Taxability of FIIs in India: Part 2

In an earlier post I had made an assertion that the law relating to taxability of FIIs remains largely unsettled. In this post I shall attempt to provide evidences/reasoning for the aforementioned assertion. It is to be noted that this post does not deal with the taxation of derivative transactions by FIIs. The same has been dealt by Ravichandra S. Hegde of J. Sagar Associates here. This post deals with the taxability of FIIs relating to the purchase and sale of equity shares.


As a starting point it is first essential to understand the business activity of a FII. Conventionally, a FII is used to denote an investor who is in the form of an entity engaged in investing money in a foreign financial market. Legally clause 2(f) of the SEBI (Foreign Institutional Investors) Regulation, 1995 defines FII to be “an institution established or incorporated outside India which proposes to make investment in India in securities.” The legal definition of a FII is functional in nature i.e. the definition signifies the principal business activity of a FII (investment in securities).

The fundamental dispute relating to taxability of FIIs in regard to purchase and sale of securities revolves around the question of characterization of Income. Simply put, the question is whether the income generated at the hands of the FII through transactions relating to purchase and sale of equity shares or other securities are in the nature of “business income” or “capital gains”. The revenue in various cases has contended that the income generated at the hands of a FII should be characterized as “capital gains”. Per contra, the FIIs have contended that the income generated through purchase and sale of equity shares is in the nature of “business income”. The rationale for this is not far to seek; if the FIIs are successful in their contention then it would necessarily mean that they can only be taxed in India if the department is able to show a permanent establishment of a given FII in India.

Prior to 2007 the AAR in various cases namely XYZ/ABC, Equity Fund, Fidelity Advisor Series, VIII, USA and Morgan Stanley had concluded that the income generated by the FIIs was in the nature of “business income”. It would not be entirely correct to apply Morgan Stanley to the present issue as the question in Morgan Stanley was regarding the taxability of derivative transaction by FIIs. However in 2007 the AAR in Fidelity Northstar Fund (hereinafter “fidelity”) held that the income generated by the FIIs through purchase and sale of equity shares was in the nature of “capital gains”. In fidelity the question before the AAR was whether securities which were the subject matter of purchases and sales by the applicant were held by the applicant by way of stock in trade so as o give rise to “business income” or investment in capital assets so as to yield “capital gains”. The AAR came to the latter view i.e. the profit arising to the applicant was in the nature of “capital gains” and not “business income”. The conclusion drawn by the AAR in fidelity was based on two grounds (i) SEBI regulations (ii) sec. 115AD of the IT Act, 1961.

(i) SEBI Regulations - The AAR relied on Lord Reid’s observation in J. Harrison Ltd. v. Griffiths ([1962] 40 TC 281 (HL)) which was quoted by the Supreme Court of India in CIT, Bombay v. Holck Larsen as a test to determine in a given situation whether one is a dealer in shares or investor in shares. Lord Reid observed as under:

“In the present case the question is not what (sic) [whether] the transaction of buying

and selling the shares lacks to be trading, but whether the later stages of the whole operation show that the first step- the purchase of the shares- was not taken as, or in the course of, a trading transaction.”

In order to ascertain the above highlighted first step the AAR in fidelity relied on the SEBI regulations pertaining to FIIs especially the 1995 regulation. After the perusal of the same the AAR was of the view that since the SEBI regulations do not allow FIIs to trade in securities in India, it would be legally untenable to conclude that the first step to purchase FIIs would be in contravention of all the SEBI regulations. The following part of the ruling is apposite”

“It cannot be lost sight of that regulation 15A of SEBI Regulations referred to above, permits dealing in offshore derivative instruments only and none other. The words transact business and the transaction of business in Clauses (a) & (c) respectively of Sub-regulation (3) of Regulation 15 postulate transaction of sale and purchase, they do not refer, as such, to the trading activity. It needs no emphasis to point out that transact business is different and distinguishable from carrying on business. Transact business is a general term which refers to carrying on all types of activities whereas business transaction refers to only commercial trading activities. Thus it follows that the aforementioned words and expressions, in the context in which they are used, do not deal with the subject of trading in securities much less do they permit activities of trading in securities by a FII. In no way, the framework of the provisions of the Guidelines, Acts and Regulations, discussed above, can be so interpreted as to lead to the inference that trading in Indian securities is open to the FIIs.”

