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Based on the recommendation of the Expert Committee for facilitating EODB, SEBI, videCircular dated December 31, 2024 have made a distinction in stock exchange disclosure relating to tax litigations and non-tax litigations. While matters pertaining to “new” tax litigations are required to be disclosed based on materiality under Reg 30(4), updates on such “ongoing” / existing tax litigations are supposed to be disclosed quarterly in the Integrated Filing (Governance). In this note, we discuss the probable questions that may come up around this disclosure.
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The provisions related to the carry forward and set-off of business losses in the context of corporate restructuring have been a critical aspect of corporate taxation. The Budget 2025[1] proposes certain amendments concerning carry forward of losses in cases of amalgamation, pursuant to which mergers shall not be used for evergreening of losses. That is to say, the benefit of carry forward shall be limited to eight years from the onset of losses, and not eight years from the merger.
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The Master Direction on Foreign Investment in India, recently updated on January 20, 2025, goes beyond a mere consolidation of the recent amendments in the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (‘NDI Rules’), providing clarifications in several areas of legislative silence. One of the key areas of clarification include the rules around downstream investments.
In this note, we have discussed downstream investment through stock deals and other significant clarifications provided in the Master Direction.
Background
Rule 6(a) of the NDI Rules deals with the investment by a person resident outside India (‘PROI’) in the equity instruments of an Indian company. The said rule refers to Schedule I, which, amongst others, specifies the modes of payment of consideration.Prior to the FEM (Non-Debt Instruments) (Fourth Amendment), Rules, 2024 dated August 16, 2024 (“Fourth Amendment Rules”), the Schedule contained an enabling provision for Indian companies to issue its equity instruments to PROI by way of swap of equity instruments. Since the term “equity instruments”, as defined under Rule 2(k) of Principal NDI Rules, means equity shares, convertible debentures, preference shares and share warrants issued by an Indian company, the provision permitting share swaps was read narrowly to refer to swap of shares of an Indian company against that of another Indian company only.
However, pursuant to the Fourth Amendment Rules, the Schedule was further amended to expressly provide for the swap of equity capital, as defined under rule 2(1)(e) of Foreign Exchange Management (Overseas Investment) Rules, 2022. The same is defined as “equity shares or perpetual capital or instruments that are irredeemable or contribution to non-debt capital of a foreign entity in the nature of fully and compulsorily convertible instruments.”
Downstream investment, on the other hand, is governed by the provisions of Rule 23 of the NDI Rules. While the said rule specified certain requirements to be complied with in the context of downstream investment, including the sources through which funds can be brought in for the purpose of such investments, the rule neither explicitly provided for the share swaps as a permitted mode of payment, nor contained any reference to Schedule I of the NDI Rules. As a result there was uncertainty among industry stakeholders on permissibility of share swaps as a form of consideration in case of downstream investment.
Meaning of Downstream Investment
The explanation to Rule 23 (also contained in Para 9.1.13 of the Master Direction) states that:
Downstream Investment is an investment made by an Indian entity which has received foreign investment or an Investment Vehicle in the equity instruments or the capital, as the case may be, of another Indian entity.
In other words, when an Indian entity owned or controlled by PROI [commonly referred to as a Foreign Owned and Controlled Entity (FOCC)] makes investments in the equity instruments/ capital of an Indian entity, such an investment will be considered as downstream investment for the PROI. Such arrangements enable PROI to hold investment in other Indian entities indirectly, thus, considered as an indirect foreign investment. As a result, the restrictions, prohibitions and limitations as applicable to direct foreign investments will be applicable at the time of downstream investment as well. For better understanding, refer to the figure below:
Guiding principle on downstream investment: what cannot be done directly, shall not be done indirectly
The recent updates in the Master Directions provide for the guiding principles of downstream investments, thereby clarifying that all permissions and prohibitions vis-à-vis direct foreign investment under the NDI Rules will be applicable to indirect foreign investment (i.e. downstream investment) as well.
Para 9 of the Recent Master Direction reads as below:
“The guiding principle of the downstream investment guidelines is that “what cannot be done directly, shall not be done indirectly”. Accordingly, downstream investments which are treated as indirect foreign investment are subject to the entry routes, sectoral caps or the investment limits, as the case may be, pricing guidelines, and the attendant conditionalities for such investment as laid down in the NDI Rules.”
Giving reference to above guiding principles, the Master Directions explicitly refers to the permissibility of the arrangements which are available for direct investment such as investment by way of swap of equity instruments/equity capital, payment arrangements/mechanism as per Rule 9(6) of the Rules etc, for the purpose of downstream investment as well.
Implication of above clarification
The above clarification has paved a way for Foreign Owned or Controlled entities (FOCC) to make further investments in Indian entities by way of swapping equity capital of foreign companies held by it in addition to other sources as already available. This arrangement of swapping of securities is known as a stock deal.
Previously, for making downstream investment, an FOCC was allowed to raise fresh funds from abroad by way of issue of securities including non-convertible debentures or by utilising internal accruals such as profits after tax. For more clarity refer to the table below:
Sources of making investment by FOCC in another Indian entity
Position prior to the clarification
After clarification
Internal accruals (i.e., profits transferred to reserve account after payment of taxes)
Allowed
Allowed
Fresh funds from abroad including issue of NCD
Allowed
Allowed
Swap of equity instruments/ capital
No express provision
Allowed
Using funds borrowed in the domestic markets
Not allowed
Not allowed
Other conditions w.r.t downstream investment in light of the guiding principle
As per the guiding principle on downstream investments as discussed above, an Indian entity which has received indirect foreign investment is subject to permissions and prohibitions as applicable to direct foreign investment under NDI Rules. Further, the onus of ensuring such compliances are on the FOCC making such investments, and not on the Indian investee entity receiving such indirect FDI.
