Detailed regulatory landscape for DVRs Instruments is varied when it comes to listed companies and unlisted companies, depending upon various factors. Similarly, tax implications for same are also varied when it comes to comparing DVRs Instruments and an ordinary equity share.
As DVRs Instruments acts a tool for commercial restructuring, it does aid an important role from tax considerations point of view. Although, there are no specific tax provisions designed for DVRs Instruments, under the Income Tax Act, 1961 (‘the ITA’), there are few provisions which can change implications for special transactions that can aid in restructuring of capital and transactions for a company. We have analysed few commonly faced issues as under:
Fair Market Value vs Commercial Pricing of DVRs Instruments:
Rights vested with holders of DVRs Instruments and ordinary equity shares differs, depending upon voting power vested with it. DVRs Instruments with SR Shares usually carry privilege to its holder as to controlling rights and accordingly, are issued at higher premium, whereas FR Shares are issued at lower premium, depending upon the variation in voting rights. Hence, Commercial value of DVRs Instrument and an ordinary share, most likely, would differ.
Under the Income Tax Act, 1961 (“the ITA”), DVRs Instrument and an ordinary shares are not treated differently. Section 56(2)(viib) of the ITA prescribes for trigger of tax event for private limited companies (i.e. closely held companies) upon issuance of equity shares at premium, in excess of fair market value (“FMV”). Further section 56(2)(x) of the ITA prescribes for trigger of tax event upon receipt of shares or securities for inadequate consideration i.e. less than FMV.
For unlisted companies, Under Rule 11UA of the Income Tax Rules, 1962, methods prescribed for determining FMV of shares or securities upon issuance are net asset value method or discounted cash flow method as determined by merchant banker. Accordingly, issuance of DVRs Instruments with SR Shares or FR Shares, needs to be in accordance with valuation report issued by merchant banker in order to mitigate tax event. Merchant banker, at the time of determining fair market value of shares would need to give consideration to factors of varied rights attached with the DVRs Instruments. Accordingly, for unlisted companies, price for issuance of DVRs Instruments with SR Shares and FR Shares would need to determined based on Valuation report obtained. However, in the past, there have been occasions where tax authorities have questioned Valuation Report itself. Accordingly, it is not free from any tax concerns from tax authorities or tax litigation. Thus, careful and detailed analysis of a DVRs Instruments is very important.
For listed companies, prices are usually driven by market forces, once same are listed. Thus, fair market of listed DVRs Instruments are governed by stock exchange prices considering various SEBI provisions.
Voting Rights vs Economic Rights:
Under the provisions of the ITA, certain provisions prescribe for trigger of tax event based on voting rights while some provisions prescribe for trigger of tax event based on economic rights. We have identified few commonly used tax provisions which emphasis on voting rights for arriving at specific tax implications. Please see below few of such analysis based on a case study developed around same:
Case Study on DVRs Instruments with SR Shares:
A Ltd is an unlisted public limited company. A Ltd has issued shares in the combination of ordinary equity shares and DVRs Instruments with SR Shares with 2 voting rights for 1 equity shares. On April 1, 2018, Z Ltd, a listed company, has made an infusion in A Ltd for economic rights of 51% into ordinary shares. Summary of capital structure of A Ltd for FY 2017-18 and FY 2018-19 is as under:
Name of Shareholders | Nature of Equity Shares | F.Y. 2017-18 | F.Y. 2018-19 | ||||||
No. of Shares | Economic Rights | Voting Rights | No. of Shares | Economic Rights | Voting Rights | ||||
| |||||||||
Mr. X | DVRs Instruments (2 voting rights for 1 equity share) | 18,750 | 18.8% | 37,500 | 30% | 18,750 | 9.2% | 37,500 | 16.4% |
Mr. Y | 6,250 | 6.3% | 12,500 | 10% | 6,250 | 3.1% | 12,500 | 5.5% | |
| |||||||||
Mrs. X | Ordinary Shares | 41,250 | 41.3% | 41,250 | 33% | 41,250 | 20.2% | 41,250 | 18% |
Mrs. Y | 33,750 | 33.8% | 33,750 | 27% | 33,750 | 16.5% | 33,750 | 14.7% | |
Z Ltd (Listed) | 1,04,082 | 51% | 1,04,082 | 45.4% | |||||
| |||||||||
Total |
| 1,00,000 | 100% |
|
| 204,082 | 100% |
|
|
Q 1. From the above table, name shareholders holding substantial interest in A Ltd for FY 2017-18 and FY 2018-19:
As per Section 2(32) of the ITA, any shareholders holding beneficial holding of more than 20% of the voting power in a company would be considered as persons holding substantial interest.
