1.1 The Department of Industrial Policy and Promotion has decided to release Discussion Papers on various aspects related to FDI. In the series of these Discussion Papers, this is the fourth paper, on the ‘Issue of shares for considerations other than cash’. Views and suggestions are invited on the observations made in the enclosed discussion paper by October 31, 2010, particularly on Paragraph 4.0: ‘Issues for consideration’. It is requested that, to the extent possible, facts, figures and empirical evidence may be furnished, in the context of the specific observations/suggestions made.
1.2 The views expressed in this discussion paper should not be construed as the views of the Government. The Department hopes to generate informed discussion on the subject, so as to enable the Government to take an appropriate policy decision at an appropriate time.
DISCUSSION PAPER
SUBJECT: ISSUE OF SHARES FOR CONSIDERATIONS OTHER THAN CASH
2.0 INTRODUCTION:
2.1 CURRENT FOREIGN DIRECT INVESTMENT (FDI) POLICY
2.1.1 As per extant FDI policy, shares can be issued to a non-resident against receipt of funds through normal banking channels. If the funds are not received through normal banking channels, prior approval of the Government is required for such issue. The only exception to the above condition is the situation where shares are to be issued against External Commercial Borrowings (ECBs) and/or royalty payments (including lump-sum technical know-how fees). In such cases, shares can be issued under the automatic route without funds being received specifically for the purpose of issues of shares.
2.1.2 The above situation has been covered under paragraph 3.4.6 of ‘Circular 1 of 2010-Consolidated FDI Policy’, issued by the Department of Industrial Policy & Promotion, which mentions that:
Indian companies have been granted general permission for conversion of External Commercial Borrowings (ECB) (excluding those deemed as ECB) in convertible foreign currency into shares/preference shares, subject to the following conditions and reporting requirements:
(a) The activity of the company is covered under the Automatic Route for FDI or the company has obtained Government approval for foreign equity in the company;
(b) The foreign equity after conversion of ECB into equity is within the sectoral cap, if any;
(c) Pricing of shares is as per SEBI regulations or erstwhile CCI guidelines[1] in the case of listed or unlisted companies respectively;
(d) Compliance with the requirements prescribed under any other statute and regulation in force; and
(e) The conversion facility is available for ECBs availed under the Automatic or Government Route and is applicable to ECBs, due for payment or not, as well as secured/unsecured loans availed from non-resident collaborators.
(ii) General permission is also available for issue of shares/preference shares against lump sum technical know-how fee, royalty, under automatic route or SIA/FIPB route, subject to pricing guidelines of SEBI/CCI and compliance with applicable tax laws.
2.2 NEED FOR REVIEW:
2.2.1 In the recent past, the Foreign Investment Promotion Board (FIPB) , has been receiving a number of cases related to issue of shares against non-cash considerations, not covered by the above categories. These relate to issue of shares against expenditure which includes trade payables, pre-incorporation expenses, import of capital goods/machinery etc. Some of these cases are listed below.
2.2.2 In the proposal of M/s Kerns Aero Products Private Limited[2], shares against machinery imported were allowed subject to a) consent of the parent company b) supporting audited statement, and c) meeting tax liability, as per law. In the proposal of M/s Quatrro BPO Solutions Private Limited, the Board allowed issuance of sweat equity shares, subject to Section 79A of the Companies Act, notification dated December 4, 2003 issued by D/o Company Affairs (now M/o Corporate Affairs) for “Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2003” and Regulation 8 of FEMA 20. The Board allowed issuance of shares against transfer of technology in the proposal of M/s Actis Biologics Private Limited. Issuance of shares for payment of rent as a part of pre-incorporation expenses also received the approval of the Board in the proposal of M/s GIA India Laboratory Private Limited. FIPB allowed a payment of $ 214,000 of the purchase price, in the form of shares, in the proposal of M/s Mold-Tek Technologies Limited. Whilst considering M/s Mitsuba Sical India Limited, the Board allowed a request from the applicant to issue equity instead of redemption, as the applicant was unable to redeem the Redeemable Preference shares. However, in the proposal of M/s Marconi Telecommunications (I) Private Limited, FIPB held that issue of shares against trade payables could not be permitted, as it involved a transaction between a parent company and its Wholly Owned Subsidiary and was, anyway, subject to pricing guidelines and relevant norms of SEBI/RBI. Similarly, in the proposal of M/s MD Group Inc, Canada, issuance of shares was sought against Franchisee rights. The Board held that the extant policy permits issuance of shares for consideration other than cash in the case of lump sum fees, royalty and ECB. Issuance of shares against internal accruals, import of second hand machinery etc. has also been allowed on a case to case basis, but it cannot be allowed against an intangible asset like Franchisee rights. The Board also rejected the proposals of M/s Sun Technics Energy Systems Private Limited (shares against trade payables), M/s TCL India Holdings Private Limited (shares against dealing with completely assembled consumer electronics like colour TV, Washing Machines etc.), and M/s Maharishi Solar Technology (P) Limited (shares against the arbitration award).
