Repatriating funds from India is a highly regulated process that continues to frustrate many foreign investors. Nishant Parikh, Siddharth Sharma and Meghana Singh identify and evaluate some commonly used exit routes
Before investing in any jurisdiction, two key questions weigh heavily on investors’ minds: can the returns earned on the investment be remitted easily; and, can the principal investment be repatriated freely at the option of the investor. In India, unfortunately, the answers to these questions are not always what investors want to hear. They can also vary considerably depending on the sector in which the investment is made, the nature of the investment instrument and the jurisdiction from which it is made or through which it is structured.
Difficulties in repatriating funds from India stem from the fact that the country’s economy is not fully capital account-convertible and the regulatory regime imposes limitations on the movement of capital into and out of India. The country’s foreign investment policies are designed to encourage long-term investment and as a result, difficulties in the process of repatriating funds frustrate many investors.
Dividends and coupon
Investments into India and the repatriation of returns are primarily regulated by two pieces of legislation: the Companies Act, 1956, and the Foreign Exchange Management Act (FEMA), 1999. However, it is the plethora of rules, regulations and guidelines under each of these laws that can be overwhelming and often confusing.
Dividends on equity shares are the most commonly used channel for remitting returns from an Indian company. The Reserve Bank of India (RBI) permits free repatriation of dividends on equity shares to non-resident shareholders. However, the fixed dividend payable on preference shares is treated slightly differently under the FEMA, which mandates that the maximum dividend payable is capped at 300 basis points above the prime lending rate of the State Bank of India on the date of the board meeting of the company in which the issue of the shares is recommended. This number could work out to approximately 11-14% per year, depending on the prevailing prime lending rate.
Dividends can, however, only be declared or paid from the company’s accumulated profits (after accounting for depreciation and losses for the previous years). As a result, situations frequently arise where a substantial amount of cash is trapped within a company and cannot be remitted through dividends. This is particularly likely to occur in capital-intensive industries where, on account of high depreciation, the distributable profits of the company are low.
Furthermore, under the present tax regime companies in India are required to pay a heavy tax of almost 17% when distributing dividends to their shareholders.
In contrast to dividends, the coupon, or interest, on convertible debt instruments is in the nature of a debt obligation and need not be paid only from amounts distributable as profits. Under tax laws, the coupon is treated as an expense. Although withholding tax is applicable to coupon payments, certain double-taxation avoidance treaties signed by India provide for a lower rate of withholding.
However, when considering this option, it is important to note that since June 2007, only compulsorily convertible debentures and preference shares are permitted as foreign direct investment. Redeemable instruments (whether partially or optionally convertible into equity) are treated as debt and are subject to the limitations and conditions set out under the External Commercial Borrowing (ECB) Guidelines issued by the RBI.
Under these guidelines, a redeemable instrument may be issued only to a certain set of eligible lenders, such as financial institutions and existing shareholders in the company, for specific permissible end uses.
The maximum coupon payable is linked to the minimum average maturity of the instrument. The coupon on ECBs with a minimum average maturity of three to five years is capped at six months’ London Interbank Offered Rate (LIBOR) plus a spread of 300 basis points. The maximum spread is 500 basis points if the minimum average maturity is more than five years. Since the instruments are rupee-denominated, these caps are calculated based on the swap equivalent of the LIBOR. The low cap on returns and stringent end-use requirements often limit the use of these debt instruments.
Redemption and share repurchase
The redemption route was previously a popular method of repatriating the principal investment. Under the Companies Act, preference shares may be redeemed out of a company’s profits (which would otherwise be available for dividends) or from the proceeds of a new share issue.
However, due to changes in the regime in June 2007 discussed above, redeemable preference share issuances are rare.
Investors often look at repatriating their principal investment amount through a share repurchase (buyback) of equity shares or a court-sanctioned capital reduction. Both processes may be initiated by a resolution of a super majority of shareholders (75% of shareholders by value that are present and voting).
A share repurchase can be executed as long as certain conditions relating to the funding of the repurchase, the debt-equity ratio and the maximum permissible limits of the buyback are met. A share repurchase can be funded from the following sources: (a) free reserves (i.e. reserves which as per the latest audited balance sheet of the company are free for distribution as dividends); (b) funds from a company’s securities premium account; and (c) proceeds arising out of the issuance of a different class of shares.
When structuring a share-repurchase, it should be borne in mind that the aggregate buyback consideration cannot exceed 25% of the total paid up capital and free reserves of a company. In addition, no more than 25% of a company’s total paid-up equity capital can be repurchased in a financial year. Companies must also maintain a debt-equity ratio not exceeding 2:1 after concluding the buyback of shares. This often proves to be a challenge for businesses that operate in highly leveraged sectors such as infrastructure.
An investor participating in a buyback offer risks dilution of shareholding in the event that other shareholders do not participate in the offer. The ultimate business objectives of the investor therefore guide a repurchase decision.
The RBI has recently announced guidelines on the pricing of a share transfer from a non-resident to a resident. The consideration payable by a resident to a non-resident for such a transfer in an unlisted company is limited to the fair value of shares arrived at under the discounted free cash flow (DCF) method. The DCF methodology is based on projected cash flows from the investee company, and hence may not provide a good exit price for exits structured at the end of a project when the investee company in not likely to have any future cash flows. The new pricing formula requires the investors to carefully determine the time of the exit to ensure that the pricing is favourable at the time of the exit.
Put-options and secondary sales
Foreign investors commonly rely on put-options granted by Indian promoters. The limitations on pricing discussed in the preceding paragraph apply equally to put-options, and therefore the aggregate returns that may be repatriated where the investee company is unlisted are limited to the valuation determined under the DCF method.
As a put-option is a contractual right, an investor’s exit greatly depends on the strength of the transaction documents and the cooperation extended by the Indian counterparty. The enforceability of put-options has come into question in recent years. However, they continue to be an important and broadly favoured exit mechanism for many investors.
Foreign investors could also transfer their shares either in a strategic sale or through an offer for sale to the public in an initial public offering. Transfer of shares by a foreign investor to another non-resident do not attract any pricing restrictions.
Exits and investment structures
India’s partial capital convertibility is undoubtedly challenging for foreign investors. However, recent media reports suggest that India has, during the first quarter of this year, witnessed approximately 10 venture capital exits. Analysts predict that there may be as many as 50 venture capital exits this financial year.
The efficiency of exits depends somewhat on the rights negotiated by investors at the time of their investments. To ensure an efficient exit, it is crucial to have a robust investment structure with various investor protection rights to ensure that risks on account of counterparty are mitigated.
A foreign investor may consider one or more of the routes discussed to structure their exit options depending, among other considerations, on the targeted returns, the predicted future cash flow from the investee company and the sector in which the investee company operates.
Nishant Parikh is a partner at Trilegal in Mumbai. Siddharth Sharma and Meghana Singh are associates at the firm.