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Independent Directors: The Global Perspective

Ajay Kumar KV, Manager and Himanshu Dubey, Executive  (corplaw@vinodkothari.com)

Introduction

The role or failure of independent directors in preventing corporate scandals became one of the central themes in corporate governance in India, and when SEBI issued a Consultation paper proposing a dual approval process for the appointment of independent directors, there was a substantial concern among leading companies in the country. Following discussions, the SEBI board has eventually decided to drop the proposal for dual approval, and instead, go for approval by a special majority. The decision of SEBI to not implement dual approval has not been appreciated by several commentators including Mr. Umakanth Varottil. Therefore, there is a sizzling controversy on the mode of appointment of independent directors.

In this article, we have made a comparison of the legislative framework for independent directors, especially the process of appointment, across various jurisdictions.  While we note that some countries have moved to a dual approval process, the concept such as a database of IDs and a proficiency test remains an Indian aberration.

Independent Directors – Evolution in India

In India, the idea, or rather the need of having Independent Directors on the board of companies (especially those involving public interest) was acknowledged in the early 2000s through the SEBI Listing Agreement. Therefrom, the concept found a concrete legislative recognition in late 2013 as the Companies Act, 2013 took shape and character covering unlisted companies as well.

A snapshot of the concept’s evolution through guidelines and report to the Companies Act and SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 is given below –

As compared to India, the western world was way ahead in the race- the concept of Independent Directors traces its inception as long back as in the 1950s when the murmurs of representation of small shareholders surrounded the corporate world. However, like in India, it took a long time for countries in Europe and North America to bring the concept within the regulatory framework. In the USA, the concept of Independent Director received regulatory recognition under the Sarbanes-Oxley Act, 2002. Thereafter the regulations issued by various stock exchanges took the lead.

Who is an Independent Director – The Indian Viewpoint

With all the hullabaloo about Independent Director, the natural question was ‘who is an independent director’; while the terminology was largely suggestive of the answer – “someone who is capable of putting forth an independent view about the business of the company”, it was crucial to define the term.

The definition of Independent Director from Section 149 of the Companies Act, 2013 (‘Act’) and Regulation 16 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘LODR’). While unlisted companies are required to adhere to the requirement under section 149 of the Act; listed companies or those intending to be listed are required to abide by LODR too.

On the same lines as discussed above, LODR identifies an independent director as someone who is not related to the company, either as a promoter or director of the company, its group companies, who do not have a material pecuniary relationship with the company or its group, as well as someone who does not or has not been related to the company in any manner in the recent position, such that s/he could influence the decisions/ business of the company.

The aforesaid is provided in Regulation 16 of LODR[1], which defines “Independent Director” as “a non-executive director, other than a nominee director of the listed entity, who:

  • who, in the opinion of the board of directors, is a person of integrity and possesses relevant expertise and experience;
  • who is or was not a promoter of the listed entity or its holding, subsidiary or associate company or member of the promoter group of the listed entity;
  • who is not related to promoters or directors in the listed entity, its holding, subsidiary, or associate company;
  • who, apart from receiving director’s remuneration, has or had no material pecuniary relationship with the listed entity, its holding, subsidiary or associate company, or their promoters, or directors, during the  [three]*  immediately preceding financial years or during the current financial year
  • none of whose relatives ;

[(A) is holding securities of or interest in the listed entity, its holding, subsidiary or associate company during the three immediately preceding financial years or during the current financial year of face value in excess of fifty lakh rupees or two percent of the paid-up capital of the listed entity, its holding, subsidiary or associate company, respectively, or such higher sum as may be specified;

(B) is indebted to the listed entity, its holding, subsidiary or associate company or their promoters or directors, in excess of such amount as may be specified during the three immediately preceding financial years or during the current financial year;

(C) has given a guarantee or provided any security in connection with the indebtedness of any third person to the listed entity, its holding, subsidiary or associate company or their promoters or directors, for such amount as may be specified during the three immediately preceding financial years or during the current financial year; or

(D) has any other pecuniary transaction or relationship with the listed entity, its holding, subsidiary or associate company amounting to two percent or more of its gross turnover or total income:

Provided that the pecuniary relationship or transaction with the listed entity, its holding, subsidiary or associate company or their promoters, or directors in relation to points (A) to (D) above shall not exceed two percent of its gross turnover or total income or fifty lakh rupees or such higher amount as may be specified from time to time, whichever is lower;]*

  • who, neither himself/herself nor whose relative(s) —
  • holds or has held the position of a key managerial personnel or is or has been an employee of the listed entity or its holding, subsidiary, or associate company [or any company belonging to the promoter group of the listed entity]* in any of the three financial years immediately preceding the financial year in which he is proposed to be appointed;

[Provided that in case of a relative, who is an employee other than key managerial personnel, the restriction under this clause shall not apply for his / her employment.]*