Investment from land border sharing countries
In order to curb opportunistic takeovers/ acquisitions of Indian companies due to COVID-19 pandemic, the Government of India restricted investment from countries sharing land borders with India or where the beneficial owner of an investment into India is situated in or is a citizen of any such country, by way of issue of Press Note-3. As a result, any foreign direct investment from such countries would be permitted with prior approval of the Government of India in permissible sectors.
This will be applicable in case of investment by FOCC as well, where such FOCC, in turn, has received investment from such countries as discussed above.
Deferred payment arrangements
Similarly, the facility of making deferred payment of up to 25% in case of transfer of equity instruments between PROI and Person Resident in India (PRI) will also be applicable in case of downstream investment. This is, subject to the compliance with the conditions as laid down in Rule 9(6) of the NDI Rules.
The Master Directions further state that a transaction intended to be undertaken using above arrangement(s) shall require the share purchase/transfer agreement to contain the respective clause and related conditions for such arrangement.
Subsequent classification as downstream investment
Where an Indian entity (i.e., investor) at the time of making further investment in another Indian entity (i.e., investee) was not an FOCC at the time of investment, but subsequently becomes an FOCC, then such investment in another Indian entity would need to be reclassified as downstream investment from the date when investor entity becomes FOCC. Consequently, such downstream investment shall be in compliance with the applicable entry route and sectoral cap compliances and shall be required to be reported by the investor entity within 30 days from the date of such reclassification in form DI.
Valuation requirement
As per para 8.4 of the Recent Master Direction, in case of swap of equity instruments, irrespective of the amount, valuation will have to be made by a Merchant Banker registered with SEBI or an Investment Banker outside India registered with the appropriate regulatory authority in the host country.
Downstream Investment by NRI/OCI on non-repat. basis to be treated as domestic investment
The investments made by NRIs/OCIs on non-repatriation basis is treated as deemed domestic investment. Accordingly, an investment made by an Indian entity which is owned and controlled by a Non-Resident Indian or an Overseas Citizen of India including a company, a trust and a partnership firm incorporated outside India and owned and controlled by a Non-Resident Indian or an Overseas Citizen of India, on a non-repatriation basis in compliance with Schedule IV of these rules, shall not be considered for calculation of indirect foreign investment.
To know more about foreign investment, check out our YouTube repository on:
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While all issuance of debentures are governed by general laws under Companies Act, 2013 and SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021 (for listed debentures), debt issuance (with maturity of more than one year) on a private placement basis, by financial entities are also subject to additional regulatory requirements issued by RBI and NHB for NBFCs and HFCs respectively. Notable, the guidelines for HFCs were stricter and more detailed than those for NBFCs imposing a higher level of regulatory oversight and compliance requirements for HFCs.
The RBI vide its circular dated the 29th of January, 2025, has made a significant modification to the HFC Master Directions stating that the guidelines applicable to NBFCs for issuance of NCDs (with a maturity of more than one year) shall mutatis mutandis apply to debenture issuances by HFCs. Accordingly, additional requirements applicable to HFCs stand deleted. Such change reflects a deliberate effort of the regulator to streamline and simplify the regulatory framework, while simultaneously easing the compliance burden for HFCs in issuing NCDs. This is in line with the overall objective of reducing the compliance burden for debt issuances through private placements, which are primarily targeted at institutional and informed investors.
In any case, NCD issuances will still be governed by other regulatory provisions. Where the existing NCDs are listed, the SEBI principle w.r.t. ‘once listed to be always listed’[1] shall continue to apply, thereby requiring listed HFCs to list every subsequent NCDs and comply with governance norms under SEBI Regulations.
This circular shall be applicable to all fresh private placements of NCDs (with maturity more than one year) by HFCs from the date of this circular, that is January 29, 2025.
Analysis of Changes:
It appears that the RBI has effectively removed such provisions from the HFC Master Directions that were not explicitly mirrored in the SBR Master Directions. The newly inserted Para 56A, drawn verbatim from Para 58 of the SBR Master Directions, retains only such provisions that are common for both .
An analysis of the impact on the applicable provisions of the HFC Master Directions is provided in the table below:
Para No.
Particulars
Applicability
Impact of the change
Earlier
Now
57.1
Use of NCD proceeds for balance sheet funding only
✅
✅
No change in the purpose of issue
57.2
Prohibition on issuing NCDs for group or parent company use
✅
✅
58.1
Minimum maturity period of 12 months for NCDs
✅
X
Removal of restrictions on exercise date, roll-over and tenor of the NCDs. However, as discussed, these guidelines will only be applicable for NCDs with a tenure of more than one year and short-term debentures will be governed by separate guidelines. Further, where the Company has obtained credit rating, quite naturally, the tenor would not exceed the validity period.
58.2
Option exercise date must exceed one year from issue date
✅
X
58.3
Roll-over of NCDs- not allowed
✅
X
58.4
Tenor of NCDs limited to Credit Rating validity period
✅
X
59.1
Requirement of Credit Rating from approved agencies for issuing NCDs
✅
X
No requirement to obtain credit rating for issuance of NCDs
59.2
Minimum credit rating requirement for timely servicing of obligations
✅
X
Since no requirement to mandatorily obtain credit rating, this provision would no longer be relevant
59.3
Ensure current and valid credit rating at NCD issuance
✅
X
No need to ensure current and valid Credit Rating for NCD issuance
60.1
Subscriber limit and security requirement for NCDs with maximum subscription of less than ₹1 crore
✅
✅
No change in maximum number of investors and minimum amount of subscription per investor
60.2
No subscriber limit or requirement for security creation for NCDs with maximum subscription of ₹1 crore and above
✅
✅
60.3
Minimum subscription of ₹20,000 per investor
✅
✅
60.4
Two categories for private placement of NCDs based on subscription amount
✅
✅
61.1
Limit on on amount of NCD issuance based on Board approval or credit rating agency guidelines
✅
X
Since credit rating is not mandatory, the requirement does not seem relevant. However, if the HFC obtains credit rating, naturally, the amount of issuance under such rating will be limited to the amount stated in the letter.
