India: Between The Lines... June, 2017

Last Updated: 28 June 2017
Article by Vaish Associates Advocates

Highlights

  1. Delhi High Court rules on piercing the corporate veil in the matter of arbitration
  2. Bombay High Court grants ad-interim relief under Section 9 to foreign award holder; holds exclusion of Part I must be in specific words
  3. Capital Gains Tax – Exemption Still Protected
  4. Are Pharma Companies in India violating FEMA provisions?
  5. Can SEBI levy interest on a penalty retrospectively?

I. Delhi High Court rules on piercing the corporate veil in the matter of arbitration

The Delhi High Court (the "Court") in the matter of Sudhir Gopi (the "Petitioner") v. Indira Gandhi National Open University ("IGNOU") and Ors. (the "Respondent") passed an order on May 16, 2017 deciding whether the corporate veil ("veil") should be lifted in the matters of arbitration and whether in pursuance of the same, a non-signatory to the agreement can be held personally liable for the claims arising out of the agreement.

Background

Mr. Sudhir Gopi was the Chairman and Managing Director of Universal Empire Institute of Technology ("UEIT") holding 99% shares in UEIT which is a Limited Liability Company incorporated under United Arab Laws. IGNOU is a statutory university that develops educational programmes for distance learning.

UEIT and IGNOU agreed to collaborate for a distance educational project in Dubai, UAE and entered into an agreement dated November 16, 2005 for three years which was further renewed by the parties. The disputes arose between them as IGNOU contended that UEIT failed and neglected to remit collected fees to it, and on the other hand, UEIT claimed that IGNOU had enrolled students that were operating illegally outside the trade free zone, thereby affecting it adversely. IGNOU terminated the agreement and also invoked its arbitration clause claiming against both UEIT and the Petitioner. Both UEIT and the Petitioner, in their replies contended that the statement of claims filed by IGNOU was bad for misjoinder of parties as the Petitioner was not a party to the agreement.

The arbitral tribunal awarded a sum of USD 664,070 along with interest at the rate of 12% per annum on the awarded amount from the date of the award till full realisation of such in favour of IGNOU against the Petitioner and UEIT, holding them both, jointly and severally liable.

The Petitioner thus filed the present petition to set aside the award under Section 34 of the Arbitration and Conciliation Act, 1996 (the "Act"). The Petitioner also raised an issue before the Court challenging the sustainability of the award to the extent that it made the Petitioner jointly and severally liable, considering the fact that the Petitioner was not a signatory to the agreement.

Arguments

The Petitioner contended that the arbitration tribunal does not have the power to proceed against a non- signatory party to the arbitration agreement. He relied upon various cases like Balmer Lawrie & Company Ltd. v. Saraswathi Chemicals Proprietors Saraswathi Leather Chemicals Ltd (decided on March 17, 2017), Oil and Natural Gas Corporation Ltd. v. Jindal Drilling and Industries Ltd. (decided on April 28, 2015), Great Pacific Navigation (Holdings) Corporation Limited v. M V Tongli Yantai (decided on October 14, 2011) in support of his contention.

The Respondent contended that the Petitioner is holding 99% shares of UEIT and therefore the Petitioner was running the business under the facade of UEIT and essentially there was no difference between the two. Also, the Petitioner and UEIT had filed a common reply to the statement of claims and had jointly filed counter claims; therefore he should be precluded from challenging the jurisdiction of the arbitral tribunal at a subsequent stage after participating in it at its initial stage. It relied on the decision in Union of India v. Pam Development Pvt. Ltd. (2014) 1 SCR 1069. It also stated that the arbitration tribunal is empowered to and should lift the veil in the cases similar to the present one, supporting the contention through case laws such as Purple Medical Solutions Pvt. Ltd. v. MIV Therapeutics Inc. and Ors. 2015 (2) SCALE 127and Ram Kishan and Sons v. Freeway Marketing (India) (P) Ltd. 2004 (2) ArbLR 508 (Delhi).

Observations of the Court and its decision

The Court observed that the Petitioner did not sign the agreement in his personal capacity. It stated,

"Like consummated romance, arbitration rests on consent. The jurisdiction of the arbitrator is circumscribed by the agreement between the parties and it is obvious that such limited jurisdiction cannot be used to bring within its ambit, persons that are outside the circle of consent. Thus, an arbitrator would not have the power to pierce the corporate veil so as to bind other parties who have not agreed to arbitrate."

