THE POLICY LAB (TPL) - 40
FEBRUARY 27, 2024

By J B Mohapatra

DIRECT listing of shares of Indian public companies has been an on-going process involving many legislative actions and putting in place new regulations across a number of legislations, beginning with (a) insertion of sub-clause 3 in section 23 of the Companies Act, 2013 vide Companies Amendment Act of 2020 dated 28-9-20, whereby "(3) Such class of public companies may issue such class of securities for the purposes of listing on permitted stock exchanges in permissible foreign jurisdictions or such other jurisdictions, as may be prescribed", and making the provision effective from 30-10-23 vide Ministry of Corporate Affairs' (MCA) Notification dated 30-10-23; (b) followed up with Notification dated 24-1-24 of MCA notifying the Companies (Listing of Equity Shares in Permissible Jurisdictions) Rules, 2024, whereby both unlisted public companies and listed public companies have been allowed to issue shares for the purpose of listing on a stock exchange in a permissible jurisdiction - that presently being the IFSC and (c) rounded up with Department of Economic Affairs' (DEA) Notification dated 24-1-24 notifying the Foreign Exchange Management (Non-Debt Instrument) Rules, 2024 (FEM (Non-Debt Instrument) Rules), which in essence (i) inserted Rule 34 in a new Chapter X and allowed a 'permissible holder' to purchase and sell equity shares of a public Indian company incorporated in India and listed on an international exchange under Direct Listing Scheme and (ii) inserted a new Schedule XI defining and issuing policy level operational guidelines for 'Direct Listing of Equity Shares of Companies Incorporated in India on International Exchanges Scheme'.

Accordingly all public Indian companies, whether listed or unlisted, are allowed to issue and list their shares on an international exchange, barring those cases referred to in Rule 5 of Companies (Listing of Equity Shares in Permissible Jurisdictions) Rules, 2024 (cases of not-for-profit companies u/s 8 or a Nidhi Company u/s 406 of the Companies Act, companies having negative net worth, pendency of winding up proceedings under the Companies Act or CIRP proceedings under IBC Code etc). Direct listing of shares under the Scheme will be on the international exchanges specified in schedule XI of the Foreign Exchange Management (Non-Debt Instrument) Rules, 2024- presently being the India International Exchange and NSE International Exchange. Explanation 1 to Rule 2 under schedule XI of the FEM (Non-Debt Instrument) Rule, 2019 as amended in 2024 by defining 'permissible holder' in the manner it has, allows purchase or sale of equity shares of companies listed in the international exchanges only by someone who 'is not a person resident in India.' Sectoral caps and limit of foreign holding of the company as per extant rules will apply under the Direct Listing Scheme. Unlisted Indian companies has the freedom to have their shares listed either in one or in both exchanges- that is the international exchanges and the domestic exchanges.

Process of interfacing the direct taxes legislation with the amendments in other legislations and regulations for permitting the full and complete fruition of the efforts to get the IFSC structure off the ground and realise the intent in establishing the IFSC regime has simultaneously progressed since long. Some areas where interface has been initiated and some aspects of legislation which now gets impacted because of the Direct Listing scheme including the operational and interpretational issues are as follows:

A: One of the seminal concessions afforded to investors at IFSC's international exchanges since 1-4-19 vide Finance Act, 2018 is towards capital gains tax. Under section 47(viiab) of the Income Tax Act (ITA) introduced via Finance Act, 2018, transfer of a capital asset being (a) bond or global depository receipt referred to in sub-section (1) of section 115AC or (b) rupee denominated bond of an Indian company or (c) derivative or (d) "such other securities as may be notified by the central government in this behalf" made by a non-resident on a recognised stock exchange in any IFSC and where consideration for transfer is paid or payable in foreign currency will not be regarded as a transfer for the purpose of section 45 of the Act. Meaning, profit or gain arising on transfer of the aforesaid capital assets will not a taxable capital gain.