61.2
Completion of NCD issuance within 30 days of opening
✅
X
No time limit for completion of the issue. However, the time lines under Companies Act, 2013 and SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021 will apply.
62.1
Board-approved policy for resource planning and NCD issuance
✅
✅
No change in the requirement of a Board approved policy
62.2
Offer document for private placement of NCDs to be issued within 6 Months of Board resolution
✅
X
No timeline is there within which offer document has to be issued from the date of passing of board resolution.
63.1
Disclosure requirements in offer document for private placement of NCDs
✅
X
The requirement for disclosure in offer documents as per the HFC Directions has been removed. However, the HFCs shall continue to comply with the disclosure requirements as per Section 42 of the Companies Act, 2013 read with Rule 14(1) of Companies (Prospectus and Allotment of Securities) Rules, 2014 and Regulation 28 of the SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021 in case of issuance of listed NCDs
63.2
Auditor’s certification requirement
✅
X
No requirement for obtaining auditor’s certificate
63.3
Compliance with Companies Act, SEBI Regulations, and other applicable laws
✅
✅
While the said provision has not been retained, in any case, any debt issuance will be subjected to provisions of Companies Act, 2013 and Rules framed thereunder shall be applicable, wherever not contradictory, along with other applicable laws.
63.4
Issuance of Debenture Certificate in accordance with legal timeframe
✅
X
This paragraph becomes redundant, as SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021 and Rule 9A and Rule 9B of the Companies (Prospectus and Allotment of Securities) Rules, 2014, stipulate that securities, must be issued in dematerialized form only.
64.1
Appointment of Debenture Trustee for each issue
✅
X
No need to appoint a Debenture Trustee
64.2
Eligibility criteria for Debenture Trustee
✅
X
64.3
Submission of information by HFCs, based on information provided by theDebenture Trustee, as required by NHB
✅
X
65.1
Requirement for fully secured NCDs
✅
X
This would be relevant only where the debentures are secured in nature. This requirement has been deleted, however, applicable provisions under Companies Act and SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021/SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 will be applicable in case of security creation for secured debentures.
65.2
Escrow arrangement for insufficient security cover
✅
X
65.3
Exemption for hybrid or subordinated debt
✅
X
65.4
Exemption for NCDs with a maturity of more than one year and having the minimum subscription per investor at ₹1 crore and above
✅
X
66
Preference for issuance of NCDs in dematerialized form
✅
X
Directions no longer prescribe a preferred mode of issuance, however, SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021 and Rule 9A and Rule 9B of the Companies (Prospectus and Allotment of Securities) Rules, 2014, stipulate that securities, must be issued in dematerialized form only.
67
Prohibition on loans against own debentures
✅
✅
Restrictions on extension of loans against security of HFCs’ own debentures continues
68.1
Disclosure in the Board’s report requirements on unclaimed or unpaid NCDs
✅
X
No requirement of disclosures in the Board’s report. However, disclosure requirements as per applicable laws will continue to apply
68.2
Disclosure in the Board’s report requirements on the remaining unclaimed or unpaid NCDs
✅
X
68A
Exemption for tax-exempt bonds issued by HFCs
✅
✅
Exemption from applicability of these Directions given to tax exempt bonds continues
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Buyback was considered as one of the most effective means of scaling down of capital by a company and distribution of accumulated profits, until the tax law changes pursuant to the Finance Act, 2024 effective 1st October, 2024. With buybacks becoming ineffective, one may want to look at reduction of capital u/s 66 of the Companies Act, 2013 (‘Act’) as an alternate route for scaling down capital. In fact, the section has been worded in a manner that seems to suggest that the capital reduction procedure u/s 66 can serve various objectives, as also highlighted in various rulings of NCLT and NCLAT, including the Supreme Court.
Manner of capital reduction u/s 66
Section 66 of the Act reads as:
Subject to confirmation by the Tribunal on an application by the company, a company limited by shares or limited by guarantee and having a share capital may, by a special resolution, reduce the share capital in any manner and in, particular, may—
XXX
Thus, the opening sub-section of the section seems to suggest that the share capital may be reduced in any manner, as the company may approve by a special resolution, upon confirmation by the NCLT.
However, the section is further followed by clauses specifying the manner in which the capital reduction may be effected.
(a) extinguish or reduce the liability on any of its shares in respect of the share capital not paid-up; or
(b) either with or without extinguishing or reducing liability on any of its shares,—
(i) cancel any paid-up share capital which is lost or is unrepresented by available assets; or
(ii) pay off any paid-up share capital which is in excess of the wants of the company,
alter its memorandum by reducing the amount of its share capital and of its shares accordingly:
(a) Extinguishment of uncalled capital
Clause (a) deals with extinguishment of uncalled capital. Hence, if a company has issued shares at a face value of say, Rs. 10 each, of which Rs. 8 per share has been paid-up, the company may reduce the share capital, by extinguishing the liability towards the uncalled and unpaid capital of Rs. 2 per share.
This results in a reduction in the face value of the share capital, although, no reduction in the voting rights or shareholding percentage of the shareholders, if effected proportionately for all the shareholders.
(b) (i) Cancellation of deteriorated capital
Clause (b)(i) deals with the capital that gets deteriorated on account of the deterioration in the value of the assets. This assists in reflecting the true value of the company by cancelling such value of the capital that is not represented by assets of equivalent value.
For instance, the face value of each share of the company is Rs. 100, represented by assets worth Rs. 80, for each share. In this case, the company may write-off its share capital to the extent of Rs. 20 per share.
