Holding of promoter shares through investment companies: Dividend restrictions clog upstreaming and create tax inefficiency

Vinod Kothari & Payal Agarwal | corplaw@vinodkothari.com

Most of the promoter holdings in India, in companies large and small, are funneled through group investment companies. These companies, often with a complicated network of cross holdings, were created historically with multiple motives. While shadier motives such as re-routing of black money belong to some decades old practice, there have been multiple other reasons – from lowering of capital gains on holdings by not offering the market value of the listed operating entity, to camouflaging beneficial holdings or defying the definition of “promoter group”, etc etc. In many cases, the division of family holdings among sons or brothers is also done by dedicating an investment company to each such participant. In short, there have existed multiple reasons for networked holdings though layers of investment companies, with natural persons or groups of natural persons (HUFs, family trusts, etc) sitting somewhere at the end of the spectrum.

Over time, these practices have become increasingly unviable, and tough. For example, the possibility of avoiding capital gains tax by disregarding the value of listed stocks at operating company level and transferring the holding entity, which is obviously unlisted, was struck at by the introduction of Rule 11UA of the Income tax Act which requires an “adjusted NAV” computation w.e.f. 1st April, 2017 that takes into consideration the fair value of the investments too. The possibility of garbing the identity of natural persons was further challenged by the introduction of sec. 90 of the Companies Act read with the Significant Beneficial Owners Rules with effect from February, 2019, mandating the disclosure of indirect holdings of significant beneficial owners. Cross-holdings may still avoid classification as a “promoter group” entity, but over a period of time, the sheer burden of compliance by itself outweighs the benefits.

Compliance costs of an NBFC tag

Among the compliance costs of maintaining investment companies is the burden of being classified as an NBFC. While it may be counterintuitive to regard a pure investment company as a financial sector entity (as also discussed in our write-up, RBI Regulation of Investment Companies: Futile, counter-productive and counter-intuitive), the fact is that the RBI gives an NBFC classification based on the preponderance of financial income and financial assets in the books of the entity. If the entity has been formed majorly for holding group shares, it is highly likely that it will be classified as an NBFC. If it is an NBFC, it will either be a “base layer” entity, or a “middle layer” entity, based on the value of assets being less than Rs 1000 crores (base layer), or  otherwise (middle layer). The value of assets is aggregated across entities forming part of a group, just in case there are multiple NBFCs in the group.

Even the base layer entities are subject to multiple compliances under the Scale Based Regulations and if it is a middle layer entity, the same is also subject to enhanced corporate governance and compliance function.  

There is a class of companies called core investment companies or CICs- which was originally envisaged to be subject to light touch regulation. So much so that if the CIC does not hold public funds, it will be completely free from RBI regulation. However, post IL&FS, RBI’s supervision on CICs has increased, on the pretext that IL&FS parent entity was a CIC and there was leverage there.

Clog on pass-through of dividends: the unavoidable consequence of NBFC classification

The RBI, vide a notification dated 24th June, 2021 imposed dividend restrictions on NBFCs,specifying a ceiling on the maximum dividend payout ratios in a year, to 50% for all NBFCs / 60% in case of CICs. Further, if there has been a breach of RBI regulations, or there is an excess of net NPA ratio over 6%, the payout ratio drops to mere 10%.  This regulation was made applicable for the financial year 2021-22, and thereafter.

There has been a lot of discussion on soft touch regulation for Base layer entities, but this regulation, with some ununderstandable intent (see below), is applicable to all NBFCs, large or small. The only exception is such NBFCs that do not accept public funds (see below for the meaning of “public funds”, as public funds do not mean funds of deposits from the public) and do not have a customer interface.

Note that Para 6(a) of the RBI circular defines “Dividend Payout Ratio” to “mean the ratio between the amount of the dividend payable in a year and the net profit as per the audited financial statements for the financial year for which the dividend is proposed…”

Therefore, the ratio is determined in reference to the net profit for the financial year, and not the total distributable profits available with the company; as such, the spillover of dividend payouts to the free reserves available with the company is out of question.

