It has been reported that the Parliamentary Standing Committee on Finance has its made recommendations upon review of the provisions of the Companies Bill, 2009. Discussions reveal that in some areas the Standing Committee’s recommendations seek a reversal of the position stated in current version of the Companies Bill. On one hand, the standing committee calls for a more liberal regime by allowing companies to issue shares with differential voting rights (that was sought to be prohibited in the Bill). On the other, it calls for tighter provisions on matters such as formation of subsidiaries and intercorporate loans and deposits. While this review exercise is beneficial as it incorporates recent experience into the legislation-making process, a fundamental turnaround on certain key issues introduces the risk of further delay in the Bill actually turning into law.

A key development relates to the treatment of corporate governance norms. The Standing Committee has sought to address governance concerns by strengthening the regime for independent directors, auditors, managerial remuneration and the like. More importantly, the Ministry of Corporate Affairs has noted that the Standing Committee “has expressed the desire that all the significant and substantive matters included in the Corporate Governance Voluntary Guidelines 2009 and the Listing Agreement prescribed by SEBI may also be mandated for listed companies and considered for inclusion appropriately in the Bill. For unlisted companies, the Guidelines may remain voluntary ...”. If this recommendation is accepted, then the recent approach (analyzed here) of exhorting companies to enhance their governance practices through voluntary and persuasive measures rather than legal mandate will undergo a significant shift.

We are pleased to share with our readers the following communication received from LexisNexis:

Each year, LexisNexis honors a select group of blogs that set the online standard for a given industry. I’m pleased to notify you that Indian Corporate Law Blog is one of the nominated candidates for the LexisNexis Top 25 Business Law Blogs of 2010, featured on the LexisNexis Corporate & Securities Law Community and the LexisNexis UCC, Commercial Contracts & Business Law Community.

We are inviting the business law community to comment on our list of nominees. If you’d like to request that readers support your nomination, please ask them to comment on the announcement post at either of the following links:

Top 25 Business Law Blogs 2010 – Corporate & Securities Law Community

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To submit a comment, log on to your free web center account. If you haven’t previously registered, you can do so on the Corporate & Securities Law Community or the UCC, Commercial Contracts & Business Law Community. Registration is free and does not result in sales contacts. The comment box is at the very bottom of the page. The comment period for nominations ends on October 8, 2010.

In December 2009, we had discussed SEBI’s order whereby Barclays was found to have failed in complying with certain disclosure norms while issuing offshore derivative instruments (ODIs) under the SEBI (Foreign Institutional Investors) Regulations, 1995. For this, SEBI had prohibited Barclays from issuing, subscribing or otherwise transacting in any ODIs until reporting systems are put in place to the satisfaction of SEBI.

After further hearing the parties and considering the steps adopted by Barclays to put in place adequate reporting systems, SEBI passed an order last week withdrawing the directions imposed on Barclays by its December 2009 order. In arriving at its conclusion, SEBI does not condone the previous non-compliance with disclosure obligations on the part of Barclays, but it is persuaded by the subsequent steps adopted by Barclays to establish robust reporting systems that would prevent a recurrence of non-compliance.

SEBI utilizes the opportunity to reiterate the policy on ODIs and emphasizes the importance of transparency in transactions by FIIs. Here are some extracts (references to the “Order” relate to SEBI’s December 2009 order):

As observed in the Order, SEBI places almost absolute faith and unqualified reliance on the ability of an FII to carry out the basic regulatory and prudential oversight. The oversight includes reporting all trades including ODIs as periodical returns as well as specific requests for information relating to its trading activity in India. … As per the scheme of the FII regulations, FII is required to provide all requisite information as sought by SEBI about its trading activity in India in terms of Regulation 20 of the FII Regulations. …

… The obligations that have been placed on an ODI issuer are two fold – issue ODIs and [ensure] further issue or transfer in strict compliance with the FII Regulations, and report as per the formats provided for by SEBI. The obligation to provide information about onward issuances is an inalienable part of the provisions under the FII Regulations that relate to issue of ODIs. This is very clear given the scheme of the FII Regulations and the duties expected of a FII as explained above.
…

The underlying principle of Regulation 15A(1) of the FII Regulations is that ODIs could only be issued directly or indirectly to persons who are regulated by an appropriate foreign regulatory authority and after complying with the “know your client” norms. It is reiterated that full and fair disclosure forms the foundation of the FII Regulations. The very objective of imposing such obligations on FIIs is because SEBI has no direct access to verify the entities who deal in the Indian Securities Market and the nature of funds that are being invested. The said concern compelled SEBI to issue necessary amendments in Regulations 15A and 20A of the FII Regulations. SEBI, as a regulator of the securities market, places absolute reliance on the ability of an FII to carry out the functions as an FII and to comply with the basic regulatory norms put in place. When an FII fails to discharge its duties and does not exercise proper diligence, inflows through such FIIs could endanger the integrity of the securities market which may further lead to manipulation and fraud. This is the reason why SEBI has mandated FIIs to provide fair, true and correct information regarding their activity. The said information would be used by SEBI for the purposes of assessing, supervising and regulating their activity in the securities market. As already mentioned in the Order, when SEBI grants registration to an FII, it is presupposed that the said FII has the required systems and processes to ensure the integrity and accuracy of the data provided by it to SEBI under the applicable regulations and its capacity to exercise the necessary oversight. A duty is cast on the FII to ensure that no further issue or transfer of any ODI is made to any person other than a person regulated by an appropriate foreign regulatory authority. …

Although SEBI laid down exacting standards on FIIs regarding their issuances of ODIs, it was satisfied with the steps taken by Barclays in establishing appropriate reporting systems to ensure compliance with such standards. In that regard, SEBI was persuaded by the report of an independent auditor, KPMG, which evaluated Barclays’ systems and practices for ODI reporting. SEBI was persuaded only after the independent auditor’s report was expanded to include within its scope of reference certain additional matters stipulated by SEBI. The order concludes by observing:

SEBI derives regulatory comfort from the work conducted by the auditor in general and the submission of auditor’s certificate in compliance with the Order, certifying that reasonable remedial measures have been taken. The deficiencies in the systems and processes of Barclays have now been remedied and a certificate to that effect has also been furnished to SEBI, in compliance with the Order. As the situation has been remedied and the aforesaid directions in the Order have been complied with by Barclays, I am of the considered view that the ex-parte directions issued against it vide the Order need not continue and can be withdrawn.