(b) (ii) Payment of the excess paid-up capital available with the company
Clause (b)(ii) deals with the payment of capital that is in excess of the requirement of the company. This is similar to Clause (a), except that in case of the former, the capital was unpaid, and hence, there is no cash outflow in the hands of the company. In case of the latter, that is, under Clause (b)(ii), the capital having already been paid by the shareholders, the cancellation of the same requires payment on the part of the company to the shareholders.
Sources of payment for capital reduction
Where capital reduction is on account of the loss in the value of assets, the same would technically, not result in any payment from the company to its shareholders. In other cases, however, there is a cash outflow on the part of the company, and hence, it becomes relevant to understand the sources from which such payment can be made.
Capital reduction essentially means a reduction in the capital of the company, being excess than required, and hence, remaining unutilised. Further, in terms of Section 52 of the Act, the application of securities premium, except for the purpose as specified in sub-section (2) or (3) thereof, as applicable, constitutes a reduction in share capital.
Capital reduction as a means of profit distribution?
A part of the consideration may also be payable from the accumulated profits of the company, thereby, also leading to distribution of profits through capital reduction. However, the same is considered as deemed dividends, for income tax purposes, attracting tax implications, as discussed in later paragraphs below.
Capital reduction for consideration other than cash
The consideration payable on account of capital reduction need not necessarily be paid in cash, the same may also be paid through other means, that is, by distributing property owned by the company. In re Aavishkaar Venture Management Services Private Limited, the NCLT Mumbai affirmed the permissibility of capital reduction for consideration other than cash, against an observation of the Regional Director, Western Region, having reference to other judicial precedents.
Capital reduction by creation of liability in any other form
An extended and striking version of capital reduction for consideration other than cash is the creation of resultant liability in the hands of the shareholders against capital reduction. In Ulundurpet Expressways Private Limited, the NCLT Mumbai rejected the scheme of capital reduction, proposing capital reduction through creation of resultant loan to be repaid to the shareholders over a period of time. It was stated that:
“…the scheme of section 66(1)(b)(ii) of the Companies Act, 2013 only enables a company to pay off excess capital to its shareholders, which is considered in excess of wants of the company. The facts of the case clearly shows that such reduced share capital can not be said to be in excess of wants of the company on the date of passing of special resolution. Accordingly, such reduction is not permissibleunder the terms of Section 66(1)(b)(ii) of the Companies Act, 2013.”
The matter was put to appeal before NCLAT, that reversed NCLT’s order, thereby allowing such a scheme of capital reduction. The appellant had referred to two similar cases where the consideration was to be discharged over a period of time and was kept outstanding as a loan between the Company and its shareholders, and such a scheme had been approved by the NCLT Mumbai. NCLAT referred to various rulings in the context of capital reduction, and concluded that the same is permissible under section 66 allowing capital reduction “in any manner”, being a domestic issue. In Indian National Press (Indore) Ltd (1989) 66 Comp Cas 387 (MP), the High Court held:
“The need for reducing capital may arise in various ways, for example, trading losses, heavy capital expenses, and assets of reduced or doubtful value. As a result, the original capital may either have become lost or a company may find that it has more resources than it can profitably employ. In either case, the need may arise to adjust the relation between capital and assets. The company has the right to determine the extent, the mode and incidence of the reduction of its capital. But the court, before it proceeds to confirm the reduction of capital, must see that the interests of the minority and that of the creditors are adequately protected and there is no unfairness to it, even though it is a domestic matter of the company. The power of confirming or refusing to confirm the special resolution of a company to reduce its capital is conferred on the court in order to enable it to protect the interest of person who dissented or even of persons who did not appear, except on the argument and hearing of the petitioner.”
Other cases where the capital reduction has been effected through creation of liability to be discharged over a period of time include Tamil Nadu Newsprint & Papers Ltd (CP No. 17 of 1995) wherein redeemable non-convertible debentures were issued in consideration for reduction of capital, Dewas Bhopal Corridor Private Limited (CP No. 252 of 2022) and Godhra Expressways Private Limited (CP No. 254 of 2022) etc. NCLAT also cited various judgements stating capital reduction as a matter of domestic concern, discussed in the paragraph below.
Proportionate rule or selective reduction?
A question that has been raised time and again in the context of capital reduction is, whether the same needs to be effected in a proportionate manner for all the shareholders, or whether it can also be structured in a manner so as to selectively reduce/ extinguish the rights of some shareholders, thereby, reducing their overall holding in the company, including a complete buy-out of the minority shareholders.
Ruling disallowing minority buy-out through capital reduction
A recent ruling by NCLT Kolkata (pronounced on 19th September, 2024) in the matter of Philip India Ltd answers the aforesaid question of selective reduction in negative. The judgement considers the two clauses u/s 66(1) to conclude that Section 66 cannot be invoked for buying out the minority stake, and that the petition is liable to be dismissed since “…share capital reduction is only incidental to the main objective of buy back of shares…”
Relevant clause of section 66
Application to the case
Sec 66(1)(a)
Not applicable as the capital reduction is not sought for extinguishing or reducing the share capital that has not been paid-up
Sec 66(1)(b)(i)
Not applicable since nothing has been pleaded to show that the the reduction in share capital is for cancellation of paid-up capital, which is lost or unrepresented by available assets
Sec 66(1)(b)(ii)
Not applicable since it is not pleaded that they wanted to pay off capital which is in excess of the wants of the Company. In fact, there are borrowings/ liabilities in the balance sheet of the petitioner
The matter has been appealed for and currently pending before the NCLAT.
Rulings allowing minority buy-out through capital reduction
While NCLT Kolkata disallowed selective capital reduction, there is a plethora of rulings – both under the existing 2013 Act and the erstwhile 1956 Act, as well as English rulings allowing selective capital reduction, where the same is not unfair or inequitable.