The Court observed that the arbitral tribunal had lifted the veil only for the reason that UEIT's business was being conducted by the Petitioner and that was impermissible under the law. It heavily relied on the judgment in the case of Life Insurance Corporation of India v. Escorts Ltd. and Ors. (1986) 1 SCC 264 wherein the Supreme Court had observed that,

"A corporate veil can be pierced only in rare cases where the Court comes to the conclusion that the conduct of the shareholder is abusive and the corporate facade is used for an improper purpose, for perpetuating a fraud, or for circumventing a statute. It is only in exceptional cases that a court would lift the corporate veil. "

The Court held that an arbitration agreement can be extended to non-signatories only in the aforementioned limited circumstances. It found that the corporate facade of UEIT was not used by the Petitioner to perpetuate a fraud. A mere failure of UEIT to meet its contractual obligations should not be a ground to lift the veil. Thus, the decision of the tribunal was flawed and opposed to the fundamental policy of Indian law that recognises a company as a separate legal entity.

It set aside the award to the extent where the petitioner was held personally liable for the awarded amounts.

VA View

This is a significant ruling coming from the Delhi High Court. As rightly noted by the Court, the arbitration tribunal will be obliged to maintain the sanctity and privity of the arbitration agreement and should not be in favour of lifting the corporate veil, in the case where one or more parties to the agreement are corporate entities. The grounds for lifting the corporate veil are specific and the arbitration tribunal should confine itself to them.

Additionally, if the parties feel that such grounds are present, they should raise it in front of the arbitration tribunal itself at an early stage and should prove the facts and circumstances that necessitate the lifting of the corporate veil. In absence of pleading of such existing grounds by the parties, the arbitration tribunal cannot disregard the distinction between the existence of a separate legal entity from its owners. If it does so, then, such would be redundant to the public policy of the country and enforcement of such impugned award can be set aside under Section 34 of the Act.

II. Bombay High Court grants ad-interim relief under Section 9 to foreign award holder; holds exclusion of Part I must be in specific words

The Hon'ble Bombay High Court in the case of Aircon Beibars FZE vs. Heligo Charters Pvt. Ltd. (decided on April 28, 2017) has held that the exclusion of Part I of the Arbitration and Conciliation Act, 1996 (the "Act") must be in specific words, saying that Part I of the Act (or some sections of it) will not apply to the arbitration between the parties. The Court allowed an urgent application of a foreign award holder for ad-interim reliefs under Section 9 of the Act.

Background

The Petitioner had an agreement with the Respondent in relation to a sale of a helicopter and had a foreign award in its favour dated January 25, 2017. The only significant asset held by the Respondent in India was an Augusta Helicopter and the Petitioner had doubts that the Respondent can remove the helicopter from the jurisdiction of the Court so as to frustrate the enforcement of the foreign award. The Court was, therefore, moved by the Petitioner for ad-interim relief under Section 9 of the Act to secure the amount of the said foreign award by preventing the Respondent from alienating the helicopter.

Arguments

The Respondent side contended that Section 9 of the Act was not applicable to a foreign award governed by Part II of the Act and hence the present petition was not maintainable. The Respondent laid emphasis on the proviso added to Section 2 (2) of the Act by the amending Act of 2016 which is as follows:

"Provided that subject an agreement to the contrary, the provisions of sections 9, 27 and clause (a) of Sub-section (1) and sub-section (3) of section 37 shall also apply to international commercial arbitration, even if the place of arbitration is outside India, and an arbitral award made or to be made in such place is enforceable and recognised under the provisions of Part II of this Act."

The Respondent argued that there was an agreement to the contrary as the arbitration clause specified that the contract was to be governed and construed in accordance with the law of Singapore and was to be referred to arbitration in Singapore in accordance with the Rules of the Singapore International Arbitration Centre. According to the Respondent, this was to be construed as a complete exclusion of Part I of the Act and even the whole of the Act.

