Rights Issue Strategy for Listed Companies

Background

Rights issue is a primary market offer in which all existing shareholders get an opportunity to acquire additional shares in the company on a pro-rata basis. Every shareholder can use his own discretion while choosing an option to buy shares and may decide to acquire entire or part of the eligible stake while renouncing balance to others.

Though there is no compulsion on any shareholder to subscribe for shares as per his entitlement, often companies offer good discount over prevailing market price and so, usually majority of the shareholders opt for exercising their rights. Any company can raise funds by launching rights issue after complying with the provisions under the Companies Act, 2013, however, if the company is listed on recognised stock exchanges then applicable provisions under multiple SEBI regulations also need to be complied with:

• SEBI Takeover code, 2011
• SEBI LODR Regulation, 2015
• SEBI ICDR Regulations, 2018
• SEBI Buyback Regulations, 2018

Rights issue can be of different types and the company may choose any one or combination of them to suit their requirements while offering an option to all its shareholders:

1. Based on paid up Status

• Fully Paid Right Issue
• Partly Paid Right Issue

2. Based on Renounce ability

• Renounceable Rights Issue 
• Non-Renounceable Rights Issue

3. Based on ICDR Regulations 

• Fast Track Rights Issue 
• Normal Rights Issue > 50 Cr 
• Normal Rights Issue < 50 Cr 

Key Process Outline & Basis of Allotment

The companies can opt for ‘Fast- Track Rights Issue’ of more than Rs.50 crores if the conditions laid down in Regulation 99 of SEBI ICDR Regulations are met and in such cases, SEBI has offered multiple relaxations. Otherwise, following standard process has to be followed by the company for the rights issue:

1. Obtaining approval from the board
2. Appointment of various intermediaries for the issue including lead manager, registrar, banker, legal advisors, advertisement / PR agency, statutory auditors, etc. Underwriter need not be appointed as underwriting is not compulsory.
3. Carrying out due diligence review and legal documentation besides determining offer price
4. Obtaining in-principle approval from the regulator
5. Fixation of record date in consultation with the lead manager
6. Sending abridged letter of offer and application forms
7. Obtaining ASBA facility through bankers
8. Crediting Right Entitlements in demat accounts through depositories
9. Opening of Issue (15-30 days) 
10. Allotment of shares and refund of balance proceeds 

Equity shares will be allotted to eligible shareholders in a pre- determined sequential hierarchy in the following manner:

1. Shareholders to the extent of their entitlement;
2. Renouncees to the extent of their entitlement;
3. If shares are still available then one share to those eligible shareholders having fractional entitlement and who applied for at least 1 additional share;
4. If shares are still available then to those eligible shareholders who applied for additional shares in proportion to their holding as on the record date;
5. If shares are still available then to eligible Renouncees who applied for additional shares;
6. If anything left even after aforesaid allotment then it would be treated as unsubscribed portion of the issue. It is generally distributed among the shareholders and renouncees who have applied for any additional shares.

Normal rights issue of more than Rs. 50 crores may usually take upto 6 months for completion. However, in case of ‘Fast-Track Rights Issue’ or issue having size less than Rs. 50 crores, the process can be completed in a span of around 3 months.

Pricing Mechanism and Impact

The companies have been given complete freedom to determine pricing for the rights issue as per their choice, however, usually significant discount is offered over the prevailing market price in order to reward loyal shareholders and make offer attractive. Given the regulatory approvals required for issuing of shares below face value, traditionally offer price has been at the face value or higher.

Due to discounted price of rights issue, the price of shares gets diluted. Hence, it is likely to go down with the increase in total number of shares after issue. Share price after issue can be estimated mathematically and is called as “Theoretical Ex-Rights Price” (TERP). Following is the formula of TERP:

TERP = [(Existing Shares X Key Process Outline & Basis pital Market Existing Price) + (Rights Shares X Offer Price)] / Total Shares

Value of Right can also be determined as the difference between TERP and offer price using following formula:

Value of Right = TERP – Offer Price Example: XYZ Company announces rights issue of 1:2 i.e.1 share for every 2 shares held at a concessional offer price of Rs.70 while the current market price is Rs. 100. Then, TERP and Value of Right can be calculated as below:

TERP = [(100 X 2) + (70 X 1)] / 3 = 90

Value of Right = 90 – 70 = 20

The shares of XYZ company may trade at ` 90 ex-rights and value of Right will be ` 20. However, it should be noted that this is merely an estimate on the basis of mathematical calculations and actual price may substantially differ based on market sentiments. Further, reduction in price may be temporary and it can even go up if there are good prospects.

Right Entitlements & Options to Shareholders

Rights Entitlements (REs) are the standard rights issued by the company to all its existing shareholders for subscribing to new shares. REs are offered to shareholders on pro-rata basis in proportion with their existing equity shares held as on the record date. If any shareholder is holding shares in physical form then he will have to provide details of his demat account for getting REs.