  • is or has been an employee or proprietor or a partner, in any of the three financial years immediately preceding the financial year in which he is proposed to be appointed, of —
    • a firm of auditors or company secretaries in practice or cost auditors of the listed entity or its holding, subsidiary, or associate company; or
    • any legal or a consulting firm that has or had any transaction with the listed entity, its holding, subsidiary, or associate company amounting to ten percent or more of the gross turnover of such firm;
    • holds together with his relatives two percent or more of the total voting power of the listed entity; or
    • is a chief executive or director, by whatever name called, of any non-profit organisation that receives twenty-five percent or more of its receipts or corpus from the listed entity, any of its promoters, directors or its holding, subsidiary or associate company or that holds two percent or more of the total voting power of the listed entity;
    • is a material supplier, service provider or customer or a lessor or lessee of the listed entity;
  • who is not less than 21 years of age.
  • who is not a non-independent director of another company on the board of which any non-independent director of the listed entity is an independent director

Evidently, the definition in India is very comprehensive compared to other major jurisdictions. Below we discuss and compare some major provisions in the definition of IDs in India, the USA and the UK –

Basis India USA[2] UK[3]
Material relationship The director shall, apart from receiving director’s remuneration, has or had no material pecuniary relationship with the listed entity, its holding, subsidiary or associate company, or their promoters, or directors, during the three immediately preceding financial years or during the current financial year;

 

None of the director’s relatives

[(A)is holding securities of or interest in the listed entity, its holding, subsidiary or associate company during the three immediately preceding financial years or during the current financial year of face value in excess of fifty lakh rupees or two percent of the paid-up capital of the listed entity, its holding, subsidiary or associate company, respectively, or such higher sum as may be specified;

 

(B) is indebted to the listed entity, its holding, subsidiary or associate company or their promoters or directors, in excess of such amount as may be specified during the three immediately preceding financial years or during the current financial year;

 

(C) has given a guarantee or provided any security in connection with the indebtedness of any third person to the listed entity, its holding, subsidiary or associate company or their promoters or directors, for such amount as may be specified during the three immediately preceding financial years or during the current financial year; or

 

(D) has any other pecuniary transaction or relationship with the listed entity, its holding, subsidiary or associate company amounting to two percent or more of its gross turnover or total income:

 

Provided that the pecuniary relationship or transaction with the listed entity, its holding, subsidiary or associate company or their promoters, or directors in relation to points (A) to (D) above shall not exceed two percent of its gross turnover or total income or fifty lakh rupees or such higher amount as may be specified from time to time, whichever is lower;]*

The director qualifies as “independent” unless the board of directors affirmatively determines that the director has no material relationship with the listed company (either directly or as a partner, shareholder, or officer of an organization that has a relationship with the company).

The references to “listed company” would include any parent or subsidiary in a consolidated group with the listed company

The director has, or had within the last three years, no material business relationship with the company, either directly or as a partner, shareholder, director or senior employee of a body that has such a relationship with the company;

 

The director has not received or receives additional remuneration from the company apart from a director’s fee, participates in the company’s share option or a performance-related pay scheme, or is a member of the company’s pension scheme

Employment The director neither himself/herself nor his relatives hold or has held the position of a key managerial personnel or is or has been an employee of the listed entity or its holding, subsidiary or associate company, [or any company belonging to the promoter group of the listed entity]* in any of the three financial years immediately preceding the financial year in which he is proposed to be appointed.

 

[Provided that in case of a relative, who is an employee other than key managerial personnel, the restriction under this clause shall not apply for his / her employment]*

 

The director is not independent if the director is, or has been within the last three years, an employee of the listed company or an immediate family member is, or has been within the last three years, an executive officer, of the listed company.

The director has received or has an immediate family member who has received, during any twelve-month period within the last three years, more than $120,000 indirect compensation from the listed company, other than director and committee fees and pension or other forms of deferred compensation for prior service (provided such compensation is not contingent in any way on continued service).

The director neither is or has been an employee of the company or group within the last five years
Promoter/director or related to them The director is or was not a promoter of the listed entity or its holding, subsidiary or associate company or member of the promoter group of the listed entity;

 

Who is not related to promoters or directors in the listed entity, its holding, subsidiary, or associate company;

 

No director qualifies as “independent” unless the board of directors affirmatively determines that the director has no material relationship with the listed company either directly or as a partner, shareholder, or officer of an organization that has a relationship with the company. The director has close family ties with any of the company’s advisers, directors, or senior employees.
Cross-directorship The director is not a non-independent director of another company on the board of which any non-independent director of the listed entity is an independent director

 

The director or an immediate family member is or has been with the last three years, employed as an executive officer of another company where any of the listed company’s present executive officers at the same time serves or served on that company’s compensation committee. The director holds cross-directorships or has significant links with other directors through involvement in other companies or bodies

 

One may find many similarities in the definition of IDs in foreign jurisdictions with that in India but as already mentioned above, the definition in India is one of the most comprehensive and meticulous ones.

