By Abhirup Ghosh & Smriti Wadehra (firstname.lastname@example.org) (email@example.com)
Usage of common brand is a common practice that we notice among companies which are part of large conglomerates. Often the brands created by one single entity of a group are used by its related parties, however, these transactions are often structured with differential pricing terms i.e. either these transactions are not charged at all or are overpriced.
Therefore, in order to increase transparency and regulate to these transactions, a Committee on Corporate Governance constituted by the SEBI under the chairmanship of Uday Kotak has proposed disclosure requirements this kind of transactions.
In this article we will primarily discuss the proposal made by the Committee threadbare. Additionally, we will also discuss the impact of indirect taxes on such transactions.
Brand usage and Royalty as per Listing Regulations
The erstwhile provisions of SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘Listing Regulations’) did not provide anything for royalties or brand usage paid to related parties. However, a SEBI constituted committee under the chairmanship of Mr. Uday Kotak on 2nd June, 2018 provided a report on corporate governance with certain recommendations for implementation. One of the recommendations was to insert provision pertaining to payments made for brand and royalty to related parties.
As noted above, often the transactions involving usage of brands and royalty payments are structured with differential pricing terms. The Committee has noted the importance of brand usage and it also brought the importance of disclosing the terms relating to payments against these brand usages, considering the role it plays in driving the sales or margin.
In this regard, the Committee suggested that where royalty payout levels are high and exceed 5% of consolidated revenues, the terms of conditions of such royalty must require shareholder approval and should be regarded as material related party transactions. The Listing Regulations currently prescribe a materiality limit at ten percent of annual consolidated turnover of the Company. Therefore, the Committee prescribed a stricter limit for brand usage and royalty i.e. 5% instead of the existing limit which is 5% of consolidated turnover.
SEBI applied its discretion to make the provision stricter and subsequently, made the following insertion in the Listing Regulations:
“23(IA) Notwithstanding the above, with effect from July 01, 2019 a transaction involving payments made to a related party with respect to brand usage or royalty shall be considered material if the transaction(s) to be entered into individually or taken together with previous transactions during a financial year, exceed two percent of the annual consolidated turnover of the listed entity as per the last audited financial statements of the listed entity.”
On reading the aforesaid provisions and basis our discussion, we understand that from 1st July, 2019 transactions involving payments made to a related party with respect to brand usage or royalty shall be considered material if the transaction(s) to be entered into individually or taken together with previous transactions during a financial year, exceed two percent of the annual consolidated turnover of the listed entity as per the last audited financial statements of the listed entity.
It is pertinent to note that all transactions entered with related party for brand usage and royalty shall always be regarded as related party transactions. However, the trigger point of qualifying such transactions as material related party transaction is when the quantum of payout exceeds two percent of the annual consolidated turnover of the listed entity.
Whether provisions applicable for payments received for Brand usage and royalties?
While the provision talks about royalty payments to be treated as material related party transactions, but what remains to be answered is whether royalty receipts would also be considered as material related party transactions.
Please note that provisions of the amendment clearly provides:
involving payments made to a related party with respect to brand usage or royalty
Therefore, the applicability of the provisions appears to apply only in case of payments made to related party for brand usage and royalty. However, this does not seems to be the intent of law. Every transaction has two parties, in the present case, the two parties are the receiver and the giver. It does not seem rationally correct to include one side of the coin within the ambit of the law while keeping the other side out. Therefore, ideally receipt of royalty must also be treated as material related party transaction for the purpose of Regulation 23(IA) of the Listing Regulations.
Meaning of “Royalty”
Despite insertion of a new regulation dealing with royalty payments, the Listing Regulations do not define the term royalty. The meaning of the term, however, can be borrowed from the Income Tax Act, 1961 which provides for an elaborate definition. Section 9(1) of Income Tax Act, 1961 reads as:
“royalty” means consideration (including any lump sum consideration but excluding any consideration which would be the income of the recipient chargeable under the head “Capital gains”) for—
(i) the transfer of all or any rights (including the granting of a licence) in respect of a patent, invention, model, design, secret formula or process or trade mark or similar property ;
(ii) the imparting of any information concerning the working of, or the use of, a patent, invention, model, design, secret formula or process or trade mark or similar property;
(iii) the use of any patent, invention, model, design, secret formula or process or trade mark or similar property ;
(iv) the imparting of any information concerning technical, industrial, commercial or scientific knowledge, experience or skill ;
(iva) the use or right to use any industrial, commercial or scientific equipment but not including the amounts referred to in section 44BB;
(v) the transfer of all or any rights (including the granting of a licence) in respect of any copyright, literary, artistic or scientific work including films or video tapes for use in connection with television or tapes for use in connection with radio broadcasting, but not including consideration for the sale, distribution or exhibition of cinematographic films ; or
(vi) the rendering of any services in connection with the activities referred to in sub-clauses (i) to (iv), (iva) and (v).