REs are issued in dematerialised form and have separate ISIN, however, they can be traded in online as well as offline mode. Separate scrip code is issued by stock exchanges for trading of REs and while its opening price is decided by the exchanges, subsequently it is determined by the market dynamics. Anybody can purchase REs and also apply for the rights issue in the given proportion during the issue period. However, if no application is made by the purchaser of REs on or before closing date of issue then such REs will lapse. Once trading in REs stop then it cannot be extended again even if there is an extension of rights issue.

Eligible shareholders can exercise any of the following options as per their discretion during the rights issue:

1. Apply for their rights fully as per their REs
2. Apply for their rights fully as per their REs and also apply for excess rights shares
3. Apply for their rights partly as per their REs and renounce balance REs
4. Apply for their rights partly as per their REs but don’t renounce balance REs
5. Renounce their REs fully 
6. Neither apply for rights shares nor renounce REs 

Advantages of Rights Issue

Since inception, rights issue has been a highly popular fund raisingstrategy which has been beneficial to both the corporates as well as shareholders. Cash-strapped companies can adopt this strategy to mobilize funds when they really need it. Following are key advantages to the companies:

1. Very rare chance of failure
2. Fastest mode of raising capital without incurring any extra debt
3. Economical option wherein costs like underwriting, advertisement, etc can be saved
4. Motivation to existing shareholders due to offer to subscribe shares at discounted rates
5. Preferred mode to attract investors as compared to preferential allotment due to relaxation in lock-in requirements

The shareholders are also benefitted in the event of rights issue as below:

1. Existing shareholders can continue to control the company if rights are not renounced
2. Lucrative option to increase stake at a price lower than prevailing market rates
3. SEBI has permitted shareholders having physical certificates to exercise their rights by providing demat account details
4. SEBI has also allowed usage of R-WAP platform to resident individual shareholders and HUF investors.

The Promoters can also take an advantage to smartly increase their overall stake and control through rights issue:

1. Under SEBI Takeover Code, the Promoters can acquire upto 5% in a financial year, however, through rights issue the Promoters can acquire even beyond 5% without triggering Open Offer under Regulation 3(2) provided issue price is less than ex-rights price.
2. REs can be bought or sold by the Promoters even during Trading Window closure period as per SEBI’s circular dated 23-7-2020.

Recent Relaxation by SEBI 

Due to ongoing Covid-19 pandemic, there is an unprecedented economic crisis resulting into huge scarcity of funds.

Every company has to compulsorily wait for at least 1 year after completion of buyback process as per Regulation 24 of SEBI Buyback Regulations, 2018 if it wishes to raise further capital in any manner including rights issue. However, SEBI has temporarily reduced this timeline from 1 year to 6 months in order to give relief to corporates in view of acute liquidity challenges faced by them.

Further, SEBI has issued various circulars after March 2020 in order to rationalise overall process and gave multiple relaxations to listed companies for mobilising funds through rights issues:

1. Filing of Letter of Offer to SEBI is not required for rights issues upto issue size of ` 50 crores which was earlier limited to Rs.10 crores only
2. Waiver of compulsory 90% minimum subscription criteria, subject to conditions 
3. Conditional relaxation to companies for ‘Fast-Track Rights Issue’ in case of pending show-cause notices provided disclosure is made about potential adverse impact
4. Truncated disclosures by restricting financial statements for last year instead of 3 years

With abovementioned positive measures taken by SEBI, rights issues have now become preferred mode of raising funds. During last few months, more than a dozen big listed companies had successfully completed rights issue process and they also got great response from the investors. Following are few examples of mega issues:

• Reliance Industries – Rs. 53,124 crores
• M&M Financial Services – Rs. 3,089 crores
• Shriram Transport Finance – Rs. 1,500 crores
• Aditya Birla Fashions –Rs. 995 crores

Higher Rates of TDS for ITR Non-Filers U/s 206AB

Section 206AB-TDS/TCS on non filer at higher rates 

Presently with introduction of new section, the purchaser/Seller should be additional care regarding  TDS/TCS rates, as another Section 206AB enables to deduct/collect TDS/TCS at higher rates in the event that the purchaser/seller(as the case might be). 

The new TDS rate in this part is higher of the followings rates:- 

• Double the rate indicated in the applicable section of the Act; or
• Double the rate or rates in applicable; or 
• The rate of 5 (five) percent 

Also Read : Declaration formate for not deduct TDS at Higher Rate U/s 206AB

Also Read : TDS on Purchase of Goods U/s 194Q W.e.f. 01-07-2021

New Provision 206AB of the Act would apply on any whole or earn or sum paid, or payable or credited, by an individual (in this alluded to as deductee) to a "Specified individual". 