 

“In our view it will be preposterous to impute an intention to FIIs, who responded to the offer of investment in securities in response to the guidelines, got themselves registered under the SEBI Regulations and undertook to abide by those regulations that they would, in the very first step itself, have intended to violate all the legislative requirements which provided them the opportunity to enter the capital market in India. That the FIIs could not have intended to trade in the first step of purchase of shares, is also strengthened by the fact that in the income tax returns filed by many of them, in consonance with the above legislative provisions, they have shown their income as capital gains”

In 2010 the AAR in Royal Bank of Canada (hereinafter “royal bank”) implied that fidelity may be incorrect inasmuch as holding that the FIIs are prohibited from trading in shares and securities as per the SEBI and FEMA regulations (see para. 15 and 15.1 of the ruling). However, the Royal Bank case may not be an authority on this point as the question in royal bank was with regard to derivative transaction by FIIs similar to the one in Morgan Stanley.



(ii) Sec. 115AD – the AAR in fidelity opined that s. 115AD is a self contained and special provision for charging to tax the income of FIIs from securities and since s. 115AD does not contemplate FIIs deriving income from “business income” there would be no question of classifying the income generated by FIIs through transfer or sale of securities as “business income”. This view has not been subscribed to by the AAR in Royal Bank. The following part of the Royal Bank case is relevant



“It must be noted that the expression “in respect of” is of wide import, more or less synonymous with the expression ‘ in connection with’ or ‘ in relation to’. There is no particular reason why the income on account of trading in securities is excluded from the purview of section 115AD.......................”


“There is no warrant to place a restricted construction on clause(a) of sub-section(1) of section 115AD that only the income on account of holding the securities (like fruits from a tree) is covered by clause(a). If such restricted scope was intended to be given to clause(a), there should have been a more explicit language to that effect especially to counteract the effect of the wide expression ‘ in respect of’. The argument of the learned counsel for the Revenue that clause(a) of sub-section(2) which excludes the deduction admissible to business income a clear pointer that income on account of trading in all types of securities is not contemplated by section 115AD does not appeal to us.”

Concluding the two latest judgements i.e. fidelity and royal bank showcase contrasting opinions on the taxability of FIIs in relation to purchase and sale of equity shares. Though one may argue that royal bank was only concerned with derivative transaction; it cannot be undermined that both royal bank and fidelity provide contrasting interpretations of S. 115AD of the IT act (a key aspect as far as the taxability of FII in relation to purchase and sale of equity shares is concerned). Apart from this fidelity does not follow the ruling in XYZ/ABC Equity Fund  and Fidelity Advisor Series on the rationale that in both the cases the AAR had not applied the test laid down by the Supreme Court in CIT, Bombay and subsequently not taken the SEBI regulations into consideration. At present the law on this point is far from settled as their are contrasting rulings delivered by the same authority. Ultimately, the taxability of FIIs would be a mixed question of law and fact. Nevertheless some uniform and well reasoned answers needs to be found for the questions mentioned as under:

(1) Is it correct to import SEBI regulations in classifying the income generated by FIIs in India?

(2) If (1) is in the affirmative, then does SEBI regulations allow FIIs to trade in Securities?

(3) What is the correct scope and application of S. 115AD of the IT Act, 1961?

CISG and India

The convention on International Sale of Goods (CISG) is arguably one of the most successful international conventions in terms of the number of countries that have ratified it. Most of the leading trading countries, common law and civil law alike have adopted the convention with the exceptions of UK and India.

