference would change and like-wise, when a discount is introduced. This blog post looks at the Competition Commission of India’s (“CCI”) view on the impact of excessive discounts and other incentives offered by taxi companies on their competitors and discusses how much (in their view) is too much?

In the matter of In Re Meru Travel Solutions Private Limited (“Meru”) and Uber India Systems Private Limited (“Uber”), Meru had alleged that the number of incentives offered by Uber to its drivers, and the large discounts and offers presented to its customers qualified as predatory pricing under the Competition Act, 2002 (“Act”) due to Uber’s dominant position in Kolkata. Meru alleged that the aggressive offers provided by Uber to both its customers as well as drives, resulted in a dip in Meru’s market share in terms of the number of cars attached to its network as well as the number of trips provided in a day as Meru could not match the low price per kilometer fare offered by Uber. Upon a perusal of the facts of the case the CCI noted that a case for predatory pricing could not be made out unless the entity engaged in such alleged acts occupied a dominant position in the relevant market. In the present case, the CCI delved into the details of the relevant market and observed that Kolkata was a peculiar market in itself due to the presence of yellow taxis along with other radio taxis, thus the relevant market for the purposes of the present case was found to be ‘services offered by radio taxis and yellow taxis’ and not merely the services of radio taxis as projected by Meru. The CCI proceeded to further discount the report which Meru had relied on to prove that Uber held a dominant position in Kolkata (“TechSci Report”). The CCI noted that the TechSci Report was based on incomplete information as the research organization had not interviewed Uber while conducting the study. Further, it did not take into account the number of yellow cabs in the city or their market share, and hence it did not provide a holistic picture of the relevant market. In arguendo, if the definition of ‘relevant market’ proposed by Meru were to be accepted, the CCI observed that Uber would still not hold a dominant position in the market due to Ola cabs, its competitor, which held a larger share in the market. The presence and inclusion of yellow taxis would further dilute Uber’s position in the market. Thus, the CCI concluded that as Uber did not hold a dominant position in the market, its conduct in the market was irrelevant and its pricing strategies and other incentives would not be regarded as predatory pricing.

This issue of methods and business models of the new age cab operators coming under scrutiny is not unheard of and in fact this is the second CCI order on the topic. Earlier in April 2015, the CCI held that Ola had indeed abused its dominant position in the radio taxi market in Bangalore in a case between Fast Track Call Cabs Private Limited (“Fast Track”) and ANI Technologies Private Limited, which owns and operates Ola cabs. The CCI had noted that Ola seemed to be spending more money on discounts and incentives on customers and drivers as compared to the revenue it was earning and engaging in predatory pricing to oust other players from the relevant market thus contravening the provisions of section 4 of the Act, which prohibits the abuse of dominant position. The CCI subsequently referred this matter to the Office of the Director General (“DG”) for a more detailed and thorough investigation into the issue. It is interesting to note, that while the DG’s findings were still pending, Fast Track moved the CCI for an interim order directing Ola to restrain from indulging in alleged predatory pricing. However, the CCI, not being convinced that there was a need for interim relief to be granted, declined to pass such an order and the DG’s final order is still awaited.

With the increased foreign funding being received by the top players in the cab services market and the discounts and incentives pouring through, the rising number of complaints against taxi aggregators in various cities has only increased. While the business policies and models of cab operators continue to come under the CCI’s scanner, one can only wait and watch to see if there is likely to be a complete ban or the imposition of controls on their aggressive pricing strategies and business methods. Until then, please excuse me while I book a cab!

In March 2015, the Securities and Exchange Board of India (“SEBI”) constituted the 21 member Alternative Investment Policy Advisory Committee (“AIF Committee”), under the chairmanship of Infosys founder Mr. Narayan Murthy, to advise on ways to encourage the development of alternative investment and start-up ecosystems in India. The AIF Committee was well represented by various stakeholders, including domestic venture capitalists like the Indian Venture Capital Association and Indian Angel Network, renowned private equity firms such as KKR & Co. and The Carlyle Group, corporations like Religare Enterprises and Piramal Group, tax advisors such as PricewaterhouseCoopers, as well as the SEBI, Reserve Bank of India, and Ministry of Finance.

This week, the AIF Committee submitted its first report, suggesting the revamp of the current regulatory regime on alternative investment funds (“AIFs”), recommending relaxations in the tax regime applicable to AIFs, encouraging pooling of domestic capital, and pushing for promoting onshore fund management. In this blog, I will focus on outlining the key recommendations made by the AIF Committee regarding the proposed amendments to/revamp of the Securities and Exchange Board of India (Alternative Investment Fund) Regulations, 2012 (“AIF Regulations”).

Regulation of fund managers

At present, apart from the AIF Regulations which regulate investment funds, the SEBI has also issued the Securities and Exchange Board of India (Investment Adviser) Regulations, 2013 (“IA Regulations”) and the Securities and Exchange Board of India (Portfolio Manager) Regulations, 1993 (“PortMan Regulations”) to regulate investment advisors and investment managers. While this regulatory regime has thus far focused primarily on encouraging transparent compliance practices by funds and protecting the interests of investors, the AIF Committee believes that it is the fund managers, and not the funds themselves, that must be regulated, as they are in control of investment decisions which could pose risks to the investors, securities market, and the economy.

Accordingly, the AIF Committee has recommended that the PortMan Regulations, IA Regulations, and AIF Regulations should be replaced with a ‘Securities and Exchange Board of India (Alternative Investment Fund Managers) Regulations’ (“Managers Regulations”). The proposed Managers Regulations would contain a general framework for fund raising and reporting, while allowing the SEBI to provide special incentives to certain funds, such as angel funds and social venture funds. As regards fund and investment managers, the Managers Regulations would mandate registration and impose minimum capitalization requirements based on their targeted customer-base.

Further, the Managers Regulations would classify investors into ‘accredited investor’ and ‘retail investor’ groups, wherein accredited investors who meet certain minimum income / asset / net-worth thresholds are exempted from several requirements that may apply to retail investors. Such categorization would give fund managers the flexibility to provide customized product offerings to institutional and accredited investors who have more sophisticated investment appetites, while at the same time protecting the interests of retail investors.