Appointment/reappointment process of IDs in different jurisdictions

In India, the extant provisions require ordinary resolution to be passed by the shareholders for the appointment of IDs and a special resolution in case of re-appointment, based on the recommendation of the Nomination and Remuneration Committee (NRC) and the approval of the Board.

Earlier, SEBI had released a consultation paper w.r.t. regulatory provisions for Independent Directors which warranted a ‘dual approval’ for such appointment/ re-appointment as follows:

  • An ordinary resolution by shareholders (Special Resolution in case of re-appointment) and
  • A resolution by “majority of minority”

(Note: The Paper defined minority shareholders to mean shareholders other than the promoter and promoter group.)

However, owing to the response received thereafter, SEBI, in its Board Meeting held on June 29, 2021[4] (SEBI Board Meeting), disregarded the earlier proposal of a dual approval and instead decided that the approval of shareholders would be required by way of special resolution for both appointment and re-appointment

[SEBI, vide (Listing Obligations and Disclosure Requirements) (Third Amendment) Regulations, 2021 ( ‘Amendments’) notified on August 4, 2021, have amended the Regulation 25 providing that the appointment, re-appointment or removal of an independent director of a listed entity, shall be subject to the approval of shareholders by way of a special resolution. Thus, listed entities henceforth shall have to obtain the approval of members via a special resolution for the appointment as well.]*

In the USA, the NASDAQ Listing Rules provide that, where shareholders’ approval is required, the minimum vote that will constitute shareholder approval shall be a majority of the total votes cast on the proposal.

Akin to the NRC in India, the UK Corporate Governance Code of 2018 requires that the Board should establish a Nomination Committee, composed of majority independent non-executive directors, to lead the process for the appointment of all directors. Any appointment must be approved by the Board and shareholders of the company by way of an ordinary resolution.

However, as per the UK Listing Rules, the appointment of IDs is dependent on the existence of a controlling shareholding[5]. A snapshot of the manner of appointment is given below

Hence, approval is required from both the set of shareholders. If the company still proposes to appoint the same person as an independent director despite failing to receive the dual nod as discussed above, it can propose another resolution to elect the same person, but after 90 days from the date when the previous proposal was put to vote. This time the resolution will only require approval by the shareholders of the company[6].

Databank of Independent Directors & the Online Proficiency Test

One of the prerequisites to become an Independent Director in India is the inclusion of their name in the Databank of Independent Directors (‘Databank’) and passing an Online Proficiency Test (‘Test’) within a period of two years from the date of inclusion of name in the databank as per Section 150 of the Act, read with Rule 6 of the Companies (Appointment and Qualification of Directors) Rules, 2014. However, certain categories of persons have been exempted[7] from the requirement of passing the Test who possess requisite experience and expertise as prescribed;

The question, however, is whether such arduous and tedious criteria required for an appointment really ensure board independence and good governance practices. It is understood that the tenet behind such steps was quality control – it was to ensure that only persons with a certain minimum level of expertise & experience are appointed as Independent Directors.

Further, some previous instances of celebrity directorships were also to be discouraged since the role of IDs is to ensure good governance practices and upholding the interest of all the stakeholders as a whole including minority stakeholders. Therefore, it should not merely be used as a tool of publicity.

However, keeping in mind the seniority of the position of directors in companies as well as lack of precedent, the requirement of passing the test seems rather odd and brings anomalies in the IDs’ regulatory regime in India vis-à-vis the rest of the world.

Constituted Body for selection of candidates for the role of IDs

As per the extant laws in India, the NRC recommends the persons to be appointed as IDs on the board of the company. This committee oversees the functions of formulation and recommendation of remuneration of the directors and the senior management. It has been decided in the SEBI Board Meeting that the process to be followed by NRC while selecting candidates for appointment as IDs, shall be elaborated and be made more transparent including enhanced disclosures regarding the skills required for appointment as an ID and how the proposed candidate fits into that skillset.

[SEBI, via the Amendments, has added a new sub-clause after sub-clause (1) in Para A in Part D of Schedule II for implementing its decision on an elobaroted and transparent selection oricess of IDs.

The NRC of every listed entities shall, for every appointment of IDs,

  • evaluate the balance of skills, knowledge and experience on the Board and on the basis of such evaluation
  • prepare a description of the role and capabilities required of IDs.
  • ensure that the person recommended to the Board for appointment as an ID has the capabilities identified in such description.