One would argue that with India extensively  engaged in International Commercial transaction, it would be apt for it to sign the CISG. However, some leading commentators and practitioners have outlined the difficulties for India in signing the CISG. In this regard two articles would be relevant. One by Monica Kilian, "CISG and The Problems with Common Law Jurisdictions" and the other one by Shishir Dholakia, "Ratifying the CISG-India's Options".

With the proposed changes being made in the Indian Arbitratin law discussed by Mihir here India would also boost its legal framework relating to International Commercial Transactions by ratifying the CISG. I would make an attempt to illucidate on these issues in some future posts.

Constitutional Validity of the NCLT: A Brief Background

The business standard and livemint both report that the Supreme Court has upheld the constitutional validity of the National Company Law Tribunal (‘NCLT’). The judgement of the Supreme Court is not yet available. In the meantime though, it is worth recapitulating the contours of this dispute.

The legislature through the Companies (second amendment) Act, 2002 had made provisions for setting up the NCLT and the National Company Law Appellate Tribunal. The NCLT was conferred the power to hear all the matters relating to amalgamation, reconstruction of companies, winding up, reduction of share capital and other related matters. Previously these powers were conferred on the High Courts. Though the amendment to set up the NCLT was made in 2002, it has not been able to see the light of day. This reason being a pending appeal before the Supreme Court of India. The appeal was preferred by the Union of India against the judgement of the Madras High Court in R. Gandhi v. Union of India. In Gandhi the Madras High Court had held that setting up of the NCLT was Unconstitutional.

The fundamental challenge to the constitutionality of the NCLT revolves around the point, whether a complete transfer of matters from the jurisdiction of the High Court to a quasi judicial body would in principle be against the indispensable constitutional principles of independence of the judiciary and separation of powers. In the Gandhi case the madras high court had answered the question in the affirmative. Essentially two simple question needs determination insofar as the constitutionality of the NCLT is concerned:

1. Whether in principle setting up of the NCLT and excluding the jurisdiction of the High Court is constitutional?

2. Whether in its present form, the provisions relating to the appointment, tenure, qualification etc. of members of the NCLT is such that it keeps the basic constitutional principles of independence of judiciary and separation of power intact?

The first question seems to be squarely covered by the Supreme Court judgement in the L. Chandrakumar case. In the Chandrakumar case a seven judge bench of the Supreme Court had held that the power of judicial review of the high court under art. 226 cannot be excluded by the legislature through a constitutional amendment; as such a power conferred on the high court constitutes the basic structure of the constitution. In essence, the Supreme Court stated that a specialized tribunal can be set up as long as that tribunal performs a supplementary role as opposed to a substitutive role to the High courts. Simply put, if the power of judicial review is kept intact then there is no constitutional issue in setting up a specialized tribunal. On this point it seems the setting of the NCLT is clear of any constitutional hurdles or the ratio of Chandrakumar. The following paragraph from the Gandhi judgement clarifies the point:

“Parliament is thus competent to enact law with regard to the incorporation, regulation and winding up of Companies. The power of regulation would include the power to set up an adjudicatory machinery for resolving the matters litigated upon, and which concern the working of the companies in all their facets. The Law Commission, as noted by the Supreme Court in the case of Chandra Kumar, had also recommended the creation of specialist Tribunals in places of generalist Courts. Creation of National Company Law Tribunals and Appellate Tribunals and vesting in those Tribunals the powers exercised by the High Court with regard to company matters cannot be said to be unconstitutional.”- Para 57

Needless to say, the second point is the critical issue as far the constitutional validity of the NCLT is concerned. In the Gandhi case the Madras High Court after the perusal of several provisions relating to the appointment, tenure, qualification etc of the members of the NCLT. had come to this conclusion:

“In the light of foregoing discussions it is declared that until the provisions in parts 1B and 1C of the Companies Act introduced by the Companies (Amendment) Act, 2002, which have been found to be defective in as much as they are in breach of the basic constitutional scheme of separation of powers and independence of the judicial function, are duly amended, by removing the defects that have been pointed out, it would be unconstitutional to constitute a Tribunal and Appellate Tribunal to exercise the jurisdiction now excercised by the High courts or the Company Law Board.” Para 123

In light of this background what one can hope from the Supreme Court Judgement is guidelines relating to the appointment, tenure etc. of the members of the NCLT so as to make it constitutionally viable.