After initially cracking down in 2007 on indirect investment routes such as those using participatory notes (P-notes), SEBI a year later reversed its decision and allowed foreign investors to participate in the Indian markets through P-notes. SEBI’s decision to allow P-notes was the subject-matter of critique on this Blog as it raises questions regarding transparency.

As observed in that post: “In a nutshell, P-notes are instruments that derive their value from an underlying financial instrument such as a share traded on an Indian stock exchange. They are issued by foreign institutional investors (FIIs) to various offshore investors on the strength of underlying equity, derivatives or other securities that are held by the FIIs.” In other words, P-note holders are able to indirectly participate in the Indian markets without being subject to registration and other requirements under Indian regulations.

Critics of P-notes may now rest easy as its market seems to have corrected itself, at least quantitatively. The Economic Times reports that the flow of funds into India through P-notes has substantially reduced. It states:

The value of participatory notes as a percentage of FIIs’ stock investments, which was as high as 50% in a couple of months during the peak of the previous bull run in 2007, has been in the range of 13-15% in the past six months. This is despite the value of FII assets under management rising to `9.7-lakh crore in July 2010, the highest since December 2007, when that bull run peaked.

It is believed that a more streamlined process for registration of FIIs allowed investors that hitherto used derivative instruments such as P-notes to access Indian markets through the front door.

Added to this is another plausible factor. P-notes were largely used by investors such as hedge funds that prefer to offer fewer disclosures to regulators in markets where they invest. However, the recent financial crisis and the resultant tightening of regulation governing such investors have made them somewhat cautious and sluggish as this Economist report observes:

The creep of regulation is one reason why hedge funds increasingly resemble more traditional investment managers. America’s financial-reform bill, passed in July, will require hedge funds with assets over $150m—a low threshold—to register with the Securities and Exchange Commission, to hire or designate a compliance officer and to maintain records on trading positions and leverage. Proposals for new EU regulations would, if adopted, lead to increased oversight of hedge funds by regulators and put limits on funds’ leverage.

The introduction of greater transparency in the affairs of hedge funds and other similar investors will encourage them to invest directly in markets (such as India), which may also partly explain the decline in P-note activity.

In this Mint column, Narayan Ramachandran calls for a shift in attention from the classic corporate model of limited liability companies to a cooperative model that involves “a voluntary agreement to share, for the mutual benefit of all parties”. Although India is no stranger to the cooperative model (as the author demonstrates), it is the co-operative societies legislation that is usually used to carry out such activity.

Strangely enough, the cooperative model finds its place in the Companies Act as well. The concept of “producer companies” was introduced by amendment in 2003 (Sections 581A onwards), but it is apparently yet to gain any popularity. There are, however, some examples of producer companies discussed in this article.

In 2005, the Supreme Court held that the transfer of branded software constitutes a sale and is exigible to sales tax, levied by State Governments under Entry 54, Schedule VII of the Constitution (Tata Consultancy Services v. State of AP). I have argued elsewhere that this decision may, with respect, require reconsideration on the question of whether the typical software transfer accompanied by a EULA is a “sale” or merely a limited licence. Controversy over the legal status of software and its taxation has continued despite the pronouncement of the Supreme Court. It is not only that software per se defy easy legal classification but also that significant differences between different types of software complicate the matter. We noted that an amendment to the Finance Act – s. 65(105)(zzzze) - proposed to levy service tax on certain transactions involving software, and discussed its implications. On 24 August, 2010, the Division Bench (Taxation) of the Madras High Court rejected a challenge to the constitutional validity of this provision. The decision, which makes for interesting reading, is available here.

The writ petition was filed by the Infotech Software Dealers Association [“ISODA”], a group comprising over 100 members engaged in software resale. The Court was careful to note that the “resale” was principally effected in three ways – through shrink-wrap software, multiple user software and internet downloads. The petitioner entered into a Master End User Licence Agreement with the developer of software, and in turn into End User Licence Agreement with its customers. Following the decision of the Supreme Court in Tata Consultancy Services, all such transactions were treated as exigible to sales tax and VAT. In the High Court, the petitioners assailed the constitutionality of the amendment for two reasons: first, that software always constitutes goods, and secondly, that all transactions in the categories mentioned above constitute a sale (or a deemed sale) – and therefore beyond the legislative competence of Parliament. The High Court accepted the first contention, but rejected the second. The second contention is by far the more significant, since most courts across common law jurisdictions have now taken the view that software does indeed constitute goods (whether a transaction in it constitutes a sale or not).