For the purpose of identifying suitable candidates, the Committee may:

  1. use the services of an external agencies, if required;
  2. consider candidates from a wide range of backgrounds, having due regard to diversity; and
  3. consider the time commitments of the candidates

Thus, the NRCs of every listed company henceforth has to first formulate the description of the role of an ID after considering the skill sets and knowledge and experience required for acting as an ID of the company. This has also widened the scope of NRC as well as the responsibility for finding the right candidate for the position of an ID. The extant practice was to give disclosures in Corporate Governance Report and the Board report that forms part of the Annual Report of the Company.]*

Just like the NRC in India, companies in the USA have to constitute Compensation Committee as per the NASDAQ Stock Market LLC Rules [5605. Board of Directors and Committees] “Each Company must have, and certify that it has and will continue to have, a compensation committee of at least two members. Each committee member must be an Independent Director as defined under Rule 5605(a) (2).”

As per the NASDAQ Rules, director nominees must either be selected, or recommended for the Board’s selection, either by:

  1. Independent Directors constituting a majority of the Board’s Independent Directors in a vote in which only Independent Directors participate, or
  2. a nominations committee composed solely of Independent Directors.

The New York Stock Exchange Listed Company Manual (‘NYSE Manual’) vests on the nominating/corporate governance committee, the sole authority to retain and/or terminate any search firm to be used to identify director candidates, including sole authority to approve the search firm’s fees and other retention terms.

The UK Corporate Governance Code, 2018 states that the board should establish a remuneration committee of independent non-executive directors, with a minimum membership of three, or in the case of smaller companies, two. In addition, the chair of the board can only be a member if they were independent on appointment and cannot chair the committee. Before appointment as chair of the remuneration committee, the appointee should have served on a remuneration committee for at least 12 months.

Tenure and re-appointment of IDs

In India, one term of appointment of IDs is for a maximum of 5 years and can be re-appointed for another term. Such re-appointment has to be made by way of passing a special resolution. Further, the performance of Independent Directors is to be evaluated every year based on which the NRC recommends whether the said director shall be re-appointed or not. However, the question of such recommendation only comes when the tenure of the director comes to its end.

Furthermore, the UK Corporate Governance Code provides that all directors should be subject to annual re-election.  The code also considers the presence of an ID for more than nine years on the Board of a company as a threat to his independence.

In Singapore, Rule 720(5) of the SGX Listing Rules (Mainboard) / Rule 720(4) of the SGX Listing Rules (Catalist)[8] requires all directors to submit themselves for re-nomination and re-election at least once every three years.

The rule requires a re-nomination & re-election of all directors of the company at least once in 3 years and it helps to ensure that the assessment of independence happens once in every 3 years by members.

Cooling-off Period for appointment/reappointment of IDs

In India, a cooling-off period of 2 years is required in case of any material pecuniary transactions between a person or his/her relative and the listed entity or its holding, subsidiary, or associate company. The LODR has prescribed a cooling-off period of three years for Key Managerial Personnel (and their relatives) or employees of the promoter group companies, for appointment as an ID in the listed entity. However, relatives of employees of the company, its holding, subsidiary, or associate company have been permitted to become IDs, without the requirement of a cooling-off period, in line with the Companies Act, 2013.

[SEBI via Amendments has provided that an ID who resigns from a listed entity, shall not be appointed as an executive / whole time director  on the board of the listed entity, its holding, subsidiary or associate company or on the board of a company belonging to its promoter group, unless one year has elapsed from the date of resignation.]*

The NASDAQ Stock Market LLC Rules[9] (‘NASDAQ Rules’) have prescribed a cooling-off period of 3 years for the appointment of an independent director where such person has a relationship with the company as prescribed under the rule.

UK Corporate Governance Code, 2018[10] (‘UK Code’) provides that a person who has or had within the last three years, a material business relationship with the company, either directly or as a partner, shareholder, director, or senior employee of a body that has such a relationship with the company shall not be appointed as an Independent Director.

The Singapore Code of Corporate Governance, 2018[11] prescribes a cooling-off period of 3 years for the appointment of an independent director where such person has a relationship with the company.

Remuneration of Independent Directors

In India, offering stock options to Independent Directors is prohibited. On the contrary, as per the New York Stock Exchange Listed Company Manual (‘NYSE Manual’), Independent directors must not accept any consulting, advisory, or other compensatory fees from the Company other than for board service.

Further, the UK Corporate Governance Code 2018 provides that remuneration for all non-executive directors should not include share options or other performance-related elements. Independent directors shall not be a member of the company’s pension scheme.

The Singapore Code of Corporate Governance 2018 the Remuneration Committee should also consider implementing schemes to encourage non-executive directors (NEDs) to hold shares in the company so as to better align the interests of such NEDs with the interests of shareholders. However, NEDs should not be over-compensated to the extent that their independence may be compromised.

