GLOBAL TAX ADVISORY SERVICES

Confidentia
MARCH 16, 2004

reserve

Financing structure

!@#
Preliminary & tentative
For discussion purposes only

Contents
1.

Purpose of the report......................................................................................................................3

2.

Executive summary........................................................................................................................4

3.

Funding options..............................................................................................................................9

4. Factors influencing the financing structure...................................................................................11

4.1
Commercial / business factors..............................................................................................................11
4.2
Regulatory factors..................................................................................................................................12
5.

Structuring investments into India................................................................................................15

6. Cash / profit repatriation..............................................................................................................17

6.1
Buy-back of shares.................................................................................................................................17
6.2
Capital reduction....................................................................................................................................19
6.3
Payment of dividend...............................................................................................................................20
6.4
Payment of interest on debt...................................................................................................................21
6.5
Issue of redeemable preference shares and redemption in cash........................................................21
7. Suitability of alternatives..............................................................................................................24
7.1
Set-up scenario........................................................................................................................................24
7.2
Subsequent scenario...............................................................................................................................25

Confidential - All Rights Reserved - Ernst & Young 2002

1. Purpose of the report

X is currently evaluating the cash / profit repatriation strategies for ABC and the mitigation of trapped
cash. However, cash / profit repatriation and mitigation of trapped cash cannot be evaluated disjointed
from the financing structure. The financing structure exercises significant influence on the repatriation
strategies.
In view of this aspect, this report is structured into the following sections:

The typical options available to fund the operations of ABC;

Some major factors that may influence designing the financing structure;

Structuring the investment into India ie discussing potential efficiencies that could be achieved
through alternate investment structures;

The alternate options that are available for cash / profit repatriation along with the regulatory
and tax implications of each of the options;

Identifying the various stages of operations of a typical high capital outlay project based on
characteristics, which are displayed in these various stages; mapping these stages against the
typical cash / profit accumulation at each stage and identifying the typical repatriation tools that
could be used at each stage to repatriate the cash / profits accumulation.

Confidential - All Rights Reserved - Ernst & Young 2004

3
Preliminary & tentative
For discussion purposes only

2. Executive summary
X is currently evaluating the cash / profit repatriation strategies for ABC and the mitigation of trapped
cash. However, such evaluation is not feasible in isolation and has to be considered in conjunction with
the financing structure. Accordingly, in this report, we have evaluated the funding options, the routing
of investments, tools for profit repatriation and their applicability at the various stages in the operations
of ABC.
Funding options
The typical options available to fund the capital structure of the project could comprise equity,
preference shares and debt (including external commercial borrowings).
Factors influencing the financing structure

There are a number of factors that influence the determination of the financing structure which can be
divided into commercial and business factors and Regulatory factors.
Commercial / business factors

Cash flow ability to service debt

Sales stability

Industry norm

Risk appetite

Regulatory factors

Cash trap: The cash traps may arise because of various factors including:

Transfer to reserves on declaration of dividends;

Transfer to reserves on redemption of preference shares;

Transfer to reserves on issue of redeemable debentures; and

Non-cash charges on the profits of the company such as depreciation.

Tax deductibility of interest on debt

Rate of interest on debt

Dividend distribution tax (DDT)

Minimum alternate tax (MAT)

Divestment clause in the FIPB approval

Capital gains on repatriation tools such as buy-back of shares, capital reduction etc

The financing structure (ie mix of debt, equity and preference capital) for ABC would depend upon all
the above parameters. However, in the absence of specific projections of cash flows, number of retail
outlets to be set up, capital expenditure plan, sales projections etc, we have not evaluated the optimum
mix at this stage. We would be pleased to assist ABC in the above matter if we are provided with the
relevant information and projections.
Structuring investments into India
Another important aspect to be considered at this stage is the structuring of investments. There are
potentially significant tax efficiencies, which can be achieved by using alternate jurisdictions (in which
X may have operations / experience / capital) that to structure investments into ABC. Some of the key
tax efficiencies that could be achieved are as follows:

A lower rate of withholding tax than those prescribed under domestic tax laws for passive
income streams such as royalty, fees for technical services, interest, etc. For example fees for
technical services paid by ABC to a Dutch company is taxable at 10% in India under the India
Netherlands Double Tax Avoidance Agreements (DTA); however fees for technical services
paid to a Mauritian company may not be taxable in India under the India Mauritius DTA.