The High Court first referred to the decisions of the Supreme Court in Gannon Dunkerley, Tata Consultancy Services and BSNL. It then distinguished between “exclusive sales” and “composite sales” in the following terms:

However, in a transaction whereby the software is delivered to the customers, the question is as to whether it would amount to an exclusive sale. In the event if it is a case of sale, then the submission of Mr. Datar as to the legislative competency of the State Government under Entry 54 of List II must be accepted. There may be cases of exclusive sale or exclusive service or where the element of sales and service is involved. In cases where an element of service is alone involved, the Parliament has the legislative competency to enact law for levying service tax under Entry 93-C…

This is clearly correct. The Union of India argued that the typical software transfer agreement is not a sale, but a limited licence, since the copyright in the software is retained by the developer, who only transfers a limited right of use to the end-user. To answer this objection, one must, as the Court put it, look to the “nature of the transaction” and the “dominant intention of the parties”. Indeed, this formulation has been firmly entrenched in the line of cases following Gannon Dunkerley. However, the 46^th Constitutional Amendment, introducing Art. 366(29A) into the Constitution, made partial inroads into this principle by allowing States to levy a “tax on sale” on specific transactions that lack on one of the constitutive elements specified in Gannon Dunkerley. For example, it had been held following Gannon Dunkerley that the State is not competent to levy sales tax on food consumed in a restaurant on the theory that the food is “sold” to the consumer. Now States may do so by virtue of the specific provision in Art. 366(29A)(f). As a result, it is possible to take the view (although this is disputed) that the meaning of “sale” for the purpose of Entry 54, List II is broader today than at the date of the inception of the Constitution.

Naturally, therefore, the petitioners relied on Art. 366(29A)(d), which provides that a “transfer of the right to use goods” is a deemed sale, to suggest that software, which is undoubtedly goods, is covered by this provision even if the Union of India’s contention is correct. This issue – whether the limited nature of the End User Licence Agreement that accompanies typical off-the-shelf software converts what appears to be a sale into a licence – deserves the closest scrutiny, and has produced divergent results in England, and within America. The Madras High Court addresses this issue in paragraph 31 of its judgment, and the following observations are crucial:

31. From the above, the dominant intention of the parties would show that the developer or the creator keeps back the copyright of each software, be it canned, packaged or customised, and what is transferred to the network subscriber, namely, the members of the association, is only the right to use with copyright protection. By that agreement, even the developer does not sell the software as such. By that Master End-User License Agreement, the members of petitioner-association again enter into an End-User License Agreement for marketing the software as per the conditions stipulated therein. In common parlance, end user is a person who uses a product or utilises the service. An end user of a computer software is one who does not have any significant contact with the developer/creator/designer of the software … On a careful reading of the above, we are of the considered view that when a transaction takes place between the members of ISODA with its customers, it is not the sale of the software as such, but only the contents of the data stored in the software which would amount to only service. To bring the deemed sale under Article 366(29A)(d) of the Constitution of India, there must be a transfer of right to use any goods and when the goods as such is not transferred, the question of deeming sale of goods does not arise and in that sense, the transaction would be only a service and not a sale [emphasis mine].

From the above observations, it would appear that the Court has held Art. 366(29A)(d) inapplicable to a typical software transfer transaction. However, in paragraph 32 and subsequently, the Court clarifies that this depends “upon the individual transaction”.

The law on characterizing software is today at the crossroads: on the one hand, the Supreme Court held that a typical software transfer agreement constitutes a “sale” on the basis that it constitutes “goods”, without, however specifically considering whether such a transaction is only a limited licence. On this basis, sales tax was levied. On the other hand, the Madras High Court has held that service tax may be levied on these transactions because it is possible that individual transactions involving software may not constitute a “sale” although software is “goods”, because of the nature of the transaction. The Courts were not considering the same type of software, of course, and the two opinions are not inconsistent – but a clear enunciation of the importance Indian law attaches to the nature of the transaction will promote the interests of clarity.

A free and active press generally provides impetus for instilling enhanced corporate governance practices in any economy, as it does in India. However, conflicts of interest that the media faces may create distorted incentives that dilute these objectives. One such conflict is presented by the concept of “private treaties” whereby media enterprises take stakes in companies in return for agreeing to provide adequate media coverage for the investee company through advertisements, news reports, advertorials, etc. It is possible that this practice may mislead investors in securities markets as media reporting may not present the accurate picture regarding companies.

In order to alleviate these concerns, SEBI last week issued a press release, which requires media enterprises to disclose (i) their stakes in companies in the news article or report relating to such companies; (ii) shareholdings through private treaty arrangements on their websites; and (iii) arrangements with companies relating to management control, board nomination and the like. These disclosures will be applicable in the case of companies that are listed or are proposed to be listed on a stock exchange.

This is bound to bring in transparency in investments by media enterprises and to provide a solution to the conflict of interest created by private treaties. For a further analysis of the impact of these disclosure norms, see the SEBI Updates Blog, the Financial Express and the Hindu Business Line.

The Ministry of Finance recently published on its website a report of the Working Group on Foreign Investment in India. The report seeks to address the complexity and overlaps in the existing regime on foreign investment in India and to propose a more streamlined framework. It focuses largely on foreign portfolio investment and less on foreign direct investment, although some of the recommendations do impact the latter as well. This report follows recent efforts to simplify the foreign investment regime, and comes in the wake of the Consolidated FDI Circular that became effective on April 1, 2010.

Before examining the key recommendations, it may help to set out the context. With the onset of the economic liberalization policy followed by the Indian Government in 1991, various modes of investment were made available to foreigners. These include the foreign direct investment (FDI), foreign institutional investment (FII), non-resident Indian (NRI) investment, overseas corporate body (OCB) investments and later the foreign venture capital investments (FVCI). Initially, these different investor classes were subject to varying regulations, and they served distinct purposes. However, in the last decade or so, continuing regulatory changes began diluting, and sometimes even obliterating, the distinctions between various investor classes. Overlaps crept into the regulatory regime. The availability of multiple classes caused uncertainties to foreign investors when it came to opting for the appropriate investment route to adopt in order to invest in India. It is in this background that the Working Group reviewed the entire policy on portfolio investments and issued its recommendations.

The key recommendations are as follows:

1. Qualified Foreign Investor (QFI) Scheme: The Working Group recommends that all portfolio investments be brought in through a common scheme. To that extent, the current NRI, FII and FVCI regimes are being collapsed into the QFI scheme.

