Changes In The Law & Their Effect On Transactions in India
Considering the growing Indian economy and market dynamics, one can appreciate the several policy and legal changes which have been, and will be, witnessed in the near future. Some of the important recent changes in law and their effect on transactions are covered below.
FDI in Single Brand Retail Trading and the Pharmaceutical Sector
Recently, the government allowed 100% foreign direct investment (FDI) in single brand retail trading subject to prior government approval and certain conditions. One such condition, which is meant to promote local industry, requires Indian companies where the proposed FDI exceeds 51% to mandatorily source at least 30% of the value of products sold from Indian “small industries/village and cottage industries, artisans and craftsmen”. ‘Small industries’ have been defined as industries with a total investment in plant and machinery not exceeding USD 1 million.
No guidance has been provided on how “value of products sold” will be calculated to meet the sourcing condition. It is unclear whether sub-components like cost of packaging material and fiscal duties / taxes will be included in the value. It is also unclear whether the sourcing requirement applies to each product sold or to the aggregate value of all the products proposed to be sold. These ambiguities have resulted in lack of investor interest in single brand retail which has tremendous potential given the market for high luxury brands in India.
Another area of ambiguity is brownfield investment by foreign investors in the pharmaceutical sector, which was recently made subject to prior government approval. The Foreign Investment Promotion Board was the approving authority till 31 March 2012 after which the Government proposed to issue guidelines for the Competition Commission of India to approve such investments. In the absence of such guidelines, all approvals for such projects have been stalled due to lack of clarity on the approving authority.
Typically, in private equity deals, an investor would have pre-defined exit rights including a “put option” pursuant to which the investor could cause the promoters to purchase the investor’s shares for a fixed return. The enforceability of such “put options” has been controversial.
Even though put options involving non-resident investors are not expressly prohibited, their use is frowned upon by the exchange control regulator, the Reserve Bank of India (RBI) and the capital markets regulator, the Securities and Exchange Board of India (SEBI).
RBI considers such put options as debt rather than equity since the investor is guaranteed a return. Further, RBI considers such put options as derivative transactions which are not permissible under the Indian securities and foreign exchange laws. Newspaper reports suggest that RBI has issued letters to various parties taking a stand that such put options are violative of the foreign exchange laws and should be deleted from agreements.
In recent informal guidance, SEBI has also questioned the enforceability of put options as they would amount to forward contracts and would also not constitute valid derivatives, and directed their removal from agreements. Interestingly, the Bombay High Court in the recent case of MCX-SX, held that put options are not forward contracts since they are completed on a spot basis once the option is exercised. However, the MCX-SX case did not consider the issue of whether such a put option is a valid derivative leading to continued ambiguity.
Given the importance of put options in exit mechanisms for private equity investors, there is a pressing need for immediate clarity on this issue from the Government.
Stamp Duty on Amalgamation, Merger & Demerger
Only a handful of states in India have included a specific entry in their stamp acts for court orders approving an amalgamation/merger/demerger scheme under sections 391-394 of the Companies Act, 1956. Most of the states which have not included a specific entry either stamp such court orders as ‘conveyance’ or do not stamp it at all.
In 2004, in the case of Hindustan Lever,the Supreme Court held that an amalgamation scheme sanctioned by the court is an ‘instrument’ and accordingly liable to stamp duty under the entry for ‘conveyance’. However, in practice, various stamp authorities take the view, based on strict interpretation, that the foregoing decision does not have any legal bearing on amalgamation of companies in those states where the relevant stamp act does not have any specific entry for such court orders.
In 2010, in the case of Delhi Towers, the Delhi High Court and in 2011, the Calcutta High Court has reiterated the position in the Hindustan Lever judgment. The Tamil Nadu government has proposed to amend their stamp act for levy of stamp duty on transfer of properties pursuant to such court orders.
In such a situation, for states whose stamp acts do not have a specific entry for such court orders, it is important for parties to ascertain the position taken by local authorities on this issue since such position could differ from the judicial position in this regard.
Clash Between SEBI Takeover Code and FDI Policy
There are certain sectors where the FDI limit is 49% or 26% (e.g. 49% in petroleum refining, 26% in defence, etc). It could become difficult for a non-resident to acquire 26% or more in Indian companies engaged in such sectors where the securities of such Indian company are also listed on Indian bourses. This is because when a non-resident acquires 25% or more shares, the acquirer is required to make a mandatory offer to the public to acquire a further 26% shares under the new SEBI Takeover Code (effective from October 2011). This would take the non-resident’s shareholding to 51% thereby resulting in breach of the FDI policy and would, therefore, need a separate exemption from the government and/or from SEBI.
Such a situation would make it difficult for Indian listed companies engaged in such sectors to raise money from non-residents. It would be helpful if the government could clarify the position. Press reports suggest that the government is working on certain guidelines to avoid such a clash between FDI Policy and SEBI Takeover Code.
Retrospective Tax on Offshore Acquisitions Involving Indian Assets
The Government has recently promulgated an extremely controversial retrospective amendment to Indian tax laws pursuant to which offshore acquisitions involving Indian assets could be subject to tax in India. This amendment seeks to nullify the impact of the Supreme Court ruling in the celebrated Vodafone case. There has been considerable outcry from foreign Governments and trade organisations following this amendment since it could lead to tax on past transactions and impact future acquisitions. This amendment is expected to have a significant impact on the investment climate in India.
The government has been responsive, to a certain extent, to the demands and requests of the industry, professionals and investors. A recent example of this is the alteration and postponement of applicability of the general anti avoidance rules for one year. Having said that, there are certain areas wherein positive legislation/policies framed by the government have not produced the desired results. There also remain certain grey areas where the industry awaits corrective action and/or clarifications on the part of the government.
Bhavik Narsanais an advocate and solicitor and is a Partner in the corporate team at the Mumbai office of Khaitan & Co. He focuses on domestic and cross border mergers and acquisitions, and private equity transactions, advising regularly on all legal and regulatory aspects of such transactions and foreign investments (both inbound and outbound). He joined the firm in 2006. He has advised several multinational and domestic clients on noteworthy cross-border and domestic M&A transactions, private equity investments and other corporate commercial matters.
Ronak Ajmerain an Associate in the corporate team at the Mumbai office of Khaitan & Co. He started his career with the firm in 2009 and has since been involved in various mergers and acquisitions, corporate restructuring exercises, capital market transactions and tax litigation and other matters involving exchange control laws, inbound and outbound structuring and securities laws.
Bhavik and Ronak can be contacted at the Mumbai office by emailing Mumbai@khaitanco.com or alternatively by calling +91 22 6636 5000.