Explanation 5.—For the removal of doubts, it is hereby clarified that the royalty includes and has always included consideration in respect of any right, property or information, whether or not—
(a) the possession or control of such right, property or information is with the payer;
(b) such right, property or information is used directly by the payer;
(c) the location of such right, property or information is in India.
Therefore, as per the aforesaid provisions, consideration for transfer of rights (including granting of a licence) in respect of a trade mark or similar property or for use of a trademark or transfer of rights (including granting of a licence) in respect of any copyright, literary, artistic or scientific work, falls under the definition of ‘Royalty’ under the IT Act. Accordingly, any transaction with the related party for the aforesaid activities shall be regarded as related party transaction for usage of royalty.
Similarly, the term ‘brand usage’ has not been defined under the Listing Regulations. In this regard, reference may be drawn from section 2(zb) of the Trade Marks Act, 1999 which identifies brand as a trade mark or label which is an intellectual property right. Accordingly, any transactions of brand usage by related party shall be regarded as related party transaction.
Impact of GST laws on brand usage transactions
After the introduction of regulation 23(1A) it is very clear the companies will have to structure the brand usage transactions properly and pricing policy of the same shall have be relooked at, however, one must not forget the potential impact GST laws can have on these transactions.
Rule 28 of Central Goods and Services Tax (CGST) Rules, 2017 states that all transactions between related persons must be carried out on arm’s length basis and should be priced at open market value. This applies to all transactions between related parties, needless to say even brand usage transactions will also be covered under this.
Therefore, if going forward the parties decide to execute the transactions without any consideration, in order to escape the provisions of regulation 23(1A), the same shall be subjected to rule 28 which provides for computation of notional value and GST will have to paid on the notional value.
However, rule 28 provides for an exception which states that if an invoice is raised by the supplier with GST on it and the recipient of the supply is eligible to claim input tax credit on the value of services, then the value quoted in the invoice shall be deemed to be the open market value of the goods or services.
Therefore, to ensure that notional value taxation does not apply, the parties must refrain from structuring transactions with nil consideration. However, if the same involves royalty payments of more than 2% of the consolidated turnover, it will have to comply with regulation 23(1A).Therefore, the companies must be mindful of both these provisions while structuring this kind of transactions henceforth.
While the Committee does not intend to stop brand usages in the country, all it wants to establish is a fair and transparent practise of charging royalty payments for the usage of brands. Accordingly, listed companies have to be more careful before charging for brand usages, as the same have come under the radar of materiality and have to be reported. Further, considering the tax implications, the structuring of such kind of transaction shall be important. To summarise, the Listing Regulations have introduced a new dimension to payments made for brand usages and royalties.
By CS Megha Saraf
Nidhi as the Hindi word denotes “sampatti” is a type of public company which may be incorporated with an exclusive object of cultivating the habit of thrift and savings amongst its members, deposits from, and lending to, its members only, for their mutual benefit. The same is a type of company which may be incorporated under Section 406 of the Companies Act, 2013, read with the applicable rules, as a public company with a minimum paid-up equity share capital of Rs. 5 lakhs. Although the activities of a Nidhi company is similar to that of a non-banking financial company, as to accepting deposits and granting loans, however, they have been exempted from the purview of the RBI Act, 1934 by virtue of the RBI Master Direction- Exemptions from the provisions of RBI Act, 1934.
Requirements for incorporating a Nidhi company
In order to incorporate a Nidhi company, it shall have:
- atleast 200 members;
- Net Owned Funds of Rs. 10 lakhs or more;
(Note: Net Owned Funds= aggregate of paid up equity share capital + free reserves – accumulated losses and intangible assets appearing in the last audited balance sheet)
- Unencumbered term deposits of atleast 10% of the outstanding deposits;
- Ratio of Net Owned Funds to deposits not more than 1:20;
- Issuance of shares of nominal value of atleast Rs. 10 each;
- To allot a minimum of 10 equity shares or shares equivalent to Rs. 100.