The other argument of the Respondent was based on Section 48 of the Act. The Respondent argued that, for Section 9 of the Act to be made applicable, the foreign award must be enforceable, meaning that it must pass through the rigour of Section 48 of the Act. Under Section 48, enforcement of a foreign award can be refused by an Indian Court on satisfaction of certain conditions as specified under the said Section. The stress was on the words "enforceable and recognised" used in proviso to Section 2(2) of the Act. As contended by the Respondent, this was "reference to a foreign award that passes through Section 48 and emerges enforceable in India and thus recognized". Therefore, the Respondent submitted that a Section 9 order could only be sought in the period between the Section 48 order and the time of execution of the award.

The Respondent further submitted that there was no assertion in the petition that the Respondent was likely to deal with the helicopter in order to defeat or delay anyone.

Observations of the Court

The Court observed that the applicability of Section 2(2) of the Act and its proviso is not excluded by an arbitration agreement merely providing for foreign venue and foreign law. The Court held that, "the exclusion must be in specific words, saying that Part I (or some sections of it) will not apply to the arbitration between the parties".

On the argument of the Respondent with regard to Section 48 of the Act, the Court rejected the reading of the proviso to Section 2(2) of the Act as suggested by the Respondent. According to the Respondent, Section 9 order could only be sought during the period between the time of the Section 48 order and the time of execution of the award. Thus, if this argument of the Respondent was to be accepted, as also observed by the Court, there would be no remedy to protect assets between the time of passing of a foreign award until an order is made under Section 48 of the Act. As the Court observed, "What the proviso seeks to do by amendment is to make available a remedy or recourse under Section 9 as a transitory provision pending the process contemplated by Section 48. This is obviously intended to ensure that a court can step in to protect an asset from being diverted or dissipated, and to ensure that the holder of a foreign award has, if he is able to get his foreign award pronounced enforceable, an asset against which he can proceed."  The Court supported its observations by citing certain passages from the 246th Report of the Law Commission.

Decision

The Court ultimately granted ad-interim injunction in favour of the Petitioner subject to a first charge of the Union Bank of India. The Court, however, clarified that the Respondent could use the helicopter for certain operations.

VA View

It is pertinent to note the Court's observations with regard to the exclusion of Part I of the Act. The Court has noted that mere applicability of foreign law and venue will not suffice. According to the Court, the exclusion must be in specific words, saying that Part I (or some sections of it) will not apply to the arbitration between the parties.

This judgment sends positive signals to foreign investors as foreign award holders can take recourse to remedy under Section 9 of the Act providing for ad-interim reliefs, unless applicability of Part-I of the Act is specifically excluded by the parties as noted above.

III. Capital Gains Tax – Exemption Still Protected

Prior to the amendment introduced by Finance Act, 2017, section 10(38) of the Income Tax Act, 1961 ("the Act") provided that the income under the head long term capital gains arising on transfer of equity shares in a company shall be exempt from tax if such transfer is undertaken after 1st October, 2004 and is chargeable to Securities Transaction Tax ("STT").

The Finance Act, 2017 amended Section 10(38) of the Act to provide that exemption under the section shall be available only if the acquisition of such share is also chargeable to STT. This amendment has been introduced to curb the practice of declaring unaccounted income as exempt capital gains by entering into sham transactions. However, in order to protect genuine transactions where STT could not have been paid, it was provided that the Central Government shall notify such acquisitions/transfers for which the condition of chargeability to STT shall not apply.

A draft of the notification for public comments / suggestions was released by the CBDT in April, 2017. After considering all the comments received from the various stakeholders, the government has now suitably amended the draft of the notification and issued the Notification 43 of 2017 dated June 5, 2017 ("the final notification").

The final notification provides that the following transactions of acquisition of equity shares will not be eligible for exemption from capital gains tax:

  1. Acquisition of existing listed equity shares in a company whose equity shares are not frequently traded in a recognised stock exchange of India, made through a preferential issue.

    However, to protect genuine cases, the following transfers have been kept outside the scope of the above clause by the CBDT:

    1. acquisition is approved by the Supreme Court, High Courts, NCLT, SEBI, or RBI.
    2. acquisition by any non-resident in accordance with FDI guidelines.
    3. acquisition by specified Investment Funds, Venture Capital Funds, Qualified Institutional Buyers
    4. acquisitions through preferential issue to which the provisions of chapter VII of the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2009 do not apply.
  2. Acquisition of equity share of a company during the period beginning from the date on which the company is delisted from a recognized stock exchange and ending on the date immediately preceding the date on which the company is again listed on a recognized stock exchange.