2. Percentage Limits: Investment into unlisted or listed securities of an Indian company would be considered as portfolio investment up to 10% shares in each company. If the shareholding is in excess of 10%, then it will be considered as FDI and hence governed under the appropriate policy. While the creation of a single portfolio investor regime is desirable, the use of a 10% limit for determination of whether an investment is under the portfolio route or FDI route may be fraught with some difficulties. To the extent that this report focuses on portfolio investments (i.e. less than 10%) and leaves excess investments to the FDI policy, it remains to be seen whether appropriate changes are to be effected to the FDI policy as well.

3. Participatory Notes: The Working Group recommends that “SEBI should have the final right to demand details about the end investor in cases of needed investigations”. Moreover, it is expected that a streamlined QFI framework will encourage investors to participate directly in the Indian markets rather than through indirect offshore instruments (such as participatory notes).

4. Debt Instruments: The QFI model is to be extended to debt investments as well in the Indian markets.

5. Legal Process: The Working Group lays emphasis on the importance of legal processes in foreign investment. Its recommendations on this count include: (i) the creation of a financial sector appellate tribunal to hear appeals on capital flows management regulations; (ii) institution of processes of public consultation before issuance of law or policy; (iii) creation of “user-friendly access to the law through public information systems”.

Although the Working Group recommendations constitute a concerted effort towards simplifying the policy on portfolio investments, the extent to which these proposals would be translated into action is not clear, and doubts are already being expressed.

 

As noted in an earlier post, the Direct Taxes Code Bill has been introduced in Parliament. If enacted, it will come into force from 2012. Below is a comparative chart discussing the differences in the provisions in the current Act and in the Code Bill. The changes below are not exhaustive, and we will be discussing other aspects of the Code in subsequent posts.

 