In order to clarify point no. 4, let us take an example; Company X has 20 equity shares of face value of Rs. 10 each. Mr. A, an individual shall be required to subscribe atleast 10 equity shares in order to deposit Rs. 2000 in the Company. Further, as evident, such subscription of equity shares shall not provide any interest to the deposit holder, but, shall form part of the shareholders’ funds of the company.
Requirements w.r.t deposits and loans
As mentioned above, the objective of a Nidhi company is to take deposits and provide loans to its members. The Ministry of Corporate Affairs (“MCA”) being the regulator of Nidhi companies has regulated the norms for taking deposits and providing loans which are as follows:
The Nidhi company shall be allowed to accept deposits with the following timelines:
- Fixed deposits- 6 to 60 months
- Recurring deposits- 12-60 months
- Recurring deposits relating to mortgage loans- Maximum period shall correspond to the repayment period of loans granted.
Interest rate on deposits
- Savings Account- Maximum 2% above the rate allowed by nationalized banks
- Fixed and Recurring deposits- At par with the RBI rate
A Nidhi company can provide loan to its members as per the following ceiling limits:
- Where total amount of deposits from its members is less than Rs. 2 Cr- Rs. 2 lakhs
- Where total amount of deposits from its members is more than Rs. 2 Cr but less than Rs. 20 Cr- Rs. 7.50 lakhs
- Where total amount of deposits from its members is more than 20 Cr but less than Rs. 50 Cr- Rs. 12 lakhs
- Where total amount of deposits from its members is more than Rs. 50 Cr- Rs. 15 lakhs
Interest rates of loans
The interest charged on any loan given by a Nidhi company shall not exceed 7.5% above the highest rate of interest offered on deposits by Nidhi and shall be calculated on reducing balance method.
General restrictions or prohibitions
Similar to a NBFC, there are certain restrictions or prohibitions on Nidhi companies as well.
Some of the major restrictions or prohibitions of a Nidhi company are that it shall not:
- carry on the business of chit fund, hire-purchase finance, leasing finance, insurance or acquisition of securities issued by any body corporate;
- open any current account with its members;
- accept deposits from or lend to any person, other than its members;
- carry on the business other than the business of borrowing or lending in its own name;
- take deposits or lend money to any body corporate;
- issue of advertisements in any form soliciting deposits;
- pay brokerage in order to mobilize deposits from members or for deployment of funds or for granting loans
Compliances to be made by Nidhi companies
Nidhi companies shall be required to do the following compliances:
- Filing of return of statutory compliances in e-Form NDH-1– Within 90 days of the close of first F.Y. and where applicable, the second F.Y.
- Filing of non-compliance with the conditions mentioned w.r.t incorporation of a Nidhi company such as minimum no. of members, Net Owned Funds etc. in e-Form NDH-2– Within 30 days of the close of first F.Y.
- Filing of half-yearly return in e-Form NDH-3– Within 30 days of the conclusion of each half year.
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Team Vinod Kothari & Company
Securities and Exchange Board of India (Listing Obligations and Disclosure Requirement) Regulations, 2015 (‘Listing Regulations’) as well as Companies Act, 2013 (‘Act, 2013’) specify the role of the audit committee and mandates the audit committee to mandatorily review certain matters. Among the matters to be reviewed by the audit committee, section 177 of the Act, 2013 provides for review of inter-corporate loans and investments. Additionally, under Regulation 18 read with Schedule II and Regulation 24 of the Listing Regulations, the audit committee shall review the utilization of the loans/advances given to subsidiaries which exceed a certain threshold and shall also review the financial statements of its unlisted subsidiary.
The intent of audit committee review is to provide an independent view of the strength, objectivity and transparency of long-term investments made by the company and financial exposures taken by the company into other entities. Additionally, the audit committee may also review whether the loans/investments are still serving the purpose that they were intended to achieve, and whether the health/fair value of the loans and investments has substantially been affected over time. The audit committee’s review may also become the basis for strategic decisions on continuing the said financial exposures.
