- The acquisition by Etihad Airways of a 24% stake in Jet Airways has exposed issues about what constitutes ‘control’ of an Indian listed company.
- We review the impact of the minority squeeze-out provisions of the Indian Companies Act 2013.
- A High Court in India disposed of a petition filed by a Vodafone Services Private Limited challenging draft orders that is subject to Indian transfer pricing regulations upon the issue of its shares to its parent company.
- Some significant changes have been made to the Indian foreign investment regime in respect of non-residents acquiring Indian securities, non-compete clauses in the pharmaceutical sector and bonus issues of non-convertible instruments through court schemes.
- Nokia has been granted temporary relief to permit the sale of its Indian assets to Microsoft Corporation as part of a global transaction
The main features of these developments are discussed below.
The unresolved issue of what constitutes “control” of an Indian listed company
The Competition Commission of India (the “CCI”), through an order (the “Order”), rejected a rectification application filed by Etihad Airways, UAE (“Etihad”) and Jet Airways, India (“Jet”) despite a previous order that approved Etihad’s acquisition of a 24% stake in Jet. The CCI stated in its rejection that Etihad will acquire joint control in running Jet’s business and that it would have the right to nominate certain members of the board of directors. This is an interesting development because acquiring only a 24% stake kept Etihad’s shareholding below the threshold needed to trigger the requirement to make a mandatory open offer (an “Open Offer”) under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 2011 (the “Takeover Code”).
Background
In April 2013 Jet and Etihad entered an agreement through which Etihad agreed to acquire a 24% stake in Jet, falling short of the threshold under the Takeover Code that would trigger the requirement to make an open offer. After approval from the Securities and Exchange Board of India (the “SEBI”), and the Foreign Investment Promotion Board (the “FIPB”), the CCI cleared this transaction from a competition law perspective on 12 November 2013.
However, the CCI said that Etihad would gain ‘joint control’ over Jet, in particular over its assets and operations, as Etihad would have the right to appoint directors to Jet’s board and other rights. In response, Jet and Etihad filed an application for rectification of two parts of the Order, contesting that Etihad would not acquire control over the operations and assets of Jet and would therefore not be in ‘joint control’. Etihad further stated that the 24% stake in Jet would be a non-controlling equity investment. The CCI rejected the rectification application.
Interpretations of ‘control’
The definitions of “control” under the Competition Act 2002 (the “Competition Act”), the Takeover Code and the Companies Act 2013 are similar but there are some subtle differences. Under the Takeover Code and the Companies Act, ‘control’ includes the right to appoint the majority of the directors or to control management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders’ agreements or voting agreements or in any other manner. The SEBI also regards a change from sole to joint control as a change of control, unless it falls in one of the permissible exemptions.
Under the Competition Act, on the other hand, ‘control’ includes the ability to ‘control’ the affairs or management of a company. In the case of Independent Media Trust, the CCI held that ‘control’ is the “ability to exercise decisive influence over the management or affairs’ whether such influence is exercised by way of majority shareholding, veto rights or contractual covenants.
Recently, in cases such as Kamat Hotels (India) Limited and Subhkam Ventures (I) Private Limited, the SEBI has stated that negative rights extended to minority investors constitute a change of ‘control’.
It would be interesting to see the SEBI’s next move following the CCI’s refusal to amend its observation on ‘joint control.’ If the SEBI does not reconsider this transaction and does not require Etihad to make the open offer, this will be a significant departure from the SEBI’s earlier position on the ‘control’ issue. The issue of control is becoming unclear with similar definitions being interpreted differently by different regulators. Investors should therefore be cautious when investing in listed Indian companies.
The minority squeeze out provisions of the Companies Act 2013
The concept of squeezing-out minority shareholders has always existed in India, but has been explicitly introduced in the new Companies Act 2013 (the “2013 Act”). India is in the process of adopting the 2013 Act, which is set to replace the Companies Act 1956 (the “1956 Act”). The minority squeeze out mechanism is similar to that of the UK Companies Act 2006 (“UK Act”), but India has not adopted all of the UK provisions.
Can the minority shareholders be compulsorily bought out?