Various Indian DTAs provide that any capital gains arising on transfer of shares in an Indian
company will not be taxable in India. Accordingly, routing investment through any such
jurisdiction could achieve significant efficiencies at the stage of divestment in future (and even
at the stage of repatriating profits using buy-backs or capital reductions).
For example in case the parent is a Dutch company, any capital gains on buy back of shares by
ABC will be taxable in India whereas if the parent is a Mauritian company, a buy-back of
shares by ABC may be sheltered from capital gains tax under the India Netherlands DTA.

DTAs typically also provide for a credit of Indian taxes against the tax liability of the parent in
its home country such as underlying tax credit, tax sparing, credit for DDT etc. For example in
case dividend is paid to a Netherlands parent, the corporate taxes paid by ABC and the DDT
paid on the dividend distribution may not be available as a credit under the India Netherlands
DTA1; however, such credit may be available under another DTA.

However, the structuring can only be explored if the Government will allow an alternate entity (other
than Y, which we understand currently has the investment approval) to make the investment into ABC.
Cash / profit repatriation

Please note that a credit for these taxes may be available under the domestic laws of Netherlands, however, we
have not examined this aspect.

Some alternatives that may be available for cash / profit repatriation and the tax and regulatory
implications of the alternatives are as follows:
Financial instruments / transactions

Buy-back of shares
Buy-back can be funded out of free reserves or securities premium account or the proceeds of
any other shares or securities. Buy-back has to be authorized by the articles and a special
resolution needs to be passed in the general meeting of the company. Buy-back cannot exceed
25% of the paid up share capital and free reserves of the company. Also, the buy back of equity
shares in any financial year cannot exceed 25% of the total paid up equity capital.
The buy-back of equity/ preference shares would not be considered to be deemed dividend under
the income tax laws. However, the buyback would be subject to capital gains tax. Possible
relief under DTAs has not been examined at this stage.
Refund of share capital to a non-resident, through buy-back of shares would require approval of
the Reserve Bank of India (RBI) and may also be subject to RBI valuation norms.

Capital reduction
Special resolution is required for reduction. Confirmation of reduction of share capital by the
jurisdictional court required. Reduction of share capital can be undertaken even in cases where
there are no profits or reserves.
Payout to the extent of accumulated profits of the company treated as deemed dividend
(however not taxable in the hands of the shareholder). DDT would be levied on the company at
the rate of 12.5% (plus surcharge) on the amount deemed as dividend. Balance payout would be
considered as consideration received for transfer of a capital asset taxable as capital gains.
Possible relief under DTAs has not been examined at this stage.
Exchange control regulations are broadly similar to buyback of shares.

Payment of Dividend
Dividend is payable from current years profits after providing for any prior years depreciation.
Dividend declaration requires a compulsory transfer of a specified percentage of current profits
to reserve. Dividend can also be paid out of accumulated profits of previous years in case of
inadequacy or absence of profits in any year subject to the certain rules.
Dividend is not a deductible expense while computing taxable profits of the company. Dividend
declared by Indian companies is not taxable in the hands of the shareholder. DDT is levied on
the company paying dividends at the rate of 12.5 per cent (plus surcharge).
Dividends are freely repatriable, unless specifically constrained (in respect of particular sectors)
by the foreign investment policy or provided in the foreign investment approval.

Payment of interest on debt

Interest can be freely paid even when there are no profits.
Interest is a deductible expense while computing taxable profits of the company and taxable in
the hands of shareholders. Possible relief under DTAs has not been examined at this stage.
Interest is freely repatriable. However, the rate of interest (in case of overseas debt) has to be
within the limits laid down under the external commercial borrowing (ECB) guidelines.

Issue of redeemable preference shares and redemption in cash

Redemption can be financed out of profits of the company which would otherwise be available
for dividend or out of proceeds of a fresh issue. A transfer is required to capital redemption
reserve (CRR) on redemption of preference shares (otherwise than by a fresh issue of shares).
Redemption of preference shares would attract capital gains on the difference between the cost
of acquisition and the value of the consideration received by the shareholder. Possible relief
under DTAs has not been examined at this stage.
Though the exchange control manual does not prescribe any guidelines in connection with
redemption of preference shares at a premium, based on our past experience, we understand
that the RBI does not permit redemption of preference shares at a premium.

