The Interconnect

Funding in India – Changing Landscape

Ketan Dalal (Managing Partner, Katalyst Advisors LLP)
Nov 14, 2017

The World Bank's recent 'Ease of Doing Business index' showed that India has risen as much as 30 positions to rank 100th amongst 190 countries, which has been amongst the world's top ten improvers worldwide and a leading regional reformer. Moreover, the latest Ease of Doing Business report did not consider the implementation of the Goods and Services Tax (GST) from July 1 and it is also expected that the GST reform and other initiatives being taken will drive India’s improvement in next year’s assessment. 

A few weeks ago, the Union Finance Minister Shri Arun Jaitley also announced an unprecedented PSU banks recapitalisation program of Rs 2.11 lakh crore which is almost half of the total market capitalisation of all public sector banks put together (Rs 4.5 lakh crore). This clearly reflects the Government’s intention to help banks make adequate provisions against bad loans and revive domestic lending, which would support a recovery in the economy and private investments. 

All these positive steps are expected to improve the investment climate and give an impetus to the domestic as well as offshore investments flows in Indian businesses across several economic corridors. But there are certain tax and regulatory roadblocks which would require Indian businesses to think and structure their fund raising plans. We have analysed below certain tax and regulatory issues which need to be borne in mind while structuring fund raising plans: 

Reclassification of Financial Instrument under IND AS:

The Indian Accounting Standards (Ind AS) are a reality now, and with effect from 01st April 2017 mandatorily apply to “Phase II companies” i.e. All listed companies / or companies in process of listing (other than companies listed on SME Exchanges) and companies with a net worth exceeding Rs 250 crore as of 31 March 2017, with certain exceptions for NBFCs, Commercial Banks and Insurance Companies. Along with these Phase II companies, their group entities (subsidiaries, associates and joint ventures), are also mandatorily required to converge to Ind AS. 

Classification of financial instruments into equity and liability is critical to reflect true and fair view of financial position of an entity. Under Indian GAAP, classification of financial instruments into equity or liability is based on the legal form of the instrument. Whereas under Ind AS, principles have been laid down to classify financial instruments into equity or liability basis the substance of the contractual obligations rather, than its mere legal form.

As per Ind AS 32 "Financial Instruments: Presentation" which establishes principles for presenting financial instruments as equity or liability, a financial instrument  can be classified as an equity instrument if it evidences a residual interest in the net assets of the issuer, and (i) there is no contractual obligation to deliver cash or another financial asset to the holder; and (ii) in case if such instrument is to be settled by issuer's own equity instruments, it should be fixed to fixed contracts (number of equity instruments and the price per unit of equity instruments is fixed). On the other hand, a financial instrument is to be classified as a liability if the issuer is required to settle the obligation in cash or another financial asset, or to exchange financial asset or liability under conditions that are potentially unfavourable to the issuer. For example, plain vanilla mandatory redeemable preference shares with fixed redemption price and date, which inherently have always been considered and reflected as part of equity would be classified as a liability under Ind AS. As a result, dividend and corresponding dividend distribution tax paid as well as redemption premium on such preference shares is treated as interest expense and charged to P&L using the effective interest method. In contrast, debentures convertible into equity shares of an issuer entity can be classified as equity if such debentures are convertible at the option of issuer and conversion ratio (ie no of equity shares and the conversion price) is fixed. In such case, interest paid on CCD is treated as Dividend and not charged to P&L.

The above are only a few of several examples to illustrate the accounting complexities that could arise pursuant to reclassification of financial instruments. Such reclassification raises a question as to for income-tax purposes whether legal form of the instrument is to be considered or the substance. This could lead to several income-tax issues; for example, deductibility of interest expense in case where such interest has been recorded as dividend in the financials as a result of reclassification of an instrument as equity, etc.

In this context, Central Board of Direct Taxes (CBDT) issued a circular[1] providing clarifications on computation of Book Profits for an Ind-AS compliant company, which clarifies that no deduction is to be allowed for dividend (treated as Interest expenses in financial statements) on Preference shares (treated as liability in financial statements) while computing MAT liability. However, for computation under normal provisions, there is no specific guidance available yet. Even though, basis the clarification issued by CBDT, in spirit of the intention, one may take a view that for income-tax purposes, legal form of instrument would be relevant, nevertheless, in order to avoid any ambiguities and litigation at lower level, CBDT should provide early clarity in this matter.

In a nutshell, with substance driving the classification of financial instrument, Indian businesses will now have to give careful consideration to this aspect in the choice of suitable funding instruments particularly in cases of fund raising from Financial Investors where instruments typically have several optionality clauses, and any potential change in classification of instrument could lead to material impact on financial ratios.

Introduction of Thin Capitalization Provisions: 

In line with recommendation of the Organization for Economic Co-operation and Development (OECD) in its Base Erosion and Profit Shifting (BEPS) project – Action Plan  4 (base erosion and profit shifting by way of excess interest deductions), the Finance Act, 2017 has introduced provisions for thin capitalisation by the insertion of Section 94B under the Income-tax Act, 1961 (IT Act).

