Rights Entitlement: Sebi puts valuation prescription in place for subscription via renounced rights

May 30, 2020 10:17 AM

The basic pricing guidelines for fresh issue to non-resident is that it must follow the SEBI guidelines for listed entity and in case of unlisted it must be not less than the fair value determined by the valuation rules

rights entitlementThe aspects around the taxation of renouncement of rights were clearly spelt out in the Indian tax statue
  • By Vishwas Panjiar

The world at large is grappling with the ongoing Covid -19 pandemic. While it may not be possible to gauge the human toll and economic fallout at this point, it is amply clear that China is fast losing its stronghold as the global factory owing to the trust deficit that exists today between China and the rest of the world. In such a scenario, India is poised to be the next best destination for entities which are looking at decoupling from China, they would be well served to look towards India. India could pave the road through a regime of incentives to sweeten the deal for such entrants.

However, at the same time the country would want to safeguard its own interests as well. In pursuit of such interest protection, the DPIIT released the press note amending the FDI policy to make investment from countries which share land borders with India under Government approval route. Further, another change was brought about in the Foreign Exchange Management Act, 1999 (FEMA) and its regulations with respect to the pricing guidelines for the right issue, if renounced in favour of the non-resident.

Conceptually in a right offering, there is no change of control and a “no-sale theory” applies. The modality of the right issue is there to enable companies to raise funds from the existing shareholders without diluting their shareholding pattern. The rights issue is governed by the Articles of Association and must be approved by the board of directors (“Board”) in a Board meeting. With the issued rights, existing security-holders have the privilege to subscribe to a specified number of new securities from the issuer at a specified price within a subscription period. However, under the right issue an existing shareholder of the company also has the right to transfer his/her rights shares to anyone who may not be even a shareholder of the company (whether being resident or a non -resident). The company law or FEMA does not prescribe any valuation norms for rights issue and the board of a company is free to determine the same provided that the price of shares if offered to non-residents shall not be lower than the price offered to residents. This provided leeway to parties to circumvent the pricing guidelines. Amidst such a situation, the government needs to stop such misconduct and that is why the change was need of the hour.

The fundamental premise under FEMA with respect to pricing guidelines under Foreign Direct Investment revolve around the same orbit that non-residents cannot acquire the shares of an Indian company at a price lower than a floor price and cannot sell to a resident at a price higher than a ceiling. The basic pricing guidelines for fresh issue to non-resident is that it must follow the SEBI guidelines for listed entity and in case of unlisted it must be not less than the fair value determined by the valuation rules; the rights issue being an exception to this rule as rights were only expected to be an exercise of capitalisation by existing shareholders without dilution of any shareholder. In many instances it has been found that resident shareholders renounce their rights offer in favour of non-resident which allow them to make fresh investment at the price lower than what pricing guidelines prescribe. However, it has always been a debatable issue between the authorised dealer bank and the Indian companies. It was an immoral exploitation of these provisions and hence to end such practices of making unethical investment by non-residents and to avoidance of regulatory compliance, the changes were introduced.

Now pursuant to the change, even non-resident looking to acquire securities of an Indian company through a renounced right, can do so only in compliance with the existing pricing guidelines as are applicable on fresh (preferential) issue case.

On the other hand, the aspects around the taxation of renouncement of rights were clearly spelt out in the Indian tax statue: renunciation of right will entail the capital gain tax in the hands of the transferor and would have tax consequences for the transferee if such renunciation is done for nil/inadequate consideration. The cost paid by the transferee towards the rights would also go to enhance the cost of shares.

However, the imposition of tax on the shareholders in case of subscription (including through rights issues) below the prescribed intrinsic net asset value based Fair Market Value has been a vexed issue. The Central Board of Direct Taxes (CBDT) released a series of clarificatory circulars on the aspect which were immediately rolled back. At the same time, judicial pronouncements have provided some respite as they have acknowledged rights issue involves only re-distribution of existing net worth and there is no further wealth creation by means of an un-skewed rights issue.

The COVID 19 which is an unprecedented pandemic, will mark the timeline of the world into Pre-Covid and Post-Covid era. However, what is to be seen is if India can emerge as the Global hub in the new world order by bridging the trust deficit through a regime of changes to lure the global investors and at the same time protect its base from unjust exploitation.

(Vishwas Panjiar is Partner at Nangia Andersen LLP. The views expressed are the author’s own)

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