“Specified person” has been defined as a person who has not filed the returns of income for both of the 2 Assessment Years relevant to the 2 Previous Years which are immediately before the Previous year in which tax is required to be deducted or collected, as the case may be 

More conditions which should be checked are: 

1) Time limit for tax return form under provision (1) of Section 139 of the Act has lapsed for both these years. 

2) Aggregate of Tax deducted at source and Tax gathered at source for his situation is Rs.50,000 or more in every one of these two earlier years. 

3) Specified individual will exclude a non-occupant who doesn't have a lasting foundation in India. 

Additionally this part will not matter where the expense is needed to be deducted under segments 192, 192A, 194B, 194BB, 194LBC or 194N of the Act. This infers that a higher pace of TDS will not be pertinent on the accompanying segments where full measure of expense is needed to be deducted: 

192: TDS on Salary 

192A: TDS on Salary to Government workers 

194B: TDS on Lottery 

194BB: TDS on Horse Riding 

194LBC: TDS on Income in regard of Investment in Securitization Trust 

194N: TDS on Cash Withdrawal more than 1 crore. 

How might the ITR Filing be checked (for appropriateness of Section 206AB)? 

The Government would give another utility on it is Income Tax Software wherein a deductor/Collector, on entering the PAN of the purchaser/vender, would get the subtleties of his ITR Filing. 

Be that as it may, as a reasonable practice the assesse should keep a duplicate of the provider's ITR for the previous two Financial Years as an affirmation to appropriately deduct/gather TDS/TCS according to the relevant rate. 

This arrangement may be an extra weight on the citizen, anyway it is an extra advance taken by the Government to get individuals who don't record their ITRs in any event, when their assessment has been deducted/gathered and is appeared in 26AS. 

More compliance burden on Taxpayer

This may more compliance burden of all the taxpayers, to collect necessary documents from their sellers, regarding ITR filed by them for Previous years. Many Sellers may not even wish to give details of their ITR with their purchases. In such a case, either the Seller will have to suffer higher TDS or commercially the cost of TDS may need to be taken by the purchaser. Thus, practically, the new section will certainly grow the compliance burden for the taxpayers. It may be notice that NRI, not having a permanent establishment in India are spared from this Section and therefore, NRIs having no presence in India but entitled to receive non-salary income from India may not be affected by this Section.

The intention of the govt. appears to be in making purchasers themselves force their sellers to comply with income tax provisions and file their Income Tax return and its decided to more income tax compliance. However, it may create a compliance burden for taxpayers having a more number of sellers, to whom such Section would apply. We will need to wait and watch how industry reacts to this Section and complies of this section.

This Provision will be applicable from 1st July, 2021.

FAQs on Corporate Social Responsibility (CSR)

‘Corporate Social Responsibility’ (CSR) is governed by section 135 of the Companies Act, 2013 

With the growing importance of ‘Corporate Social Responsibility’ (CSR) towards socio-economic development of nation, corporates are required to comply with the provisions failing which stringent penal provisions are imposed.

An attempt is made to explain the provisions of CSR in a very unique way:

There are two brothers named Mr Jay and Mr Viru. Mr Jay had just recently incorporated a new company named Socially Responsible Management Pvt Ltd where as Mr Viru is a Chartered Accountant by profession having expertise in company law. Mr Jay was reading an article in the news paper regarding ‘Corporate Social Responsibility’ (CSR) and was highly impressed with the efforts taken by government towards CSR.

Mr Jay, as a person is always motivated to contribute for the betterment of the society (we can clearly reconcile it too with name of his company). So he decided to consult his brother Mr Viru having detailed knowledge of Companies Act & also complete understanding of CSR provisions; to understand various provisions and rules so that he can be a part of contribution towards socioeconomic development of the nation.

Here is the summary of conversation that happened between two brothers which highlights and explains important provisions of ‘Corporate Social Responsibility’under the Companies Act, 2013

1. Jay: What is the provision in Companies Act, 2013 relating to Corporate Social Responsibility (CSR)? Can you explain me in simple terms?

Viru: Every company having net worth of Rs 500 crores or more OR Turnover of Rs. 1000 crores or more OR net profit of Rs 5 crores or more during the immediately preceding financial year is required to spend in every financial year atleast 2% of average net profit of 3 preceding financial years.

Provisions of section 135 are attracted to the company if, in the immediate preceding Financial Year, company falls into ANY of three below given criteria:-

 - Net worth of Rs.500 crore or more

 - Turnover of Rs. 1000 crore or more 

 - Net Profit of Rs. 5 crore or more

2. Jay: I also read, that the Company has to form a CSR committee of the Board. Can you explain me what is composition of such CSR committee, how many minimum and maximum directors can be in such CSR committee?

Viru: Section 135 of Companies states that the CSR committee shall consist of 3 or more directors of which atleast one director should be an independent director.

3. Jay: But according to my knowledge, private limited companies can be incorporated with only 2 directors in its board. So in that case how to form CSR committee of 3 Directors?