In British and American Trustee and Finance Corporation v. Couper, (1894) AC 399, the House of Lords of England held that:
“…if there is nothing unfair or inequitable in the transaction, I cannot see that there is any objection to allowing a company limited by shares to extinguish some of its shares without dealing in the same manner with all other shares of the same class. There may be no inequality in the treatment of a class of shareholders, although they are not all paid in the same coin, or in coin of the same denomination.”
“…the general rule is that the prescribed majority of the shareholders is entitled to decide whether there should be a reduction of capital, and, if so, in what manner and to what extent it should be carried into effect”
The principle has been followed and restated in various rulings of the Indian courts from time to time.
In Reckitt Berickiser (India) Ltd (2005) 122 DLT 612, the Delhi High Court approved the scheme of capital reduction resulting in paying off the minority public shareholders based on the aforesaid judicial dicta, while also laying down the principles for capital reduction in the following manner:
(i) The question of reduction of share capital is treated as matter of domestic concern, i.e. it is the decision of the majority which prevails.
(ii) If majority by special resolution decides to reduce share capital of the company, it has also right to decide as to how this reduction should be carried into effect.
(iii) While reducing the share capital company can decide to extinguish some of its shares without dealing in the same manner as with all other shares of the same class. Consequently, it is purely a domestic matter and is to be decided as to whether each member shall have his share proportionately reduced, or whether some members shall retain their shares unreduced, the shares of others being extinguished totally, receiving a just equivalent.
(iv) The company limited by shares is permitted to reduce its share capital in any manner, meaning thereby a selective reduction is permissible within the framework of law (see Re. Denver Hotel Co., 1893 (1) Chancery Division 495).
(v) When the matter comes to the Court, before confirming the proposed reduction the Court has to be satisfied that (i) there is no unfair or inequitable transaction and (ii) all the creditors entitled to object to the reduction have either consented or been paid or secured.”
The aforesaid has been referred to in various judgements such as in RS Livemedia Pvt Ltd, and Bombay Gas Company Ltd, thereby answering the question of permissibility of selective capital reduction in affirmative.
On the question of whether the special resolution which proposes to wipe out a class of shareholders (through capital reduction) after paying them just compensation can be termed as unfair and inequitable, the Bombay High Court, in Sandvik Asia Ltd. vs. Bharat Kumar Padamsi (2009) SCC Online Bom. 541 has answered in negative, having reliance on the judgment of the House of Lords in the case of British and American Trustee and Finance Corpn (supra). The Bombay High Court also referred to the judgment of the SC in Ramesh B. Desai v/s. Bipin Vadilal Mehta, (2006) 5 SCC 638 for the same.
“As the Supreme Court has recognised that the judgment of the House of Lords in the case of British & American Trustee and Finance Corporation Ltd. is a leading judgment on the subject, we are justified in considering ourselves bound by the law laid down in that judgment. As we find that there is similarity in the facts in which the observations were made in the judgment in the case of British & American Trustee and Finance Corporation, we will be well advised to follow the law laid down in that case.”
“…Section 66 of the Companies Act, 2013 makes provision for reduction of share capital simpliciter without it being part of any scheme of compromise and arrangement. The option of buyback of shares as provided in Section 68 of the Act, is less beneficial for the shareholders who have requested the exit opportunity.”
The aforesaid ruling does not only permit selective reduction of capital, it expressly puts capital reduction u/s 66 as an alternative to buyback of shares u/s 68 where the former is more beneficial to the shareholders than the latter. The ruling has also been referred to by NCLT Mumbai in Reliance Retail Ltd.
Tax implications on capital reduction
Capital reduction qualify as “transfer” u/s 2(47) of IT Act
In order to qualify for taxability as capital gains, or claiming set-off of capital losses pursuant to a capital reduction, it is necessary that the transaction falls within the meaning of “transfer” u/s 2(47) of the IT Act. The term “transfer” has been defined in the following manner:
“transfer”, in relation to a capital asset, includes,—
(i) the sale, exchange or relinquishment of the asset ; or
(ii) the extinguishment of any rights therein ; or
XXX
The question of whether reduction of capital amounts to ‘transfer’ has been a matter of discussion before courts, including the Supreme Court in several instances. The Supreme Court has, recently (pronounced on 2nd January, 2025), in the matter of PCIT v. Jupiter Capital Pvt Ltd 2025 INSC 38 considered the matter at length and answered in affirmative. In the facts of the case, while the number of shares held by the shareholder assessee had reduced on account of capital reduction, the shareholding pattern remained the same, due to which the Assessing Officer concluded that there is no “extinguishment of rights”, thereby the capital reduction cannot amount as ‘transfer’ u/s 2(47) and no capital losses can be booked by the assessee on the same.
The Supreme Court, having regard to its judgement in previous matters concerning the question of whether capital reduction amounts to transfer, dismissed the petition filed by Revenue, thereby, allowing the assessee to claim capital loss.
Reference was made of the decision of Supreme Court in Kartikeya V. Sarabhai v. Commissioner of Income Tax, (1997) 7 SCC 524, where, on account of capital reduction, the face value of shares were reduced although the number of shares remained the same. The SC, having regard to its another decision in Anarkali Sarabhai v. Commissioner of Income-Tax, Gujarat 138 I.T.R. 437 (pertaining to redemption of preference shares) held that:
“Section 2(47) which is an inclusive definition, inter alia, provides that relinquishment of an asset or extinguishment of any right therein amounts to a transfer of a capital asset. While, it is no doubt true that the appellant continuous of a share capital but it is not possible to accept the contention that there has been no extinguishment of any part of his right as a share holder qua the company. It is not necessary that for a capital asset. Sale is only one of the modes of transfer envisaged by Section 2(47) of the Act. Relinquishment of the asset or the extinguishment of any right in it, which may not amount to sale, can also be considered as a transfer and any profit or gain which arises from the transfer of a capital asset is liable to be taxed under section 45 of the Act.”