Sub-classification of Category III AIFs

Industry appetite for investing in listed securities is quite large, but is currently undertaken by institutional investors and high net-worth individuals directly, rather than through any organized fund platform. In the interest of creating such a formal fund structure under the AIF Regulations, the AIF Committee has recommended that Category III AIFs be further classified into 2 categories, based on their investment horizon, preferred instruments, and investment objectives.

At present, funds which employ diverse trading strategies and invest in listed securities, such as hedge funds, funds looking to make short-term returns, and open-ended funds, are permitted to be registered as Category III AIFs. The proposed sub-category A under Category III AIFs would comprise of funds which primarily invest in listed securities without employing leverage, except for the purposes of hedging, with long fund life of at least 3 years. Sub-category B funds, termed ‘Complex Trading Funds’, would be those funds that have complex trading strategies and employ leverage, through investment in listed or unlisted derivatives.

Further, Category III AIFs are currently prohibited from investing more than 10% of their corpus in 1 company. The AIF Committee has recommended that this static threshold be replaced with a dynamic one, where the restriction is a function of market value of the fund’s portfolio as on the date of an investment.

The recommendations of the AIF Committee are geared towards sustaining the continued growth of the AIF industry by incorporating global practices that recognize the fiduciary role of fund managers, the limitations on capacity and risk tolerance of investors, and diversity in investment objectives. We would have to wait and see whether any of these recommendations are implemented, and if so, in what form, by the SEBI.

The corporate sector has been very keen on helping the Government of India in its various initiatives whether it is the Swach Bharat Abhiyaan or the introduction of the Corporate Social Responsibility Norms, there have been efforts by the corporate sector to take these missions forward. In continuation to the same, there have also been discussions since November 2015 for the introduction of the Green Bonds and the process with regards to the issuance of such bonds.

A Green Bond is similar to any other bond, where a debt instrument is issued by an entity for raising of funds from the investors. However, the difference between a regular bond and a green bond is the proceeds of such issuances are earmarked for “green” projects. As per the projections of the Indian Government there is a plan to build a capacity of 175 gigawatt of renewable energy by the year 2022 and the same requires an investment of USD 200 billion. The Government in addition to the regular routes of raising the funds such as from the financial institutions and banks has plans of tapping the investors’ base not only in India but outside India, the prime targets being the pension funds, sovereign wealth funds and insurance companies respectively.

The Securities and Exchange Board of India (“SEBI”) had in the month of December 2015 issued a concept paper on the issuance of the Green Bonds in India which had recommended quite a few measures for the entities willing to raise funds through this route and had also invited comments from the public. In a recent development, the SEBI at its meeting held on January 11, 2016 came out with the broad parameters for the issuance of such Green Bonds.

The parameters to be followed for the issuance of Green Bonds are as follows:

● The issuance and listing of Green Bonds shall be governed by the SEBI (Issue and Listing of Debt Securities) Regulations, 2008 and such issuer of Green Bond shall also have to make certain incremental disclosures/follow procedures.

● The definition of Green Bonds shall be as specified by SEBI from time to time.

● Requirement of independent third party reviewer / certifier / validator, for reviewing/certifying/validating the pre-issuance and post-issuance process including project evaluation and selection criteria shall be mandatory.

● Escrow account is not mandatory, however the issuer is required to provide the details of the system/procedures to be employed for tracking the proceeds of the issue including the investments made and/or investments earmarked for eligible projects and the same has to be verified by the external auditors.

● Issuer is also required to make disclosures including use of proceeds, list of projects to which Green Bond proceeds have been allocated etc. in the annual report/periodical filings made to the Stock Exchanges.

While the above parameters are in line with the concept paper issued by SEBI, one key change which looks interesting is that in the concept paper the amount raised by the entity was required to be kept in an escrow account and the usage would be decided as and when the opportunity to invest arose, however, as stated above, the requirement of escrow account has been made non mandatory as long as the usage of funds is in line with the offer document.

As mentioned in the concept paper the Green Bonds appear to an interesting way of tapping funds from a different set of investors for the renewable energy sector, and improve the issuer’s image, the success of the same would lie in implementation of the projects and how quickly one would be in a position to give a healthy return to the investors, given the timelines this sector is subject to. There have been couple of banks who have tried this route and we need to see many more entities come forward to raise investment and be part of changing the renewable energy sector.

Though the Companies Act, 2013 (“Act”) had provided for the treatment of dissenting shareholders and their exit in case of a company which, after raising funds from the public through a prospectus, has varied the terms of a contract referred to in the prospectus or the objects for which the prospectus was issued, it is only recently that the Securities and Exchange Board of India (“SEBI”) has actually come out with a discussion paper on implementing the same and laying down the framework (“Paper”). Subsequently, the SEBI took up the suggestions made in the Paper and approved amendments to the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 at its board meeting held on January 11, 2016. This blog aims to discuss the suggestions made in the Paper and the decision of the SEBI at the recently concluded board meeting accepting the same. It has also been specifically mentioned that the provisions shall be applicable on a prospective basis, i.e., for public issues which opened after the commencement of the related provisions in the Act.

Under the Act, dissenting shareholders have been said to be those shareholders who have not agreed to the proposal to vary the terms of contracts or objects referred to in the prospectus, and such shareholders shall be given an exit offer by promoter(s)/ persons in control at such exit price, and in such manner and conditions as may be specified by the SEBI.

It had been proposed in the Paper and accepted by the SEBI that the promoter(s)/persons in control of a company shall provide an exit to investors through the purchase of their shares if at least 10% of the shareholders of the company dissent to any change in the objectives which were stated in the offer document or prospectus filed during fund-raising. The Paper also added that to prevent frivolous claims, it has also been stated that these provisions should be made applicable to variation of only such contracts which may substantially affect the main line of business or revenue generation of the company. This point has not been mentioned in the SEBI board meeting minutes, but in my view may be added to the final regulations and might have been left out for the sake of brevity.

Additionally, the Paper rightly states that it is presumed that investors in the secondary market take an informed decision of investing in the shares of the company and hence such investors as of a cut-off date (of course, in addition to those who have invested through the public offer) should also be given the opportunity to exit in case they do not agree to the change in the objects of the company. The SEBI board meeting minutes are silent on this point, however, it cannot be discounted that such a provision may find its way in the final regulations.