Point	Current Treatment under the Income Tax Act, 1961, as amended up to the Finance Act, 2010	Proposed Treatment under the Direct Taxes Code, 2010
Residence of companies	U/s 6(3), a company is treated as a resident, if it is an Indian company, or if its control and management is situated 'wholly' in India.	Under cl. 4(3) of the Bill, a company is treated as resident if it is an Indian company, or if its place of 'effective management' at any time of the year is in India. The test for determining residence has been altered and made broader. 'Place of effective management' is defined under cl. 314(192) to mean either the place where the Board/executive directors of a company make their decisions or, in a case where the board of directors routinely approve the commercial and strategic decisions made by the executive directors or officers of the company, the place where such executive directors or officers of the company perform their functions.
'Indian company'	U/s 2(26), an Indian company is one which is formed and registered under the Companies Act, 1956 or established by or under a Central or State Act. A Proviso requires the registered/principal office to be in India.	Under cl. 314(132), an Indian company is a body corporate which is registered or established or constituted by or under the Companies Act, 1956 or another State or Central Act. The requirement of the proviso is separately included. The change in language seems clarificatory.
Residence of other legal persons	U/s 6(4), other legal persons are treated as residents in India in any previous year in every case, except where the control and management of his affairs is situated wholly outside India.	Under cl. 4(4), every other legal person is to be treated as a resident in any financial year, if the place of control and management of its affairs, at any time in the year, is situated wholly, or partly, in India. The language seems to have changed, but the test seems same – if any part of management is carried out in India, the person is a resident.
Scope of total income	Residents are taxed on worldwide income; non-residents on a source-based model	Essentially the same model, but 'source' has been widened. In particular, please refer to the discussions on deemed accrual below.   In addition, cl. 3(3) provides that any income which accrues to a resident or is received by a resident outside India during the year shall be included in the total income of the resident, whether or not such income has been charged to tax outside India.
Deemed accrual in India	Section 9(1)(i): Through or from any business connection, property, or asset/source in India, or through the transfer of a capital asset situate in India. Where operations are not carried on entirely in India, only that income which is reasonably attributed to operations in India is deemed to accrue in India.	Cl. 5(1): The same four categories apply – it is clarified that income arising 'through or from' all the 4 would be covered (as opposed to the present Section, where 'through or from' qualifies the other 3 categories but the provision only read 'through' the transfer of a capital asset. Business connection has been defined in cl. 314(40) to include a permanent establishment. PE is defined under cl. 314(183) to mean a fixed place of business through which the business of a non-resident is wholly or partly carried out – the general clause. The definition of PE then goes on to give a list of activities/installations/ structures which are included in the general clause; and then lists certain other elements which are deemed to be included.
Deemed accrual of income from interest, royalties and fees for technical services	Section 9(1)(v), (vi) and (vii): The income is deemed to accrue in India if it is: (a) payable by the Government; (b) payable by a resident except where it is payable in respect of any debt/right/property/information/ services utilised for the purposes of a business or profession carried on by such person outside India or for the purposes of making or earning any income from any source outside India (c) payable by a non-resident where the royalty is payable in respect of any right, property or information used or services utilised for the purposes of a business or profession carried on by such person in India or for the purposes of making or earning any income from any source in India	Cl. 5(2): The interest income is deemed to accrue or arise in India if it is: (a) According to cl. 5(2)(d)/(f)/(h), accrued from or payable by the Government or any resident; (b) According to cl. 5(2)(e)/(g)/(i), accrued from or payable by a non-resident if it is in respect of / for the purposes of a business carried on in India or for the purpose of earning any income in India.     The royalty provision has been broadened. Any royalty payable by a resident is now covered, even if that royalty was entirely in respect of a business carried out outside India. To my mind, this looks as if nexus requirements have been removed in respect of taxing a non-resident.   There is an exception under cl.5(4), where the income is not to be treated as accruing "in India under sub-section (1)" if it is in respect of a business carried on by a resident outside India or for the purpose of earning any income outside India. Curiously, the provisions on interest, royalty and FTS are under cl. 5(2), while the exception is only in respect of income under cl. 5(1). This is either a drafting error (and the notes on clauses indicate that this is the case), or a case of giving with one hand and taking away with the other. Interestingly, clause 5(2) is specifically stated to be without prejudice to cl. 5(1).   Additionally, it is provided under cl. 5(5), that income under clause 5(2)(c) to (k) shall be deemed to accrue or arise in India whether or not the payment is made in India, the services are rendered in India, the non-resident has a place of business/business connection in India, and irrespective of the actual place of accrual. This is probably to ensure that the 'render+utilize' debate does not arise again.
Calculation of income in case of indirect transfers	It is arguable that when there is a transfer of a share / interest outside India, there is no transfer of a capital asset in India; and no part of the consideration whatsoever is chargeable in India.	Cl. 5(6) provides that where the income of a non-resident, in respect of transfer, outside India, of any share or interest in a foreign company, is deemed to accrue in India under the 'transfer of a capital asset situate in India' provision [thereby implying that such an accrual is possible under the wordings of the Bill], the income shall be calculated by the formula Income = 'A' multiplied by 'B' divided by 'C', where: A = Income from the transfer computed in accordance with provisions of this Code as if the transfer was effected in India; B = fair market value of the assets in India, owned, directly or indirectly, by the company; C = fair market value of all assets owned by the company.   Under cl. 5(4)(g), the fair market value of the assets in India, owned, directly or indirectly, by the company, must represent at least 50% of the fair market value of all assets owned by the company, in order for the same to be taxable in India.
Definition of 'fees from technical services'	Explanation II to Section 9(1)(vii) specifies that FTS means consideration for the rendering of any managerial, technical or consultancy services (including the provision of services of technical or other personnel) but does not include consideration for any construction, assembly, mining or like project undertaken by the recipient or consideration which would be income of the recipient chargeable under the head "Salaries".]	Cl. 314(97) defines FTS to mean any consideration: i. for the rendering of any managerial, technical or consultancy services ii. for provision of services of technical or other personnel.   The exclusion is available. The difference is that point (ii) is included separately, as opposed to the current act where it is included within managerial, technical or consultancy services. Now, on its plain reading, the clause is quite broad – FTS includes consideration… for the provision of services… of other personnel. The word 'other' in the second sub-clause should, it seems, be read in conjunction with 'technical' as opposed to all other personnel.
Definition of Royalty	U/s 9(1)(6), Explanation 2, royalty was defined to mean consideration for, inter alia, the transfer of all or any rights (including the granting of a licence) in respect of a patent, invention, model, design, secret formula or process or trade mark or similar property.	Under cl. 314(220), royalty is defined to mean consideration for, inter alia, transfer of all or any rights (including the granting of a licence) in respect of a patent, invention, model, design, trade mark, secret formula, process, or similar property. The change in the language is relevant – for example, there is debate in current law (see the Tribunal decisions such as New Skies and PanAmSat) as to whether the word 'secret' qualifies only 'formula' or both 'formula ' and 'process'. The Bill, by inserting the comma in place of the 'or' clarifies that the word 'secret' does not qualify process. This clarifies the existing provision – interestingly a Special bench of the Tribunal had come to the same conclusion in any case on the existing wording.   The other clauses seem to be similar to the existing definition, except for the change noticed above.
Treaty and Act interplay	Under Section 90(2), a tax treaty will override and the act will apply only to the extent it is more beneficial.	The principle remains the same. However, the wording of cl. 291(8) states that the principle applies "Where the Central Government has entered into an agreement under sub-section (1) or sub-section (2), or has adopted an agreement entered into by the specified association under sub-section (4)…"   What about treaties which are entered into under Section 90(1) of the existing Act, as opposed to cl. 291(1), (2) or (4) of the Bill? Can the Revenue tomorrow argue that the treaty was actually not entered under this clause, but under Section 90; and hence, the Act will override in all cases? There was some amount of controversy in the first draft of the DTC regarding this; if there has been a rethink by the Government, there should be a specific mention of Section 90 as well to forestall the Revenue argument.   The treaty benefits are further restricted under cl. 291(9); according to which notwithstanding anything in sub-section (8), the provisions of this Code relating to (a) General Anti-Avoidance Rule (cl. 123), levy of Branch Profit Tax (cl. 111), or (c) Control Foreign Company Rules referred to in the Twentieth Schedule, shall apply to the assessee.
General Anti Avoidance Rule	There is no GAAR in the current Act.	Cl. 123 proposes a GAAR which is extremely wide. "Any arrangement" may be declared as an impermissible avoidance arrangement. Separately, in cl. 124(15), "impermissible avoidance arrangement" is defined to mean a step in, or a part or whole of, an arrangement, whose main purpose is to obtain a tax benefit and it: (a) creates rights, or obligations, which would not normally be created between persons dealing at arm's length; (b) results, directly or indirectly, in the misuse, or abuse, of the provisions of this Code; (c) lacks commercial substance, in whole or in part; or (d) is entered into, or carried out, by means, or in a manner, which would not normally be employed for bona fide purposes.   Cl. 125 contains a presumption of purpose.   Cl. (3) states that the provisions of the GAAR shall apply subject to such conditions and in the manner as may be prescribed. It remains to be seen as to what these conditions will be.   There are serious concerns to my mind about the constitutional validity of the GAAR provisions; and it is submitted that if enacted, the provisions should be either read down severely, or struck down. This aspect will require a fuller discussion; and we will discuss constitutionality-related aspects after enactment of the Bill.
Best judgment assessment	U/s 144, a best judgment assessment is allowed in cases where there is a failure to file a return/failure to comply with the terms of certain notices etc.	Under cl. 156, in addition to the existing requirements, a best-judgment assessment can also be made if the fails to regularly follow the prescribed method of accounting, or if the AO is not satisfied about the correctness or completeness of the accounts of the assessee.