As is the case with investment companies, the only assets they hold are in the form of investments in companies, and dividend payouts from such investments constitute the only income. The investment companies hold investments in the operating companies, and do not have any business operations – hence, it is an interesting question as to what they do with the conservation buffer created by pooled dividend income.  One may easily appreciate the added bottleneck if there is more than one NBFC, one over the other.

While there may not be a perceptible reason for the NBFC to keep bulging their balance sheets with force-retained earnings, the ultimate promoters, at the end of the chain of holdings, are left craving for distributions. They get only half of what their operating companies have earned.

Contrary to the credit companies, which may require to retain a part of their profits to safeguard against the systemic risk, the investment companies have no specific purpose for which the profits can be utilized and hence, no need to retain such profits. This issue  becomes even more enigmatic in case of CICs, that is, what does a CIC do with the retained profits, as CICs cannot be engaged in any business and indeed, cannot make any investment, other than the investment in group companies. Maximum part of these profits, therefore, must flow upstream to their shareholders, and the most common and tax-transparent mode for the same would be through payment of dividends, shifting the tax to the ultimate recipient. In fact, if investment vehicles do not distribute their dividend income, they become liable to tax on the part not distributed, as the tax deduction under sec. 80M is limited only to the distributed dividends. This tax on the investing vehicle amounts to an eventual tax burden on the shareholders, who have paid tax, through the company, on what is not even received by the shareholders.

However, being an NBFC, the maximum dividend payout can be upto 50% of the total net profits for a particular financial year and therefore, the remaining half of the profits are retained and carried forward to the next financial year. This continues over the upcoming financial years, since the dividend payout is calculated as a percentage of the net profits for each  financial year, disregarding the brought-forward profits.

Let us understand the same through an hypothetical example.

X Ltd declares dividend @500% per share on 10 lac shares of face value Rs. 100 each for FY 21-22. Z Ltd (an NBFC being in the nature of an investment company) holds 5 lac shares in X Ltd. Therefore, dividend income in the hands of Z Ltd = 5 lacs* Rs. 100* 500% = Rs. 25 crores. Let us assume that Z Ltd receives further dividend amounting to Rs. 75 crores from other operating investee companies. The total net profit of the NBFC Z Ltd amounts to Rs. 100 crores in this case.

Now, in compliance with the RBI dividend payout restrictions, Z Ltd will be able to distribute a maximum of (50% of Rs. 100 crores), i.e., Rs. 50 crores to its shareholders by way of dividend. Since the tax deduction on account of distributions is limited to the dividends distributed, the remaining amount of Rs. 50 crores is subjected to tax in the hands of Z Ltd. Assuming a tax rate of 25%, the post-tax retained earnings of X Ltd amount to Rs 37.50 crores. If this was to happen year on year, in 5 years,  X Ltd would have amassed a retained profit of Rs 185 crores, paying tax every year. If this amount is eventually distributed to the shareholders, say, at the time of liquidation, there will be a third incidence of tax on the shareholders. Note, the three layers of tax, on the same profits, are – tax on the Operating company, tax on the investing vehicle to the extent of dividends that could not be distributed, and tax at the time of liquidation on the release of accumulated profits.

Thus, there are two major issues – clogging of the flow of dividends, and tax inefficiency.

Was regulatory mandate for conservation of profits required for investment companies:

Restrictions on dividends are a common feature of financial regulations, applicable to banks and financial intermediaries. In the language of Basel III, this is called “capital conservation buffer”.  The underlying rationale is to create a buffer of retained profits, and strengthen the capital base of banks.  The intent is increased solvency.

While banks and financial intermediaries should not follow aggressive dividend policies, is this applicable to investment vehicles? The sole reason for investment vehicles is to act as conduits for holding group investments. If at all capital conservation was an objective, it would have been needed more at the operating company level.

It is notable that the RBI mandate to hold back 50% or 40% of profits, in case of NBFCs in general and CICs respectively, goes much beyond the provision of the statute, in sec. 45IC  of the RBI Act, requiring reserving of only 20% of the profits into a special reserve.