    In addition to the exceptions listed in a) above, all the following transactions for acquisition of existing listed equity share in a company made in accordance with the provisions of Securities Contracts (Regulation) Act, 1956 (wherever applicable) shall also continue to remain tax exempt :

    1. acquisition through an issue of share by a company other than the issue covered under preferential issue;
    2. acquisition by scheduled banks, reconstruction or securitization companies or public financial institutions during their ordinary course of business;
    3. acquisition under ESOP/ESPS scheme framed under SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines,1999;
    4. acquisition made under SEBI (Substantial Acquisition of Shares and Takeovers) Regulation, 2011
    5. acquisition from government;
    6. acquisition by mode of transfer referred to in section 47 or through slump sale under section 50B of the Act, if the previous owner of such shares has not acquired them by any mode which is not exempt under the final notification.
VA View

The final notification, as applicable for assessment years 2018-19 and onwards, providing a negative list of transactions which would not be exempt is definitely a step in the right direction as it negates the concerns of genuine investors. While the notification seems to encompass several off- market transactions, the government has cut the frills by capturing only secondary purchase of existing listed equity shares and not primary transactions like issue of new shares (IPOs, FPOs, bonus issue, rights issue) unless the same falls under clause (a) of the notification. Further, by exempting bonafide transactions such as shares acquired through ESOPs, gifts, family partitions, inheritance, will, amalgamation, demerger, slump sale, etc. the government has mitigated the unintended consequences of taxing transactions which are not anti-abuse.

IV. Are Pharma companies in India violating FEMA provisions?

Recently, the Reserve Bank of India ("RBI") has noted that some Indian pharmaceutical companies have been transferring their assets including Intellectual Property ("IP") to their offshore subsidiaries in the tax haven jurisdictions as a matter of common practice. The regulator is of the view that these activities of the companies may amount to violation of Foreign Exchange Management Act ("FEMA") provisions and External Commercial Borrowing ("ECB") rules.

The modus operandi that most of the Indian pharma companies follow is that they transfer their asset to their overseas subsidiary, which in turn, raises a loan against a guarantee or collateral given by its Indian parent company in order to pay for the purchase consideration of such asset. The following is a diagrammatic representation of this arrangement:

It is pertinent to reproduce the relevant FEMA and ECB provisions attracted by such activities here:

Regulation 3 of the Foreign Exchange Management (Guarantees) Regulations, 2000, (notified vide Notification No. FEMA 8 /2000-RB dated May 03, 2000),provides that:

"Save as otherwise provided in these regulations, or with the general or special permission of the Reserve Bank, no person resident in India shall give a guarantee or surety in respect of, or undertake a transaction, by whatever name called, which has the effect of guaranteeing, a debt, obligation or other liability owed by a person resident in India to, or incurred by, a person resident outside India"

Regulation 6 of the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004, (notified vide Notification No. FEMA 120/2004-RB dated July 07, 2004),provides that:

"An Indian party may make direct investment in a Joint Venture ("JV") or Wholly Owned Subsidiary ("WOS") outside India which is engaged in a bona fide business activity.

The Indian Party may extend a loan or a guarantee to or on behalf of the JV/WOS abroad, within the permissible financial commitment, provided that the Indian Party has made investment by way of contribution to the equity capital of the Joint Venture."

The RBI circular on Routing of funds raised abroad to India (A.P. (DIR Series) Circular No. 41 dated November 25, 2014) provides that:

"(i) Indian companies or their AD Category – I banks are not allowed to issue any direct or indirect guarantee or create any contingent liability or offer any security in any form for such borrowings by their overseas holding / associate / subsidiary / group companies except for the purposes explicitly permitted in the relevant Regulations.

(ii) Further, funds raised abroad by overseas holding / associate / subsidiary / group companies of Indian companies with support of the Indian companies or their AD Category – I banks as mentioned at (i) above cannot be used in India unless it conforms to the general or specific permission granted under the relevant Regulations.

(iii) Indian companies or their AD Category – I banks using or establishing structures which contravene the above shall render themselves liable for penal action as prescribed under FEMA, 1999."