As regards the offer price for the exit offer, though the Paper made a remark that the exit price should be based on the existing market value of the stock and not on historical price, however the actual suggestion is to have the exit price be based on price determined in case of exit offers given to the existing shareholders under Regulation 8(2) of the SEBI (Substantial Acquisition of Shares and Takeovers), Regulations, 2011 (“Takeover Code”) and the relevant date for pricing shall be the date of the board meeting in which the proposal for change in objects was approved. This suggestion has also been accepted by the SEBI.

The Paper had also discussed a couple of exemptions to be provided to certain companies from the obligation to provide an exit to the dissenting shareholders. One of these is for companies where there are no identifiable promoter(s)/ persons in control, since the exit is to be provided by way of a purchase of the dissenting shareholders’ shares by the promoter(s)/ persons in control. This appears to be a fair position and has been accepted by the SEBI.

Another exemption proposed in the Paper, which does not find mention in the SEBI board meeting minutes, was for companies which had already used a majority of the Initial Public Offering proceeds and wished to change the objects by a small degree due to certain reasons. In such a case, the promoter(s)/ persons in control were required to give exit only if the amount utilized is less 75% of the total amount raised for the objects of the issue (including the amount earmarked for general corporate purposes as disclosed in the offer document).

While we are on the topic, we cannot ignore the implications of the Takeover Code. The Paper has suggested, and the SEBI had accepted it in its board meeting, that in case the shareholding of the promoter(s)/ persons in control crosses 25% due to the purchase of dissenting shareholders’ shares, such acquisition shall not trigger an open offer under the Takeover Code. Furthermore, in case the promoter(s)/ persons in control are already holding a 75% stake in the company, they cannot use the provisions of Regulation 3(2) of the Takeover Code to refuse honouring the dissenting shareholders’ exit rights and shall still be required to provide them an exit. However, in case the aggregate shareholding of the promoter(s)/ persons in control post the provision of exit to the dissenting shareholders results in their shareholding exceeding 75% in the company, they will have to comply with the provisions of the Securities Contracts (Regulation) Rules, 1957 and bring their shareholding back to 75% within a period of 1 year. This can cause unfair hardship and economic losses to the promoters/persons in control if the stock price goes down after the exit has been provided to the dissenting shareholders as they would then have to sell down shares forcibly in poor market conditions to comply with the 25% minimum public shareholding requirement.

The SEBI at its meeting has also specified that such investors who held shares as on the date of the board meeting in which the proposal to change the objects is approved and those who cast their vote against the resolution shall be eligible to avail of the exit opportunity under this provision and has also provided exemption for contra trade restrictions on promoters / controlling shareholders / dissenting shareholders, under the SEBI (Prohibition of Insider Trading) Regulations, 2015.

Additionally the Paper also lays down in detail the procedural aspects of the manner of providing exit opportunity to the dissenting shareholders and provided for suitable changes to be made to the Act as well to implement the suggestions, which has also been mentioned in the SEBI board meeting minutes, should find their way into the proposed regulation as well.

In my view, this is a positive reformist step taken by the SEBI to bring harmony with the Act and would ensure that companies do not blindly jump on the fund-raising bandwagon without any consequence. They will need to ensure that they raise funds with complete clarity of purpose and a proper utilisation plan. Though earlier, these proposals were at the discussion paper stage and hence not crystal clear, with the recently concluded board meeting, it is expected that the SEBI shall formally enact them with further clarity to ensure consistency with the Act on this issue.

The Arbitration and Conciliation (Amendment) Act, 2015 (“Amendment Act”), which was passed by the Parliament towards last year-end has come into force after its notification in the official gazette on January 1, 2016. The Amendment Act, brings about a slew of changes to the Arbitration and Conciliation Act, 1996 (“Arbitration Act”) and addresses several concerns that had befallen the Indian arbitration regime. The thrust of the Amendment Act is towards the completion of arbitration proceedings in a time bound and efficient manner with minimal court interference.

While the Amendment Act ticks most boxes, it has failed to address the contentious issue regarding the differentiation of ‘seat’ and ‘venue’ of arbitration.

The ‘seat’ of arbitration is of cardinal significance as it determines the law governing the arbitration procedure and the courts which would have supervisory jurisdiction over the arbitration process. While internationally, it is well understood that ‘seat’ of arbitration (which refers to the juridical seat) is different from the ‘venue’ of arbitration (which is the place at which the arbitration proceedings/hearings are held), the Arbitration Act does not differentiate between the two and uses the term ‘place’ in reference to both ‘seat’ and ‘venue’ of arbitration.

This has led to a flawed understanding of the concepts of ‘seat’ and ‘venue’ in India and arbitration clauses being drafted between parties which would often use the term ‘venue’ interchangeably with ‘seat’. As a consequence, the courts in India have been peppered with several cases emanating from this issue.

The Supreme Court in the much-discussed case of Bharat Aluminium Co. vs. Kaiser Aluminium Technical Services Inc. (“Balco Case”) had highlighted the difference between ‘seat’ and ‘venue’ of arbitration, and held that the courts of the country in which the ‘seat’ of arbitration is located shall regulate the conduct of arbitration and challenge to an arbitration award; and that ‘venue’ only refers to the place where the arbitrators may hold proceedings for their and the parties’ convenience.

The issue of ‘seat v. venue’ came up as one of the primary discussion points before the Supreme Court in Enercon (India) Limited v. Enercon GmBH (“Enercon Case”). In the case, the disputed contract had an arbitration clause which did not specify the ‘seat’ of arbitration, though the agreement mentioned that the venue of the arbitration proceedings shall be London. Further, it was mentioned that provisions of the Arbitration Act shall apply with respect to arbitration. The court noted in the case that the substantive law of the contract was Indian law, law governing the arbitration was Indian law, the contract was to be acted upon in India; enforcement of the award was to be done in India, and the relevant assets were in India. Thus, applying the “closest connection” test, the Supreme Court held that the ‘seat’ of arbitration should be India and accordingly the Indian courts, and not the British courts, should have jurisdiction over the dispute. The court disregarded the argument that

London was intended to be the ‘seat’ by holding that London was merely the choice of convenient venue for the parties for the hearings.