2.2.3 The FIPB Review, 2009, observed that issues of shares, for other than cash considerations, require a much deeper look and with the increasing numbers of such cases, some objective norms would have to be evolved soon. The Review further observed that, though the Board has been, by and large, liberal in facilitating the industry, this route for FDI cannot be allowed to become a norm, rather than exception it is supposed to be, since the purpose of FDI gets defeated through this mode. Keeping in view the observations made in the Review and the fact that the number of such cases has been on the increase, it is necessary to evolve guidelines on this subject, consistent with overall FDI policy and the genuine requirements of business which have evolved over a period of time.
3.0 CATEGORIES OF CASES ARISING FOR ISSUE OF SHARES ON NON-CASH CONSIDERATIONS:
3.1 IMPORT OF CAPITAL GOODS/ MACHINERY/ EQUIPMENT (INCLUDING SECOND-HAND MACHINERY)
3.1.1 Any import by a resident in India has to be in accordance with the Export/ Import Policy issued by Government of India. Payment against the same also needs to be in compliance with the Foreign Exchange Management Act, 1999 (FEMA) provisions relating to imports. Further, import of such goods is fully documented by the customs authorities, who also make an assessment of the fair-value of such imports. Since adequate checks on the fair value of such imports are available, allotment of shares against the latter could be permitted, with prior Government approval.
3.2 SERVICES
3.2.1 As per the FEMA, services are classified as transactions under the current account. Payments against the same are, in general, freely permitted, without any limit, under the general permission route. The only exceptions are consultancy payments, wherein approval of the Reserve Bank of India (RBI) is required for payments beyond specified monetary limits.
3.2.2 If issue of shares against services was to be permitted, the challenge from the regulatory perspective could be possible over-invoicing, which may result in allotment of excess shares. This challenge arises from the fact that there is no extant mechanism that can verify the fair value of the services rendered, unlike in the case of import of goods. However, given the fact that, under the FEMA, payment made against supply of services are freely permitted, it could be argued that shares could be issued through Government route against services supplied, subject to the following stipulations:
(a) Compliance of FEMA regulations in relation to import of the services
(b) The service fee being in accordance with the service-fee agreement
(c) Furnishing of an auditor’s certificate that the services have actually been rendered by the concerned non-residents and that the payment is in accordance with the agreement
(d) Obtaining of separate RBI approval, in case the services qualify as consultancy services and the payment is beyond threshold limits.
3.2.3 On the other hand, it could be argued that transactions in the current account should be consciously excluded from the purview of Foreign Direct Investment, which should be confined to transactions in the capital account. Therefore, such cases should not be considered. It may be noted that the conversion of technology transfer/license/royalty fees etc., which is permitted at present, is also a current account transaction.
3.3 ISSUE OF SHARES AGAINST IMPORT OF RAW MATERIAL/ TRADE PAYABLES
3.3.1 In a number of cases, requests have been received by FIPB, for issue of shares against import of raw material. As in the case of import of capital goods/machinery etc., any import, made by a resident in India, has to be in accordance with the Export/ Import Policy issued by Government of India. The same also needs to be in compliance with FEMA provisions relating to imports. Further, import of such goods is also documented by the customs authorities, who also make an assessment of the fair-value of such imports. Since adequate checks on the fair value of such imports are available, similar to the approach of Para 3.1, allotment of shares against imports of raw material could be permitted, with prior Government approval. Conversely, as pointed out in Para 3.2.3, such transactions are current account transactions, and it can equally well be argued that they fall outside the ambit of FDI and permitting them may inhibit transactions in the capital account which is the bedrock of FDI.
3.3.2 A similar argument can be made against the issue of shares against trade payables. These are also current account transactions which fall outside the ambit of FDI which should confine itself to capital account transactions.