In an important fallout of the Satyam controversy, the Supreme Court, earlier this month, reiterated the law on the amendment of section 34 applications, and also clarified the kinds of fraud that would justify the setting aside of arbitral awards on grounds of public policy. After the fraud perpetrated Mr. Raju, Venture Global sought to amend its section 34 and bring the facts about the fraudulent conduct on record. Before the AP High Court, Satyam successfully contended that the amendment of the pleadings was hit by the limitation period prescribed under section 34, and could not be allowed. Venture’s appeal against this decision fell for the Supreme Court’s consideration.

Section 34 of the Act, in its relevant part, reads-

34. Application for setting aside arbitral award.

(1) xxx

(2) xxx

(a) xxx

(b) the Court finds that-

(i) the subject-matter of the dispute is not capable of settlement by arbitration under the law for the time being in force, or

(ii) the arbitral award is in conflict with the public policy of India.

Explanation.-Without prejudice to the generality of sub-clause (ii) it is hereby declared, for the avoidance of any doubt, that an award is in conflict with the public policy of India if the making of the award was induced or affected by fraud or corruption or was in violation of section 75 or section 81.

(3) An application for setting aside may not be made after three months have elapsed from the date on which the party making that application had received the arbitral award or, if a request had been made under section 33, from the date on which that request had been disposed of by the arbitral tribunal:

Provided that if the court is satisfied that the applicant was prevented by sufficient cause from making the application within the said period of three months it may entertain the application within a further period of thirty days, but not thereafter. [emphasis supplied]

Based on the language of the provision, there were two arguments available to the Satyam- (a) that the extended period of 30 days, contained in the proviso to clause (3), had expired and it was not open to the Court to allow any further extension; and (b) that the fraud in question had not induced or affected the award, and was not relevant for the purposes of section 34. The first of these arguments had been considered and rejected by the Supreme Court in State of Maharashtra v. Hindustan Construction Company. In this case, the Apex Court had been called on to consider whether the limitation period applied only to fresh applications for setting aside awards, or also to amendments to existing section 34 applications. The Court held that amendments to existing applications, if necessary in the interests of justice, and not amounting to a fresh application, would not be barred by the proviso to section 34(3). (A more detailed discussion of the decision is available here).

That then left only the question of whether the fraud perpetrated by Mr. Raju could be said to have induced or affected the impugned award. Mr. Salve contended for Satyam that the phrase ‘making of the award’ had to be read narrowly, and that events subsequent to the award had no bearing on a section 34 application. Mr. Venugopal, for Venture Global, contended that since the facts were not revealed by Mr. Raju until after the award, there was no way they could have been made part of the original section 34 application. Also, since the concealment had materially affected the passing of an award in Satyam’s favour, it was material for the purposes of setting aside the award. Accepting the Respondent’s contentions, the Supreme Court overturned the decision of High Court and allowed the amendment of the application. The Court observed that the phrase ‘making of the award’ could not be read narrowly, especially since the scope of the provision was widened by the phrase ‘induced or affected’. Further, the Court went on to elucidate on its conception of public policy in the following words-

The concept of public policy in ABC, 1996 as given in the explanation has virtually adopted the aforesaid international standard, namely if anything is found in excess of jurisdiction and depicts a lack of due process, it will be opposed to public policy of India. When an award is induced or affected by fraud or corruption, the same will fall within the aforesaid grounds of excess of jurisdiction and a lack of due process. Therefore, if we may say so, the explanation to Section 34 of ABC is like `a stable man in the saddle' on the unruly horse of public policy. [emphasis supplied]

Thus, the Court concluded that the amendment of the section 34 application could not be barred by limitation in the interests of justice, and that the fraud alleged was such as to fall within the scope of fraud which had ‘induced or affected the making of the award’. On this basis, the decision of the High Court was overturned. (Another exhaustive discussion of the decision is available here).

On a concluding note, one issue discussed earlier seems to be interesting in the context of the discussion above. In Moore Stephens, the House of Lords had held that fraud by the ‘directing mind and will’ of a company will be attributable to the company is all cases, except when the company itself is a victim (as opposed to a vehicle) of the fraud. In the case of Satyam, whether the company was a vehicle or a victim of the fraud is open to argument. Hence, in a case like this, it may be possible to argue that the fraud perpetrated by Mr. Raju is not attributable to Satyam. However, on the text of section 34, there is no requirement that the fraud which ‘induced or affected the making of the award’ be attributable to a party to the arbitration proceedings. It is probably for this reason that the question of attribution was not argued before or considered by the Court. It is instructive to contrast the Indian language with that of the English Arbitration Act, 1996, which talks of an award ‘being obtained by fraud’. The use of the word obtained (as opposed to influenced or affected) can be taken to signify that under English law, the fraud in question should be attributable to a party.

On this reading of the provision, it seems that the question of attributability of the fraud is not relevant for the purposes of section 34(3). However, on a closer examination of the decision of the Supreme Court, there are a couple of observations which can be taken to be assumptions by the Court that fraud under section 34 is fraud attributable to a party. First, the Court cites and approves the provision in the English Arbitration Act, which, as seen above, can be interpreted as containing the requirement of attribution. Secondly, there is the observation of the Court that “If the argument advanced by the learned counsel for the respondents is accepted, then a party, who has suffered an award against another party who has concealed facts and obtained an award, cannot rely on facts which have surfaced subsequently even if those facts have a bearing on the facts constituting the award ... Such a construction would defeat the principle of due process and would be opposed to the concept of public policy incorporated in the explanation” [emphasis supplied]. Admittedly, neither of these instances are authority for the proposition that attribution of the fraud to a party has been read into section 34 by the Court. This is especially so given broad observations like “if the concealed facts, disclosed after the passing of the award, have a causative link with the facts constituting or inducing the award, such facts are relevant in a setting aside proceeding and award may be set aside as affected or induced by fraud”. However, since the Court only decided that the application may be amended to make fraud a ground, and did not dispose of the question of whether the award may be set aside on grounds of fraud (which being a question on merits, is still to be decided by the lower courts), there is always the possibility that this question comes up for consideration in future.

