Round-up of regulatory updates during 2021

We have attempted to collate all major regulatory amendments notified throughout the year, with our resources on the same. Below we present a regulatory round-up for the year 2021, be it for MCA, SEBI, RBI or the like, along with the links to our major articles/ FAQs on the same.

This version: 4th December, 2021

Can companies avail GST benefits on CSR spending?

– By Harsh Juneja | Executive (corplaw@vinodkothari.com)

Background

Section 135(5) of the Companies Act, 2013 (‘the Act’) requires every eligible company (as per section 135(1)) to spend at least 2% of the average of net profits of immediately preceding 3 financial years towards Corporate Social Responsibilities(‘CSR’) activities. The CSR spending may sometimes include contributions made to NGOs or other beneficiaries, or money paid to implementing agencies. However, quite often, the expense may relate to procurement of goods or services which are applied to one or more CSR activities. This procurement of goods or services comes with the tax cost, viz., GST. So the question is, does this GST paid, while acquiring goods or services, give rise to an input tax credit, such that the same may be claimed as a set off? A related, and more important question is, whether CSR expense for the purpose of sec. 135 (5) be the amount net of the ITC, if the ITC is claimable, or the gross amount paid?

Input Tax Credit

Eligibility

Section 16(1) of the Central Goods and Service Tax (‘CGST Act, 2017’) prescribes the eligibility criteria for taking Input Tax Credit. It states that “Every registered person shall, subject to such conditions and restrictions as may be prescribed and in the manner specified in section 49, be entitled to take credit of input tax charged on any supply of goods or services or both to him which are used or intended to be used in the course or furtherance of his business and the said amount shall be credited to the electronic credit ledger of such person.”

Hon’ble CESTAT Mumbai, in the case of M/s Essel Propack Ltd. vs Commissioner of CGST, Bhiwandi, gave a view that the CSR gives a company an economically, socially and environment sustainability in the society in the long run, as a company can not operate without providing benefits to its stakeholders. Therefore, it held that if companies are unable to claim input services in respect of activities relating to business, production and sustainability of the companies themselves would be at stake.

Hon’ble High Court of Karnataka, in its judgement, in the case of M/s Commissioner of Central Excise, Bangalore vs. Millipore India (P) Ltd., also was of view that CSR Expenses are mandatorily incurred by employers towards benefit of the society and “to maintain their factory premises in an eco-friendly manner”. Therefore, the tax paid on such services shall form part of the costs of the final products and thus, the company can claim these taxes paid as input services.

Uttar Pradesh Authority for Advance Ruling (‘AAR’) in the matter of M/s Dwarikesh Sugar Industries Ltd held that a company is mandatorily required to undertake CSR activities and thus, forms a core part of its business process. Hence, the CSR activities are to be treated as incurred in “the course of business”.

Section 135(7) is a penal provision under the Act which deals with penalty on non-compliance of section 135(5)  and (6). It was observed by the AAR that a Company fulfilling eligibility criteria under section 135(1) of the Act is required to mandatorily spend towards CSR and thus, must comply with these provisions to ensure smooth run of business.

Thus, Uttar Pradesh AAR held that the expenses incurred by the Company in order to comply with requirements of CSR under the Act qualify as being incurred in the course of business and are eligible for ITC in terms of the Section 16 of the CGST Act, 2017.

Contrary ruling: Free Supply of Goods

Section 17(5)(h) of the CGST Act excludes “goods lost, stolen, destroyed, written off or disposed of by way of gift or free samplesfor the purpose of availing ITC on payment of GST. The term ‘gift’ is not defined anywhere in the CGST Act. However, in layman’s language, gift means a thing given willingly to someone without payment.

In the matter of M/s. Polycab Wires Private Limited, Kerala AAR held that distribution of necessaries to calamity affected people under CSR expenses shall be treated as is if they are given on free basis and without collecting any money. Hence, for these transactions, it was held that ITC shall not be available as per section 17(5)(h).