Thus, when an off-shore entity is not engaged in the bona fide business or if it does not utilize the loan funds in its overseas business and rather remits those to the Indian parent company, it can clearly be held in violation of the FEMA provisions and ECB rules. RBI in that case, can force Indian company to unwind such investment and also hold it liable for contravention of FEMA provisions thereby attracting penalty as mentioned under FEMA or settlement fee for compounding such offence.

RBI through its circular Overseas Direct Investment (ODI) – Rationalization and reporting of ODI Forms (A.P. (DIR Series) Circular No.62 dated April 13, 2016) has mandated various compliances to be done by the companies in relation to their overseas entity, inter alia, requiring them to file annual performance report on their WOS and JV. On scrutiny of these filings, the RBI is viewing them to be merely a tax avoidance arrangement and round-tripping of funds.

This entire arrangement can also bear major implications from an Income Tax standpoint, wherein, it may be construed as an Impermissible Avoidance Agreement under the General Anti-Avoidance Rules ("GAAR"), if the Indian company is unable to prove that the transaction wasn't carried out for the sole purpose of obtaining tax benefits. Further, if it is proved that the overseas subsidiary is an accommodating party within the meaning of GAAR, or that the transaction is carried out for cross-border shifting of profits from the said IP assets, the entire arrangement may be subjected to severe adjustments under the Income Tax Act, 1961.

VA View

In light of the abovementioned FEMA provisions and ECB rules, one can conclude that the Indian parent company can legally transfer its IP assets to its offshore entity, but this entire arrangement should be for bona fide business activity and not a tax avoidance or round-tripping arrangement, else such companies involved in such activities can attract major implications under FEMA as well as tax laws and may also be directed to unwind such investment by the RBI.

V. Can SEBI levy interest on a penalty retrospectively?

In M/s. Pyramid Saimira Theatres Limited, the Securities and Exchange Board of India ("SEBI") found Mr. K.S. Kasiraman ("Appellant") guilty of negligence and imposed a penalty of INR 4,000,000 without any interest thereon vide order dated July 29, 2011 ("Penalty Order"). Consequently, the Penalty Order was challenged before the Hon'ble Securities Appellant Tribunal ("SAT") and the same was upheld against the Appellant. Thus Appellant was required to deposit the amount of penalty with the SEBI. However, the Appellant could not deposit the money owing to which recovery proceedings were initiated by SEBI under Section 28A of Securities and Exchange Board of India Act, 1992 ("SEBI Act"). Section 28A was introduced to the SEBI Act with retrospective effect from July 18, 2013.

The children of the Appellant deposited the entire amount of penalty by October 10, 2014 and requested for waiver of interest under Section 220(2A) of Income Tax Act, 1961. However, the recovery officer of SEBI passed an order on January 14, 2016 ("Impugned Order") demanding an interest @ of 1% per month from the Appellant from the date of Penalty Order till the date of the payment of the entire penalty amount aggregating to INR 14,70,398.

The children of the Appellant preferred an appeal against the Impugned Order before the SAT thereby challenging the retrospective levy of interest by SEBI even prior to July 18, 2013. SAT in the said appeal held that SEBI cannot levy interest for the period prior to July 18, 2013 and consequently quashed the Impugned Order and reverted the matter back to the recovery officer for computation of the interest from July 18, 2013.

Vaish Associates advised and represented the Appellants before SAT in the matter of K.S. Kasiraman v/s Securities and Exchange Board of India -Appeal No. 159 of 2016.

VA View

The impugned order of the recovery officer ignored the following very prominent principle of law:

"The legislations which modify the accrued rights or which impose obligations or impose new duties or attach a new disability have to be treated as prospective unless the legislative intent is clearly to give the enactment a retrospective effect."

The legislative intent, for imposition of interest was specifically enacted under Section 28A mandating its application from July 18, 2013. Since Section 28A was introduced between the date of Penalty Order and payment of the penalty amount, the interest can only be charged prospectively for the period commencing from introduction of Section 28A and till the date of payment of penalty.

© 2016, Vaish Associates Advocates,
All rights reserved
Advocates, 1st & 11th Floors, Mohan Dev Building 13, Tolstoy Marg New Delhi-110001 (India).

The content of this article is intended to provide a general guide to the subject matter. Specialist professional advice should be sought about your specific circumstances. The views expressed in this article are solely of the authors of this article.

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