The 2013 Act lays down a process for buying out minority shareholders in certain situations. For instance, a majority shareholder holding at least 90% of the shares in a company has the right to notify its intention to buy-out the minority shareholders. The minority shareholders may sell their shares to the majority shareholder at a price to be determined as per draft rules prescribed under the 2013 Act.
The concept of buying out shareholders who have dissented to a scheme of contract involving the transfer of shares has been retained from the Companies Act 1956. However, it is unclear whether the minority shareholders can be forced to sell their shares to the majority shareholder(s). The 2013 Act provides that if the majority shareholder(s) fail to acquire all the shares from the minority shareholders, the residual minority shareholders will continue to be governed by the relevant provisions in the 2013 Act. Unlike the UK Act, there are no prescribed time lines for the minority shareholders to tender their offers and it is therefore doubtful that the 2013 Act provides for a compulsory minority squeeze-out mechanism.
Is there clarity on how to calculate the exit price?
Minority shareholders have the right to sell their shares at a price to be determined by a registered valuer under the draft rules of the 2013 Act. The draft rules provide the following ways of valuing shares of companies:
- for public listed companies, the offer price is to be determined in the manner specified by the SEBI; or
- in the case of public unlisted companies and private companies, the offer price is to be determined by considering the highest price paid by the acquirer for the acquisition of the shares during the previous twelve months, and the fair price of the shares as determined by the registered valuer.
However, the method of calculating the exit price for minority shareholders has been contested several times in Indian courts and, where the exiting shareholder is also a foreign investor, the exit price would need to be computed as per the Indian foreign exchange laws and regulations.
Judicial Trend in India
Minority squeeze-outs, through court approved capital reduction schemes, have been permitted provided that the majority of the minority shareholders approve the scheme. Indian courts do not usually look into valuation unless they believe there are inherent defects in the valuation process. In Sandvik Asia Limited v Bharat Kumari Padamsi, an Indian High Court held that the court would not overrule a resolution for reducing share capital if the minority shareholders were being paid a fair value and an overwhelming majority of shareholders voted in favour of the scheme.
It remains to be seen whether the Indian judiciary will be able to protect the rights of minority shareholders like in other countries such as the USA.
The application of transfer pricing regulations upon the issue of shares to the parent company of Vodafone India Services Private Limited (“Vodafone India”)
A High Court in India (“High Court”) dispensed of a petition filed by Vodafone India challenging draft orders that sought to tax the notional income of Vodafone India in respect of a shortfall in consideration received from its parent company in return for the issue of shares, by deeming this shortfall to be a loan to the parent company. The HC did not rule on the merits of the case and directed the matter to the Dispute Resolution Panel (“DRP”) to decide whether the Indian transfer pricing regulations applied. The HC stated that if Vodafone India disagreed with the DRP’s ruling on the legal issues, it could approach the HC to rule on the merits of the case.
Background
During the 2008-09 fiscal year Vodafone India, the wholly owned subsidiary of Vodafone Tele-Services (India) Holdings Ltd, Mauritius (“Parent Company”), issued shares to the Parent Company for which it received consideration in compliance with the Indian exchange control regulations. In its filed return for the year, Vodafone India reported the issue of shares as an international transaction and stated that the issue did not affect its income. A reference made by the Accessing Officer (“AO”) to the Transfer Pricing Officer (“TPO”) led to the TPO issuing an order to Vodafone India to address:
- why the issue price of the shares should be accepted as an arm’s length price, and why the arm’s length price should not be determined on the basis of Vodafone India’s Net Asset Value?
- why the shortfall of payment by the Parent Company to Vodafone India should not be deemed as a loan from Vodafone India to the Parent Company for which interest at a rate of 13.5% should be charged?
After this the AO passed a draft assessment order calculating the entire income, consisting of the following components:
- the difference between the subscription price received by Vodafone India and the value determined on the basis of the net asset value; and
- the interest on the deemed loan to the Parent Company.
Neither the AO nor the TPO dealt with Vodafone India’s objection that the Indian transfer pricing regulations are not applicable to the transaction, as it involved the issue of shares to its parent company and did not give rise to any income. Vodafone India filed a petition to the HC challenging the applicability of the transfer pricing regulations to the issue of the shares.