In the context of domestic arbitration, the issue arose last year before the Delhi High Court in PCP International Limited v. LANCO Infratech Limited (“PCP-Lanco Case”). In the case, the contract between two Indian parties had an exclusive jurisdiction clause conferring the jurisdiction to the courts in New Delhi and the arbitration clause specified New Delhi as the venue for arbitration. The court observed that though the parties to the contract conferred exclusive jurisdiction to the courts in New Delhi, it was not the place where the contract was executed, or contract was to be performed, or payments under the contract were to be made, or the respondent was located. Consequently, applying (i) the principles under Code of Civil Procedure, 1908 for determining the jurisdiction of courts and (ii) the legal position that the parties by consent cannot confer jurisdiction on a court which does not have any such jurisdiction, it was held that courts in New Delhi would not have jurisdiction to grant interim injunctions during the arbitration process.

The petitioner in the case relied on the Balco Case which held that “the legislature has intentionally given jurisdiction to two courts i.e. the court which would have jurisdiction where the cause of action is located and the courts where the arbitration takes place,” and argued that the courts in New Delhi should have jurisdiction since the venue of arbitration is New Delhi. However, rejecting this argument, the court held that the Balco Case gave jurisdiction to courts located at the ‘seat’ of arbitration; and that the arbitration clause in the instant contract merely specified the ‘venue’ for holding the arbitration proceedings and New Delhi was not to be construed as the ‘seat’ of arbitration.

One may note that the Supreme Court in the Enercon Case gave prime importance to the law governing the arbitral proceedings in determining the ‘seat’ of arbitration and reiterated the position that “it would be rare for the law of the arbitration agreement to be different from the law of the ‘seat’ of arbitration”. However, the above test to determine the ‘seat’ of arbitration would not be relevant in case of domestic arbitrations as the law governing arbitration across India is the Arbitration Act. The court in the PCP-Lanco Case did not delve into determining the ‘seat’ of arbitration; and the question of what would be the ‘seat’ in a domestic arbitration, if the ‘venue’ is specified and the ‘seat’ is not, remains unanswered.

Based on the above, one would say that the legal positions on (i) whether the ‘seat’ of arbitration in an international commercial arbitration would be the place whose law governs the arbitration agreement or whether any other considerations such as the substantive law of contract, location of the parties, etc. should be looked into while determining the ‘seat’, and (ii) what would be the ‘seat’ in a domestic arbitration in case the ‘venue’ is specified in the arbitration agreement, are not yet fully crystallised.

Given this background, the government had a great opportunity to resolve this uncertainty by adequately explaining the concept of ‘seat’ of arbitration and differentiating between ‘seat’ and ‘venue’ vide the Amendment Act. This was, in fact, one of the recommendations of the 246th Law Commission which had submitted its report last year on the amendments required to the Arbitration Act.

Such amendment would have made the provisions of the Arbitration Act more consistent with the international standards and would have washed away the cloudiness surrounding the understanding of the difference between ‘seat’ and ‘venue’ in India.

In addition, in a recent decision in the case of Sasan Power Ltd v. North America Coal Corporation India Pvt Ltd, the Madhya Pradesh High Court broke new ground and held that two Indian parties could resolve disputes through a foreign seated arbitration with foreign substantive law and the same was not opposed to the public policy of India. If this ruling were to be upheld by the Supreme Court, there could be situations where two Indian parties choose foreign laws like the SIAC or ICC rules for an arbitration to be held in India (as venue). In such a scenario, it becomes imperative to have adequate clarity on the concept of ‘seat’ of arbitration to determine whether the courts in India or such foreign place would have jurisdiction over such arbitration.

Hence, the government choosing to ignore the recommendation of the Law Commission and not defining the concept of ‘seat’ of arbitration through the Amendment Act would go down as a missed opportunity.

The subject of this blog post is the Ministry of Finance’s Draft Guiding Principles for Determination of Place of Effective Management of a Company (“Draft Guidelines”), and their impact on the taxability of the gains made by offshore funds that have an onshore advisory/investment manager entity. The Draft Guidelines do not yet have the force of law, but they will most likely come into force (possibly in a modified form) after a public consultation.

The Income Tax Act, 1961 (“ITA”) decides whether an offshore company is ‘resident’ in India or not for tax purposes by looking at whether the company’s place of effective management (“POEM”) is in India. In the event an offshore company is deemed to be a ‘resident’ in India under the ITA, a ‘tie-breaker’ test will be triggered under the relevant double tax avoidance agreement (“DTAA” or “treaty”) to determine the offshore company’s treaty residency and thus, its eligibility for treaty protection. The ‘tie-breaker’ test used by India’s DTAAs with Mauritius, Singapore, Netherlands, Luxembourg etc., is also a POEM test – however, these DTAAs do not define the term ‘POEM’, but state that terms not defined in the DTAA will be given the meaning they have under the domestic law of the treaty partner state applying the DTAA, unless the context of the DTAA requires otherwise (emphasis added; each DTAA employs a slightly different formulation of this language).

Until 2015, the ITA’s definition of POEM was quite narrow, and offshore companies could easily avoid being found to have their POEM in India. The Draft Guidelines now propose to widen the ITA’s definition of POEM by putting in place an aggressive ‘substance-over-form’ test to determine an offshore company’s POEM, with the intent being to align the scope of the term under the ITA with its meaning under India’s tax treaties (where the term, though undefined, has been understood to have a wider scope). As per the Draft Guidelines, an offshore company’s POEM will be the place where the key management and commercial decisions of the entity’s business are, in substance, made. The Draft Guidelines also state that a de facto delegation of decision making authority by an offshore company’s board of directors will ordinarily result in the POEM being the place where the delegates of such authority make decisions.

In the context of offshore funds, this could be an issue because, while such funds may formally take investment decisions offshore, deal sourcing, evaluation, & negotiation, and numerous other important functions may be carried out by their affiliated onshore advisory entities. The Draft Guidelines give the Revenue the power to reject evidence such as board meetings held offshore, or other similar document trails, and instead look into the actual fact situations underlying the management of the offshore fund – such as the activities of its onshore investment advisory entity, to determine the offshore fund’s POEM. This can potentially expose an offshore fund to the risk of being deemed a ‘resident’ of India under the ITA, and possibly under the relevant DTAA as well – an undesirable tax outcome.

It must be added that the Draft Guidelines do contain a few safe harbours that might be utilized by offshore funds: for example, the Draft Guidelines propose that the existence in India of support functions that are preparatory and auxiliary in character will not be conclusive evidence that an offshore company’s POEM is in India.