In case of subsidiaries, they are a part of the extended enterprise led by the holding entity. The holding entity puts in capital and other resources into subsidiaries. The subsidiaries are engaged in specific activities/verticals based on the business model of the enterprise. The subsidiaries may make further downstream investments and thus, create a network, once again, within the larger group objective of the enterprise. However, the review by the audit committee ensures that the subsidiaries are serving the larger group objective that they were designed to serve.
The following is a guideline as to what should be the perspective of the review and the specific areas of concern for such loans and investments which are placed for review/scrutiny before the audit committee; when such review is to be made etc. Further, the perspective and purpose of the audit committee is different while reviewing the loans and investments to its subsidiaries and that given to others.
Relevant provisions of Listing Regulations:
“The audit committee of the listed entity shall review the financial statements, in particular, the investments made by the unlisted subsidiary.”
Para A of Part C of Schedule II:
“The role of the audit committee shall include the following:
- Scrutiny of inter-corporate loans and investments.
- reviewing the utilization of loans and/ or advances from/investment by the holding company in the subsidiary exceeding rupees 100 crore or 10% of the asset size of the subsidiary, whichever is lower including existing loans / advances / investments existing as on the date of coming into force of this provision”
Parallel provisions of Companies Act, 2013:
“Every audit committee shall act in accordance with the terms of reference specified in writing by the board which shall, inter alia, include:
(v) Scrutiny of inter-corporate loans and investments;
Clarification on the terms loans, advances and investment
Need to review inter corporate loans and investments by the audit committee:
Inter corporate loans and investments made by the company implies a long term financial exposure. Generally speaking, unless the company is into the business of making investments, the inter-corporate investments are not directional investments; they are strategic in nature. Similarly the inter-corporate loans, except in case of companies engaged in the business of lending, are not intended for reaping interest income. Therefore, the review of these long-term financial exposures to be taken by the audit committee is to ensure that these outlays of funds do not lead to long-term resources of the entity being diverted to a purpose which is not congenial or related to the corporate objective. The objective also includes review of the health and integrity of these loans and investments. Where required, disinvestment calls may also have to be taken based on review by the audit committee.
While the law requires the audit committee to review the inter-corporate loans and investments, there seems to be no reason for excluding the review of guarantees/ securities provided by the company in connection with the loan.
Need to review investments in and made by the unlisted subsidiaries:
The holding company invests in the capital of subsidiaries. While the need for reviewing the investment in subsidiaries does not come from the Companies Act, 2013, the Listing Regulations specifically requires the listed holding company to review the investments of its unlisted subsidiaries. The investments made by the subsidiaries are indirect investments of the holding company itself. Where the subsidiaries are listed entity, the investments made are subject to similar review by their audit committee. However, in case of unlisted subsidiaries, there is less likelihood that the subsidiary will have its own audit committee. Irrespective, the audit committee of the holding listed entity is entrusted with the responsibility of monitoring and reviewing the investments made by such subsidiaries. The audit committee of the holding company has to review such investments to understand if there is any diversion from the objectives of the investment. Further, in case of downward investment by the subsidiary, the audit committee shall review whether the larger objective of the holding company is being served.
Need to review loans given to unlisted subsidiary
The audit committee the holding company is required to review whether the loans granted by it to its subsidiary is being utilized for the approved purpose or not. Any case of diversion of funds has to be brought to the notice of the audit committee since any sort of funding to the subsidiary is always with an intent of expanding or stabilizing the operations of the holding company. Further, the audit committee while reviewing needs to check whether the terms on the loan are reasonably fair and at arm’s length.
Scope of ‘loans’ to be reviewed by audit committee:
The audit committee of the listed entity is required to scrutinize inter-corporate loans availed/ granted by the listed entity. Inter- corporate loans for the purpose of review shall include-
- Inter-corporate guarantees given by the listed entity;
- Inter-corporate security provided by the listed entity;
- Loans with terms and conditions substantially at variance with the loans ordinarily provided;
- Guarantees with terms and conditions substantially at variance with the guarantees usually provided;
- Loans other than in the ordinary course of business
Loans/ guarantees which are granted or security provided in the ordinary course of business or to exempted categories need not be reviewed by the audit committee.