Recharges
Recharges for various costs can also be evaluated as a means to repatriate cash / profits. Typically,
ABC would use the services / facilities etc of various group companies, the X brand name etc. Recharges for deputation of personnel, provision of assets, transfer of technology, right to use trademark,
provision of shared services etc could be considered as a means to repatriate profits / cash. These
recharges offer advantages such as these costs are typically tax-deductible expenses, these costs are
payable even if the company is operating at a loss and some DTAs that India has entered provide for
very beneficial taxation for such charges.
However, these alternatives are not discussed in detail at this stage since they will depend on the terms
of the re-charges and the underlying services.
Suitability of alternatives
The suitability of the various alternatives would depend on the stage of operations of the project based
on typical characteristics that are observed in similar high capital projects.

Set-up stage
This stage will typically characterised by large capital outlays; accordingly, any cash generated via sales
would be used for financing the capital outlays, high non-cash depreciation charges, and overall a loss
making phase.
Accordingly, in view of the limited or no cash / profit accumulation there will be limited play for the
repatriation strategies. However, an important aspect to be considered at this stage is that the
divestment clause may be triggered at some point in this stage; accordingly, this has to be appropriately
planned for.
Subsequent stage
Pre break-even
There may be cash accumulation but no profit generation. Accordingly, instruments such as dividend
and share-buyback may not be feasible. Options such as cash charges (ie interest, royalties etc) or
capital reduction (against losses) may be alternates that could be explored.
Post break-even
At this stage, ABC may have profits and surplus cash, accordingly all alternative repatriation options
could be evaluated. Pre-payment of debt, which typically should not trigger any tax implications in India
is an attractive option.

3. Funding options
The typical options available to fund the capital structure of the project could comprise of the following
types of instruments (though various hybrid options are also available, the same have not been
considered for the purpose of this report):
Equity

Forms a part of owners contribution.

Represents permanent capital of the company.

Generally, carries voting rights proportionate to the stake held by the shareholder; however, in
certain situations, equity shares with disproportionate rights may also be issued.

Preference shares

Preference shares form part of the ownership funds of the company but are distinct from equity
shares since they ordinarily carry a fixed rate of dividend and no voting rights.

Preference dividend is payable only when a company makes profit but is paid out before
dividend on equity shares.

These shares may or may not be convertible into equity .

The maximum tenure of preference shares can be 20 years.

Debt
ECBs

ECB refer to commercial loans availed from non-resident lenders with minimum average
maturity of 3 years

Form a part of the debt funds of a company

ECBs are governed by the ECB guidelines issued by RBI. Under the guidelines, ECB upto
USD 500 million with minimum average maturity of five years can be raised under the
automatic route (subject to specified conditions) (refer Annexure 1 for the detailed ECB
Guidelines)

These borrowings can be raised from foreign collaborators and foreign equity holders

Carry a fixed rate of interest and repayment schedule (or conversion option)

Domestic debentures / loans

Form a part of the debt funds of a company

Carry a fixed rate of interest and repayment schedule (or conversion option)

The debt may also be raised via issue of debentures (subject to complying with the requirements under
company law).

4. Factors influencing the financing

structure
Some major factors that may exercise an influence on designing the financing structure ie the mix of the
alternate funding options (in the context of ABC) include as follows:
4.1

Commercial / business factors

Cash flow ability to service debt
Debt carries a fixed liability in regard to payment of interest. In this regard, the projected cash
flows of a company need to be examined to determine whether there would be sufficient cash
flows to pay interest on debt; especially in the initial years.

Sales stability
The optimum capital structure would also be a function of the sales trend of the company. In
case of ABC, the sales would be expected to increase at a high rate in the initial years owing to
the large number of outlets that would be set up in the initial years.

Industry norm
The typical industry norm can also be considered as an indicative guide for determining the
financing mix. Prima facie, there are no comparable companies in the industry in India.

Risk appetite
As the proportion of debt in the capital structure increases, the financial risk of the company
would increase. As a result, the risk appetite would also be a determinative factor in deciding
the optimum debt-equity ratio.

4.2

Regulatory factors
Cash trap
The most significant factor that will influence the financing structure is the creation of cash
traps. The cash traps may arise because of various factors including:

Transfer to reserves on declaration of dividends;

Transfer to reserves on redemption of preference shares;

Transfer to reserves on issue of redeemable debentures; and

Non-cash charges on the profits of the company such as depreciation.

These factors are discussed below.