Narco-analysis, Brain-Mapping, Polygraph Test Unconstitutional

In a recent landmark judgement Selvi v. State of Karnataka, the supreme court had held that compulsory narco-analysis, brain-mapping and polygraph tests are in violation of article 20(3) and article 21 of the constitution.

Prof Mrinal Satish in his article analyzes the judgement in some detail. The article is here. Prof. Satish is a visiting professor at NLSIU, Bangalore and had earlier completed his LLM from Yale University.

Right of Nominee of Shares

In a previous post on this blog Avantika had discussed a recent ruling of the Bombay High Court pertaining to the right of nominee of shares over legal heirs. The same judgement has been discussed by Somasekhar Sundaresan, Partner at J Sagar&Associates in a Business Standard article dated 10th May, 2010. The article is here.

Taxability of FIIs in India: Part 1

The economic times has stated here that the Bombay High Court has ruled that FII earnings aren’t taxable in India. This view/analysis is erroneous because the Bombay High Court did not have an occasion to consider the question of the taxability of FII earnings in India. In the concerned case, Prudential Assurance Company Ltd. v. DIT the assesse had obtained a ruling from the AAR in its favour i.e. the AAR held that the earnings of the petitioner a FII was not taxable in India. Subsequently there was a ruling by the AAR in Fidelity Northstar fund which stated that the earnings of a FII from selling of shares are taxable in India. Based on the Fidelity ruling the DIT proceeded to tax the petitioner on the ground that there was a change in law. It is in light of this background that the assesse invoked the jurisdiction of the Bombay high court under section 263 of the IT Act. The question before the court was whether the DIT was correct to hold that the AAR ruling obtained by the petitioner was not binding on the revenue as a consequence of a change in law brought about by the fidelity ruling. It is in this regard the Bombay high court held that the ruling obtained by the petitioner was binding on the revenue. The following paragraph of the Bombay high court judgement is apposite:

“Evidently, the Commissioner has ignored the clear mandate of the statutory provision that a ruling would apply and be binding only on the Applicant and the Revenue in relation to the transaction for which it is sought. The ruling in Fidelity cannot possibly, as a matter of the plain intendment and meaning of Section 245S displace the binding character of the advance ruling rendered between the Petitioner and the Revenue.”

It is clear that the question of taxability of FII’s in India had never arisen before the Bombay High Court. The following observation of the court manifests this point:

“We would clarify, in conclusion, that we have had no occasion having regard to the nature of the jurisdiction that was invoked by the Commissioner to inquire into the correctness of the ruling of the AAR in the case of the petitioner and we leave it open to the Revenue to take recourse to such remedies in law in respect of the ruling of the AAR, if so advised.”

Concluding the Bombay High Court does not in any way settle the law on the taxability of FII’s in India. In my subsequent posts I will attempt to analyse the present law (which remains largely unsettled) on the taxability of FII’s in India in light of the existing precedents.

RNRL v. RIL

The full text of the Supreme Court judgement in RNRL v. RIL is available here. I shall analyse some facets of the judgement in subsequent posts.