Fees payable to non-executive directors shall be by a fixed sum, and not by a commission on or a percentage of profits or turnover. (Appendix 2.2 Articles of Association)

Important determinants of Independence across jurisdictions

Determinants of Independence India USA UK Singapore
Present or past employment relationship Yes Yes Yes Yes
Relationship of close family members Yes Yes Yes Yes
Pecuniary relationship with company* Yes Yes Yes Yes
Cooling-off period Yes Yes Yes Yes
Restriction on Stock options Yes Yes Yes No
ID databank & Proficiency test Yes No No No

* Subject to specific monetary limits

Conclusion

The regulatory framework for Independent Directors in India has a lot of things in common with other jurisdictions around the world. However, the requirement of passing an online test for becoming eligible to be appointed as an Independent Director is something peculiar to India. The regulators across jurisdictions have been proactive in bringing changes to the Independent Director regime, to strengthen the corporate governance in listed companies. One may expect some of the above discussed benchmark practices in different foreign jurisdictions may soon be adopted in India as well.

Related presentation – https://vinodkothari.com/2021/08/ensuring-board-continuity-and-balance-of-capabilities/

[1] https://www.sebi.gov.in/legal/regulations/sep-2015/securities-and-exchange-board-of-india-listing-obligations-and-disclosure-requirement-regulations-2015-last-amended-on-may-5-2021-_37269.html

[2]  https://nyse.wolterskluwer.cloud/listed-company-manual

[3]https://www.frc.org.uk/getattachment/88bd8c45-50ea-4841-95b0-d2f4f48069a2/2018-UK-Corporate-Governance-Code-FINAL.PDF

[4] https://www.sebi.gov.in/media/press-releases/jun-2021/sebi-board-meeting_50771.html

[5] A company is said to have controlling shareholder(s) if a shareholder/ an entity/ a group holds more than 30% voting power in the company

[6] https://www.mondaq.com/uk/acquisition-financelbosmbos/315598/new-dual-process-for-appointing-independent-directors-amendments-to-articles-of-association

[7] https://www.independentdirectorsdatabank.in/pdf/databank-rules/FifthAmdtRules_18122020.pdf

[8] https://rulebook.sgx.com/rulebook/board-matters-1

[9] https://listingcenter.nasdaq.com/rulebook/nasdaq/rules

[10] https://www.frc.org.uk/getattachment/88bd8c45-50ea-4841-95b0-d2f4f48069a2/2018-UK-Corporate-Governance-Code-FINAL.PD

[11] https://www.mas.gov.sg/-/media/MAS/Regulations-and-Financial-Stability/Regulatory-and-Supervisory-Framework/Corporate-Governance-of-Listed-Companies/Code-of-Corporate-Governance-6-Aug-2018.pdf

*[ The changes are applicable with effect from 1st January, 2022].

Re-appointment of Independent Directors: An Analysis

Sharon Pinto, Manager, corplaw@vinodkothari.com

Introduction

Proxy advisors are entities that undertake research on corporate governance norms and practices followed across different corporates. They formulate their policies based on their research and appropriately established benchmarks. The proxy advisory firms play a role in strengthening the corporate governance as investor clients access the reports and recommendation of the said advisory firms while forming their opinions. As investors due to their vast shareholding may not be privy to the working of the company, they may rely on the analysis done by the proxy advisors and their recommendations. We have discussed the scope of guidelines issued by proxy advisors in a separate article[1].

While such reports and guidelines as mentioned above can act as a guidance for the investors to take a sound decision, the legal standing of the report can be considered a hiccup in the said process as the same does not obtain regulatory approval. We have discussed the scope and legal validity of such guidelines in a separate article.[2]

One such guideline has been issued w.r.t. re-appointment of Independent Directors under Section 149 (10) of the Companies Act, 2013 (‘the Act’). The said contention has been a question of interpretation with different practices being followed by various companies. In this article we have discussed the interpretation of the said provision while stating the process of re-appointment of Independent Directors (‘IDs’).

Pre-requisites for appointment of IDs

Section 149 (6) of the Act read with Rule 5 of the Companies (Appointment & Qualification of Director) Rules, 2014 states the criteria that shall determine the independence of the director proposed to be appointed. In case of an entity with its specified securities listed on the stock exchange, the conditions set forth by Regulation 16 (1) (b) of SEBI (Listing Obligation and Disclosure Requirements) Regulations (‘SEBI Regulations’) shall also be fulfilled in order to be eligible for appointment as an ID. The said provisions under the Act and SEBI Regulations entail certain pecuniary limits which are necessary to ascertain any monetary relationship of the director with the company, which may affect their independence. As the given criteria is a pre-requisite at the time of appointment of a director, it shall also be mandatory to be fulfilled at the time of re-appointment. Thus, if an ID continues to be eligible as per the said conditions, they shall be proposed to be re-appointed for a second term in the company.