Transfer to reserves
Under the provisions of the Companies Act, 1956 (Co Act), any declaration of dividend on
equity shares out of current profits requires transfer of a prescribed amount to a statutory
reserve. This transfer is made on an ascending scale, and depends on the percentage of dividend
sought to be declared:
Proposed dividend

Minimum transfer to reserve

Less than 10% of paid-up capital

Nil

10-12.5% of paid up capital

2.5% of current profits

12.5-15% of paid up capital

5% of current profits

15-20% of paid up capital

7.5% of current profits

Exceeds 20%of paid up capital

10% of current profits

Transfer to Capital Redemption Reserve (CRR)

The Co Act provides for transfer to CRR on redemption of preference shares (otherwise than by
a fresh issue of shares) to the extent of the nominal amount of the shares redeemed out of the
profits, which would otherwise have been available for dividend. Thus, the accumulated profits
of the company would be reduced to the extent to which the amount is transferred to CRR. The
CRR can be used for issue of bonus shares.
Accordingly, using redeemable preference shares as a funding option will have to be carefully
considered in light of the requirement to create the reserve.

Transfer to Debenture Redemption Reserve (DRR)

If a company issues debentures, it is required to create a DRR via transfer of profits each year,
to create a fund for the redemption of debentures. Accordingly, if debentures are used as a
financing option, profits may need to be appropriated from the year of issue itself to generate
funds for the redemption of debentures.

Non cash charges

Another significant reason for creation of cash traps is the non-cash charges such as
depreciation. While such charges lower the profits, there is no corresponding cash flow,
accordingly, cash to this extent is trapped.
Accordingly, a high debt in the capital structure with a high interest charge can help to mitigate
this accumulated cash. Similarly, other cash re-charges such as payment for shared services etc
may also help in this aspect.

Tax deductibility of interest on debt

Debt is a cheaper source of funds in case of a company having stable profits and high returns.
This is because, the rate of interest on debt is fixed and the interest is tax deductible while
dividend on equity is not deductible for tax purposes.

Rate of interest on debt

The rate of interest on ECB or domestic debt would also be a relevant factor for determination
of optimum capital structure.
In case of overseas debt ie ECBs, the ECB guidelines provide for all-in-cost ceilings as follows:
Minimum Average Maturity Period

All-in-cost Ceilings over six month LIBOR

Three years and up to five years

200 basis points

More than five years

350 basis points

All-in-cost includes rate of interest, other fees and expenses in foreign currency except
commitment fee, pre-payment fee, and fees payable in Indian Rupees.

DDT
Declaration of dividend by Indian companies requires a payment of DDT at the rate of 12.5%
(plus surcharge) on the amount of dividend distributed.
At times, any tax withholding on dividend income is creditable against the tax on the dividend
income in the home country of the parent, accordingly, such dividend withholding is only a flow
through cost.
However, there is ambiguity on the availability of DDT as a credit against the tax liability of the
parent company in its home country under the terms of most DTAs2 that India has.
Accordingly, potentially, DDT may be a dead cost (unless the domestic laws of the home
country of the parent provide for credit for DDT).

MAT
MAT is payable at the rate of 7.5% (plus surcharge) of adjusted book profits, by companies
whose income tax computed under normal provisions, is less than 7.5% of book profits. Book
profits referred to above are subject to certain adjustments before determining levy of MAT.
One of the adjustments in the book profit (in determining the profit for MAT) is the brought
forward losses or depreciation. Accordingly, a high interest charge (via high debt in the capital
structure) should increase the losses and mitigate exposure to MAT.

However, please note that the India Mauritius DTA provides a credit for DDT on dividends declared to a
Mauritian parent, against the Mauritian tax liability of the parent.

Divestment clause in the FIPB approval

The FIPB approval lays down the condition that ABC would have to divest 26% of its equity in
favour of resident Indians over a period of 5 years. Therefore, ABC would have to find an
equity partner in India for the retail outlets.
The above condition could also have an influence on the choice of the optimal capital structure
and final debt equity ratio. A very high debt equity ratio may be perceived as increasing the risk
of the venture because of the fixed obligations to service debt; in case the cash flows do not
conform to a uniform pattern, this risk may be accentuated.