There are other complications at play here: offshore funds always hold a tax residency certificate (“TRC”) from a treaty partner state. This is in part because the Supreme Court (“SC”), in the landmark Azadi Bachao Andolan v Union of India decision (“Azadi”) upheld the Central Board of Direct Taxes’ (“CBDT”) Circular No.789/2000 (“Circular 789”), which stated, inter alia, that a TRC is sufficient evidence of its holder’s residency in Mauritius, thus effectively providing that the treaty residency of Mauritian funds holding a TRC cannot be questioned by the Revenue (a proposition recently reiterated by the High Court of Punjab & Haryana in Serco BPO Private Limited v The Authority for Advanced Rulings). Interestingly while Azadi was pending before the SC in 2003, the CBDT, presumably in an attempt to strengthen the Revenue’s arguments before the SC, published another circular, Circular No.1/2003 (“Circular 1”) which seems to state that if an entity is found to be resident in both India and Mauritius (emphasis added), the TRC will no longer be the final word on such entity’s treaty residency, but the POEM test will be applied to determine the same.

While Circular 1 carries weight, at that time it did not really have teeth because the POEM concept under the ITA was not wide enough to capture offshore funds as residents in India. An illustrative case is an Income Tax Appellate Tribunal (“ITAT”) ruling from 2007, Saraswati Holding Corporation v DDIT: in this case, the Revenue tried to deny treaty benefits to a TRC-holding Mauritian company by applying Circular 1. The ITAT held that the Revenue first had to show that the Mauritian company was a resident in India by applying the POEM test as it then stood under the ITA, and observed that the POEM test under the ITA and the India-Mauritius DTAA are “materially different”. Upon finding that the Mauritian company was not ‘resident’ in India because its POEM was not in India, the ITAT allowed the Mauritian company to take the benefits of the India Mauritius DTAA.

Keeping the above paragraphs in mind, these are some issues to ponder:

i. Due to the Draft Guideline’s expansion of the POEM concept, Circular 1 may not so much gain teeth as grow fangs – the Revenue may now be able to apply Circular 1 on the back of a determination that a Mauritian company is resident in both India and Mauritius, and potentially render TRCs held by Mauritian funds ineffective. However, given the strong judicial support for Circular 789 and the proposition that a TRC-holding Mauritius based fund is a Mauritian resident for treaty purposes, and the fact that Circular 1 is largely untested, this is a grey area.

ii. While the ITA imposes a ban on ‘treaty override’ i.e., anti-abuse rules from domestic tax law prevailing over a DTAA, the expansion of the POEM concept in the ITA proposed by the Draft Guidelines may function as a ‘back door’ treaty override because DTAAs themselves provide that the meaning of the term POEM, for treaty purposes, is to be taken from domestic tax law. That said, it is not clear whether courts will interpret the words ‘place of effective management’, which is employed as a ‘tie-breaker’ in the

DTAAs, in line with the POEM concept under the ITA since the intent is quite different in each case; the words ‘unless the context requires otherwise’, or variations thereof found in DTAAs, may become significant.

Further, I would like to highlight two points regarding the policy choice of using the ‘substance-over-form’ approach in the Draft Guidelines. First, the yet-to-be-implemented General Anti Avoidance Rule, and the extant judicial anti avoidance rule both allow the Revenue to apply a ‘substance-over-form’ approach – however, if taxpayer can demonstrate that the structuring it has put in place has a commercial rationale, the Revenue will not be allowed to apply a ‘substance-over-form’ approach. In contrast, the Draft Guidelines do not limit the Revenue’s ability to apply the ‘substance-over-form’ approach if the taxpayer demonstrates a commercial rationale. Second, the ‘substance-over-form’ approach is a highly subjective one that is antithetical to a stated goal of tax policy: to ensure that taxpayers have a high degree of certainty regarding tax outcomes.

In conclusion, it is hoped that the Government will further the pro-funds industry thrust of the last Budget and provide a safe harbour from POEM risk to offshore funds that have onshore advisory/investment management entities when the final guidelines on POEM come out. In the event the Government chooses not to do so, the Revenue will gain one more tool in its arsenal to challenge the treaty residency of offshore funds that use favourable DTAAs to attain tax efficiency.

The Reserve Bank of India (“RBI”), in August 2015 granted in-principal approval and licenses to 11 applicants to begin operations as payment banks. It is interesting to note that the recipients of the licenses include individual persons, namely, Mr. Vijay Shekhar Sharma and Mr. Dilip Shantilal Shanghvi, entities such as the Department of Posts and the National Securities Depository Limited, conglomerates and multinationals such as Reliance Industries Limited and Tech Mahindra Limited, as well as existing payment system providers such as Vodafone m-pesa Limited and Airtel M Commerce Services Limited, amongst others. The grant of such approvals has been orchestrated by the RBI with the intent to meet credit and remittance needs of small businesses, unorganized sector, low-income households, farmers, and migrant work force.

As per the Guidelines for Licensing of Payments Banks (“Guidelines”), payments banks are not permitted to undertake lending activities. However they shall be permitted to set up outlets such as branches, set up automated teller machines, and business correspondents through which they may accept demand deposits and savings bank deposits. It is interesting to note that such banks will have to have at least 25% of physical access points (including business correspondents) in rural centers. Payment Banks are not permitted to accept deposits from non-resident Indians, and neither are they permitted to hold a balance of greater than INR 100,000 per individual customer. While payment banks are permitted to issue ATM and debit cards, they are not permitted to issue credit cards. Further, they are permitted to accept remittances to be sent to or receive remittances from multiple banks under a payment mechanism approved by the RBI; they are also permitted to handle cross border remittance transactions in the nature of personal payments and remittances on current accounts. It must be noted that all foreign exchange transactions will have to be approved by the RBI upon an application made by the payment bank for such activities.

As the RBI’s primary intent for setting up such payment banks was financial inclusion, the Guidelines have specified that payment banks are expected to leverage technology to offer low cost banking solutions and also invest in technological infrastructure for its operations. All payment banks are required to have a minimum paid-up equity capital of INR 1 billion. Further, foreign direct investment (“FDI”) is permitted in payment banks and the conditions stipulated for private sector banks would be applicable to such FDI. While FDI up to 49% is permitted via the automatic route, FDI beyond 49% and up to 74% is permitted via the government approval route. Additionally, at all times at least 26% of the paid-up capital of the payment banks will have to be held by Indian residents.