In Notification dated 5-3-20, exercising the powers under section 47(viab)(d), Department of Revenue notified a further list of securities namely (i) foreign currency denominated bond (ii) unit of a mutual fund; (iii) unit of a business trust;

(iv) foreign currency denominated equity share of a company (v) unit of Alternative Investment Fund for their coverage under section 47(viiab), provided the aforesaid securities are listed in a recognised stock exchange in a IFSC. Since the aforesaid Notification includes foreign currency denominated shares of a company listed in a recognised stock exchange in a IFSC, it may at some level sound logical to infer that profit on transfer by a non-resident of shares of company, whether or not the company is incorporated in India, and listed in an exchange at the IFSC would not be considered as a taxable capital gain. Even in the Working Group Report on 'Direct Listing of Listed Indian Companies on IFSC Exchanges' dated 20-12-23 addressed to the Chairperson, IFSCA, at pages 59-60 of that Report, the following finds mention:

"TAXATION

As per the extant provisions of the Income-tax Act, 1961 (IT Act), the mechanism for taxation of equity shares listed on recognized stock exchanges is as under:

a) Capital Gains

A specific exemption has been provided to non-residents on transfer of 'foreign currency denominated equity shares of a company' (*) undertaken on a recognised stock exchange located in IFSC and where the consideration for such transaction is paid or payable in foreign currency.

The exemption does not make any distinction between shares of an Indian company or a foreign company. Thus, any such capital gains on transfer of equity shares of Indian companies listed on IFSC exchanges shall be exempt in the hands of non-residents.

(*) Notification No. 16/2020 dated 5 March 2020 issued under section 47(viiab) of the IT Act"

The above view may find opposition both on grounds of timing of the amendments to various legislations as also on the operational aspects of specific provisions in the Income Tax Act that address the investors and other business units in IFSC.

B: On timing of the amendments, the Notification of CBDT bringing foreign currency denominated shares within the scope of section 47(viiab) is dated 5.3.20. Amendment to section 23 of the Companies Act that enabled a permitted class of company to have their securities listed in permissible foreign jurisdictions is dated 28-9-20. Notification to make amendments to the FEM (Non-Debt Instrument) Rules, 2019 to explain and operationalise the direct listing scheme is dated 24-1-24. There could be a valid argument that the Notification of CBDT in March 2020 could not have possibly envisaged in any manner the amendments to the Companies Act 6 months later or amendments to FEM (Non-Debt Instrument) Rules 4 years later , and that a clearer intention of including foreign currency denominated shares of a company incorporated in India as well needs be spelt out either in section 47(viiab) of ITA or any notification thereunder.

C: On specific operational issues with regard to specific IFSC related provision, there are at least 2.

D:. One, under section 10(4D) of ITA, computation of exempt income of specified fund located in any IFSC, is to be determined by consolidating the following 4 individual parts:

(a) any income accrued or arisen to, or received by the eligible investment division as a result of transfer of a capital asset referred to in clause (viiab) of section 47 of the Act held by it, on a recognised stock exchange located in any International Financial Services Centre and where the consideration for such transaction is paid or payable in convertible foreign exchange;

(b) any income accrued or arisen to, or received by the eligible investment division as a result of transfer of securities held by it (other than shares in a company resident in India);

(c) any income accrued or arisen to, or received by the eligible investment division from securities held by it and issued by a non-resident (not being a permanent establishment of a non-resident in India) and where such income otherwise does not accrue or arise in India;

(d) any income accrued or arisen to, or received by the eligible investment division from a securitisation trust which is chargeable under the head "profits and gains of business or profession".