Viru: In that case, private limited companies can form the CSR committee with 2 directors only.

4. Jay: Please tell me; do all the companies are required to appoint independent director in its CSR committee because I also read in newspaper that many companies are exempted from appointing independent director; so for forming CSR committee do such exempted companies also require to appoint independent director?

Viru: Companies that are not required to appoint independent director under Companies Act, 2013; its CSR committee can also be without independent director i.e. such companies are exempted from appointing independent director in its CSR committee.

5. Jay: Whether CSR provisions are applicable only to private limited company or applicable only to public limited company or applicable only to section 8 company or applicable to every company?

Viru: Section 135 of the Act reads “Every company” So provisions of CSR is applicable to all the companies whether private limited, public limited or section 8.

6. Jay: What if the company has not completed 3 years from its incorporation? So how to calculate 2% of average net profit in such case?

Viru: In such case, 2% of average net profit of the years since its incorporation is to be taken into consideration.

7. Jay: Whether the ‘average net profit’ criterion is Net profit before tax or Net profit after tax?

Viru: Computation of net profit criterion is net profit before tax.

8. Jay: How to compute net profit for particular financial year?

Viru: It is to be calculated as per section 198 of Companies Act, 2013.

9. Jay: Which activities are considered as CSR activities?

Viru: The activities enlisted in Schedule VII of Companies Act, 2013 are considered as CSR activities. However MCA has clarified that the activities enlisted in Schedule VII must be interpreted liberally so as to capture the essence of the subjects enumerated in the said Schedule. The items enlisted in the Schedule VII of the Act, are broad-based and are intended to cover a wide range of activities.  Activities like educational relief, medical relief, relief to poverty, promotion of sports etc. are included.

10. Jay: How to calculate the amount to be spent by way of CSR & what is the year of spending the CSR amount? Please explain with illustration?

Viru: Say for example the profit of the company for various years are as under:

Financial year	Net profit calculated as per section 198
2015-16	Rs. 2 crore
2016-17	Rs. 3 crore
2017-18	Rs. 3 crore
2018-19	Rs. 6 crore
2019-20	Rs. 4 crore

In Financial year 2018-19, net profit calculated as per section 198 exceeds Rs. 5 crs, hence CSR provisions (i.e. provisions of section 135) are applicable to the company for Financial year 2019-20 and CSR activities is to be undertaken in FY 19-20.

Further in order to calculate the amount of CSR to be spent; 2% of average net profit of preceding three financial years is to be taken. The preceding three financial years in this case are FY 2016-17, FY 2017-18 & FY 2018-19 and the amount to be spent in FY 2019-20 is atleast Rs. 8 lakhs [{(3cr+3cr+6cr)/3}*2%]

11. Jay: What if the company is unable to spend amount of CSR as required (i.e what if the company is unable to spend atleast 2% of average net profit of 3 preceding financial years)?

Viru: If the company fails to spend the amount of CSR as required by the provisions of the Act then following compliances needs to be done by the company as per Amended Companies Act:

a. The Board has to state the reasons for not spending (to the extent of amount of unspent) in its Director’s report vide provisions of section section 134(3)(o). In the above illustration; the board has to state the reasons in the Director’s report of FY 2019-20. 

b. IN CASE OF “NO ONGOING CSR PROJECTS”:

The company has to transfer such unspent amount to any of the following funds within 6 months of closure of financial year in which it was required to be spent (i.e. within 6 months from the end of FY 2019-20 in the above illustration):

~ Swacch Bharat Kosh fund set up by central government for promotion of sanitation 

~ Clean Ganga Fund set up by central government for rejuvenation of river Ganga

 ~ Prime Minister National Relief fund or any other fund set up by central government for socio economic development and relief and welfare of SC/ST other backward classes, minorities and women.

c. IN CASE OF ANY “ONGOING CSR PROJECTS”:

In this case, the company is required to open a separate bank account to be termed as “UNSPENT CSR ACCOUNT’’ within 30 days of closure of financial year (i.e. within 30 days from the end of FY 2019-20 in the above illustration) and such amount shall be spent by the company on the ongoing project within a period of 3 years from the date of such transfer.

12. Jay: What if in case of “ongoing projects”, such CSR amount still remains unspent after the end of 3 years?

Viru: In such case the company shall transfer the amount to Swacch Bharat Kosh Fund or Clean Ganga Fund or Prime minister national relief fund within 30 days of completion of 3 years.

13. Jay: What is the meaning of ‘ongoing projects’ and what are the conditions to be fulfilled to qualify as ongoing projects?

Viru: Ongoing projects shall mean any activity or program being undertaken by the company and still some expenditure is to be incurred for such activity or program which is being undertaken. Still MCA will prescribe conditions to qualify as ongoing projects in due course.

14. Jay: One of my friend who is a director of foreign company told me that as far as foreign companies are concerned, they are not required to prepare director’s report, so in such case whether it is mandatory on the part of foreign companies to give reporting of CSR Activity?