Computation of the PE "Duration Test" under the India- Mauritius Tax Treaty

In a recent decision in ADIT (Int’l taxation) v. Valentine Maritime (Mauritius) Ltd., ITAT Mumbai has thrown some light on the computation of PE “Duration test” under art. 5(2)(i) of the India-Mauritius tax treaty. In the present dispute the assesse, a Mauritian entity engaged in the business of marine and general engineering and construction had executed three contracts in the India. The duration of these contracts individually were less than “nine months” however if the contracts were taken cumulatively then the entire period would exceed the “nine month” threshold limit under Art. 5(2)(i) of the Indo- Mauritian Tax treaty.
The issue before the tribunal was whether the duration of the projects in the present dispute shall be taken cumulatively or separately. The contention of the revenue was that unlike the India UK DTAA, the India- Mauritius treaty does not specifically incorporate the provision that for the purposes of applying the “Duration test” each project site is to be considered separately. Thus, the revenue contended that under Art. 5(2)(i) of the India Mauritius tax treaty the duration of project sites are to be construed cumulatively and if such a period exceeds nine months then the assesse shall be deemed to be having a permanent establishment in India (PE). As a starting point it is first important to reproduce Art. 5(2)(i) of the India- Mauritius treaty:

Article 5 - Permanent Establishment

1. For the purpose of this Convention, the term 'permanent establishment' means a fixed place of business through which the business of enterprise is wholly or partly carried on.

2. The term 'permanent establishment' shall include:

(i) a building site or construction or assembly project or supervisory activities in connection therewith, where such site, project or supervisory activity continues for a period of more than nine months.

On a plain reading of the above quoted provision it is clear that Art 5(1) lays down a general test of “permanence” for establishing an entity as a PE. On the other hand Art 5(2)(i) lays down a specific “duration test” for establishing a building site, construction or assembly project as a PE. In the present dispute the tribunal has laid down the scope and application of this “duration test”. The tribunal while rejecting the contention of the revenue stated that under art. 5(2)(i) the “duration test” is to be applied to individual projects separately and not cumulatively. The apposite part of the judgment is reproduced as under:

“In other words, each of the building site, construction project, assembly project or supervisory activities in connection therewith is to be viewed on standalone basis. Broadly, the underlying rationale of this approach is that various business activities performed by one and same enterprise, none of which constitutes a PE, cannot lead to a PE, if combined. In our humble understanding, the very conceptual foundation of this approach rests on the assumption that various business activities of the enterprise in different locations are not so inextricably interconnected that these are essentially required to be viewed as a coherent whole. The locations are thus separate places of business, and activities at different locations are, therefore, required to be viewed on standalone basis. In a typical building site, assembly or installation project, or supervisory activities in connection therewith, each of site or project is an independent unit, and the approach to these types of PEs recognize this normal business practice.”- Para. 9

The court also rejected the argument of the revenue that since the India- Mauritius treaty does not specifically exclude (like the India UK treaty) the application of the “duration test” to all projects taken cumulatively, it would necessarily mean that the duration of the projects should be tabulated together inorder to ascertain whether an entity qualifies to be a PE. The court stated as under:

“The provisions set out in protocol to the tax treaties need not necessarily be substantive provisions, and these can also be, and often are, merely clarificatory provisions 'ex abundanti cautela'. What is stated in the said protocol to Indo UK tax treaty is nothing other than what is anyway within the scope of the construction PE clause, as analyzed in the OECD Model Convention Commentary (adopted by the UN Model Convention Commentary as well) - an analysis, with which we are in considered agreement. The protocol provision is merely clarificatory in nature and is apparently set out as a measure of abundant caution. The absence of similar protocol clarification in other tax treaties entered into by India would not, therefore, warrant a different interpretation of the treaty provision.”- Para. 10

The tribunal further lays down two grounds under which the aggregation principle (duration of all the project sites taken together in computing the threshold duration) can be applied. Firstly, where the contracts have been artificially divided inorder to reap the benefits of the tax treaty. The onus of showing such an artificial division would be on the revenue. Secondly, when there is an inextricable interconnection and interdependence between the project sites so that they form a coherent whole. The test of “interconnection and interdependence” is an expanded version of the test laid down in the OECD commentary i.e. “coherent whole- geographically and commercially” test.