The Direct Taxes Code Bill, 2010 was introduced in Parliament earlier today. A copy of the Bill can be downloaded from here. Over the next few days, we will discuss some of the provisions of the Bill in greater detail. For now, some news reports on the DTC are linked below:

Corporate India Cautious in welcoming DTC (Economic Times)

DTC may boost investment flow into capital markets: Analysts (Economic Times)

Direct Tax Code tabled: What do experts make of it? (Moneycontrol)

Earlier this month, the Bombay High Court issued its judgment in the case of Price Waterhouse & Co. v. Securities and Exchange Board of India. The court ruled that SEBI possesses necessary powers to initiate investigations against an auditor of a listed company for alleged wrongdoing.

Facts: A writ petition was filed before the Bombay High Court by Price Waterhouse & Co. (PWC) and some of its partners and affiliates challenging a show cause notice issued to them by SEBI. This pertains to PWC’s audit of Satyam Computers and their alleged failure to detect financial wrongdoing within the company of significant magnitude that in turn resulted in severe losses to Satyam shareholders. The financial wrongdoing included overstatement of cash and bank balances, non-existent accrued interest, overstated debtor position and the like. SEBI’s show cause notice sought to initiate action against PWC under Sections 11, 11B and 11(4) of the SEBI Act and Regulation 11 of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Markets) Regulations, 2003. Although PWC raise objections regarding jurisdiction of SEBI before its member, no order was passed on jurisdiction, which then prompted PWC to file the writ petition before the Bombay High Court for quashing the pending proceedings before SEBI.

Arguments: The principal arguments raised by PWC are that SEBI does not have the requisite jurisdiction to initiate action against auditors who are discharging their duties as professionals. SEBI can only regulate the securities markets and that auditors can never be considered to be associated directly with the securities markets. Moreover, PWC argued that there is already an established legal regime in the form of the Chartered Accountants Act, 1949 (and the Institute of Chartered Accountants of India (ICAI) established therein) that governs the accounting profession and hence any restrictions on the practice of that profession can be imposed only by the ICAI. Only the ICAI can determine whether there has been a violation of applicable auditing norms. Failing this, SEBI would be seen as encroaching upon the powers of the ICAI.

On the other hand, SEBI argued that the investigation pertains to a corporate scam that had a cascading effect on the price of Satyam’s shares and consequently on the securities markets as a whole. Since the auditor’s role is to certify the books of accounts of the company, persons dealing in the securities markets are likely to place reliance upon those accounts while making investment decisions. Consequently, it is argued that SEBI has jurisdiction to take appropriate steps in relation to auditors of listed companies.

Issues: The key questions before the court were (i) whether the show cause notice issued by SEBI was without jurisdiction so as to require quashing of such proceedings; and (ii) whether the proceedings initiated by SEBI amount to an encroachment of the powers of the ICAI under the Chartered Accountants Act.

Decision: The court analyzed the powers of SEBI under various provisions of the SEBI Act. It found various measures were available to SEBI that could be employed in regulating the securities markets. Those powers were of wide amplitude which would “take within its sweep a chartered accountant if his activities are detrimental to the interest of the investors or the securities market”. The court found that by taking remedial measures to protect the securities markets, it cannot be said that SEBI is regulating the accounting profession. SEBI’s general domain extends to protecting investors of listed companies and the securities markets. In exercise of such powers, there is no reason why SEBI cannot prevent any person from auditing a public listed company. Even though the auditors are not directly involved in the securities markets, the court found that since investors rely heavily on the audited accounts of the company, the statutory duty of the auditors and discharge thereof “may have a direct bearing in connection with the interest of the investors and the stability of the securities markets”. The court finally ruled that the powers of SEBI are independent of those held by the ICAI and hence SEBI cannot be said to encroach upon the powers of the ICAI under the Chartered Accountants Act.

Analysis: The judgment is important as it establishes the regulatory domain of SEBI over auditors of listed companies. The court largely arrives at its conclusions based on an analysis of SEBI’s powers to regulate the securities market, which is then contrasted with ICAI’s powers to regulate the accounting profession.

A greater significance of this judgment is that it establishes the role of an auditor to be closely linked with the functioning of the securities markets. Inherent in this analysis is the fact that proper performance of audit role in listed companies is a prerequisite for investor protection which is crucial to maintain robust securities markets. If audit and investor protection are said to be interconnected, it then takes us to a fundamental legal question: do auditors owe a duty to shareholders/investors? The Bombay High Court, in this case, appears to answer in the affirmative: “The auditors in the company are functioning as statutory auditors. They have been appointed by the shareholders by majority. They owe a duty to the shareholders and are required to give a correct picture of the financial affairs of the company.” [emphasis added]. Although the court cites to Institute of Chartered Accountants of India v. P.K. Mukherjee to state that auditors owe duties to shareholders in a company, that case had largely to do with a provident fund and its beneficiaries and it is not clear whether the ruling has any direct application to the present situation.

More importantly, the fact that auditors owe duties to shareholders seems to move away from conventional wisdom. In cases involving civil liability, the general position appears to be that the duty of reasonable care in carrying out audit of the company’s accounts is owed to the company in the interests of its shareholders, and that no duty is owed directly to individual shareholders. This has been solidified ever since the House of Lords pronounced its decision in Caparo Industries Plc v. Dickman [1990] 2 A.C. 605 (H.L.). The Bombay High Court’s judgment in the PWC steers clear of any detailed discussion regarding this jurisprudence. At one level, it may be argued that this discussion is not necessary in view of SEBI’s wide powers under the SEBI Act, but since those powers are derived from the investor protection mandate of SEBI, those powers may not be available if auditors do not have duties to individual shareholders in the first place. It is not clear if the discussion of auditors’ civil liability to individual shareholders can be divorced from auditors’ subjection to powers of a securities regulator acting to protect the investor community.