However, a contrast has been drawn in the Uttar Pradesh AAR Ruling towards goods given as ‘gift’ and given as a part of CSR activities. Gifts are voluntary and occasional in nature whereas CSR expenses are obligatory and regular in nature. AAR held that since CSR expenses are not incurred voluntarily and have to be incurred regularly, they are not to be treated as ‘gift’ and thus, should not be restricted under section 17(5)(h) for claiming ITC.

Availing Benefit through Beneficiary

A company contributes a sum towards a beneficial organisation such as NGOs, Charitable Trusts and Section 8 Companies (‘implementing agencies’) towards fulfillment of CSR activities. However, these implementing agencies also need to hire services of vendors to complete these activities. These vendors charge GST on the services rendered by them. Since these implementing agencies often do not generate any output, the question raises can these organizations also claim ITC on the services rendered by them?

There is a concept of ‘pure agent’ in GST. Explanation to Rule 33 of CGST Rules, 2017 prescribes that a pure agent means a person who –

The implementing agencies fulfill this eligibility criteria of being a ‘pure agent’. Rule 33 also contains some conditions on the fulfilment of which, expenses incurred by the supplier as a pure agent of the recipient of the supplier of goods or services, are excluded from the value of supply-

In our case, if an implementing agency avails any goods or services from a vendor to fulfil the CSR activities for a company, then the payment of any such amount to the vendor shall be treated as a supply made as a pure agent by the implementing agency on behalf of recipient of supply, i.e., the company. Thus, these expenses incurred by the implementing agencies shall be excluded from the value of supply and therefore, are not liable for payment of GST.

CSR Contribution: Pre-GST or Post-GST?

The Act does not clarify that the amount to be contributed towards CSR activities should be inclusive or exclusive of taxes. However, it seems that since GST is charged on supply of goods and services, irrespective of the intention of social benefit, the amount contributed towards CSR can be both inclusive and exclusive of GST. Having said that, the question still pertains on the inclusivity of the amount of GST paid towards the amount of CSR expenditure for the purpose of section 135(5) of the Companies Act, 2013.

Conclusion

While it seems that rationally, expenses incurred on GST for fulfillment of CSR activities should be eligible for claiming ITC, however, there is still some ambiguity in terms of legal provisions. There is one view of Kerala AAR which restricts CSR contribution under section 17(5)(h) while the Uttar Pradesh AAR had a complete inverse view. A clarification from the relevant authorities is sought in this regard so that this perplexity created by different rulings may be solved. When all is said and done, a question still pertains on the amount of the expenditure which is to be considered for the purpose of calculation of CSR expenditure.

 

 

Unspent CSR & Role of IAs

Unspent CSR

Other ‘I am the best’ presentations can be viewed here

Our other resources on related topics –

  1. https://vinodkothari.com/2021/01/csr-comply-or-suffer-provisions-made-effective/
  2. https://vinodkothari.com/2021/01/corporate-social-responsibility-2021-amendments/
  3. https://vinodkothari.com/2021/01/faqs-on-csr-2021-amendments/
  4. https://vinodkothari.com/csr/

Business Responsibility and Sustainability Reporting

Business Responsibility and Sustainability Reporting

Other ‘I am the best’ presentations can be viewed here

Our other resources on related topics –

  1. https://vinodkothari.com/2021/06/brsr-reporting-actions-and-disclosures-required-for-business-sustainability/
  2. https://vinodkothari.com/wp-content/uploads/2020/08/Cartload-of-details-in-BRSR.pdf
  3. https://vinodkothari.com/2020/08/brr-in-process-to-become-a-fully-loaded-electronic-form/
  4. https://vinodkothari.com/2016/01/global-overview-of-business-responsibility-reporting/

RBI Guidelines at odds with the Companies Act on appointment of Auditor

A comparative analysis between the Companies Act, SEBI Guidelines and SEBI Circular dated 18th Oct. 2019

– Ajay Kumar K V | Manager (corplaw@vinodkothari.com)

Introduction

The Reserve Bank of India has issued Guidelines[1] for Appointment of Statutory Central Auditors (SCAs)/Statutory Auditors (SAs) of Commercial Banks (excluding RRBs), UCBs and NBFCs (including HFCs) under Section 30(1A) of the Banking Regulation Act, 1949, Section 10(1) of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/1980 and Section 41(1) of SBI Act, 1955; and under provisions of Chapter IIIB of RBI Act, 1934 for NBFCs, on 27th April 2021.