Right of Nominee versus Right of Heir: Transmission of ownership of shares through nomination

The Bombay High Court in the case of Harsha Nitin Kokate v.The Saraswat Co Op. Bank Ltd. & Ors put to rest the debate involving inheritance of shares by heirs and the legal right over the shares through nomination in consonce with section 109A of the Companies Act,1956. The application of a widow was therefore dismissed by the Court who held that the legal right and title of the shares after the death of the shareholder( the applicants husband in this case) would be with the nominee of the shareholder and not with the heir of the shareholder.

In the instant case the applicant, the widow of the shareholder filed a suit for an interest in the shares which she claimed to have sold. The court affirmed that the foremost question in the instant case was whether the applicant had any legal right or title over such shares.
Her husband proir to his death in 2007 had made his nephew the nominee to the shares in the prescribed form of the Depository Participant. The effect of S.109A therefore results in vesting absolute rights of the nominee over the shares, notwithstanding other laws being in force. Consequent to the dematting of shares in 1996, the amendment in 1998 resulted in the inclusion of Sec.109A to govern nomination of shares. Shares being intangible movable property which can be bequeathed through word of mouth or over the internet result in transfer of rights over these with the change in holders. Therefore it became important for the inclusion of S.109A governing nomination. Furthermore in accordance with S.9.11 of the depositories Act,1996, which relates to the Transmission of Securities in the case of nomination, the shares automatically get transferred to the nominee so appointed on the death of the Nominating person.Consequently such nomination comes into effect notwithstanding anything contained in a testimentory disposition or any other nomination under any other law relating to securities at the time being in force.
The counsel for the plaintiff argued that the nominee would serve only as a trustee for the shares and thus the plaintiff being the widow of the deceased is entitiled to the right over these shares. However the Court went on to further disagree and concluded that it is the property of the shares which has been transferred along with exclusive rights of ownership. The Court further lay stress on the term 'vest' used in the statutory provision of the Companies Act as well as S.9.11 of the Depositories Act,1996 and concluded that the term has to be interpreted in the light of S. 109A to mean that the right and title over the property of the shares along with the absolute ownership belongs with the nominee. The use of the term 'vest' in other legislations as used in S.39 of the Insurance Act denotes the right to receive payment of the policy without conferring absolute ownership in the nominee.Thus the court acknowledged the right of the nominee over the property of the shares in consonance with s,109A of the Companies Act,1956 and dismissed any right of the plaintiff over such shares of the deceased husband.

The judgement has conclusively detremined the application and ambit of the S.109A of the aforementioned Act so far as a nomination has been made with regard to transmission of shares. Further it has dismissed any presumption which would prevent the nominee from absolute ownership of the shares.

Laws Relating to "Sweat Equity Shares" in India

Though it is premature to comment on the root cause of the Indian Premier League (IPL) fiasco, it would not be incorrect to assert that the term “sweat equity” has certainly been at the forefront of the initial mess. So what is “sweat equity” and what are the legal regulations surrounding it. This post attempts to answer some of these questions.

Generally at the time of incorporation, IPO or other similar instances the company issues equity shares for a certain price i.e. monetary consideration (this is subject to the company being limited by shares). The cash that is collected through such a mechanism forms the capital of the company. Contrastingly, sweat equity is issued by the company to its directors /employees at a discount or for consideration other than cash i.e. to say that the consideration is generally kind and not cash (S.79A, Explanation II). It requires no Einstein to figure out that the basic idea behind the issuance of sweat equity shares is to incentivise the employees by providing them with some direct stake in the company. Sweat equity shares are quite akin to Employee Stock Option Plans (ESOPs), but there are some differences between the two. For e.g. sweat equity shares is grant of shares at discount or without any monetary consideration whereas ESOPs are grant of an option to purchase shares at a predetermined price (Compare section 2(15A) and section 79A of the companies Act, 1956).

