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Sunday, February 26, 2012

Want to do well in corporate finance? Know these Indian legal/tax nuances

Corporate finance is less about number crunching, and more about navigating multiple minefields of people, institutions, procedures and laws. More so in highly regulated environments like India. Though I've not worked in corporate finance before and defer to to the judgement of my seniors in this regard, the below is my perceptions from the varied theory I've studied before this.
  1. Although operating cash flow/FCF are modeled for purpose of financial calculations, know that Section 205 of the Indian Companies Act 1956 allows declaring of dividends only out of profits post depreciation charge. So do not assume that 100% FCF can be paid out as dividend.
  2. For listed securities, capital gains tax is nil for holding period over 1year(but only IF sold on exchange, and not if through buyback/open offers) but dividend distributions are taxed @18% or so. Hence, irrespective of shareholder preferences/liquidity desires, it may make sense to reward shareholders through long term capital appreciation rather than dividends/buy backs. 
  3. While listing carries associated obligations, note that it has tax advantages like being considered widely held company for tax purposes(hence freedom to make certain related party loans, get certain tax benefits etc) besides the tax free exit option for investors post listing. Hence, factor that in during the cost benefit analysis for listing.
  4. Some companies prefer to infuse equity as shareholder loans to benefit from the tax shield. To avoid this quasi equity structuring, some tax authorities have thin capitalization rules wherein in certain circumstances, excessive leverage will be treated as equity for tax purposes. Even India is considering such a proposal in the Direct Tax Code bill. So take that into consideration.
  5. Transfer pricing may be seen as an internal management tool to ensure the overall coordination and efficiency of different sub units, but tax authorities(be it excise, customs or direct tax) are taking an increasing interest in ensuring that the transfer prices between units are at arms length. Hence, be it intragroup treasury transactions for cash management; transactions between vertically integrated units etc, transfer pricing does attract the long arm of the law, and may pose problems if the policy is not easily defensible or negotiations cannot be proven.
  6. Depreciation for statutory financial reporting is NOT just a business decision, but is subject to certain minimum statutory limit under Schedule IV of the Companies Act. Adopting higher depreciation rates may result in lower profits, but also a lower tax base for the Minimum Alternative Tax(MAT/AMT) which is based on adjusted reported profits.
  7. Many economic laws/fiscal laws/competition laws have a default provision of vicarious liability which hold the company/its officers/other responsible person liable in case of violations. However, permitted defenses include good faith/ignorance(in case of non executive directors) or entrusting a competent/reliable person with the compliance duty-IF he was actually in a position to discharge it. Hence to save their skin under Section 205(5) of the Companies Act 1956 and other similar laws, directors are well advised to ensure that their top accountants/legal personnel are top notch and given appropriate organizational respect
  8. For investing surplus funds in shares of other companies, Section 372(5) of the Companies Act 1956 mandates a specific Board resolution for every transaction, with the unanimous consent of every director present and entitled to vote on the matter. And this power cannot be delegated.  There is no legal distinction between treasury investments and strategic investments for this purpose. There are other restrictions on investments/lending under both Section 292 and Section 372 as well. 
  9. In case long term leverage limits(measured as a multiple of paid up capital+free reserves, numerator excluding short term loans in course of business) exceeds 1x, there is shareholder consent needed, and for certain other borrowings/investments as well.
  10. In a public offering, a company is not permitted to raise more than 5x of its existing equity funds in domestic markets, as per SEBI ICDR Guidelines. To circumvent this, companies have gone for ADR/GDR offerings in the past, but now SEBI is clamping down on this by mandating disclosures of fund utilization, and also an earlier norm of simultaneous domestic IPO along with GDR/ADR. 
  11. Before capitalizing profits into reserves or into bonus shares, remember the impact on dividends or additional restrictions like appointing audit committee/secretarial compliance etc. For example, once profits are transferred to reserves, using them to declare dividends becomes cumbersome with limits of 20% etc, and once paid up capital(as opposed to shareholder funds) crosses Rs 5 crore, Section 292A mandates appointing an audit committee with independent directors and all. Also, Section 294 mandates Government approval for appointing a sole selling agent in every case that paid up capital>Rs 50 lakh.  So take note of these unintended consequences that may hamper confidentiality and financial flexibility, especially for unlisted companies.

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