The Guidelines provide for appointment of SCAs/SAs, the number of auditors, their eligibility criteria, tenure and rotation as well as norms for ensuring the independence of auditors.

However certain provisions of these Guidelines are either completely different or stringent as compared to the provisions of the Companies Act, 2013 (Act). Further, in case of listed entities the question would arise whether the SEBI circular CIR/CFD/CMD1/114/2019[2] dated 18th October 2019 shall be applicable, where the existing auditor is ineligible to continue as the auditor of the company and a new auditor is to be appointed.

In this write up, we have discussed the requirements under both RBI Guidelines as well as the Act.

Read more

MCA circular on excess spent done by contribution to PM-Cares

-raises more questions than it settles.

Nitu Poddar, Senior Associate ( corplaw@vinodkothari.com )

Setting off excess-spent on CSR

Pursuant to Rule 7(3) of the CSR Rules, 2014, a company is allowed to take benefit of the excess amount (more than the requirement under section 135(5) spent by it on CSR activities upto three succeeding financial years. This provision has come into effect from January 22, 2021.

Accordingly, the common view that has formed is that only amount that is spent in excess on and from January 22, 2021 can be set off against the CSR obligations of three succeeding year. However, the second view, and the more appropriate one is, even amount spent in excess before Jan 22, 2021 may also be set-off against the CSR obligations of a year, subject to such excess spent is done within three years of taking such set-off. That is to say, any excess spent done in FY 2019-20, 2018-19, 2017-18 could have been set-off in FY 2020-21.

The reason for the second view is that, all that the provisions of Rule 7(3) allows is “setting off “the excess spent, which is being done post January 22, 2021. 

Clarification Circular by MCA:

MCA, on May 20, 2021, has issued a Circular, purportedly clarifying the following:

  1. Any amount spent in excess during FY 2019-20;
  2. On March 31, 2020;
  3. By contribution to the PM-Cares

may be set off against the CSR obligation for FY 2020-21 (only) subject to the following conditions:

  1. Unspent amount, if any, of the previous years, should have been factored;
  2. CFO and statutory auditor to certify that such amount was
    1. contributed on 31.03.2020;
    2. pursuant to the appeal by the MCA.
  3. Details of such contribution to be disclosed separately in the CSR Report and Board’s Report. 

Issues arising from the Circular

The MCA Circular rather raises several questions and leave then unanswered:

  1. What about the contribution done prior to 31.03.2020?;
  2. What about the excess spent done in any other activity as mentioned in schedule vii?;
  3. What about the excess spent done in FY 2018-19 and 2017-18?
  4. Why a certificate from statutory auditor? This is not required for any other excess spent done neither is this part of Rule 7(3).

The Circular seems to support the view of the ICSI, as mentioned in Q-47 of the FAQ released on April, 29, 2020, which says that only excess spent done after January, 22, 2021 may be allowed to set-off in subsequent years. However, taking such view would may not be the correct interpretation of the applicability of the provisions.

 

Our other resources on CSR can be accessed at : http://vinodkothari.com/csr/

Changes in Auditors’ Report and Financial Statements to reveal camouflaged financial transactions

Team Corplaw, Vinod Kothari & Company [corplaw@vinodkothari.com]

[This version: 25th March, 2021]

Accountants and auditors will have to grapple with a ton of new details and disclosures while preparing financial statements and audit reports, come financial year 2021-22. MCA brought, vide separate notifications dated 24th March, 2021 amendments in the Companies (Audit and Auditors) Rules,2014 (“Audit Rules”), the Companies (Accounts) Rules, 2014 (“Accounts Rules”) and Schedule III of the Companies Act.

