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In the previous post, we discussed some problems of equity funding that are faced by investors in India. In this post, we will look at some alternatives to equity funding that are used by companies globally and in India. None of these replace the fundamental principle of investing in equity. However when used in tandem with equity funding, they can optimise outcomes for both the investor and investee.
1. Brand or trademark licensing
Subsidiaries often use their parent company's brand or trademark without paying any royalty. If the subsidiary has surplus cash flows, it is advisable – and correct – to charge a royalty for use of assets. Royalty is an operating cost and is tax deductible. In case of an overseas parent and Indian subsidiary, however, such an arrangement is subject to transfer pricing norms. Failure to meet these norms can trigger substantial tax liabilities.
2. Other fees and charges
Holding companies often provide actual services to subsidiaries (admin, treasury, space, expertise on systems/processes), which should be formalised in an agreement. The services contract should price these correctly and require the subsidiary to pay a management charge to the parent. Transfer pricing rules continue to apply. This is one of the commonly used and well-understood alternatives to equity funding.
3. Loans and debentures
Another of the alternatives to equity funding is providing a loan. In case a subsidiary requires additional capital, especially if it is for a limited term (e.g. less than five years) a vanilla loan or structured loan/instrument from the parent is a good option. The terms are usually better than those offered by a bank and the parent company still earns a good rate of return on its loan to the subsidiary. Interest costs are tax-deductible but do not reduce company EBITDA.
The subsidiary may also issue convertible debentures, which the parent can redeem or convert to equity when the timing is right. Overseas investors in Indian companies provide loans in foreign exchange through the ECB (External Commercial Borrowing) route prescribed by the RBI.
4. Advances for goods or services
Several subsidiaries (especially subsidiaries of overseas companies) provide goods or services to the parent. In case of extremely short-term cash requirements (e.g. 1-3 months), one of the simplest alternatives to equity funding is for the parent to provide an advance payment against future supplies. It however becomes important to complete the supply within a certain timeline for GST as well as FEMA compliance. Transfer pricing considerations apply to the pricing of goods and services as well.
Over time, most companies (especially Indian subsidiaries of foreign companies) have rationalised their cash inflows and outflows using methods other than equity. While equity involves restrictions, the other options also require compliances with FEMA rules, transfer pricing and income tax. Often there are accounting guidelines that may recognise a transaction as quasi-equity or loan even if it is presented differently. In all these cases, it is helpful to get expert structuring advice to ensure there are no loopholes and all possible regulations are complied with.
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