Section 94B provides that interest expenses (exceeding INR 10 million) claimed by an Indian company or a permanent establishment of a foreign company in India, being the borrower who pays interest in respect of any form of debt issued to a non-resident ‘associated enterprise’, shall be restricted to 30% of its earnings before interest, taxes, depreciation and amortization (EBITDA) or interest paid or payable to ‘associated enterprise’, whichever is less. Further, the debt shall be deemed to be treated as issued by an associated enterprise where it provides an implicit or explicit guarantee to a non-resident third party lender or deposits a corresponding and matching amount of funds with such lender.

In order to target only large interest payments, a de-minimis threshold of interest expenditure of INR 10 million is provided. Additionally, any interest that exceeds the cap and is disallowed under these rules, can be carried forward up to 8 years and qualify for a future deduction, to the extent of maximum allowable deduction under Section 94B.

As of now, Indian companies or permanent establishment of foreign companies engaged in the business of Banking or Insurance are kept outside purview of this section. However, it is pertinent to note that no specific exemption has been provided for NBFCs for whom interest expense is a significant cost. Hence, the provision of Section 94B may apply to NBFCs which could result in substantial quantum of interest disallowance while computing taxable business income. Also, at present, the provision of Section 94B covers within its ambit Indian companies or permanent establishments of foreign companies in India and thus, one may take a view that these provisions do not apply to Indian partnership firms / LLPs and Trusts (not being permanent establishments of foreign company).

Furthermore, tax treaties with countries such as France, Cyprus, have Non-discrimination Article (NDA) which provides that any interest paid by an Indian entity to a non-resident AE shall be deductible in the same manner as if it has been paid to a resident in India. In light of this, it is to be seen whether beneficial provisions of NDA can override the applicability of thin capitalisation rules.

Largely these rules will impact companies with high debt-equity ratios operating in capital intensive infrastructure projects like roads, ports, telecom, power, etc. as well as real estate companies where NCDs and debt push down structures are typically used. Moreover, disallowance of excess interest under this provision will impact projected return of investments for financial investors / private equity funds investing in debt instruments of Indian businesses.

Preferential Issue of Shares: 

The Finance Act 2017 has inserted a new clause (x) in section 56(2) applicable w.e.f 1st April 2017 which has considerably widened the scope of taxing deemed gift as income. It provides that if any person receives any sum of money or property (which inter-alia includes “shares and securities”) without consideration or for a consideration below the FMV of the property (determined in prescribed manner), the difference is taxable in the hands of the recipient, provided the difference is in excess of INR 50,000. The earlier provisions [ie Section 56(2)(vii) and (viia)] were applicable only in case of individual or HUF and in limited cases, to firm or closely held companies. With the introduction of section 56(2)(x), the scope of this specific anti- abuse provisions has been widened to include all persons under the Act such as LLP, Association of persons, Body of individuals, listed companies etc. 

In the context of ambit of 56(2)(x), an issue arises as to whether the provisions of section 56(2)(x) can be invoked in the hands of respective shareholders upon issue of shares by the company at a price lower than the FMV determined as per prescribed rules. 

Mumbai ITAT in the case of Sudhir Menon HUF[2] dealt with similar issue and has held that a proportionate issue of shares at a price below the FMV to all shareholders of the company may not lead to any tax implications under section 56(2)(viia) [which is now superseded by 56(2)(x)]. However, one wonders whether in case of disproportionate issue of shares, i.e., issue of shares to a particular shareholder or a group of shareholders at a price lower than the FMV, provisions of section 56(2)(x) can be invoked.

Additionally, listed companies determine issue price for preferential issue of shares basis the valuation guidelines prescribed under the Preferential Allotment Guidelines of the SEBI (ICDR) Regulations, 2009, which is derived basis the volume weighted average price on the stock exchange. In practice, there could be a situation where the price derived as per such valuation guidelines could be lower than the break-up value of share as prescribed under the provisions of section 56(2)(x). In such cases, invoking provisions of section 56(2)(x) and taxing difference (between the actual issue price and fair market value determined as per prescribed rules) in the hands of shareholders does not seem to be in line with the legislative intent. in any case, section 56(2)(x) seems to rope in several unintended and genuine cases and hence, CBDT should clarify the scope of section 56(2)(x) to such situations.

Concluding Remarks: 

While India has long been derided for its dense labyrinth of laws, in the recent times, we have witnessed several regulatory changes with the Government’s strong intent to provide “Ease of doing business” in India. However, actual ground level implementation of such reforms is the key to achieve the underlying objectives and the regulators need to adopt a proactive approach in terms of providing clarifications, approvals, etc. Additionally, new regulations need to be aligned from tax and regulatory perspective and existing gaps need to bridged so as to avoid any ambiguities and further ease of doing business at a grand level.

  • This article has been co-authered by Deep Chandan. 

[1] Circular no. 24/2017 dated 25th July 2017
[2] ITA No. 4887/Mum/2013

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