While Schedule III changes will require wide ranging disclosures [to be covered by a separate write up], the amendments in Audit Report Rules  and Accounts Rules require the following new disclosures: 

  • Camouflaged lending or investment, that is, where out-bound or inbound loans, advances and investments are intended to be routed through a conduit entity, masking the identity of the ultimate beneficiary
  • Compliance with respect to payment of dividend
  • The need for accounting software to maintain an audit trail, that is, edit log, of the primary entries, possibly with a view to enable the detection of any changes in primary entries
  • Gaps in valuations of securities, so as to reflect the valuations at the time of borrowing money, and at the time of OTS

We briefly discuss these.

Applicability – scope and date

  • The changes as will be discussed below will be applicable on the Auditor’s Report and Board’s Report from the financial year 2021-22 and onwards
  • Since statutory audit is a mandatory requirement for all the companies, the changes in the Auditor’s Report shall be applicable on all companies.
  • From the language of the amendments, it is apparent that the changes are applicable only for the annual financial statements; neither are they applicable to interim financial statements, nor to special purpose financial statements.
  • An important question will remain whether the required management representation and the auditors’ check will pertain to transactions done during the financial year 2021-22 and thereafter, or does it pertain to opening balances of transactions as on 1st April, 2021. In absence of any suggestion as to retroactivity, it should be logical to assume that the required management representation and the auditors’ checking should pertain to the transactions done during the financial year.
  • The changes in relation to Board Report shall be applicable on all the companies, since the Board Report is a mandatory requirement for all.
  • The requirements of audit trail and edit log are applicable on companies maintaining their accounts in the electronic form. However, practically, all companies maintain accounts in electronic format, so the same can be said to be applicable on all companies.

Camouflaged lending and investment:

What is the offence?

The issue under consideration is “camouflaged investments”. By using the term camouflage investments, we mean those transactions which are undertaken by a company for some identified beneficiary. However, the transaction does not take place between the company and the ultimate beneficiary directly, but is masked by the inclusion of an intermediary acting as a conduit entity (an entity acting on the instructions of the company for channelizing the funds to any other entity identified by the company).

These transactions mask the identity of the real beneficiary. In a world where financial transactions are regularly used for carrying illicit transactions, money-laundering transactions or other suspicious activities, it is important that the trail of financial transactions is transparent. Hence, if the identification of the end beneficiary is consciously being masqueraded, there is a concern. The proposed amendments are a means to address this issue.

What is the MCA intending to do?

The MCA, vide the amendment notification, is aiming to unveil the ultimate beneficiary behind the camouflage financing. Though investment through “conduit entities” is not barred by law, the same needs to be adequately disclosed in the notes of accounts of the company. Therefore, MCA, vide its amendment notification, requires the management of the company to give a representation that, except as otherwise disclosed in the notes to accounts, the company has neither employed, nor is itself acting as a “conduit entity” for any financial transaction.

Is it illegal to have investments via conduits?

Several laws refer to indirect lending or investment –

  • Sec 185 of the Act prohibits both direct and indirect loans, investments, guarantees or security to the directors and other specified entities.
  • Under the FEMA Regulations, the definition of “foreign equity holder” includes those equity holders having minimum 51% of indirect equity holding
  • Sec 186 (1) also refers to investment “through” one or more layers of subsidiaries, which is again a case of indirect investments.
  • In many commercial transactions, it is understood that the recipient is acting as a conduit – for example, lending through a fintech platform
  • Special purpose vehicles, which are well allowed to operate under various laws, are intended to be conduits only
  • Use of conduits is commonplace practice in many commercial transactions

Hence, while it is not illegal on the face of it, the use of a masquerading entity camouflages the real nature of the financial transaction. It acts as a subterfuge and hence, creates opacity. In the context of PMLA, these transactions may also be hiding the real identity of the real beneficiary.

Hence, it is important to ensure that the identity of the real beneficiary, if so targeted by the lender or investor, is disclosed.

What sort of transactions will be covered?