Scope of ‘Investments’ to be reviewed by audit committee:
Investments as are assets held by an enterprise for earning income by way of dividends, interest, and rentals, for capital appreciation, or for other benefits to the investing enterprise. Assets held as stock-in-trade are not ‘investments’.
Investments which shall be reviewed by the audit committee of the listed entity will include strategic investments made with the motive to earn yield or regular investment income. Investing the funds reduces the investible funds of the entity, funds available for business and therefore it is necessary to review the same. Investments should not be restricted to investments in securities only. Investment in the assets/property should also be covered within the ambit. Certain investments, as specified here under, need not be included within the ambit:
- Trade investments made by the listed entity or its unlisted subsidiary;
- Investments made in the ordinary course of business;
- Statutory investments made under applicable law;
Specific concerns for review by the audit committee:
The perspective of the audit committee is different while scrutinizing loans and investments of the listed entity as well as while reviewing the investments made in/by the unlisted subsidiary. For this purpose the following points should be included by the audit committee in its review –
1. Specific concerns for loans to other entities
- Purpose of loan, how does it serve the business interest of the company;
- Tenure of loan;
- Where the company has raised any money by issuing any shares/ debentures, does the giving of the loan amount to utilization of issue proceeds for a purpose other than that disclosed in the offer document;
- Rate of interest appropriate in view of credit risk of investee;
- Security interest and liquidity;
- Whether the loan is being serviced or has become impaired;
- Whether the quality of the borrower has deteriorated;
- Whether repayment happens as per stated repayment schedule;
- Whether there exists a scope for premature repayment;
- Whether there exists any reason to opt for premature repayment;
- If loan is not to a related party, how and why the transaction emanate;
- Whether the loan has been extended on reasonably fair terms and conditions and at arm’s length.
2. Specific concerns for investment in other entities
- Purpose of investment, how does it serve the business interest of the company;
- Whether there has been any diversion in utilizing the investment of the company from the objects and purposes approved by the audit committee;
- Whether the subsidiary has made any downstream investment and whether such downstream investment is at par with the objectives of the investment of the company
- Performance of investment – in terms of yield, returns;
- Likely performance of the investment in future;
- Liquidity of the investment;
- Any reason to seek liquidation/ exit from investment.
- Specific concerns in case of subsidiaries
While many of the above may not be relevant in case of subsidiaries, the following areas of concern shall be looked into by the audit committee in case of loans and investment made:
- Whether the loan is being utilized for the purposes approved by the company;
- Is there any diversion in the end use of the loan;
- Covenants of the loan, particularly, with a view to ensure that there are no chances of diversion of funds from the purpose for which they are purportedly intended to be provided.
- Whether there has been any diversion in utilizing the investment of the company from the
objective and purposes approved by the audit committee;
- Whether the subsidiary has made any downstream investment and whether such downstream investment is at par with the objectives of the investment of the company;
- Whether the investment made is a fit case for impairment considering the performance of the investee company.
On-going review by audit committee:
As per Regulation 24(2), investments of the unlisted subsidiary shall be reviewed by the audit committee of the holding listed entity at the time of review of financial statements of the unlisted subsidiary. Financial statements are prepared annually; therefore, the review shall be done on an annual basis for the investments made by unlisted subsidiaries during the year.
Further, as per Clause 9 of Para A, Part C of Schedule II to Listing Regulations the loans/ investments of the listed entity shall be subject to scrutiny by its audit committee before making investment/disbursing loans, to the extent possible or after the same have been made.
Furthermore, the holding company also reviews the following in case of its unlisted subsidiary, on an on-going basis:
- Whether the subsidiary has sufficient accumulated reserves while considering its performance;
- Whether the dividend policy of the subsidiary is in line with the larger objectives of the holding company;
- Whether the subsidiary has large amount of surplus lying in its books so as to enable it to plan a buy back.
Format for reporting to the audit committee
There is no specific format for reporting the performance / status report to the audit committee for enabling the committee to review the same. However, the same may be reported in the following manner:
|Sr. No||Particulars of investment / loan
[Name of the party, date of investment or loan, purpose, tenure, etc.]
|Concerns||Amount involved||Performance / Update|
|Whether Secured or unsecured|
|What is the yield|
|Whether liquid or illiquid|
|Market price of the securities|
|Whether there is any potential risk associated with the investment /loan|
|Servicing / repayment schedule|
|Any change in the credit rating of the investee company|