Capital gains
Any transfer of a capital asset (shares of an Indian company will be considered as a capital
asset) attracts capital gains tax in India on the difference between the cost of acquisition of the
asset and the consideration for transfer.
Accordingly, a strategy to issue bonus shares against reserves and redemption of the same in
cash, could be an expensive repatriation strategy as the entire gains (in the hands of the
shareholders) could be taxable as capital gains.

The debt equity ratio for ABC would depend upon all the above parameters. However, in the absence of
specific projections of cash flows, number of retail outlets to be set up, capital expenditure plan, sales
projections etc, we would not be able to provide a specific capital structure. We would be pleased to
assist ABC in the above matter if we are provided with the relevant information and projections.

5. Structuring investments into India

X is a multi-national corporation with interests in various parts of the world and having operating/
holding companies in various countries. X can therefore leverage its global presence and knowledge of
operating in various countries, for investing into ABC.
While, at this stage, we have not analysed the alternate jurisdictions that could be used to structure
investments into ABC, some of the key tax efficiencies that could be achieved by routing investments
into India via a tax efficient structure (using one or more intermediate jurisdictions) are as follows:

Various DTAs provide for a lower rate of withholding tax than those prescribed under domestic
tax laws for passive income streams such as royalty, fees for technical services, interest, etc
arising to a nonresident. Accordingly, in case, any such passive income is envisaged to be
earned from ABC, an efficient DTA could be used3.

Various DTAs that India has signed provide that any capital gains arising on transfer of shares
in an Indian company will not be taxable in India. Accordingly, routing investment through any
such jurisdiction could achieve significant efficiencies; because capital gains tax costs are a
substantial cost in implementing any repatriation strategy such as capital reduction, or buy back
of shares etc (discussed in detail in the next section).

DTAs typically also provide for a credit of Indian taxes against the tax liability of the parent in
its home country. Different DTAs could provide various form of tax credits such as:

Underlying tax credit credit for taxes paid on income from which dividend has been
declared. For example if ABC pays corporate income tax in India on its business
income. The balance profits post tax are declared as dividend. Some DTAs provide
that the corporate income taxes paid in India is available as a credit against the tax
liability of the parent (on the dividend income earned from ABC).

Tax sparing for example ABC is eligible for a tax holiday on some of its income, even
in this case, some DTAs could provide that the taxes that ABC would have paid (if the
tax holiday was not available) would be available as credit to the parent company.

Credit for DDT - Typically, any tax withholding on dividend income is creditable against
the tax on the dividend income in the home country of the parent, accordingly, such
dividend withholding is only a flow through cost.

However, please note that flow of passive incomes could be independent of the ownership structure depending
on the contractual relations established

However, there is ambiguity on the availability of DDT as a credit against the tax
liability of the parent company in its home country under the terms of most DTAs 4 that
India has signed. Accordingly, potentially, DDT may be a dead cost (unless the
domestic laws of the home country of the parent provide for credit for DDT).
Hence, huge potential tax savings can be achieved by structuring investments into India via a favourable
route. For example:

Fees for technical services paid by ABC to a Dutch company is taxable at 10% in India under
the India Netherlands DTA; however FTS paid to a Mauritian company may not be taxable in
India under the India Mauritius DTA.

In case the parent is a Dutch company, any capital gains on buy back of shares by ABC will be
taxable in India whereas if the parent is a Mauritian company, a buy-back of shares by ABC
may be sheltered from capital gains tax under the India Netherlands DTA.

In case dividend is paid to a Netherlands parent, the corporate taxes paid by ABC and the DDT
paid on the dividend distribution may not be available as a credit under the India Netherlands
DTA5; however, such credit may be available under another DTA.

However, please note that the India Mauritius DTA provides a credit for DDT on dividends declared to a
Mauritian parent, against the Mauritian tax liability of the parent.
5
Please note that a credit for these taxes may be available under the domestic laws of Netherlands, however, we
have not examined this aspect.

6. Cash / profit repatriation

Alternatives that may be available for cash / profit repatriation and the tax and regulatory implications
are discussed below. The alternatives could be divided into two parts, financial instruments /
transactions that can be used for repatriation and recharges such as charges for use of brand name etc.
Financial instruments / transactions
6.1

Buy-back of shares
Procedure under company law

6.1.1

Section 77A of Co Act provides the procedure and regulations with respect to buy-back of shares.

Sources of buy-back
Buy-back can be funded out of free reserves or securities premium account or the proceeds of
any other shares or securities (of a security other than the security being bought back).
Free reserves include those reserves which, as per latest audited balance sheet of the company,
are free for distribution of dividend including securities premium account but not share
application money.