Pursuant to the SEBI (Listing Obligation and Disclosure Requirements), 2021 (Third Amendment Regulations), the criteria of independence prescribed under Regulation 16 (1) (b) has been revised aligning the same with the provisions of the Act. However, while the Act provides for the period of 2 immediately preceding financial years for determining whether the person or his relatives have any material pecuniary relationship with the company, the revised SEBI Regulations now prescribe for a period of 3 immediately preceding financial years for determination of the same.

Further, the conditions prescribed under the Act relating to holding of any interest or security, indebtedness, any guarantee or security provided in connection to indebtedness of a third person or any other pecuniary relationship with the company or its holding or subsidiary or associate company have also been inserted in the SEBI Regulations, which provide for stricter period of compliance of the said conditions. While, the relatives may be employees in the entities stated above, they are prohibited from holding the position of a KMP. As the criteria of independence is to be observed even in the case of re-appointment, these conditions will ensure the independence of the ID.

In addition to the criteria of independence, the existing IDs of the company are required to abide by the code of conduct prescribed under Schedule IV of the Act. Any breach of the code by the directors shall make them ineligible for continuing in the position of ID of the company.

Performance Evaluation

The re-appointment of an existing director for a second term, in addition with the establishment of their independence shall also be subject to performance evaluation. The Act under Section 178 (2) states that the Nomination and Remuneration Committee (‘NRC’) of the company shall formulate a criteria for determining the qualifications, positive attributes, independence for appointment of a director. Further the committee shall also establish a criteria for the evaluation of performance of the Board as well as individual directors. Thus on the basis of such performance evaluation and establishment of independence and possession of requisite skills by the director, the NRC shall recommend the appointment or in case of an existing director, re-appointment of the said director to the Board.

SEBI[3] has detailed an elaborated process to be followed by NRC for selection of ID, including more transparent and enhanced disclosures regarding  the  skills  required  for  appointment  as  an  ID  and  how  the proposed candidate fits into that skillset. As per the Third Amendment Regulations, the said additional disclosures stating the skills and capabilities required for the role and the manner in which the proposed person meets the requirements, will be required to be provided in the notice in the case of re-appointment of an ID. Thus, NRC of the company will be required to undertake an assessment determining whether the person proposed to be re-appointed as the ID possesses the skills required for the position in addition to performance evaluation even in the case of re-appointment.

SEBI under Regulation 17 (10) of the SEBI Regulations has stated that the performance evaluation of the IDs shall be done by the entire Board of Directors where the concerned ID shall not participate in the said discussion. The Board shall consider performance of the director in addition to fulfilment of independence criteria similar to the provisions stipulated under Companies Act, 2013 as discussed above. Thus the director proposed to be re-appointed has to satisfy the afore-mentioned dual conditions.

Process of re-appointment

Section 149 (10) of the Act has specified the process of reappointment of an ID. It states that a director shall be eligible for re-appointment by passing of a special resolution. Thus we may infer that in order to be re-appointed as an ID, a special resolution is required to be passed. Regulation 17 (11) of SEBI Regulations provides for stating recommendation of the Board for every for every special item of business in the explanatory statement annexed to the notice. As discussed above, Board on the basis of performance evaluation carried out and the recommendation of the NRC shall recommend the re-appointment of the ID. Criteria of independence being a pre-requisite for such re-appointment as established herein, the director shall be considered as an additional independent director until approval of shareholders is obtained at the general meeting of the Company.

Further, SEBI vide its consultation paper on Independent Directors[4] had proposed prior approval of shareholders for appointment and re-appointment of IDs, while stating that the existing procedure entails proposal of candidate by the NRC and appointment/re-appointment by Board which is subsequently approved by shareholders by an ordinary resolution in case of appointment whereas special resolution in case of re-appointment. Accordingly, seeking prior approval of shareholders is not a pre-requisite at present.

After end of first tenure of the ID, the office of director shall cease. Accordingly, Board will approve appointment as additional director till ensuing AGM and propose re-appointment as an ID for second term of upto 5 consecutive years.

As discussed above, re-appointment after the end of the tenure is required to be considered akin to fresh appointment of the person, thereby necessitating the confirmation with criteria of independence, assessment of skills and capabilities and the manner in which such appointee continues to meet the requirements of the company. Therefore, the Board has a power to appoint the person as an additional ID, whose appointment shall thereafter be approved at the general meeting.

Timeline for re-appointment

In order to understand the timeline in the case of re-appointment, we will have to consider the revised Regulation 17(1C) SEBI Regulations. Regulation 17 (1C) provides for approval of appointment of a person as a director of the company to be done within the next general meeting or 3 months, whichever is earlier. Since, re-appointment on account of end of term results into fresh appointment, the same shall also apply in case of re-appointment of an ID. Further, Regulation 25 (2A) has now provided for a special resolution to be obtained in case of appointment as well as re-appointment. The same prescribes for the mode of obtaining approval but is silent on the timeline, to be followed, requiring reference to Regulation 17 (1C). For a better understanding of the same, let us look at the following cases.