The views expressed in Kartikeya V. Sarabhai (supra) was reiterated in the matter of CIT v. G. Narasimhan, 1999 (1) SCC 510.
In Anarkali Sarabhai (supra), it was held that both reduction of share capital and redemption of shares involve the purchase of its own shares by the company and hence will be included within the meaning of transfer under Section 2(47) of the Income Tax Act, 1961. Relevant excerpts are reproduced below:
The view taken by the Bombay High Court accords with the view taken by the Gujarat High Court in the judgment under appeal. In the judgment under appeal, it was pointed out that the genesis of reduction or redemption of capital both involved a return of capital by the company. The reduction of share capital or redemption of shares is an exception to the rule contained in Section 77(1) that no company limited by shares shall have the power to buy its own shares. When it redeems its preference shares, what in effect and substance it does is to purchase preference shares. Reliance was placed on the passage from Buckley on the Companies Acts, 14th Edn., Vol. I, at p. 181: “Every return of capital, whether to all shareholders or to one, is pro tanto a purchase of the shareholder’s rights. It is illegal as a reduction of capital, unless it be made under the statutory authority, but in the latter case is perfectly valid.”
14. The word “extinguishment” is the kingpin of this expression. It is a word of ordinary usage having the widest import. Usually it connotes the end of a thing, precluding the existence of future life therein (see Black’s Law Dictionary, fourth edition, page 696). It has been variously defined as meaning a complete wiping out, destruction, annihilation, termination, cancellation or extinction and it is ordinarily used in relation to right, title, interest, charge, debt, power, contract, or estate (see Corpus Juris Secundum, volume 35, page 294). In Rawson’s Pocket Law Lexicon, the meaning assigned to it is : “the destruction or cessation of a right either by satisfaction or by the acquisition of one which is greater”. In Ramanlal Gulabchand Shah v. State of Gujarat AIR 1969 SC 168 at page 175, the word “extinguishment”, which is employed in conjunction with the expression “of any such rights” in Article 31A of the Constitution, was interpreted as meaning ” complete termination of the rights “.
15. The word “extinguishment” is here used in a similar context, namely, in combination with the expression “of any rights therein”. This expression again has a wide ambit and coverage. The word “therein” refers to “capital asset” mentioned earlier in the definition. So far as the expression “any rights” is concerned, it was observed by this court in Commissioner of Income-tax v. R.M. Amin [1971] 82 ITR 194 at page 201, while interpreting this very provision :
” ……the word ‘ any ‘ is a word which ordinarily excludes limitation or qualification and it should be given as wide a construction as possible, unless, of course, there is any indication in the subject-matter or context to limit or qualify the ordinary wide construction of that word……There being no contrary intention in the subject-matter, or context, the words ‘any rights’ must include all rights……”
16. It was there pointed out that where the capital asset consists of incorporeal property, such as a chose-in-action, the bundle of rights which constitutes such incorporeal property would be comprehended within the meaning of the words “any rights”. It would thus appear that the expression. “any rights therein ” is wide enough to take in all kinds of rights–qualitative and quantitative–in the capital asset.
In view of the judgements cited above, the SC held that:
“…the reduction in share capital of the subsidiary company and subsequent proportionate reduction in the shareholding of the assessee would be squarely covered within the ambit of the expression “sale, exchange or relinquishment of the asset” used in Section 2(47) the Income Tax Act, 1961.”
Distribution of accumulated profits taxable as “dividend”
Reduction of capital results in extinguishment of some rights on the part of the shareholders, and hence, can be construed as “transfer” within the meaning of sec 2(47) of IT Act, resulting in the tax implications u/s 54 (capital gains or loss, as the case may be).
However, as stated above, some part of the consideration may be paid out of the accumulated profits of the company. To that extent, the consideration received by the shareholders is taxable as dividend u/s 2(22)(d) of the IT Act. The section reads as below:
(22) dividend includes –
XXX
(d) any distribution to its shareholders by a company on the reduction of its capital,to the extent to which the company possesses accumulated profits which arose after the end of the previous year ending next before the 1st day of April, 1933, whether such accumulated profits have been capitalised or not;
Thus, to the extent the consideration for capital reduction is paid from the accumulated profits of the company, the same would be taxable as dividend in the hands of the shareholders. In Commissioner of Income-Tax v. Urmila Remesh, 230 ITR 422, the Supreme Court clarified that:
Section 2(22) of the Act has used the expression `accumulated profits’ Whether capitalised or not”. This expression tends to show that under Section 2(22) it is only the distribution of the accumulated profits which are deemed to be dividends in the hands of the share-holders. By using the expression “whether capitalised or not” the legislative intent clearly is that the profits which are deemed to be dividend would be those which were capable of being accumulated and which would also be capable of being capitalised. The amounts should, in other words, be in the nature of profits which the company could have distributed to its share-holders. This would clearly exclude return of part of a capital to the company, as the same cannot be regarded as profit capable of being capitalised, the return being of capital itself.
This was further reiterated in the matter of G. Narasimhan (supra).
Whether the new buyback taxation rule applies on capital reduction?
In various rulings, capital reduction has been employed as a means to buy back the shares of the minority investors. Therefore, a question arises on whether the new taxation rule on buyback (refer our article here) would apply to capital reduction as well.