Conditions / procedure
-

Buy-back has to be authorized by the articles of association of the company. In the

absence of such a provision, the articles need to be amended.

A special resolution needs to be passed in the general meeting of the company

authorising the buy-back. A special resolution requires that votes cast in favour of the
resolution are not less than three times the number of votes cast against the resolution
by members entitled to and voting.
However, where the buy-back does not exceed 10% of the total paid up equity capital
and free reserves of the company and such buy-back has been authorised by a
resolution of the Board of Directors, the special resolution of the company in a general
meeting would not be required.

Buy-back cannot exceed 25% of the paid up share capital and free reserves of the
company. Also, the buy back of equity shares in any financial year cannot exceed 25%
of the total paid up equity capital.

The ratio of debt (includes unsecured and secured debts) to capital and free reserves of
the company after the buy-back should not be more than 2:1.

All the shares involved in buy back must be fully paid up.

The buy back of shares of private limited companies and unlisted public companies are
subject to certain rules6. These rules provide for procedural guidelines to be followed by
the company for buy back of shares.

The rules are called Private Limited Company and Unlisted Public Limited Company (Buy-back of Securities)
Rules, 1999

6.1.2

The Company cannot make an issue of the same kind of security (which is bought
back) for 6 months.

The gap between two offers of buy-back has to be at least 365 days.

The buy-back has to be completed within 12 months from the date of the special
resolution by the members or board (where the buy-back does not exceed 10% of the
total paid up equity capital and free reserves).
Significantimplicationsunderincometax

Under section 2(22) of the Act, distributions to shareholders to the extent of accumulated profits
are deemed as dividend. Deemed dividends, like ordinary dividend are subject to DDT at the
rate of 12.5% (plus surcharge).
However, there is a specific exemption for buy-back of shares. The buy-back of equity/
preference shares would not be considered to be deemed dividend [section 2(22)].

Under section 46A of the Act, where a shareholder receives any consideration from any
company for purchase of its own shares, then the difference between the cost of acquisition and
the value of the consideration received by the shareholder shall be deemed to be capital gains.
The capital gains would be chargeable at the normal tax rates (40% plus surcharge where the
shareholder is a foreign company) where the period of holding of the shares does not exceed 12
months. For shares (being unlisted securities) where period of holding exceeds twelve months,
the gains are chargeable at the rate of 20% (plus surcharge).
As discussed in the previous section, this capital gains could be sheltered if the gains arise to a
resident of a country with which India has a favourable DTA (such as Mauritius etc).

6.1.3

Exchangecontrolimplications

Refund of share capital to a non-resident, through buy-back of shares would require approval of
the RBI.

Although no specific guidelines have been prescribed for buy-back share capital, RBI valuation
norms may be attracted (since it may be viewed as transfer of shares from a non-resident to a
resident).

The RBI (vide Notification No FEMA 20 /2000-RB dated May 3, 2000) has specified that
where the shares are not listed on any recognised stock exchange, the RBI shall while granting
permission, take into account the price which is lower of the two independent valuations of
share, one by statutory auditors of the company and the other by a Chartered Accountant or by
Category I merchant banker who is registered with Securities and Exchange Board of India.

An intimation may also be required to be filed with FIPB.

6.2

Capital reduction

Capital reduction broadly means cancelling the share capital against cash payouts to the share-holders
or against accumulated losses of the company.
6.2.1

Procedureundercompanylaw

Special resolution is required for reduction.

The company may reduce its share capital in any way including:
-

Extinguish or reduce the liability on any of its shares in respect of share capital not
paid up

Either with or without extinguishing or reducing liability on any of its shares, cancel
any paid up share capital which is lost, or is unrepresented by available assets

Either with or without extinguishing or reducing liability on any of its shares, pay off
any paid up share capital which is in excess of wants of the company.

Confirmation of reduction of share capital by the courts (though the Government has indicated
a change in law and a National Company Law Tribunal [a quasi-judicial authority] is expected
to be set-up to adjudicate on these matters) required.

In cases of reduction of share capital involving either diminution of liability in respect of unpaid
share capital or the payment to any shareholder of any paid up share capital, creditors would be
entitled to object to the reduction. There are various provisions to safeguard the interests of the
creditors in case of reduction and the power for ensuring the interest of the shareholders is
vested with the courts.