There are several elements in the camouflage rule that need to be understood:

There are 3 legs of the transaction: a source transaction, a conduit or intermediary transaction, and an ultimate beneficiary transaction.

The source transaction may be

  • Investments,  
  • Advances, or
  • Loans

At the source stage, the money has come as a result of any borrowing, issue of shares or share premium or any other source or kind of funds. Since these expressions are wide enough, it does not matter what the source of the funds at the source level is.

The intermediary transaction may be by way of

  • Loan or advance
  • Investment
  • Provision of any guarantee or security

The ultimate beneficiary is the end beneficiary of the source transaction.

The following points may be noted about the scope of the Camouflage rule:

  1. Commercial transactions are not covered: Notably, the transactions covered by the rule are financial transactions, in the nature of loans, advances or investments. Real sector transactions such as sales, purchases, services, including payment and collection services, etc., are not covered by the rule. 
  2. Non-discretionary transactions as regards the intermediary: In order to attract the offence of the camouflage rule,the source must have identified the ultimate beneficiary. This is clear from the words: “identified in any manner whatsoever by or on behalf of the company”. Thus, if the intermediary had the discretion in identifying the beneficiary, this rule is not attracted. Hence, the identification of the beneficiary is done by the source, and without any discretion on the part of the intermediary.
  3. Pre-contemplated transfer to the ultimate beneficiary: Next important element is the existence of an understanding with the intermediary that the funds passing through the intermediary are intended by the ultimate beneficiary. This is clear from the words “with the understanding, whether recorded in writing or otherwise”. The form of the understanding or the formal nature of the understanding also doesn’t matter, but the understanding must have been there.
  4. Direct nexus: This suggests that the flow of funds from the source of the intermediary, and from intermediary to the ultimate beneficiary must be part of the same transaction, showing a clear nexus.
  5. The intent of camouflaging the chain financial transaction is present: It is only when the real nature of the transaction is sought to be garbed, and the transaction purports to be a financial transaction with the intermediary, whereas the real intent is to provide funding to the ultimate beneficiary. For example, if a special purpose vehicle collects money from the investors, it is evident on the face of the transaction that the money is intended to go to another beneficiary. There is no garbing of the identity of the end beneficiary. These transactions are explicit and transparent transactions. The whole intent of the camouflage rule is to eliminate opacity. If the transaction was itself transparent, the rule has no relevance at all.

There are several interconnected financial transactions that abound in the world of finance. Hence, it will remain a matter of intrigue as to what all transactions may be regarded as falling under the offence of the camouflage rule. There are several questions that arise in this respect:

 

  • Does a time gap matter?

 

For instance, the transaction by the source to the intermediary happens on 1st of 1st month, and the transaction by the intermediary to the beneficiary happens on 1st of 4th month. There may be a suggestion as to the existence of an understanding between the parties, but the very fact that there is a gap of time between the two legs of the transactions helps to create some opacity. It may be noted that the whole purpose of the camouflage disclosures is to pierce  through the opacity and create transparency. Hence, if the gap in timing is merely a device to create opacity, it should not matter.

 

  • Does a change in nature of the instrument at the intermediary level matter?

 

For example, the transaction from the source to the intermediary may be by way of loans. The transaction from the intermediary to the ultimate beneficiary may be by way of investment in shares. The terms of the two investments obviously differ. The first may have a limited tenure. The second one may be perennial. The entire approach has to be driven by substance over form – if the substantive view of the transaction suggests the two inter-connected transactions being part of the same chain, it will be wise to disclose the same.

 

  • Does the infusion of some extent of funds by the intermediary matter?

 

For example, the source may have contributed Rs 1000. The intermediary may add another Rs 100 of its own, and transfer Rs 1100. To the extent of Rs 1000, there may still be a chain financial transaction requiring disclosure, while the remaining Rs 100 may be an independent transaction by the intermediary.

 

  • Does the existence of a trust or fiduciary or agency relationship matter?