Two points are relevant to note. One, 'specified fund' must have a certificate of registration under IFSCA (Fund Management) Regulations, 2022; it should be located in an IFSC; and of which all the units must be held by non-residents other than unit held by a sponsor or manager. Two, permissible investments by specified funds which have been established and operating under a certificate of registration from IFSCA under IFSCA (Fund Management) Regulations, 2022 and offering various schemes such as Venture Capital Fund Scheme, or Retail Scheme, or Restricted Scheme etc include "securities listed or to be listed or traded on stock exchanges in IFSC, India or foreign jurisdiction"- vide Regulation(s) 22, 34, and 46 of the aforesaid Regulations.

In a manner, part (b) above mentioned in section 10(4D) of Income Tax Act not allowing exemption to income arising to a specified fund as a result of transfer of shares of companies resident in India runs against the intendment of section 47(viiab) (if it were to be assumed that section 47(viiab) does permit exemption in cases of transfer of shares of companies incorporated in India and listed on an international exchange in an IFSC), and also IFSCA (Fund Management Regulations), 2022.

E: Similarly, section 10(4G) exempts from tax any income received by a non-resident from (i) portfolio of securities or financial products or funds, managed or administered by any portfolio manager on behalf of the non-resident or (ii) such activities as may be notified by the government, in an account maintained with an Offshore Banking Unit (OBU) in any IFSC, "to the extent such income accrues or arises outside India and is not deemed to accrue or arise in India." While it is correct that under Regulation 3 of Foreign Exchange Management (International Financial Services Centre) Regulations, 2015, "Any financial institution or branch of a financial institution set up in the IFSC and permitted/ recognised as such by the government of India or a regulatory authority shall be treated as a person resident outside India", there is presently no such assumption within the Income Tax Act to deem any OBU operating in a IFSC as a person resident outside India. Second, without explicitly shutting off the applicability of section 5(2) of the ITA (which requires inclusion in the scope of total income of a non-resident income from all sources which is received or deemed to be received, or arises or accrues or deemed to arise or accrue to him in India) in section 10(4G) itself, there could be possibility of a contrary interpretation to section 10(4G) than what the amendment could have intended.

Another matter in section 10(4G) relates to management and administration of non-resident's funds in respect of his portfolio of securities through a 'portfolio manager', who is defined in the Explanation below section 10(4G) in peri materia with definition of 'portfolio manager' as assigned in Regulation 2(1)(z) of IFSCA (Capital Market Intermediaries) Regulations, 2021. Since the above sub-regulation in the IFSCA Regulations has been omitted with effect from 19-5-22, one needs to ascertain and propose a suitable substitute through an appropriate clause.

F: Without adverting to the capital gains tax implications resulting from the Direct Listing scheme per se, the interplay between what section 47(viiab) provides for and what is stated in another part of ITA- in section 111A and 112A- also needs a relook. While section 47(viiab) and the notification thereunder exempt a non-resident from any tax on income on any transfer of a capital asset being bonds, shares, derivatives and notified securities and where the transfer is conducted in an exchange in any IFSC and paid or payable in foreign exchange, the concessional tax regime for capital gains tax (10% for long term capital gains and 15% for short term capital gains under section 112A and 111A) arising on transfer of equity share of a company include a mandatory condition that the aforesaid transfer should be chargeable to securities transaction tax (section 111A(1)(b) in case of short term capital gain) or securities transaction tax has been paid in respect of transfer resulting in a long term capital gain (section 112A (1)(iii)). In order that the concessional tax regime without the condition of securities transaction tax is afforded to transactions in an exchange in IFSC, both section 111A and 112A contain identical relaxation clause as below:

112A(3): "The condition specified in clause (iii) of sub-section (1) shall not apply to a transfer undertaken on a recognised stock exchange located in any International Financial Services Centre and where the consideration for such transfer is received or receivable in foreign currency"

2nd proviso to section 111A(1): "Provided further that nothing contained in clause (b) shall apply to a transaction undertaken on a recognised stock exchange located in any International Financial Services Centre and where the consideration for such transaction is paid or payable in foreign currency."