Case 1: Re-appointment of a person as an ID before the end of his/her tenure:

  1. The NRC of the company will be required to follow the due process for evaluation of the person for re-appointment as stipulated under the revised provisions and recommend the same to the Board.
  2. The Board will thereafter confirm on the skills and capabilities as required for the position and that the proposed appointee possesses the same and provide disclosure of the same to the shareholders in the notice for re-appointment.
  3. At the ensuing general meeting the company may re-appoint the person as ID for a second term by passing a special resolution with effect from the date immediately following the last day of the current tenure.

Case 2: Re-appointment of a person as an ID post the end of tenure:

  1. Since the tenure of the ID has been terminated, the office of the ID will stand vacated and the Board will be required to appoint the person as an Additional Director (Non-executive, ID category).
  2. The process as mentioned under points a & b above in relation to assessment of the candidate and requisite disclosures to be done will be required to be followed.
  3. As per Regulation 17(1C), shareholder approval for the re-appointment will be required to be obtained within 3 months of appointment by the Board as an additional ID or next general meeting, whichever is earlier.

Effect of re-appointment by the Board

The provisions of the Act mandate the shareholders to approve appointment of IDs at general meeting but does not mandate appointment from the date of general meeting. ‘Independent Director’ is the nature of directorship and ‘Additional Director, Non-Executive’ is the category of directorship. It cannot be inferred that the said director was not independent from the date of Board resolution appointing him as Additional Director till the date of general meeting. Therefore, the effective date of appointment can be considered from the date of Board resolution or any subsequent date prescribed by the Board.

The recent changes in the provisions as stated above will result in reducing the gap between appointment of an ID on the Board of the company and approval of the said appointment by shareholders. While it is seen that some companies take up the re-appointment of the IDs by way of postal ballot before the end of tenure in case there exists a gap between the AGM and the end of term, the same shall be construed as a good governance practice, as prior approval of shareholders has not been mandated by law on account of the same not being specifically stated. Thus in case of re-appointment post end of tenure, the same cannot be viewed as a violation of provisions.

Conclusion

The ambit of proxy advisors in India is as prescribed under SEBI regulations and guidelines issued in this regard. While they may issue guidelines based on the best governance practices as established by them and recommend the same to the investors, there is a need to incorporate a check for discerning the nature and scope of such guidelines, so the investor may have a clear view of the propositions put forth. With the process of appointment of IDs being enhanced in the manner specified above, in addition to the newly inserted disclosure requirements, will make the appointment/re-appointment process of IDs more transparent and effective while ensuring greater conformity of their independence.

 

Related presentation – https://vinodkothari.com/2021/08/ensuring-board-continuity-and-balance-of-capabilities/

[1] https://vinodkothari.com/2021/06/scope-of-proxy-advisors-to-issue-general-voting-guidelines/

[2] https://vinodkothari.com/2021/07/proxy-advisors-corporate-decision-making/

[3] https://www.sebi.gov.in/media/press-releases/jun-2021/sebi-board-meeting_50771.html

[4]https://www.sebi.gov.in/reports-and-statistics/reports/mar-2021/consultation-paper-on-review-of-regulatory-provisions-related-to-independent-directors_49336.html

GST on consideration paid to a director

Demarcation of salary and fees makes the difference

-Kanakprabha Jethani and Qasim Saif

(finserv@vinodkothari.com)

Introduction

The Goods and Services Tax laws (GST) introduced in 2017, also brought with itself, a concept of Reverse Charge Mechanism (RCM). GST is a tax on supply, however, under the concept of RCM, the liability to pay tax is on the recipient of supply of goods and services instead of the supplier of such goods or services.

Section 9(3) and 9(4) of the Central Goods and Services Tax Act, 2017 (CGST Act) provide two scenarios in which tax shall be chargeable on RCM basis:

  1. Supplies notified by Government u/s 9(3)
  2. Taxable Supplies by unregistered person to registered person

The government, pursuant to section 9(3) notified that any services supplied by a director of a company to the said company shall be taxed on RCM basis.  

While it is clear that as per section 7(2) and schedule III of the CGST Act keep the services provided by an employee to its employer outside the purview of GST. This raised concerns on differential treatment between services of an executive director and an employee of a company.

The recent ruling of Rajasthan Authority of Advance Ruling (AAR) has provided a landmark decision that would be guiding the tax treatment of services provided by the directors. The following write-up intends to provide a basic understanding of RCM and critically analyse the ruling of Rajasthan AAR.