No sources have been specified for reduction of share capital. Therefore, reduction of share
capital can be undertaken even in cases where there are no profits or reserves.

6.2.2

Significantimplicationsunderincometax

Payout to the extent of accumulated profits of the company would be considered to be deemed
dividend under section 2(22)(d) of the Act (however not taxable in the hands of the shareholder).
DDT would be levied on the company at the rate of 12.5% (plus surcharge) on the amount
deemed as dividend.

Balance payout (ie payout less deemed dividend) would be considered as consideration received
for transfer of a capital asset and taxable as capital gains (on difference between cost of
acquisition and balance payout).

As discussed in the previous section, capital gains could be sheltered if the gains arise to a
resident of a country with which India has a favourable DTA (such as Mauritius etc).

6.2.3

Exchangecontrolimplications

Refund of share capital to a non-resident, through a reduction of share capital would require
approval of the RBI.

Although no specific guidelines have been prescribed for refund of share capital through a
capital reduction, RBI valuation norms may be attracted (since it may be viewed as transfer of
shares from a non-resident to a resident).
Refer para 7.1.3 for the valuation norms.

An intimation may need to be filed with FIPB

6.3

Payment of dividend

6.3.1

Procedureundercompanylaw

Dividend is payable from current years profits after providing for any prior years depreciation
(section 205).

Dividend declaration requires a compulsory transfer of a specified percentage of current profits

to reserve [section 205(2A)]. This transfer is made on an ascending scale, and depends on the
percentage of dividend sought to be declared (the maximum transfer capped at 10% of profits).
Refer section 5.2 for details.

Dividend can also be paid out of accumulated profits of previous years in case of inadequacy or
absence of profits in any year. However, such payment is subject to the Companies (Declaration
of Dividend out of Reserves) Rules, 1975. According to the rules:
-

The rate of dividend declared cannot exceed the average of the rates of dividend in the
five preceding years or ten percent whichever is lower. Thus, the rate of dividend cannot
exceed 10%;

The total amount that can be withdrawn from reserves cannot exceed 10% of paid up
share capital and free reserves; and

The balance of reserves after such withdrawal cannot exceed 15% of paid up share
capital

6.3.2

Significantimplicationsunderincometax

Dividend is not a deductible expense while computing taxable profits of the company.

Dividend declared by Indian companies is not taxable in the hands of the shareholder under
section 10(33) of the Act.

DDT is levied on the company paying dividends at the rate of 12.5 per cent (plus surcharge) of
the dividends distributed.

6.3.3

6.4

6.4.1

6.4.2

Exchangecontrolimplications
Dividends are freely repatriable, unless specifically constrained (in respect of particular sectors)
by the foreign investment policy or provided in the foreign investment approval.
Payment of interest on debt7
Procedureundercompanylaw
Interest can be freely paid even when there are no profits.
Significantimplicationsunderincometax

Interest is a deductible expense while computing taxable profits of the company.

Interest paid by the company would be taxable in the hands of the shareholder.

The rate of tax would be either 20% (as per the domestic Indian laws) or lower rate if the
relevant DTA provides for a lower rate.

6.4.3

Exchangecontrolimplications
Interest is freely repatriable. However, the rate of interest has to be within the limits laid down
under the revised ECB guidelines.

Further, it may also be relevant to note that repayment of the debt (ie the principal) is also an effective
tool to mitigate trapped cash (without any significant tax implications). This tool can be used with a lot
of flexibility since under the existing ECB guidelines; prepayment of overseas debt is also permitted.
6.5
6.5.1

Issue of redeemable preference shares and redemption in cash

Procedureundercompanylaw

Redemption can be financed out of profits of the company which would otherwise be available
for dividend or out of proceeds of a fresh issue.

A transfer is required to CRR on redemption of preference shares (otherwise than by a fresh

issue of shares) to the extent of the nominal amount of the shares redeemed out of the profits
which would otherwise have been available for dividend. The capital redemption reserve
account can be applied in paying up unissued shares of the company to be issued to members of
the company as fully paid bonus shares.

Please note that if the debt is in the form of debentures, additional company law requirement may need to be
complied with

Any premium payable on redemption of preference shares shall be provided for out of profits or
securities premium account.

The Co Act does not prohibit issuance of preference shares with a put or call option.
Accordingly, the terms of issue of preference shares may provide for a put or call option to
provide flexibility to the parties in redeeming the capital.