Viru: In case of foreign companies, the balance sheet filed by them shall contain an Annexure regarding report on CSR.

15. Jay: Whether CSR expenditure by the company can be claimed as business expenditure?

Viru: The amount spent by the company for CSR activities cannot be claimed as business expenditure as per Finance Act, 2014. Explanation 2 to section 37(1) of Income tax Act, 1961 states that any expenditure incurred relating to CSR u/s 135 of Companies Act, 2013 shall not be treated as expenditure for business purpose.

16. Jay: What if the company to whom CSR provisions are applicable; donates the amount to charitable institutions such as trusts and/or societies and/or section 8 companies?

Viru: Subject to compliance of Rule 4 of Companies (Corporate Social Responsibility Policy) Rules, 2014 by the company; if the company donates the amount to charitable institutions it will be deemed that CSR provisions are complied by the company as per clarification by MCA through circular No. 21/2014 dated 18.06.2014.

17. Jay: It is quite possible that in order to comply with CSR provisions, company donates the amount to various charitable institutions like trusts and/or societies and/ or section 8 companies and such charitable institutions is yet to utilize such CSR amount received. So will this be treated as non compliance?

Viru: The Amendment in Companies Act has failed to address such issue. So even if such charitable institutions to whom amount has been donated fails to utilize such CSR amount then also it will be deemed as company has complied with CSR provisions.

However company has to also comply with proviso to Rule 4(2) of Companies (CSR Policy) Rules, 2014 which states that company to whom CSR provisions are applicable; can donate to charitable institutions (i.e. trusts and/or societies and/ or section 8 companies) who has an established past trackrecord of charitable activities of 3 years in undertaking similar programs or projects as that of the programs or projects in which company has given the direction for spending and the company monitors the modalities of utilization of such funds and its reporting mechanism. The 3 years are to be counted from date of such donation. (In a nut shell; company has to comply with proviso to Rule 4(2) of Companies (CSR Policy) Rules, 2014)

18. Jay: Whether any amount given directly or indirectly to political parties will be considered as CSR activity?

Viru: Contribution of any amount whether directly or indirectly to any political parties under section 182 will not be considered as CSR activity.

19. Jay: Can the Company collaborate with other Companies for projects or programs undertaken in CSR?

Viru: Yes company can collaborate with such other companies. However reporting of CSR activities is to be done separately by such companies.

20. Jay: What if the company undertakes CSR activities that benefits only the employees of the company & their families. Will it be treated as CSR activity?

Viru: In the above case, it will not be treated as CSR activity as the rationale behind CSR activities is the benefit of the society as a whole and not to particular section or class.

21. Jay: What are penal provisions in case of non compliance of CSR provisions of Companies Act, 2013?

Viru: No specific penal provisions are laid down in section 135 of Companies Act, 2013 in case company fails to spend the amount required. However the company has to specify in its Director’s report the reasons for the amount remaining unspent under section 134(3)(o).

(i) So if the company fails to comply with the provisions of section 134 then:

a) The company shall be punishable with a fine of Rs. 50,000/- minimum which may extend upto Rs. 25,00,000/- and

b) Every officer who is in default shall be punishable with an imprisonment upto maximum 3 years or with a fine of minimum Rs. 50,000/- and maximum upto Rs. 5,00,000/- or both.

(ii) Further there is provision in Companies Act, 2013 vide section 450 which states that in case no specific penalty is provided in the Act then general penal provisions will be attracted which is as follows:

a) Company and every officer in default shall be punishable with fine maximum upto Rs.10,000/- and

b) Further fine maximum upto Rs. 1,000/- per day during which such contravention continues in case of continuing offence.

Tax on Real Estate Sector

Tax Issues : Real Estate Sector

The contribution of real estate sector is significant to the economic development of our country. While we understand that the Government’s moto is “Housing for all”, unfortunately in recent past, this sector is going through a gloomy patch with plethora of challenges piling up. In line with the Government’s moto & to boost this sector, various amendments have been made under the Income Tax Act, 1961 (‘the Act’). However, the tax aspects of this industry are not free from ambiguity. This article seeks to highlight & redress the tax issues specifically focusing on the Joint Development Agreements, profit linked deduction u/s 80IBA of the Act & Valuation of real estate companies.

I. Taxation of the Joint Development Agreements

In recent past, Joint Development Agreements(JDAs) has emerged as an effective & a trending business model, wherein the land owner transfer the development rights to the Developer who in turn develops the project. Typically, the Land owner either gets a share in the constructed units or a consideration in money or a combination of both for transferring the development rights. Since, this transactions different from the traditional model; following are the grey areas which needs to be focused upon:

a. Determination of Date of Transfer:

The most litigated tax issue arising in JDA is the determination of date of transfer for land owner, who will be subjected to capital gain tax.Section 2(47) of the Act defines transfer, which inter alia includes “any transactions involving the allowing of the possession of any immovable property to be taken or retained in part performance of a contract of the nature referred in Section 53A of Transfer of Property Act, 1882”. Based on these provisions, revenue contends that the date of transfer is effectuated on giving the possession of the land to the developer. However, it is very draconian to charge tax in the year of transfer, as the land owner in reality has not earned any income by virtue of entering into the JDA.