Implication of the above 2 parts in section 111A and 112A extending a concessional tax regime to transfer of shares transacted in an exchange in an IFSC without insisting on payment of securities transaction tax is not clear when one notices that there already is a blanket exemption available to capital gains under section 47(viiab) in respect of the said transfer.

G: On certain salient macro aspects of the Direct Listing Scheme, the implication of 'permissible holder' for ITA would be significant. It is logical to read the reference to "permissible holder" in chapter X of the FEM (Non-Debt Instrument) Rules which allows only the permissible holder to purchase and sell equity shares of a public Indian company listed in any of the IFSC exchanges under the Direct Listing Scheme, and definition of 'permissible holder' as per Explanation 1 to clause 2 of schedule XI - " For the purposes of this clause, permissible holder is not a person resident in India"-, in line with the definition as provided in section 2(w) and section 2(v) of FEMA,1999, and not as per section 5 of the ITA. Provisions of FEMA do not enforce the test of mandatory 182 days residence in India for recognising a person resident in India or a person resident out of India unlike those available in IT Act on three exceptions : (a) for purposes of or taking up employment (b) for carrying on a business or vocation and (c) person's intention to stay in or out of India as per circumstances of his case. Thus we have one residential status for a person under the ITA for one financial year, whereas there is possibility of more than one residential status under FEMA, 1999. Resolution of this asymmetry in statutory definition of resident and non-resident between what is provided in the ITA and in the FEMA, 1999 has never been legislatively attempted, but looking at the scale of tax arbitrage likely from the Direct Listing Scheme, there may be a requirement here to introduce an explanation for obviating a genuine hardship or preventing attempts at gaming the scheme.

H: Finally, the twin issues of pricing and valuation need to be coordinated for removing distortion in interpreting the changes brought about through amendment to FEM (Non-Debt Instrument) Rules qua what the ITA presently provides. The first of the issues will be the pricing of issue price for initial listing of equity shares. While in case of listed public company, issue price shall not be less than the price applicable to a corresponding mode of issuance of such equity shares to the domestic investors , in case of unlisted public company, issue price is required to be governed by the pricing guidelines in Rule 21 of FEM (Non-Debt) Management Rules 2019 and generally follows any internationally accepted pricing methodology for valuation on an arm's length basis duly certified by a chartered accountant or a merchant banker registered with the Securities and Exchange Board of India or a practising cost accountant. This mode is at variance with Rule 11UA of IT Rules and may throw up a very different valuation than what is derived under the IT Rules.

Second, it is not mandatory for an unlisted company intending to list on international exchange to also list on domestic exchange. In case of these unlisted companies getting listed only any international exchange in IFSC, the operational issue could be the ability of the issuer to achieve the minimum public shareholding as mandated under Rule 19(2)(b) of the Securities Contract (Regulation) Rules, 1957 given the further sectoral and foreign shareholding limits that the issuer would be subject to. Minimum public shareholding for a listed company is the sine qua non for the best possible price discovery. Under section 2(18) of the ITA, a company being listed in a recognised stock exchange in India can make that company be regarded as a company in which public are substantially interested, provided the listing is in terms of Securities Contract (Regulation) Act, 1956. Thus any relaxation of the minimum public shareholding requirements for the unlisted company getting listed in a IFSC exchange in a manner other than under the Securities Contract (Regulation) Rules or that getting permitted under some other framework may end up in a skewed valuation and have far reaching consequences.

Direct listing of Indian companies on IFSC exchanges intends to let Indian companies access global capital markets, infuse liquidity in the capital market, and obtain better shareholder value by expanding the Indian corporates' ability to raise equity and expand shareholder base, and requires utmost synergy in calibrating various legislations and regulations to arrive at a common goal. Rejigging the ITA to either clarify a contentious point that arises from the changes, or putting in place changes to the ITA itself to provide meaningful contribution to the larger intent of the scheme would be vitally important in this unfolding story.