3.4 PRE-OPERATIVE/ PRE-INCORPORATION EXPENSES (INCLUDING PAYMENTS OF RENT ETC.)
3.4.1 A significant amount of expenditure is incurred between the conceptualization of the company, its incorporation and commencement of commercial production. This expenditure is often capitalized. If the overseas promoter has incurred these expenses, it is often proposed that shares be issued against such expenditure. Considering that payments made against pre-incorporation are allowed to be remitted under the general permission route, it could be considered whether issue of shares against such expenses should also be permitted, subject to the following stipulations:
(a) Submission of FIRC for remittance of funds by the overseas promoters
(b) Verification and certification of the pre-incorporation/pre operative expenses by the statutory auditor.
(c) Other accounting and regulatory norms on such expenditure being complied with.
3.4.2 A view also has to be taken whether such issue of shares should be on the automatic route or on the government route.
3.5 SHARE SWAPS
3.5.1 An increasing number of Indian companies are expanding their operations to cover overseas markets. While investing in overseas companies, such Indian companies are required to comply with the Overseas Direct Investment (ODI) regulations, framed under FEMA. Such companies often undertake share-swap transactions. Share-swap transactions are based on the mutual benefits accruing to both the Indian entity, as well as the foreign entity. They reduce the need for cash flows, while simultaneously meeting the end objectives of investment. As far as the Indian companies are concerned, such transactions help by reducing the requirement of funds for making overseas investments. It is argued that such transactions are synergetic and do not supplant conventional FDI but supplement it. This framework presumes swap of shares in an Indian company with shares in a foreign company. There could also be a situation of share swaps of two Indian companies held by either Indian residents or non-residents. Keeping in view the fact that FIPB has been receiving a number of cases related to share swaps, it is necessary to evolve standardized criteria for such cases.
3.5.2 It is felt that share-swaps could continue to be permitted on the Government route, subject to the following requirements:
(a) The overseas investment being in accordance with the Overseas Direct Investment guidelines and the inward investment compliant with FDI policy
(b) Valuation norms in relation to overseas investment, as well as in relation to inbound investment in the Indian companies, being complied with.
3.6 ISSUE OF SHARES AGAINST INTANGIBLE ASSETS (INCLUDING FRANCHISEE RIGHTS):
3.6.1 The need for issue of shares against intangibles has often been expressed. There are, however, no widely accepted criteria for valuation of intangibles. There is a possibility that such cases may lead to situations of issue of excess shares, in the absence of detailed criteria. Since such cases may pose significant challenges in terms of valuation, and would require evolution of detailed guidelines, the balance of convenience may lie in not considering such cases for the present.
3.7 ISSUE OF SHARES AGAINST ONE TIME EXTRAORDINARY PAYMENTS (INCLUDING ARBITRATION AWARDS):
3.7.1 An approach similar to that outlined in Para 3.6 may be preferable.
4.0 ISSUES FOR CONSIDERATION:
4.1 The following issues need consideration in this regard:
a) Does the issue of shares for considerations other than cash represent a valid and unaddressed business need? Should the Government amend the FDI policy to address this need? Will adoption of such an approach dilute the objective of FDI policy by decelerating the flow of physical capital into the country?
b) Should the Government consider categories not covered under extant policy for the issue of shares against considerations other than cash? Should such considerations be limited to the cases mentioned in Section 3 above or should other categories also be added? What regulatory safeguards should be prescribed for each such case/category?
c) Where allotment of shares for considerations other than cash is permitted, should Government be concerned with the valuation of shares? Should objective valuation of services/goods received as consideration for the issue of shares be the prime concern in such cases and should it form the basis for the amendments to the FDI policy What are the guidelines that should be adopted for listed/non listed companies in such cases ? Can concerns relating to valuation be effectively addressed elsewhere?
d) Should issue of shares to set off payment in the current account/intangibles/ onetime extraordinary payments be permitted? Should the broad principle be adopted that whenever money has been received in India or value has been received in India in lieu of money and valuation protocols are in place, issue of shares may be permitted, with prior Government approval?
e) Is there a possibility that the issue of shares for non cash considerations listed in Section 3 above could be misused especially in the context of money laundering? If so, what steps should be taken to address such a contingency?
[1] Now discounted cash-flow method
[2] FIPB Review, 2009