Generally real estate projects run into years, therefore deferring the taxability in the year of completing the project is very essential. Finance Act, 2017 inserted Section 45(5A) to redress this issue, but unfortunately it extended the benefit of deferment only to Individuals & HUF.

Therefore, following Judicial precedence may be still relevant while dealing with this issue, wherein the courts have held that the tax will not be levied in the year in which the JDA is entered or when the land is handed over to the Developer:

i. PCIT, Jalandhar-I vs Chuni Lal Bhagat [2019] 103 taxmann.com 379 (SC),

ii. PCIT, Kolkata-1 Vs Infinity Infotech Parks Ltd. [2018] 96 taxmann.com 274(Calcutta)

iii. Smt. Lakshmi Swarupa Vs ITO, Ward 4 (4), Bangalore [2018] 100 taxmann.com 148(Bangalore - Trib.)

Also, from the way the courts have opined the date of transfer, it is very critical to note the way in the which the JDA is drafted.While, this has been a long-litigated issue, Government should extend the benefit of deferment to all assesses considering the liquidity crisis.

b. Capital Gain Tax arises even if Part CC of project is received

 As discussed above,the new Section 45(5A) inserted by the Finance Act,2017 extended the benefit of deferment only to Individuals and HUF. Furthermore, if we do a minute reading of this Section one will note that, the tax is levied on the whole project even if completion certificate for part of the project is received. While the term “project” is not defined under the Act, in case of big projects consisting of many towers, the land owner may be burdened with the tax liability in the initial year itself if the part CC of the project is received; therefore, the benefit of deferment in reality is not practically met.

c. Ambiguity on tax treatment for assesses holding the land as “Stock in Trade”

In case the Land is appearing as “stock in trade” of the assessee who enters into a JDA, then the income arising by virtue of JDA, may be charged as business income. However, the Act does not contemplate a specific computation mechanism unlike the provisions of capital gain under section 45(5A) of the Act.

It is worthwhile to note that there is no specific ICDS (Income computation and disclosure standard) governing the Income recognition on the real estate projects, therefore there is an ambiguity on the quantum of income and the time of chargeability as discussed below:

As regards to the time of chargeability the assessee may opt to defer the tax by following project completion method which may be litigated by the revenue. Also, there are no provisions in the Act to govern the quantum of income that would be taxed. One may take a view that the stamp duty value of the constructed units be considered as the business income &  other may consider the stamp duty valuation on registering the JDA. Clearly,the Government should come up with specific ICDS to govern revenue recognition on real estate projects addressing these issues & reduce the scope of litigation. However, it is important to note that the provisions of the Section 50D of the Act may not be applicable as the asset held is not the capital asset.

II. Profit Linked deduction for developing and building housing projects

The current law exempts 100% profits arising on the developing and building housing projects.Section 80IBA was inserted in Finance Act 2016 in line with the Government’s objective of “Housing for all”. While the section seems attractive, there are still some tax issue and ambiguity that needs to be addressed.

a. Restriction of allotting one unit is only applicable in case of Individuals

Currently, the section 80IBA provides for various conditions that needs to be satisfied in order to claim the tax exemption which inter alia stipulates a condition that, only one residential unit can be allotted to an Individual, his spouse and a minor child. However, this restriction is not applicable to other assesses. For instance, if the assessee sells more than one unit to HUF of an individual, then the provisions of this section have been said to be complied with. Going further, the developer may also allot all the units of the project to a single assessee other than individual & claim deduction. However, if one goes by the intent of “Housing for All” this may be questioned.

b. Sale & lease back transactions may also be eligible for deduction

Presently, this Section does not preclude sale and lease back transaction,implying if the Developer sells the units to Investors who in turn lease back the units to the Developer for earning rental income, then also the deduction may be allowed. However, as stated going by the intent of housing for all which was clearly mentioned in the Memorandum to Finance Bill 2016, tax authorities may invoke GAAR (General Anti Avoidance Rules) on such transactions.

c. No clarity on charging back Income claimed in previous years if any of the other provisions are not complied

Presently, the deduction claimed under this section for previous years is charged back only in case when the project is not completed within a period of 5 years. However, there is no clarity as to what happens if the assessee fails to comply with any other provisions of this Section. Let us say, the assessee claimed exemption under this section for initial 4 years, however in year 5 it has contravened the provisions of this Section by say allotting 3 units to an Individual. Now, the important question is whether the exemptions claimed in earlier years be taxable in the year of contravention. Possibly a view may exist that, as there is no specific clause under the Act, the previous exemption may not be charged back.

d. SPVs may not benefit from this section

The provisions of this Section may not be attractive in case of SPVs specifically formed for this project as the assessee may be subject to MAT/AMT which will not be utilized in future years leading to an effective tax cost of 15% plus cess & surcharge.