S. 79A of the companies act, 1956 is the primary legal provision governing the issuance of sweat equity shares. S. 79A(1) confers a right on the company to issue sweat equity shares if certain conditions as laid down in the same provision are fulfilled. The conditions are as follows:

1. Issuance of such shares is authorized by a special resolution by the company

2. The resolution specifies the number of shares, current market price, consideration (if any) and the class of employees to whom such shares are issued

3. One year has elapsed after the date of commencement of business.

4. For listed companies, other regulations of SEBI are complied with

5. For unlisted companies, the guidelines as may be prescribed by the Central Government( Generally would be the Ministry of Corporate affairs (MCA))

S. 79A seems to lay down broad guidelines for the issuance of sweat equity shares, but the provision by no means is exhaustive. I say this because clause (4) and clause (5) [please note that clause 5 is actually a proviso under s. 79A(1), but for convenience I have used it as a distinct clause since the meaning does not change at all] grants power to SEBI and MCA to issue any further regulations or guidelines.

It is in this regard the SEBI came out with a regulation in 2002 titled SEBI (Issue of Sweat Equity) Regulations, 2002. Needless to say the regulation only applies to listed companies. It would not be feasible to reconcile all the facets of the regulation here, apart from just briefly touching upon the clauses dealing with the aspect of pricing of shares and valuation of intellectual property. Clause 7 of the Regulation specifies that the minimum price of sweat equity share should be (a) the average of the weakly high and low of the related equity shares during the last six months preceding the “relevant date” or (b) the average of the weakly high and low of the related equity shares during the two weeks preceding the “relevant date”; whichever is higher. “Relevant date” is defined as the date which is thirty days prior to the date on which the general meeting is convened as per s. 79A(1) of the companies act, 1956. As for the valuation of intellectual property or know how, clause 8 of the Regulation specifies that a merchant banker shall make such valuations after consultation with industry specific experts (it is to be noted that valuations of intellectual property and know how are important as sometimes the employees are given sweat equity shares in return for any know how that the employee may provide to the company).

Similarly for unlisted companies in 2003 the MCA came out with rules titled Unlisted Companies (Issue of Sweat Equity) Rules, 2003. As per the Rules the minimum price of sweat equity shares and the valuation of intellectual property are to be determined by an independent valuer. The MCA rules also imposes a restriction on the company not to issue sweat equity shares for more than 15% of the total paid up share capital in a year or shares of the value of 5 crores; whichever is higher.

The law with regard to sweat equity shares revolves mostly around the conditions for issuance of such shares. However one may be curious to know what happens after the employee is allotted the sweat equity shares. In this regard the law only prescribes that the sweat equity shares shall be locked in for a period of three years after the date of allotment i.e. to say that the employee or the director cannot dispense of these shares within a period of three years (See clause 12 and clause 10 of the 2002 SEBI regulations and 2003 MCA Rules).

Interestingly in India which is based on a “promoter controlled model” i.e. most of the shares of a given company are owned by a family group, the issuance of sweat equity shares could be fraught with difficulties. An illustration would drive home the point. Consider a Pvt. Ltd. company X having a shareholding pattern of 80:20 held by family Y and another company Z respectively. Now, if Y inducts a family member as an employee then it can easily offer sweat equity shares to the employee at a discount or any other consideration except cash and further increase the shareholding of the family Y without actually paying the actual price of the shares. The reason why family Y can easily do that is because in case of a special resolution family Y can easily have its way considering its 80% shareholding. The law relating to issuance of sweat equity shares should be based on the basis of the corporate structure prevalent in India and not merely a legal transplant i.e. borrowed from some other countries like the UK or the US where the corporate structure is quite different(shareholding is much more dispersed in companies).

In subsequent posts I shall discuss the taxability of sweat equity shares.