6.5.2

Significantimplicationsunderincometax

Redemption of preference shares would attract capital gains on the difference between the cost
of acquisition and the value of the consideration received by the shareholder.

The capital gains could also be claimed as exempt under the terms of a favourable tax treaty
like Mauritius. In other words, if the investment in shares in Indian company is made through a
Mauritius resident company, capital gains on transfer of shares would not be taxable on the
basis of the India Mauritius Double Taxation Avoidance Agreement.

6.5.3

Implicationsunderexchangecontrol
The exchange control regulations do not prescribe any guidelines in connection with redemption
of preference shares at a premium. However, based on our experience, we understand that the
RBI does not permit redemption of preference shares at a premium, ie preference shares can be
redeemed at par only.

Recharges
Recharges for various costs can also be evaluated as a means to repatriate cash / profits. Typically,
ABC would use the services / facilities etc of various group companies, the X brand name etc. Recharge of costs of these could be considered as a means to repatriate profits / cash. These recharges
offer the following advantages:

These costs are typically tax-deductible expenses;

These costs are payable even if the company is operating at a loss and hence will help in
mitigating cash traps created by non-cash charges such as depreciation; and

Some DTAs that India has entered provide for beneficial taxation for such charges.

Broadly, the following alternates could be evaluated:

Deputation of personnel;

Provision of assets (such as fixed assets, goods, process know-how, catalogues, books);

Transfer of technology, process, design, layout plan, formula, patent;

Right to use trademark, brand name and corporate name. In this regard, it may be pertinent to
note that the FIPB approval obtained, provide for payment of a royalty of 5% of sales as
royalty towards use of technology and trademarks;

Provision of services (such as underwriting services, agency/ selling services, market research
services);

Provision of shared services (such as IT support, data processing facilities, software license fee,
research and development); and

Reimbursement of expenses (such as preliminary expenses, professional services, bandwidth

charges, web-site development, advertising, content sourcing).

At this stage, we have not detailed the tax and regulatory implications, as these will depend on the terms
of the agreement for the above.

7.Suitability of alternatives
In this section, we have identified the various scenarios that may typically be witnessed in the operations
of a high capital outlay project based on typical characteristics, which are displayed. We have
attempted to map these scenarios against the typical cash / profit accumulation under each scenario and
have identified the typical repatriation tools that could be used to repatriate the cash / profits
accumulation.
7.1

Set-up scenario

This scenario would have the following characteristics:

Cash flows from sale of products;

Capital outlays on creation of the outlets; accordingly, most of the cash generated would be
used for financing the capital outlays;

High non-cash depreciation charges;

Pre break-even and hence possible loss making scenario; and

Divestment may be required.

In the set-up scenario, there will be limited profit accumulation and limited cash accumulation;
accordingly, there will be limited play for the repatriation strategies; however, the following need to be
considered:

The designing and implementation of the financing structure will be effected in this stage;

In case, the cash flows is not used for internal accruals, the same may be repatriated through the
cash charges such as interest; recharges etc;

Repatriation via dividend may not be an option in view of possible loss-making scenario.

ABC has to be an attractive venture to invest (when the divestment clause may need to be
complied with); accordingly, there may be rationale for low interest costs and hence low levels
of charges for debt servicing. This gearing may subsequently be increased to get the advantages
arising from high interest charges.

7.2

Subsequent scenario

This scenario would have the following characteristics:

Cash flows from sale of products;

Lower non-cash depreciation charges;

Absorbing prior tax losses (ie from the set-up phase);

Potential tax liability under MAT; and

Break even and profit earning.

In this phase, the need to repatriate cash / profits will arise. In this regard, the following options may be
explored:
7.2.1

Pre break-even

There may be cash accumulation but no profit generation. Accordingly, instruments

such as dividend and share-buyback (which require profits / reserves) may not be
feasible.

Options such as cash charges (ie interest, royalties etc) or capital reduction (against
losses) may be explored.
In evaluating interest charges vis--vis capital reduction, a capital reduction may be
made tax neutral (if the gains can be sheltered under the provisions of a favourable
DTA) and hence may be advantageous.

7.2.2

Post break-even

At this stage, ABC may have profits and surplus cash, accordingly all alternate
repatriation options could be evaluated.

Pre-payment of debt, which typically should not trigger any tax implications in India is
a significant option.