III. Valuation of shares of a Real Estate Company in accordance with Rule 11UA

As per the provisions of Section 50CA & 56(2)(x) of the Act, the transferor and transferee cannot transact less than the fair market value as per Rule 11UA(1)(c)(b). There are certain challenges that may be encountered while valuing the shares of a real estate company which may be as under:

a. No mechanism to protest the stamp duty valuation

As per the valuation mechanism prescribed under Rule 11UA, immovable property is valued at the value adopted or assessed or assessable by any authority by the Government for the purpose of payment of stamp duty. As per the provisions of Section 50C, if an assessee transfers a land or a building & the sale consideration is less than the Stamp Duty Valuation, then he has the right to ask the assessing officer to refer it to the Departmental Valuation officer. However, there are no such provisions while valuing the shares of a company which has a immovable property, therefore there may be unwarranted exposure to tax.

b. No Clarity on WIP valuation

The real estate companies typically have an inventory of work in progress (WIP) which is nothing but the capitalization of the project related expenses. There is no clarity on valuation of WIP as to whether WIP qualifies as an immovable property? While the term immovable property is not defined in Rule 11UA, one may take a view that, WIP cannot be considered as immovable property & therefore to be valued at cost.

c. Whether TDRs qualifies as an immovable property?

Another dilemma that needs to be addressed is how the valuation of TDR (Transferable Development Rights) is to be determined. In case of SRA projects or a rehabilitation projects if the developer fulfills its obligation by constructing units to the Slum Dwellers or society members, then certain amount of TDR/FSI is generated for the sale building. Now the question arises is whether the definition of immovable property includes TDR or FSI? It is interesting to note that the term immovable property is not defined in the Rules. However, Section 269UA of the Act defines immovable property which inter alia includes any rights in land or building which is constructed or which is to be constructed. 

Therefore, one may take a view that stamp duty valuation might be considered. However, it is worthwhile to note that this definition is applicable only for that chapter, therefore one may take a view that it cannot be extended to Rule 11UA and not to be treated as Immovable Property.

What is the Purpose of a Share Buyback and How can Shareholders Benefit from it ?

Buyback of shares

Deployment of Profits/ Capital

Normally, a company uses its profits and funds for:

Reinvestment: Investment in current/future value creating and innovative projects, salaries, research and development, repayment of existing/excess debt. Retained earnings lay the foundation for investment in future innovation. For instance,Apple Inc. issued a Press Release on January 17,2018, planning to repatriate billions of overseas cash, pay repatriation tax of approximately US$38 billion, open a second campus and expand its current workforce of 84,000 by 20,000, thereby contributing US$350 billionto the US economy over the next 5 years.

Dividend: Distribution of dividend to its shareholders.

Share Buyback: The net surplus capital/funds left after the above, can be used for share buyback from the existing shareholders.

However, each company will either deploy/reinvest the profit/funds in the business or return it to the shareholders in the form of dividend or share buyback depending heavily also on the stage of the company (start-up or established player), industry in which it operates (old economy like steel, energy, consumer durables or new economy like information technology, cloud computing, artificial intelligence, biotech, electric vehicles).

Forms of Buybacks

Share buybacks can be executed as under:

Tender Offer: The shareholders are given a tender offer, whereby they have the option to submit/ tender some/all their shares with a prescribed period at a specified price, which normally is at a premium to the current market price.

Open Market Purchase: The company buys back shares in the open stock market at the market price over a period of time.

The Buyback Impact

When a company repurchases equity shares, the selling shareholders get an infusion of funds. Theoretically speaking, once these shares are off the market, each remaining equity share becomes more valuable since the future profits would be divided/allocated among fewer equity shares i.e., earnings per share (EPS) increases followed by an increase in stock price. However, this perfect cycle will work if and only if the profits/ earnings, and in turn the share price, keeps rising – but, no company can guarantee future profits!

When a company has surplus cash (after repayment of highcost debt) and lucrative growth opportunities and its stock is reasonably priced, a buyback can provide an impetus to the long-term returns of its shareholders.

Why do Companies prefer Buybacks?