Although the judgment is confined to auditors, it remains to be seen whether third parties such as other advisors involved in securities markets activity (generally referred to as “gatekeepers”) could be drawn into the ambit of SEBI’s powers. Even here, courts in other jurisdictions have been slow to impose civil liability on such third parties. E.g. the U.S. Supreme Court decision in Stoneridge v. Scientific Atlanta. As far as certain gatekeepers such as investment/bankers and credit rating agencies are concerned, they are subject to SEBI's domain by virtue of registration under relevant SEBI regulations that apply to them.

The last word is yet to be spoken in the matter, since the judgment itself indicates that PWC has sought to file a special leave petition before the Supreme Court.

Earlier this week, the U.S. Securities and Exchange Commission (SEC) adopted the much anticipated proxy access rule which allows shareholders to nominate candidates for directorship. The essence of the new rules is as follows:

The new rules require companies to include the nominees of significant, long-term shareholders in their proxy materials, alongside the nominees of management. This "proxy access" is designed to facilitate the ability of shareholders to exercise their traditional rights under state law to nominate and elect members to company boards of directors.

Under the rules, shareholders will be eligible to have their nominees included in the proxy materials if they own at least 3 percent of the company's shares continuously for at least the prior three years.

This has generated an extensive debate (e.g. on the Conglomerate Blog) as to whether such proxy access to shareholders has merit when it comes to nomination and appointment of directors.

All of this might seem like “much-ado-about-nothing” in parts of the Commonwealth where shareholder rights to nominate directors have been available traditionally within law. For example, in India, shareholders have extensive rights under the Companies Act, 1956 to determine the composition of the board (Sec. 257: propose candidates for directorship; Sec. 263: vote for appointment of directors; Sec. 284: vote for removal of directors). To that extent, the developments under U.S. federal law continue to trail behind the position in many parts of the Commonwealth such as India as regards shareholder democracy under corporate law. Even though proxy access has enhanced rights of shareholders in U.S. companies, those additional rights come along with stringent conditions (such as the requirement to own 3% over 3 continuous years).

1. SEBI and Auditors: It was reported a few days ago that the Bombay High Court has allowed SEBI to proceed with its enquiry against the auditors in connection with the Satyam scam. The judgment is now available on the Bombay High Court website.

2. Satyam Saga: With all the accused persons now having been released on bail, questions are being raised regarding the investigative and prosecutorial processes in India. On the other hand, the current state of affairs may be viewed as resulting from the undue complexity of the case. See Shyamal Majumdar in the Business Standard and this discussion on CNBC.

3. Foreign Investment in Pharma: The Department of Industrial Policy and Promotion has released a discussion paper titled “Compulsory Licensing” that seeks to ensure the “availability and affordability of pharmaceutical products” to Indian consumers. Noting the several recent instances of takeovers of Indian pharma companies by multinationals, it seeks to restrict the foreign investment regime in the pharma industry. One of the options proposed is as follows:

Presently, investment up to 100% in the pharmaceutical sector is on the automatic route. This could be shifted to the government route so that proposals for mergers and acquisitions in this important sector could be scrutinized by the FIPB. This could be a way of monitoring whether new technology is being brought in by a foreign company while taking over an Indian company.

4. CSR: Mandatory or Voluntary: We had earlier discussed the merits and demerits of imposing mandatory CSR requirements among companies. In this Wall Street Journal column, Aneel Karnani is agnostic about managers’ ability and their motivation to pursue CSR. He notes:

Very simply, in cases where private profits and public interests are aligned, the idea of corporate social responsibility is irrelevant: Companies that simply do everything they can to boost profits will end up increasing social welfare. In circumstances in which profits and social welfare are in direct opposition, an appeal to corporate social responsibility will almost always be ineffective, because executives are unlikely to act voluntarily in the public interest and against shareholder interests.
…

Executives are hired to maximize profits; that is their responsibility to their company's shareholders. Even if executives wanted to forgo some profit to benefit society, they could expect to lose their jobs if they tried—and be replaced by managers who would restore profit as the top priority. The movement for corporate social responsibility is in direct opposition, in such cases, to the movement for better corporate governance, which demands that managers fulfill their fiduciary duty to act in the shareholders' interest or be relieved of their responsibilities. That's one reason so many companies talk a great deal about social responsibility but do nothing—a tactic known as greenwashing.

Managers who sacrifice profit for the common good also are in effect imposing a tax on their shareholders and arbitrarily deciding how that money should be spent. In that sense they are usurping the role of elected government officials, if only on a small scale.

Karnani then discusses the role of various players such as the government/regulators and civil society as well as of self-regulation by companies, and then concludes:

In the end, social responsibility is a financial calculation for executives, just like any other aspect of their business. The only sure way to influence corporate decision making is to impose an unacceptable cost—regulatory mandates, taxes, punitive fines, public embarrassment—on socially unacceptable behavior.

Pleas for corporate social responsibility will be truly embraced only by those executives who are smart enough to see that doing the right thing is a byproduct of their pursuit of profit. And that renders such pleas pointless.

Such arguments, often adopted by opponents of the social responsibility movement, tend to take a pure economic approach. That approach does not call for voluntary CSR, let alone mandatory CSR. Such an extreme stance may not be beyond question, because both regulation and practice are beginning to recognize the existence of interests other than shareholders that corporate managers must cater to. In India, the Corporate Social Responsibility Voluntary Guidelines 2009 exhort companies to act in a socially responsible manner, while there are plenty of instances where reputable Indian companies have already embarked on serious CSR initiatives.