While there were fears that payment banks would serve as a threat to other banks as they would impact the business of full-service banks, proponents of payment banks, including Mr. Raghuram Rajan, the Governor of the RBI, argue that such institutions would only complement the existing system as they have a very limited scope of services. The cap of accepting deposits only till INR 100,000 and the mandatory provision to invest excess cash in low-yielding government bonds are limiting factors curbing the extent of permissible activities of such differentiated banks, which are set up to offer basic services such as acceptance of demand deposits, remittance services, internet banking, and so on to the unbanked sectors.

The licenses have been granted to these 11 applicants for a period of 18 months, during which period each recipient will have to comply with the requirements and conditions stipulated by the RBI. Subsequent to this, the RBI will grant the eligible persons a license to begin banking operations as stipulated under the Guidelines. Thus, we will have to wait until the first payment bank commences operations to comment on whether this move by the RBI is a hit or a miss, how far the government’s goal of financial inclusion is fulfilled, and whether other banks have to up their ante as they face stiff competition from these institutions, or whether they had no cause to worry at all.

In a previous post on the Lexygen Blog, I had noted that due to recent merger control rulings by the Competition Commission of India (“CCI”), the exemption given to acquirers from notifying minority/significant minority acquisitions that were made “solely as an investment” (“Investment Exemption”) had more or less evaporated. Ideally, funds would like the Investment Exemption to be available to them because it obviates the need to go through the CCI’s (sometimes lengthy) merger review process.

In interpreting the Investment Exemption, the CCI had tried to draw a line between purely financial ‘portfolio’ investors and investors that it perceived as ‘strategic’, and limit the benefit of the Investment Exemption to the former – fair enough, given the intent of antitrust merger review. However, the CCI’s interpretation of the term “solely as an investment” in the Investment Exemption was somewhat out of sync with commercial realities: in the CCI’s view, if the terms of an acquisition provided an acquirer with affirmative rights and a seat on the investee’s board, the acquirer took on the colour of a ‘strategic investor’, and such an acquisition was not considered to be made “solely as an investment’.

Interpretational issues aside, there were two issues with the CCI’s interpretation of the Investment Exemption: (a) the parameters it employed to characterize an investor as ‘financial’ or ‘strategic’ were subjective; and (b) it was not a desirable outcome for funds since it would result in more deals having to go through CCI review. The CCI has now amended the Investment Exemption, and this amendment is discussed below.

The Investment Exemption as it previously stood was designed thus: it had two ‘limbs’: the ‘solely as an investment’ limb and the ‘ordinary course of business’ limb. To take the benefit of the Investment Exemption, an acquisition had to fall under one of these two limbs, could not result in an acquisition of over 25% of the target’s shares or voting rights, and further, could not result in an acquisition of control over the target.

Now, an explanation has been added to the Investment Exemption which states that an acquisition of a sub-10% stake shall be treated as being made “solely as an investment”, provided the following two conditions are met: (I) the acquirer’s rights are on par with the rights of ordinary shareholders of the investee (“Proviso Condition I”), and (II) the acquirer does not have a board seat, does not have the “right or intention” to get a board seat, and does not intend to participate in the affairs and management of the investee (“Proviso Condition II”, and together, the “Proviso Conditions”).

Despite some language issues, the intent seems to be clear that any acquisition of a 10%+ stake (or any acquisition where the deal terms include affirmative rights or a board seat for the acquirer) would not be regarded as being made “solely as an investment”. The amendment now seems to split the Investment Exemption into layers based on the shareholding acquired:

(i) between 0% and 10%, the ‘solely as an investment’ limb and the ‘ordinary course of business’ limb are available (if the Proviso Conditions are met); and

(ii) between 10% and 25%, only the ‘ordinary course of business’ limb is available.

Coming to the Proviso Conditions, they now codify the stand the CCI has been taking in its rulings. Consequently, investments/acquisitions by funds that breach the financial thresholds enacted in section 5 of the Competition Act, 2002 (the “Act”) will have to undergo CCI review since customary deal terms such as affirmative rights and a board seat will immediately disqualify such funds from availing the Investment Exemption.

The Proviso Conditions on a closer look reveal ambiguities: What does the CCI mean when, in Proviso Condition I, it refers to rights on par with ordinary shareholder’s rights? Does ‘ordinary shareholders’ connote holders of equity shares? What would the outcome be when an investor acquires preference shares of a certain class that carry special rights – but are also held by all extant shareholders save the promoters? How will the CCI try to gauge whether a fund plans to participate in the affairs and management of an investee under Proviso Condition II, absent tell-tale indications in the deal documentation? These questions must be looked at keeping in mind the intent behind the amendments to the Investment Exemption.

To understand the intent behind the amendments to the Investment Exemption, it might be useful to look at a similar ‘investor only’ exemption available in the United States under the Hart-Scott-Rodino Antitrust Improvements Act, 1976 (the “HSR Act”). The HSR Act’s ‘investor only’ exemption is designed much like the Investment Exemption, (it has a 10% cap and a disqualification for acquirers who intend to participate in the target’s management), and has been interpreted by the American antitrust regulators in a strict manner based upon an inquiry into the entire background of circumstances and behaviour involved in an acquisition. For example, the HSR’s ‘investor only’ exemption was very recently denied to an activist hedge fund that acquired a small stake in a large tech company and attempted to participate in the company’s management and affairs by trying to influence the company’s board composition. The jurisprudence behind the HSR Act’s ‘investor only’ exemption, though criticised by American legal practitioners and academics, is clear on the point that any acquisition that results in the acquirer being in a position to influence an investee’s management and affairs is a potential antitrust concern. With these amendments to the Investment Exemption, the CCI seems to have bought into this logic.

In fact, the CCI’s stance appears to have hardened considerably on this matter: previously, the CCI only considered the power to influence the ‘basic business decisions’ of a target to be off limits for an acquirer that wanted to avail the Investment Exemption, whereas Proviso Condition II now seems to place a complete embargo on an acquirer participating in a target’s affairs and management, if the acquirer is desirous of availing the Investment Exemption.