Accordingly, for FY 2017-18, Mr. X, Mrs. X, Mrs Y would be considered to be holding substantial interest, while Mr. Y would not be considered to be holding substantial interest in A ltd.
For FY 2018-19, Mrs. X and Z Ltd would be considered to be holding substantial interest in A Ltd.
As can be observed, even though Mr. X holds less than 20% economic rights in FY 2017-18, he would still be considered as holding substantial interest in the company since his voting rights exceeds 20%. For FY 2018-19, even though Mrs. X’s economic holding is slightly more than 20%, she would not be considered as person holding substantial interest in A Ltd as her voting rights are below 20%.
Q 2. Whether upon infusion of 51% economic interest by Z Ltd, A Ltd would be considered as company in which public are substantially interested?
Under sub-clause (b) of Section 2(18) of the ITA, if a listed company holds more than 50% of the voting rights in an unlisted public company, such unlisted public company would be considered as company in which public are substantially interested, if such holding is held for entire year.
During FY 2018-19, Z Ltd holds less than 50% of the voting power in A Ltd, accordingly, A Ltd would be considered as a company in which public are not substantially interested.
Q 3: If during FY 2018-19, A Ltd advances loan to X LLP, a LLP where Mr. X is partner and is entitled to share of profit of 25%, whether such advance be considered as deemed dividend in the hands of Mr. X?
Considering all the following conditions are satisfied, advance made by A Ltd to X LLP would be considered as deemed dividend u/s 2(22)(e ) of the ITA in the hands of Mr. X, even if economic interest of Mr. X in A Ltd during FY 2018-19 is lower than 10%:
- Mr. X holds more than 10% voting power in A Ltd; and
- Mr. X is entitled to share of income of more than 20%, and
iii. A Ltd possess accumulated profits.
Q 4: Assuming A Ltd had incurred tax business loss in the FY 2017-18, whether such loss be carried forward in FY 2018-19 upon change in shareholding pursuant to infusion made by Z Ltd?
Since A Ltd is a company in which public are not substantiated, provisions of section 79 of the ITA would be required to be analysed for determination of eligibility of carry forward and set off of losses. As per the provisions of Section 79 of the ITA, in order to carry forward tax business loss of A Ltd in FY 2018-19, minimum 51% of the voting rights held by shareholders in the year in which such loss was incurred i.e. FY 2017-18, should continue to be shareholders in FY 2018-19. Considering Mr. X, Mr. Y, Mrs. X and Mrs. Y, together, continues to hold more than 51% of the voting rights in FY 2018-19 i.e. 54.57%, tax business loss incurred by A Ltd in FY 2017-18, should be available to be carried forward in FY 2018-19 and set off against taxable business profits of FY 2018-19, if any.
Q5. Management of A Ltd is contemplating conversion of A Ltd into A LLP. Whether such conversion would be considered as tax-neutral?
If say during FY 2018-19, management of A Ltd proposes to convert its legal status from company to limited liability partnership, than assuming all the conditions of Section 47(xiiib) of the ITA, are satisfied, post such conversion, more than 50% of the shareholding in A Ltd would be required to continued be held by same shareholders. Since Z Ltd holds more than 50% of the shareholding in A Ltd solely, if it seeks retirement from A LLP within the period of 5 years from the date of conversion, it may trigger tax implication for not complying with all the conditions of section 47(xiiib) of the ITA for tax neutral conversion.
Accordingly, from the above it can be seen how tax implications changes based on each and every fact while issue of DVRs Instruments has been made by A Ltd. Issue of DVRs Instrument can play a vital role in partnership scenarios, fresh investments, joint venture for restructuring the capital without affecting adverse tax implications. Especially for Start-ups environment, it can play a vital role in protecting interest of founders as well as investors. Each and every transaction can be looked through and examined while restructuring the capital for a company.
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