Exclusions for NBFCs with no public funds and customer interface

As discussed above, the dividend payout restrictions are not applicable to NBFCs that do not have (a) public funds, and (b) customer interface. The absence of a customer interface would be one of the inherent features of group investment companies and therefore, what remains to satisfy is the condition with respect to acceptance of public funds.

The nomenclature seems to be suggesting as if there is some real participation of “public” funds, but the definition includes even inter-corporate loans, which, very well can be from group companies too. The term is defined under clause (xxviii) of the SI-Master Directions as –

“Public funds includes funds raised either directly or indirectly through public deposits, inter-corporate deposits, bank finance and all funds received from outside sources such as funds raised by issue of Commercial Papers, debentures etc. but excludes funds raised by issue of instruments compulsorily convertible into equity shares within a period not exceeding 5 years from the date of issue.”

Now consider a case where an investment company does not have any bank finance or public money as liabilities, however, has availed finance from one or more of known companies as “inter corporate deposits”, the same will still be considered to have access to public funds, making the same ineligible to enjoy the exemption from dividend restriction.

Buyback option: a case of tax inefficiency and leverage restrictions

The restriction, imposed only a year ago, creates a significant clot on upstreaming of profits by investment companies. Therefore, one may want to explore the other modes through which accumulated profits may be distributed to the shareholders. One of the common means include by way of buyback of securities, however, that again is subject to various threshold and leverage restrictions in terms of section 68 of the Companies Act, 2013^[1]. Notably, there is a post-buyback leverage limit of 2:1, which is mostly not possible for NBFCs to comply with.

Buyback also results in duplication of tax, as the retained dividends would have already been tax by virtue of sec. 80M, and get taxed again under sec. 115QA.

Convert into LLP?

There are no dividend restrictions on LLPs and therefore, it seems an intuitive solution to convert NBFCs into LLP, thereby, bringing them outside the scope of the RBI regulation above. The law contains enabling provisions for various forms of legal entities, such as a partnership firm registered under the Indian Partnership Act, a private company or unlisted public company etc to get themselves converted into an LLP. This requires filing of an application with the ROC, obtaining its approval for the proposed conversion and registration of an entity as an LLP.

While the LLP Act itself does not contain a bar on the financial activities through an LLP structure, RBI has been raising concerns on an LLP carrying out non-banking financial activities, and therefore, the ROC granting registration to an LLP whose business evidently has investments as its main activity, would be a challenge.

Another hindrance to the proposed alternative are the stringent tax preconditions on companies converted into LLPs. While clause (xiiib) of Sec 47 of the Income Tax Act, 1961 exempts the transfer due to conversion of a company into LLP from capital gain implications, the same is subject to various pre-conditions. This includes maximum thresholds with respect to turnover and asset size not exceeding Rs. 60 lakhs and Rs. 5 crores respectively in any of the 3 FYs preceding the FY in which the conversion takes place. Therefore, NBFCs having asset size larger than Rs. 5 crores will not be able to take the benefit of the tax exemptions, and therefore, the conversion itself will not be tax neutral.

Upstreaming of profits to shareholders – quest for other feasible options

There does not seem to be any other viable option through which an investment company may be able to upstream its assets to its shareholders who are natural persons. In case of a simpler shareholding structure, operating companies may consider merging the holding investment company into the operating company, such that shareholders of the investment vehicle get shares of the operating company.  In case of listed entities, this will be a scheme of arrangement, requiring the approval by majority of minority vote as per a SEBI circular dated 10th March 2017, which itself may be a challenge.

Need for straightening shareholding structure

It is very important for Indian promoters to come out of the mindset of an opaque, staggered shareholding structure. Hazy ownership structures are no more seen as signs of good corporate culture^[2]. In any case, proliferated promoter entities and interlocking shareholdings create the issues discussed above. Promoters need to realize to keep it simple!

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^[1]https://vinodkothari.com/wp-content/uploads/2021/09/Buy-back-of-securites.pdf

^[2] See on complex ownership structures and the risks created by the same: Complex Ownership Structures: Addressing the Risks for Beneficial Ownership Transparency https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4040794

Our resources on Scale Based Regulations for NBFCs can be accessed here.

Watch our YouTube video on Restrictions on dividend distribution on NBFCs