Going forward, it should be noted that certain de minimis exemptions from the merger review provisions of the Act are set to expire early this year. Combined with the amendments to the

Investment Exemption detailed above, the effect is that the universe of acquisitions by funds that fall under the scope of the CCI’s merger review provisions is set to expand. However, it should also be noted that the Act exempts Foreign Portfolio Investors and a sub-category of Category I Alternative Investment Funds (Venture Capital Funds), from its merger review provisions.

In conclusion, funds must, when contemplating deals in the sub-10% space, consult their advisors and: a) identify entities that form part of their ‘group’ as defined under the Act (for the purpose of computing whether the financial thresholds for notification to the CCI are breached or not); and b) holistically consider the deal terms and the surrounding circumstances to ascertain whether the Investment Exemption will be available for that particular deal.

As per a latest newspaper article, the External Commercial Borrowings (“ECB”) as percentage of the nominal GDP climbed to 9% at the end of June 2015, which according to them is the highest in the past decade or so. The Reserve Bank of India (“RBI”) on its part had amended the ECB Policy and introduced a host of new concepts in its circular dated November 30, 2015. This blog discusses the changes brought in by the circular and certain further clean-ups that would be helpful to the industry.

The broad reasons for the amendments to the ECB framework, as mentioned in the circular, relate to liberalizing the ECB regime, incentivizing the Indian Rupee (“INR”) denominated ECBs to transfer the exchange rate related risk to the lenders, expanding the list of the overseas lenders and aligning the list of infrastructure entities borrowing ECB with the ‘Harmonised List’ of the Government of India.

Tracks – MAM and currency based.

The revised ECB framework has now categorized ECBs based on Minimum Average Maturity (“MAM”) and currency denomination and has introduced three tracks routes based on the same. Track I comprises of medium term foreign currency denominated ECBs availed with a MAM of 3/5 years, Track II is long term foreign currency denominated ECBs availed with a MAM of 10 years, and Track III is INR denominated ECBs availed with a MAM of 3/5 years. While these fall under the automatic route, there are certain ECBs which still are under the RBI approval route viz. Foreign Currency Exchangeable Bonds, borrowing and on lending by the Export Import Bank of India and ECBs for the purpose of importing second-hand goods.

Change in borrowing limits

The circular has also prescribed certain changes with regards to the borrowing limits. Now the companies falling under the infrastructure sector (including hospitals and hotels) can avail ECBs upto USD 750 million, as against the earlier limit of USD 200 million and the companies in the software sector can now avail ECBs upto USD 200 million. Further, the companies in the micro finance sector are permitted to raise ECBs upto USD 100 million. All other entities can avail ECBs upto USD 500 million in a financial year. While this move looks very favorable to the infrastructure sector, in case of the other sectors, the ECB limit has been cut down by USD 250 million from the earlier regime.

Eligible lenders / Investors

The most important change with regards to the eligible lenders has been the introduction of pension funds, insurance companies, sovereign wealth funds, and financial institutions, which

are located in the “Institutional Financial Services Centres” in India, as overseas long term investors, with this move of adding pension funds, insurance companies etc., to the eligible lenders, the scope of raising ECBs has increased and keeping in mind the fact that these fund houses who have off late been showing interest in the Indian debt market. Further, the RBI has also included the group companies of eligible borrowers within the foreign equity holder definition, resulting in such group companies (having common overseas parent) to lend to Indian companies.

Certain other changes

There have also been certain additions / tweaks to the ECB framework such as (i) the list of eligible borrowers has been expanded to include REITs, Infrastructure Investment Trusts and companies providing logistic services, (ii) the permitted end uses under the revised ECB framework provide that the group companies can provide ECBs for general corporate purposes with a lower MAM of 5 years, as against 7 years in the erstwhile regime, and (iii) extension in the time limits for parking of the ECB proceeds (meant for INR expenditure) for a period of 12 months as against 6 months earlier.

Conclusion

While the above revised framework does show interesting opportunities for the infrastructure sector, sectors like the airline industry, where the working capital facilities would be phased out by March 2016 or the low cost housing schemes would face new challenges on the funding part as there would be a further dry up of funds on this financially starved sectors. The revised ECB framework has not provided any clarity on the structured obligations, trade credits and bridge financing, and we would need to await further circulars to clarify the same.

Foreign direct investment (“FDI”) into the defense sector has always been something of a contentious issue. Two reasons for this were articulated in a discussion paper published by the Department of Industrial Policy and Promotion (“DIPP”) in 2010 (“Discussion Paper”), though some of these reasons have been in the forefront since India’s independence: firstly, a desire to protect the domestic defense sector from foreign competition, and secondly, concerns regarding foreign ownership/control of a sector that is very sensitive from a national security perspective.

However, of late there has been sustained wave of liberalization on the FDI front, not only in defense, but also in other so-called ‘sensitive’ sectors; and at the political level, there are signs of increased engagement between India and its key defense partners – for example, the recent progress of the Indo-US Defense Technology and Trade Initiative, or the US’ recent relaxation of export control restrictions on transfer of jet engine technology to India.

In this backdrop, the DIPP has recently further liberalized the rules for foreign investment into India’s defense sector by issuing a press note (“PN12”) that amends the DIPP’s Consolidated FDI Policy, 2015 (“FDI Policy”). This blog post will discuss PN12 and its implications for FDI in defense, but we first need to take a broad look at the commercial and strategic aspects of FDI in the defense sector.

Foreign investors see a lucrative opportunity in India’s defense sector: Western defense markets are showing signs of saturation, the Indian defense budget has been trending upwards year-on-year, India’s armed forces are looking to buy advanced defense equipment, and the lack of indigenous development in the Indian defense sector has led to import dependency for advanced weaponry and a consequent demand-supply gap. For its part, the Government wants India to be free from import dependency and become self-reliant in defense manufacturing – and it sees FDI in the defense sector as a key tool through which domestic players will acquire the elusive know-how and technical expertise necessary to make this a reality.

Despite the above, foreign defense industry players have shown reluctance to invest in India and collaborate with Indian partners. One of the reasons for this is technology. Simply put, foreign defense companies are not willing to bring their know-how and advanced technologies into domestic defense sector joint ventures (“JVs”) unless they are able to control the JV, and thereby protect the technology they have poured billions of dollars’ worth of R&D into.

