It is said that “every calamity has an opportunity”. Perhaps that explains why the turbulent global economic scenario and upheavals in the Indian economy have not deterred global corporates and investors from heading here. There is belief in India’s long-term prospects — the challenge is to seize opportunities and manage risk efficiently.
A significant contribution to India’s growth has come from the service sector and young entrepreneurs with path-breaking ideas. Entrepreneurs, with promises of big returns, require funding. The need is to balance risks and rewards when making these investments, especially given that the Indian tax and regulatory environment is still evolving.
Let us look at two scenarios — new investments in companies, and buying out of existing shares.
When investing in a company, it is common to use instruments with conversion options such as compulsory convertible debentures (CCDs) and compulsory convertible preference shares (CCPS), where the conversion is linked to future performance or pricing if there is an IPO. It may be tempting to make the conversion optional, but this would be tantamount to a foreign borrowing, which has its own end-use restrictions. For exits, the tendency is to have put options on the promoter or company, which regulators are challenging as they are viewed as backdoor foreign borrowings.
Under Indian tax laws, a CCD conversion is an exempt transaction, while the taxability of CCPS conversion is litigious. Interest on CCD is tax deductible and subject to withholding, while the preference dividend is not deductible and is subject to dividend distribution tax. It is also important to see how different lenders treat these instruments in computing the debt-equity ratios. Besides tax, under the exchange control regulations, the minimum price of conversion should be the discounted cash-flow value per share at the time of investment. However, these norms are not applicable to foreign venture capital investors. For listed companies, these conversion prices should conform with SEBI’s pricing norms.
The challenges are more when buying existing shares. Take, for example, a case where the shares of an Indian company are bought by a non-resident partly through down payment, and an additional future payment linked to certain performance parameters such as revenue or profit. The moot question is, can a non-resident buy shares of an Indian company from a resident for a deferred consideration under the existing exchange control regime? The policy framework does not expressly permit this, and though theoretically one can approach the RBI for approval on a case-by-case basis, past precedents indicate they are rare.
From a tax perspective, based on a recent ruling by the Delhi High Court in the matter of Ajay Gulia, and the Mumbai Tribunal in the matter of Indira Shete, there is a risk that the entire future contingent consideration could be taxed in the hands of the seller in the first year itself — leading to tax gain and cash-flow mismatch. The issue is even more complex if the contingent payment is linked to the efforts of the seller, wherein the Advance ruling in the case of Anurag Jain held that such payments are not capital gains but employment compensation.
So, what does one do in such cases? There is need to explore alternative solutions such as purchase of shares in instalments, escrow mechanisms, clear split of transactions between sale of shares and performance upsides, and so on.
The essence is in meticulous planning. One should carefully navigate through conflicting tax and regulatory parameters to come up with a solution which is not merely legally perfect but also stands the test of time.
(Girish Vanvari is Partner and Alok Mundra is Director, KPMG in India)