Understanding RCM

RCM can be understood as a method of levying GST under which the liability to pay tax is upon the recipient of services rather than on supplier. Following figure explains taxation on RCM basis:

For further understanding of taxability on RCM basis- read our detailed FAQs here- http://vinodkothari.com/2017/08/faqs-on-gst-on-directors-remuneration/#_ftn3

Levy of GST on Director’s Remuneration

As discussed above, the focal point of issued in GST on director’s remuneration is that GST is not chargeable on services provided by employees but is chargeable of services of directors. Hence, the key question for determination of GST liability will be determining the nature of the employment of a person.

Can director be an employee?

Principally yes. Going by the principles of the Companies Act, 2013 (CA), there is no bar on a director handling operations of a company like any other employee. In fact, the CA has a concept of executive and non-executive directors. Rule 2 (k) of the Companies (Specification of Definitions Details) Rules, 2014 defines executive director as-

“Executive Director” means a whole time director as defined in clause (94) of section 2 of the Act;

Further, whole-time director is defines in the CA as-

“whole-time director” includes a director in the whole-time employment of the company

From the above, it is clear that a director can also be an employee of a company.

Taxability on services of ‘Director + Employee’

The above discussion clarifies that a person can be both employee as well as director of a company. The question in this case will be the whether services provided by such person would be taxable under GST law? Would an executive director be treated as an employee of a company both under CA and CGST Act?

This issue was raised in the matter of Clay Craft India Private Limited[1] (‘Company’), where advance ruling was sought on whether GST would be payable on RCM basis on the salary paid to directors, given that-

  • directors are compensated by way of regular salary and other allowances as per the employment contract;
  • the Company is deducting TDS on salary and also PF norms are being complied;
  • the income of directors is shown as “income from salary” by the directors in their ITRs;
  • the Company deducts EPF contribution from the salary of directors as it does for its other employees;
  • the Company pays GST on commission paid to the directors but not on the salary paid to them.

The AAR, considering the above facts, provided the following observations:

  • GST law does not recognise payment of salary to directors. It only recognises ‘consideration’ paid to directors- which shall mean any payment made or to be made, whether in money or otherwise, in respect of, in response to or for inducement of, the supply of goods or services or both.
  • Consideration paid to directors is specifically recognised through notification[2] issued under section 9(3).

Based on the above observations, the AAR held that any consideration paid to directors shall be taxable on RCM basis.

Analysis of the Ruling

The above discussed ruling failed to consider the existence of relationship of master and servant which is present in the employer-employee relationship.

Also, the AAR did not consider that the definition of whole time director under section 2(94) of the CA. The contention that director cannot be an employee does not hold good at all times.

It is pertinent to note that the outcome of an advance ruling is applicable only on the assessee who was involved in the case. However, the rulings provide guidance on the stand of revenue authorities.

Clarification issued by the CBIC

The CBIC issued a circular on June 10, 2020[3], which clearly demarcated between services provided by an independent director and a whole-time director.

Consideration for services of Independent Director

The circular clarifies that an independent director cannot be an employee of the company as definition of Independent director under section 149(6) of companies Act, 2013 state that a person being employee of Company, or its holding, subsidiary or its associate cannot be an independent director.

Hence, GST will be levied on his remuneration and the company shall be liable to pay the same on reverse charge basis.

Consideration for services of a Whole-time Director

The circular also clarified that the employer-employee relationship of a director in a company may be established on following grounds:

  • Existence of “contract of service”;
  • Remuneration paid to such director being disclosed as salaries in the accounts of company;
  • TDS being deducted under section 192 of Income Tax Act on the consideration paid to such director;

Where the above grounds are satisfied, the services provided by director in such cases shall be exempt under Schedule III of CGST Act, 2017.

However, if the remuneration is declared as any expense other than salary say professional fees, and TDS is deducted under section 192J of IT Act (Fees for professional or technical services) it shall be treated as consideration for providing service and tax on such consideration shall be paid by the company on RCM basis.

Conclusion

A person may provide his/her services to a company as an employee or a director or both. If the consideration paid is recorded as income from salary, the same is not chargeable under GST. If it is not shown as salary income under IT Act, GST on the same will be chargeable on RCM basis. Obviously, where part of consideration is shown as salary income and part is shown as other income, the GST shall be charged on the part other than salary.

The AAR ruling failed to recognise the principles of the CA that differentiate between executive and non-executive directors. However, the clarification issued by CBIC recognises those principles and provides guidance on taxability in both cases.

[1] http://www.gstcouncil.gov.in/sites/default/files/ruling-new/RAJ_AAR_33_2019-20_20.02.2020_CCIPL.pdf

[2] https://www.cbic.gov.in/resources//htdocs-cbec/gst/Notification13-CGST.pdf

[3] https://www.cbic.gov.in/resources/htdocs-cbec/gst/Circular_Refund_140_10_2020.pdf