However, the FDI Policy did not, and still does not, allow a foreign JV partner to control an Indian defense sector JV. The FDI Policy previously allowed foreign investment in Indian defense companies only up to 26% of the investee company’s share capital under the approval route. In 2014, this was increased to 49%, but numerous (vaguely worded) strings remained attached, such as: (a) the company applying for the FDI must be owned and controlled by resident Indian citizens, and its management had to be in Indian hands; (b) the majority of its Board of Directors, and its chief executives, must be resident Indians; and c) the Chief Security Officer of a defense JV must be a resident Indian citizen (“Defense Conditions”). The Defense Conditions resulted in considerable ambiguity regarding the board composition and the management of a defense sector JV with FDI, and largely, the industry was dissatisfied with the FDI Policy. The Defense Conditions seemed to be aimed at adding an extra layer of protection against a foreign defense industry player exercising influence and control over its Indian defense JV.

That said, it was not as though the DIPP and the Foreign Investment Promotion Board were blind to the concerns of foreign defense companies: FDI above 49% into the defense sector was allowed through the approval route (applications in such cases would be considered by the Cabinet Committee on Security) whenever the FDI was likely to result in access to modern and ‘state-of-art’ technology – thus giving the foreign collaborator the necessary comfort when transferring advanced proprietary technology into an Indian defense sector JV.

PN12 has now modified the FDI Policy vis-à-vis the defense sector in two significant ways: firstly, FDI in the defense sector up to 49% is now permitted under the automatic route, and secondly, the Defense Conditions have been omitted from the FDI Policy.

While this development is positive because the ambiguity surrounding the Defense Conditions is now gone, and the timelines for setting up a defense sector JV may be reduced, the 49% sectoral cap remains, and in my view, this implies that the regulatory thinking – that foreign control over defense sector companies is undesirable and may only be permitted in exceptional cases when the technology transfer benefits arising from the investment outweigh other concerns – has not really changed. Consequently, the Government may not be comfortable with contractual arrangements that give a foreign JV partner rights that are not commensurate with its 49% shareholding.

This absence of a ‘big bang’ reform for the defense sector has therefore left the core issue unaddressed, and reports in the press suggest that at an international level, India has assuaged concerns about protection of transferred defense technology by agreeing to allow investments above the 49% sectoral cap (presumably under the approval route), whenever there is a concern regarding the same. However, this will most probably be the exception rather than the rule, and such investments may require significant political will to achieve, both in the source country of the FDI and in India.

With PN12, the Government seems to want substantial FDI inflow as well as technology transfer, but is unwilling to cede ground on the ‘control’ issue by allowing foreign investment in excess of the 49% sectoral cap. From a long term point of view, it may not be possible for the Government to ‘have its cake, and eat it too’ in this regard, and it is hoped that the rules for FDI in the defense sector will be further liberalized.

Under the extant FDI Policy, 100% FDI under the automatic route is permitted in entities engaged in B2B e-commerce activities, i.e., trading amongst manufacturers, wholesalers, and retailers on e-commerce platforms, but FDI is prohibited in retail trading (B2C activities) through e-commerce. Further, Indian entities having FDI engaged in single brand retail trading (“SBRT”) or multi-brand retail trading (“MBRT”) are specifically prohibited from retailing their products through e-commerce portals.

The Government has, vide a press note dated November 24, 2014, partially relaxed this restriction, and permitted SBRT entities that have a physical presence in India through ‘brick and mortar stores’ to distribute products by way of e-commerce. This allows brands such as Decathlon, Brooks Brothers, and Promod, which already operate stores in India, to also market their products online directly to customers.

Apart from SBRT entities, trading through e-commerce portals has now also been opened to entities which manufacture at least 70% of their products in India and source the remaining 30% from other Indian manufacturers. Such entities having FDI are permitted to sell their ‘branded’ products directly to customers through e-commerce means, provided that the brands are ‘owned and controlled’ by resident Indian citizens. While there was no specific restriction on this under the extant FDI Policy, the existing prohibition on SBRT entities had caused some confusion in this regard. This clarification has therefore been welcomed by Indian brands such as Zovi and American Swan, which have already been distributing their products on e-commerce sites.

Despite these liberalizations, there is still ambiguity regarding permissibility of FDI in entities that own and operate e-commerce marketplaces, like Snapdeal, which allow various sellers to list and market products to customers. In fact, shortly after these FDI relaxations were announced, the Delhi High Court ordered the Government to investigate FDI violations by 21 ‘e-commerce companies’, including Jabong and Limeroad.

Companies that operate e-commerce portals under the ‘marketplace model’ have argued that they merely provide a technology-powered platform to connect retail traders with customers, and do not themselves sell products to directly customers, thereby operating within the confines of the FDI regime. In fact, several companies which have both technology and retailer arms within their group, have raised FDI in the entity that owns and operates the e-commerce platform, while putting complex structures in place to ensure that these FDI-raising entities are distinct from the entities engaged in retail trading through the platform.

On the other hand, Indian retailers’ and traders’ associations have alleged that such entities, while claiming to be technology companies operating marketplaces, are in reality B2C retailers engaged in MBRT through e-commerce, which is specially prohibited under the extant FDI Policy. Some examples of the B2C behavior exhibited by such entities include the ability of the marketplace operator to offer discounts on products listed by various sellers despite not having any inventory in their own name, the extensive advertising conducted by marketplaces to boost sales on their portals, and the fact that delivery, payments, returns and refunds are processed by the marketplace. It was these associations that filed a petition with the Delhi High Court alleging breach of FDI rules, which caused the court to order a probe into the operations of 21 companies engaged in the online retail sector.

The need for clarity on this issue is quickly escalating. E-commerce is a rapidly growing industry in India which is dependent on funding to fuel the development of supply chain and logistics infrastructure, and there are concerns that the current policy uncertainty is likely to affect investor sentiment and restrict access to funding. E-commerce companies claim that such capital is rarely available from domestic banks and investors, whereas foreign investors have shown greater interest in providing the large ticket funding that is required by the industry.

The industry is therefore keenly awaiting comprehensive clarifications on e-commerce, including with respect to definitions of ‘e-commerce’, tax treatment, and FDI, which the Ministry of Commerce and Industry has promised to provide after consultations with various stakeholders.