 

There are numerous transactions where a servicing agent, collecting agent, paying agent, etc acts merely as a conduit. This is the explicit nature of the transaction itself. Same goes with fiduciary transactions where the trustee or fiduciary discloses on the face of it that the trustee is merely a stop-over. However, trusts with undisclosed principals, while doing financial transactions, may be hit by the rule.

Duty of the auditor

The provisions are not just casting a responsibility on the directors, but the auditors are also required to substantiate the statement of the directors by applying their audit procedures. While the auditors can have ways and means to identify the instances of “outward” surrogate lending well, how the auditors can assure there are no instances of “inward” surrogate lending will require some new auditing methods.

Reasons of such reporting requirement

The amendments can be looked upon as a way to ensure that the companies do not use masquerades for the purpose of distinguishing the identity of the ultimate beneficiary of the funds.  These might be to also check the instances of money laundering and terrorism financing.

Impact of the change

Though no specific punishments have been specified, on a conjoint reading of Sections 447 and 448 of the Act, it seems that the directors may be liable for fraud in cases of active concealment of material information or making mis-statements deliberately. 

Since the Auditors are required to substantiate that there are no material mis-statements made by the directors as aforesaid, where the auditor fails to prove his innocence, he might also be penalised in cases of material misstatement.

Other additional disclosures required to be made in the Auditor’s Report

Compliance of Section 123 of the Act with respect to declaration/payment of dividend

The amended Audit Rules require the auditor to report on compliance with Section 123 of the Act by the company where it has declared/paid dividend. This has been done to ensure that the companies pay dividend on the basis of their profits and satisfies all the necessary conditions, and not when the companies may be suffering losses and it is practically impossible to pay dividend to its members.

Proper maintenance of audit trail at all times during the financial year

The auditors are also required to report on the maintenance of the audit trails and edit logs by the companies who opt to maintain their books of accounts in electronic mode. A discussion of the same is given in the later part of the write-up.

Accounting in electronic form – maintenance of audit trail

With effect from 1st April, 2021 the companies that maintain their accounts electronically by means of accounting software shall be required to ensure that the software is capable of maintaining audit trail and edit logs, and the same is not disabled at any point of time. The auditors are also required to report on the proper maintenance of such systems as discussed earlier.

Impact of the change

The compulsory maintenance of audit trail is a way to ensure the fabrication of books and any subsequent overwriting in the books of accounts. Through the audit trails, any person scrutinising the books of accounts can very easily track what changes have been made to the accounts and can require the company to explain the reasons thereof.

Additional disclosures in the Board’s Report

Applications/proceedings under IBC

Vide the amendments, the directors will be required to report the applications initiated or proceedings pending under IBC. Though the language of the law is not very clear on this, the understanding is that the directors will be required to report on the applications initiated or the proceedings pending against the company. Where such an application or proceedings are pending, the Board’s Report is also required to contain the status of the same as at the end of the year.

Impact of the change

The aforesaid amendment may be said to be an additional reporting requirement to keep the members, the real owners of the company as well as other stakeholders of the company updated about the current status of the company. The “insolvency” is a serious matter and shall not come as a shock to the stakeholders of a company, when the same is announced publicly at a later point of time.

Diabolical valuations of assets 

Another very interesting insertion in the Board’s report is the details including the reason for the differences between the valuations of the company done at the time of one-time settlement and that at the time of taking loans from banks or other financial institutions. This is with a motive to ensure why there is a difference in valuation of the assets of the company at the time of one-time settlements v/s at the time of borrowing funds from the banks and financial institutions.  

Reason of the change

The change is to ensure that the company has not inflated the value of their books at the time of seeking loans from the banks and financial institutions, nor has it deflated the same at the time of proposing one-time settlement.

We understand that there may be various reasons for the differential valuation, like difference in time period and resultant depreciation, amortization etc, or due to varying market forces. Whatever be the reasons, the same needs to be adequately captured in the Board’s Report for the company. 

 

[The version above is a work in progress and we will continue to develop it further. Please do come back to this page. Please feel free to post your comments/questions in the space below.]