HC Ruling
Although it refrained from ruling on the merits of the case, the HC disposed of the petition with specific directions to the parties. Some key aspects of the HC ruling are as follows:
- Jurisdiction and Alternative Remedy: Differentiating from an earlier petition in Vodafone India’s case, the HC held that the DRP can decide issues other than valuation and is therefore an effective remedy available to Vodafone India.
- The principle that a court shall not entertain a petition when an alternate remedy is available is a self-imposed restriction and at the court’s discretion. Vodafone India asked the HC to step in because neither the TPO nor the AO decided whether Indian transfer pricing regulations apply to the issue of shares and Vodafone India was not granted a hearing before the AO made a reference to the TPO.
- Taxing Notional Income: Vodafone India argued that the AO must be satisfied that there is income or potential income before referring the matter to the TPO for making an arm’s length price determination. The HC agreed in principle to this, as there was no element of income in an international transaction and therefore determining the arm’s length price is purely ‘academic.’ The AO must consider this prior to commencing proceedings against a taxpayer, especially where an objection is raised on the application of Indian transfer pricing regulations.
- Right of personal hearing: Under Indian law, the AO is bound to pass an order which conforms with the arm’s length price determined by the TPO. The AO does not typically have to hear the taxpayer before making a reference to the TPO. However, the taxpayer should be given a hearing where they object to the application of transfer pricing regulations and the jurisdiction of the institution looking at the case. The HC observed that failure to examine such an objection was illegal and the application of transfer pricing may have serious civil consequences.
- The HC directed the DRP to consider the issues under the Income Tax Act 1961 (“IT Act”), in relation to Vodafone India’s objection that the issue of shares could not be subject to Indian transfer pricing regulations.
Observations
Although Vodafone India’s petition was dispensed with by the HC, the HC was sympathetic to the fact that Vodafone’s India’s preliminary objection was not considered by the AO or the TPO. The HC’s ruling states that if a preliminary objection is raised on the jurisdiction itself and the very application of law to a case is questioned, the taxpayer is entitled to have the preliminary objection heard. It also stated that the presence of an alternative remedy does not preclude the HC from hearing the petition. The HC stopped short of providing answers to Vodafone India’s questions, leaving them for the DRP, and therefore avoided setting a precedent that each time the tax department takes an aggressive stand, the only remedy is for the tax payer to approach the HC under a petition. We await the DRP’s ruling on the issue, noting that it will have far reaching implications on the much needed foreign investment in India.
Changes to the Indian Investment Regime
The first few days of 2014 saw the Ministry of Commerce & Industry, the SEBI and the Reserve Bank of India (the “RBI”) make some significant changes to the Indian foreign investment regime.
RBI allows put and call options for non-residents
The RBI published a notification (the “Options Notification”) that permits non-residents (“NRs”) to acquire Indian securities with options attached. The Options Notification clarifies RBI’s position on call options, put options and other exit-linked terms, but contains certain limitations:
- Assured returns: NRs cannot have assured returns on their securities as part of the exit mechanism.
- Lock-in: NRs with such securities will be subject to a lock-in that will be the higher of: (i) 1 year from the allotment date; and (ii) any sector specific lock-in applicable under the FDI policy (for instance the lock-in for investment in the construction / development sector is three years).
- Exit pricing: Exit by NRs cannot be at a price that is higher than:
- for listed securities, the market price prevailing on the recognised stock exchange; and
- for unlisted securities that are:
- equity shares: at a price to be determined on the basis of Return on Equity (“ROE”) based on the latest audited balance sheet of the company; and
- preference shares or debentures: at a price arrived at by a chartered accountant or a SEBI registered merchant banker (based on an internationally accepted pricing methodology).
The Options Notification applies to all existing agreements and will apply to any new agreements entered into.
End of non-compete provisions in the pharmaceuticals sector
The Government has stated that a ‘non-compete’ clause in an investment made in the pharmaceuticals sector in India will only be allowed in special circumstances and requires the prior approval of the Foreign Investment Protection Board (“FIPB”). Considering the government’s protectionist outlook towards the Indian pharmaceuticals sector, it will be interesting to see what circumstances the FIPB might regard as ‘special’ to permit non-compete terms.
Bonus issues of non-convertible instruments through court schemes
Previously, Indian foreign exchange laws were silent on the issue of non-convertible instruments to NRs by an Indian company. The RBI has traditionally, on, a case to case basis, approved the issue of non-convertible instruments to NRs, for example Hindustan Unilever Limited, Dr. Reddy’s Laboratories Limited and Coromandel International Limited have issued non-convertible instruments under a scheme of arrangement.