Here, reference may be made to the language of Section 2(22)(f) of the IT Act, that reads as:
(f) any payment by a company on purchase of its own shares from a shareholder in accordance with the provisions of section 68 of the Companies Act, 2013 (18 of 2013)
The provision, thus, clearly refers to buyback u/s 68 of the Act, whereas, capital reduction is effected u/s 66 of the Act. On the other hand, distribution of profits on capital reduction is explicitly covered u/s 2(22)(d) of the IT Act. Hence, there is no reason one should take a view that the new rules on taxation of buyback also extends to capital reduction.
Illustration showing tax implications upon capital reduction
The below table contains a few illustrations with respect to the tax implications upon reduction of capital.
Sl. No.
Particulars
Part consideration from accumulated profits & Capital gains
Capital loss on account of capital reduction
No consideration paid on capital reduction
Amount (Rs.)
Amount (Rs.)
Amount (Rs.)
A.
Consideration received on capital reduction
1,00,000
10,000
–
B.
Amount paid out of accumulated profits
30,000
–
–
C.
Amount taxable as deemed dividends u/s 2(22)(d) [(B)]
30,000
–
–
D.
Cost of acquisition of shares
20,000
20,000
20,000
E.
Amount taxable as capital gains/ (loss) [(A) – (C) – (D)]
50,000
(10,000)
(20,000)
Conclusion
The aforesaid discussion reveals how capital reduction has been given the widest possible meaning by the courts and tribunals, in the interpretation of the expression “in any manner”. Capital reduction can be used in scaling down the capital in any manner, so long as the same is (i) not unfair or inequitable to the shareholders and creditors, and (ii) duly approved by the shareholders through a special resolution. Though the process requires an approval of NCLT, the role of the Tribunal is supervisory in nature, since the matter is one of “a domestic affair”.
https://vinodkothari.com/wp-content/uploads/2023/06/vinod-kothari-logo.png00Payal Agarwalhttps://vinodkothari.com/wp-content/uploads/2023/06/vinod-kothari-logo.pngPayal Agarwal2025-01-30 16:55:312025-01-31 23:52:15Reduction of capital - an alternate to buyback and minority exit?
https://vinodkothari.com/wp-content/uploads/2023/06/vinod-kothari-logo.png00Team Corplawhttps://vinodkothari.com/wp-content/uploads/2023/06/vinod-kothari-logo.pngTeam Corplaw2025-01-28 22:40:402025-01-28 22:42:05FAQs on Business Responsibility and Sustainability Report (BRSR)
Despite global macroeconomic challenges, including persistent inflation, securitization volumes and ratings across most structured finance asset classes demonstrated remarkable stability in FY 2024. Strong housing markets bolstered credit performance in sectors like U.S. and Australian RMBS, while European housing markets faced concerns of overvaluation.
Overall, the performance of the securitisation market in FY 2024 was considered to be stable with a few exceptions of leveraged lending and collateralized loan obligations (CLOs) which remained in focus for numerous reasons, including their elevated exposures to lower-rated obligors.1
This article delves into the securitization trends observed in FY 2025, analyzing the market’s performance and offering insights into future projections.
Global Securitisation Volumes for FY 2025
US
As of December 2024, the total US Structured Finance issuance reached USD 770 Billion. In this, the total RMBS issuance accounted for USD 137.9 Billion (17.9% of the total structured finance issuance). It may be noted that total RMBS issuance for FY 2023 amounted to USD 78 Billion, therefore leading to an increase of roughly 76% in the current fiscal year. Securitisation of Credit Card receivables accounted for about USD 20.6 Billion while auto loans accounted for USD 126.4 Billion.2
As per S&P Global, the total credit card ABS issuance will be about $33 billion in 2025 thus leading to a 60% increase from the previous year. It also estimates the total RMBS issuance to reach USD 160 Billion supported by home price appreciation and low unemployment rates.
The below chart shows structured finance issuances by sub-sector:
Traditionally, US data has excluded agency-backed transactions (the data above, therefore, would mostly be non-qualifying residential mortgage loans). SIFMA data shows that agency and non-agency RMBS issuance added to USD 1.592 trillion, registering an increase of 21%. This includes an increase of 119% in non-agency RMBS, and about 19% in agency-RMBS.
Yet another segment which is typically boosted by the benign credit conditions is CMBS. US CMBS volumes touched USD 103 billion [S&P data]. This is over 2.5 X of the volume seen last year.
European Market
European securitisation issuance in 2024 reached USD 142 billion, reflecting an over 50% increase compared to 2023.While fewer outstanding transactions in the European securitisation market are anticipated to hit their call dates in 2025, typically a factor that negatively impacts volumes; improvements in underlying credit originations offer a positive outlook3.
A highlight of 2024 was the record-setting bank-originated securitisations, which soared to a 12-year high of over USD 36 billion. Additionally, sustainable-labelled securitisation rebounded strongly, with issuances exceeding USD 5 billion during the year. RMBS volumes in Europe rose by approximately 60% to USD 46 billion, a trend likely to persist into 2025.
The below chart shows the RMBS and ABS issuance over last 3 years in the European market:
China
In China, new securitization issuances grew by 4.8% year-on-year to USD 200 billion during 1Q-3Q 2024. Issuances of consumer loan ABS and account receivables ABS saw noticeable growth and MSE loan ABS issuances surged by 76%. However, the issuance of certain major asset classes, such as auto loan ABS declined significantly (Auto loan ABS issuance fell 39% in 1Q-3Q 2024 to USD 11.83 billion. The number of transactions issued during the period dropped to 22 from 29 a year earlier).4
Consultation on Securitisation
A highpoint of the EU securitisation market in 2024 is the consultation by the European Commission to mend the regulatory framework for securitisation. This exercise was prompted by several positive noises about securitisation at a policy-makers’ level. Enrico Letta, former Italian Prime Minister, in his report to the EU, made a strong case for securitisation. He said: “Securitization acts as a unique link between credit and capital markets. In this sense, the securitization market offers significant potential. Increasing its utilization brings two key benefits: i) broadening and diversifying the pool of assets available for investment, and ii) unlocking banks’ balance sheet capacity to facilitate additional financing. Moreover, the adoption of green securitization, whether through securitizing green assets or directing securitization proceeds towards green financing, holds promise as a significant contributor to the transition towards sustainability. Therefore, we advocate for reforms in the European securitization framework to enhance its accessibility and effectiveness”5 In addition, comments by Noyer and those by Mario Draghi favoured changes in securitisation framework. Thus, in October, 2024, the Eurpean Commission began a targeted consultation on several aspects of securitisation market. The responses from the consultation are currently available on the Commission’s website.