Advantages

• Many companies prefer share buybacks over dividends since a buyback is flexible and can be altered (reduced/ increased), if a company is suddenly facing adverse business conditions.
• In contrast to a cut/reduction in dividend, a change in the timing and quantum of buyback is less likely to be considered adversely by the shareholders.
• A buyback or special dividend is better than increasing the ordinary dividend since the latter implicitly increases the expectations of the shareholders to maintain the higher dividend in the future.
• A buyback gives an opportunity to the selling shareholders to invest the funds elsewhere, where they can earn higher returns than what the company is earning. According to the legendary investor, Warren Buffett, CEO of Berkshire Hathaway Inc., “If we reach the point that we can’t create extra value by retaining earnings, we will pay them out and let our shareholders deploy the funds.”   Buybacks enable corporate earnings being deployed from old economy companies not needing funds for their business to the shareholders, who in turn can invest it in other companies, who need funds or in industries of the future viz. new economy companies.
• A buyback reduces the risk that the management may use the excess cash to make value-destroying investments, expansion, management glorification. A buyback helps keep pressure on the company management to use capital prudently or return it, so that companies don’t waste shareholders’ funds.
• A company can achieve the optimal/target capital structure via a buyback, especially with debt finance, provided the company has sufficient profits for the interest expense to shield from taxation and the debt servicing won’t entail financial distress in the future.
• From an income-tax perspective, in India, with effect from April 1, 2020, dividend paid by a company to a shareholder is taxable under the Income-tax Act, 1961 (Act) in the hands of the shareholder at the regular rate and is subject to income-tax deduction at source (TDS)/withholding tax, at the applicable rates. 
• However, in the case of buyback of shares by a listed company, the profit/gain to the shareholder is exempt under section 10(34A) of the Act but the company is liable to pay tax on distributed income under section 115QA of the Act on the difference between the repurchase/buyback price and issue price at 20% plus surcharge and cess, as applicable. Similarly, in U.S.A., dividend is taxed as ordinary income while gains from stock buybacks are taxed at a lower rate of incometax at 20%, if the stock is held for more than a year giving rise to long-term capital gains. Therefore, from a shareholders’ perspective, the income-tax under a share buyback can be lower than under dividend payout – a shareholder-friendly way to distribute cash.
• It can support the market price of the share during sluggish/bear market conditions.
• It enables the consolidation of the stake in the company.

Disadvantages

• When a company announces a large buyback, it may be viewed adversely and raise a red flag, especially in a high growth industry. It provides a lens into what the management thinks about the future prospects of the company – the best investment the company can make is in its own shares?
• When an immediate spike in the EPS rather than value creation is the sole reason for a buyback, the selling shareholders gain at the expense of the non-tendering/ continuing shareholders, if the overvalued shares are repurchased.
• A company may overpay for its own shares, if the management’s estimate of the fair value of the shares is overly optimistic.
• If the management and promoters participate in the buyback themselves as tendering shareholders, then it may indicate an underlying weakness in the long-term business of the company.
• Buyback of shares offsets the dilution in EPS once stock options are granted to the employees/ management of the company.
• In recent years, companies have been using borrowings to fund buybacks, reducing equity and hence, increasing leveraging, which can increase the financial risk of the company and its investors in difficult times.
• When management compensation of companies is linked to the growth in EPS on account of the dilution/reduction in the number of outstanding shares in a buyback, they can earn higher compensation under buybacks although the actual profit is the same. To counter this drawback, the Boards of the companies should delink management compensation to EPS, especially under a buyback.
• If a majority of the compensation of senior management consists of stock options/awards, buybacks may be used to prop-up the stock price.

The Right Timing and Price

Smart companies repurchase shares only when the company’s shares are trading below the management’s best estimate of its fair/intrinsic value and no better investment opportunities or returns are available in the business. When a company follows this practice, it will benefit the long-term interest of the non-tendering shareholders at the expense of the tendering /selling shareholders, if the managements estimates are indeed correct.

Conversely, when a company’s shares are expensive and there are no lucrative investment opportunities available in the business, then paying dividend is probably the better option. Some companies and corporations also set parameters for stock buybacks. 

Buyback ROI from a Company’s Standpoint

The buyback return on investment (ROI) = (Reduction in dividend on the repurchased shares + Change in the stock price since the buyback ) /Amount spent on buyback. For a real world analysis, see Buy it Back.

A high/positive ROI, as of Apple Inc. of 48.81% and LVMH Moët Hennessy - Louis Vuitton of 1.59%, indicates pragmatic financial management by buying shares when they are undervalued and investing the funds for prudent use. While a low/negative ROI, as of Berkshire Hathaway Inc. of (5.19%) and Tata Consultancy Services Ltd. of (4.56%), indicates that the company bought its shares at a high price and that the money could have been used wisely, which investors would hate to hear/ observe.

When companies repurchase their share at a prudent time and price then only the company and its shareholders will benefit. We can also infer that the size of a buyback is no guarantee for an increase in earnings or stock price.

Conclusion

When a share buyback is prudently applied for capital allocation after evaluating various options and aligning it with the short/long-term objectives of the company, it can create value for not only the company but also its shareholders. After all, it is the shareholders’ freedom to invest/deploy cash/ money in companies, where it is being used efficiently, thereby with the rise in the productivity of companies, its employees and other stakeholders will also prosper.