The RBI recently issued a circular on 6 January 2014 which, when read with another notification, permits Indian companies to issue non-convertible or redeemable bonus preference shares or debentures (“Non-Convertible Instruments”) to NRs by way of a bonus distribution from its general reserves under a scheme of arrangement approved by a competent court in India. Such an issue will be subject to the following terms:
- the NRs original acquisition of the permitted securities must have been in compliance with the existing laws at the time;
- obtaining approval from the Income Tax Authorities; and
- the issuing company being engaged in sectors that are permitted under the automatic route for foreign investments.
This move will have significant merits to stakeholders as it will:
- defer cash outflow until the payment of the coupon or redemption of the debentures, leading to a lower financial burden on the issuing company when compared to issuing dividends to the shareholders, which may also have adverse tax consequences;
- improve the return on earnings as shareholdings would not be diluted;
- have tax benefits to the issuing company as interest on debentures is tax deductible; and
- enable the shareholders to get their money instantly when the issuing company is listed.
Delhi High Court grants temporary relief to Nokia and permits the sale of Indian assets to Microsoft Corporation
Nokia India Private Limited (“Taxpayer”) was granted relief by an Indian High Court (“High Court”) and was given the go-ahead to sell its assets in India as part of a global acquisition whereby Microsoft Corporation, USA (“Microsoft”) proposes to acquire the devices and services business of Nokia Corporation Finland (“Nokia Finland”), which is the Taxpayer’s holding company. The relief is subject to the Taxpayer and Nokia Finland fulfilling certain conditions.
The tax authorities initiated proceedings against the Taxpayer for failure to withhold tax at source on payments made to Nokia Finland over a number of years, and disallowed the expense deduction of payments made to Nokia Finland, due to the non-withholding of tax on such payments, and orders were passed under which the Taxpayer was directed to pay INR 7 billion by March 2014. As there was no restriction on repatriation of the reserves to Nokia Finland, the Taxpayer remitted INR 35 billion by way of a divided to Nokia Finland. The dividend payment resulted in a cumulative outgoing of INR 40.95 billion. This led the tax authorities issuing a provisional order arguing that the Taxpayer did not have sufficient assets to meet the anticipated tax liabilities. This order was challenged by the Taxpayer.
The Taxpayer had entered an agreement with Microsoft, under which its subsidiary Microsoft International Holdings BV (“Microsoft International”) would acquire a substantial portion of Nokia Finland’s devices and services business. Microsoft was only interested in purchasing the assets if approvals were granted. The Taxpayer argued that if Microsoft refused to purchase the Indian assets, it would be forced to wind up its manufacturing operations within 12 months.
The High Court allowed the Taxpayer to sell its assets to Microsoft / Microsoft International, subject to the fulfilment of certain conditions including the following:
- Nokia Finland would be bound by the statement that they shall be jointly liable with the Taxpayer and shall pay a tax demand payable due to non-withholding of taxes at source;
- Nokia Finland would be liable to pay taxes including penalty and interest;
- the Taxpayer/ Nokia Finland would deposit at least INR 22.5 billion in an escrow account (to meet the tax liabilities) within one month of the agreement with Microsoft / Microsoft International and the amount of deposit would increase upon higher consideration being received;
- Nokia Finland would file another letter in the form of a guarantee / undertaking to the High Court incorporating the terms and conditions mentioned in the High Court order. A copy of the letter was also required to be filed by Nokia Finland with their government; and
- the Taxpayer / Nokia Finland would continue to pay INR 7 billion in instalments in terms of an earlier order to keep the demand suspended, regardless of the amount in the escrow amount.
The High Court can be seen as having ruled in favour of the Taxpayer, permitting the sale of the assets, but made such a sale subject to certain conditions to protect the interest of the tax authorities.
We are very grateful to Khaitan & Co, the leading Indian law firm with offices in Mumbai, New Delhi, Kolkata and Bangalore, for allowing us to use their newsletters to prepare this briefing note.
You can contact Khaitan & Co at editors@khaitanco.com for further information or specific advice on the issues covered by this briefing note.