Surge in CLO market
One of the notable developments in 2024 was the surge in CLO volumes. US CDO/CLO issuance, as per SIFMA statistics, recorded an issuance volume of USD 85 billion, which is 195% higher than the issuance last year. European CLO volume registered a volume of Euro 46 billion, substantially higher than last year. One report, citing a BofA research, states that the global outstanding CLO volume reached nearly USD 1.2 trillion.
The growth in the CLO market is a direct result of the activity in the leveraged loan market, as the feedstock of CLOs primarily is leveraged loans. Leveraged loans, a term that is rather understood than defined, is mostly low-rated loans to entities that are already carrying significant leverage. The US leveraged loan market adds to upwards of USD 1.2 trillion, and that in Europe stood at about Euro 280 billion. Most of these leveraged loans tend to “syndicated” or downsold in pieces to various participating banks – which may number from a dozen to even 200, and hence, reflecting the extent of lender participation, this market is called “broadly syndicated loan” or BSL market.
While private credit financiers are increasingly making inroads into the space, a lot of capital in the leveraged loan market comes from CLOs.
Another interesting development in the US CLO market has been the growth of CLO ETFs. A report by S&P says that CLO ETFs’ AUM rose from USD 120 million in 2020 to USD 19 billion in Nov., 2024.
Regulatory updates
UK enacted the Securitisation Regulations, 2024, which replaced the earlier 2017 Regulations. Pursuant to the Regulations, the Financial Conduct Authority has framed the set of rules called Securitisation Sourcebook. The rules lay particular emphasis on the Simple, transparent and standardised (STS criteria) of securitisation transactions, and by way of amendments made later in the year, bar the domiciling of SPVs in certain high risk jurisdictions.
Growth in synthetic securitisation
Synthetic securitisation, also sometimes known as synthetic risk transfer or significant risk transfer (SRT) transactions, were mostly limited to Europe and SE Asia jurisdictions, due to lack of clarity on regulatory capital treatment in the USA. In Sept., 2023, the Federal Reserve board clarified that capital relief will be applicable in case of synthetic transactions. Since the clarification, US share in global synthetic securitisations grew to over 30%, from a small fraction earlier. The IMF Global Financial Stability Report of October, 2024 states that globally, more than $1.1 trillion in assets have been synthetically securitized since 2016, of which almost two-thirds were in Europe.
The said IMF report highlights several risks of SRT transactions. First of all, it states, basis anecdotal evidence, that banks are providing funding to credit funds for buying tranches of SRT deals of other banks, thereby implying that the risks are eventually within the banking system. It also states that SRTs may “mask banks’ degree of resilience because they may increase a bank’s regulatory capital ratio while its overall capital level remains unchanged.” Furthermore, overreliance on SRTs exposes banks to business challenges should liquidity from the SRT market dry up. Financial innovation may lead to securitization of riskier asset pools, challenging banks with less sophisticated tools for risk management, because some more complex products make the identity of the ultimate risk holder less clear. Finally, although lower capital charges at a bank level are reasonable, given the risk transfer, cross-sector regulatory arbitrage may reduce capital buffers in the broad financial system while overall risks remain largely unchanged.
Sustainable-labelled Securitisation
The European market saw an issuance exceeding USD 5 Billion during 2024 with first time issuances in solar ABS sectors.
In the U.S., government-sponsored enterprises are purchasing mortgage pools targeting low-carbon buildings and refinancing these assets in the mortgage-backed securities market to finance energy and water efficiency programmes6. For instance, in September 2024, Fannie Mae a GSE came up with a single family green bond framework. Under this framework, loans which conform to the eligibility requirements are acquired from lenders and are securitised into Fannie Mae MBS which are either delivered to the lenders or sold to investors. Here, only projects achieving certain environmental performance standards such as Solar Loans and water efficiency loans are eligible7
Securitisation volumes surged about 27% on-year to Rs 1.78 lakh crore in the first nine months of FY 24-25, supported by large issuances from private sector banks. In the third quarter alone, issuances touched Rs 63,000 crore with private sector banks contributing to 28% of this (HDFC bank alone securitised new car loans by issuing PTCs valued at just over Rs 12,700 crore). However, originations by NBFCs were only up by 5%. The market also saw 15 first time NBFC issuers, bringing the total number of originators to 152, compared with 136 in the last financial year.
Among asset classes, vehicle loans (including commercial vehicles and two-wheelers) accounted for 48% of securitisation volume (vs 40% in the corresponding period last fiscal).
Mortgage-backed loans accounted for about 23% of securitisation volume (vs 20% in the corresponding period last fiscal).
Overall, the Indian Securitisation Market volume is expected to reach Rs 2.4 trillion by the end of FY2025.
On the regulatory front, SEBI, in its board meeting dated December 18, 2024, approved amendments to the framework for the issuance and listing of Securitised Debt Instruments (SDIs). These amendments aim to expand the SDI market and align the regulations with the current securitisation norms prescribed for RBI-regulated entities.
This growth trajectory is expected to persist into FY26, fueled by strong securitization volumes and the expanding involvement of private sector banks. With evolving market dynamics and growing investor confidence, the securitization market is poised for sustained momentum for years to come.
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