RBI flexibility on deferred purchase consideration - An M&A Booster

When it comes to attracting foreign monies and making India an investment hub, the Modi Government is leaving no stone unturned and the efforts are clearly visible.  The slew of amendments on the tax front, such as bringing clarity on the issue of “business income” vs “capital gains”, bringing sale of private limited companies also within the ambit of lower rate of taxation, granting a favorable tax regime for certain start-ups, handling the age-old Mauritius tax controversy in a matured way and the recent one on the Goods and Service Tax (‘GST’), are to name a few.  Equally, the Government is working hard on the regulatory front – be it on the single window clearance scheme, providing clarity on treatment of investments made by an Alternative Investment Fund (‘AIF’) having foreign investment or exposing various sectors to a higher and / or liberalized foreign direct investment regime.  The other recent one is providing the much needed clarity/ framework on deferred payments and escrow arrangements qua transactions with non-residents.

The Reserve Bank of India (‘RBI’)  through its Notification (Notification No 368/2016-RB) dated May 20, 2016 has amended the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (‘Inbound regulation’) to provide for the following:

-          Transfer of shares whether by resident (‘R’) or non-resident (‘NR’) on a deferred payment basis;

-          Creation of an escrow arrangement between the buyer and seller of shares; and

-          Furnishing of indemnity by seller qua sale of shares.

The above, however, comes with riders, namely (i) the amount involved in any of the arrangements mentioned above should not exceed 25 percent of the total consideration and (ii) the period of any arrangement described above should not exceed 18 months from the date of the transfer agreement (in case where the buyer chooses to discharge only part payment initially ie =>75 percent consideration as upfront payment and the differential =<25 percent, is deferred) or the date of payment of full consideration (where entire consideration is paid by the buyer and indemnity is provided by the seller for an amount not exceeding 25 percent).  Where these conditions are satisfied, the arrangement would be under the automatic route ie without seeking RBI’s prior approval, obviously, the pricing guidelines will have to be complied with in all cases vis-à-vis the total effective consideration finally paid by the buyer to the seller.

Hitherto, transfer of shares of an Indian company by R to NR on a deferred payment basis required prior RBI approval and an escrow arrangement was allowed to be maintained for a maximum period of 6 months.  The Inbound regulations were silent when it came to deferred payment to be made by R in connection with purchase of shares from NR, however, parties used to generally approach the RBI to seek its blessings in such cases as well.  The current Notification is a step towards liberalizing/ clarifying the earlier position in this regard and is a welcome move.  However, couple of points that merit attention in this regard are as under:

-        Date of the transfer agreement

“Date of the transfer agreement” is the reference date for counting the 18 month period in case where the buyer chooses to pay only 75 percent (or more) consideration as upfront payment and the differential is deferred as per the provisions of this Notification.  In certain cases, there is good enough time lag between the “signing” and the “closing”, especially where conditionalities are attached.  Signing could be equated with date of the transfer agreement whereas, closing with transfer of share from seller to buyer and consideration from buyer to seller.  It would have been better had the reference date be pinned to the latter rather than the former.

-          Transfer of shares from R to NR

This can be explained better with the help of an example.  Say, Mr R wants to sell 10,000 shares of company XYZ, an Indian company, to Mr NR @ INR 200 per share.  The pricing guidelines suggest that the fair value of XYZ is INR 100 per share.  The commercial arrangement between Mr R and Mr NR is such that INR 125 per share will be paid at the time of the transaction and INR 75 per share will be deferred for a period of 18 months.  However, given the conditionality of 25 percent cap on the deferred consideration under the current Notification, the total consideration may have to be reduced from INR 200 per shares to INR 166.67 per share to meet this condition; alternatively, the initial consideration will have to be increased to INR 150 per share.  The seller, and most importantly India, will have a loss to the exchequer to the tune of INR 33.33 per share (INR 200 – 166.67) in case the commercial understanding is not to pay anything more than INR 125 upfront.  This leads us to question; is there a genuine requirement for a 25 percent threshold, if the pricing guidelines are anyways met in the first tranche itself?

-          Transfer of shares from NR to R

On the other hand, say Mr NR wants to sell 10,000 shares of company XYZ, an Indian company, to Mr R @ INR 75 per share.  The pricing guidelines suggest that the fair value of XYZ is INR 100 per share.  The commercial arrangement between Mr NR and Mr R is such that INR 50 per share will be paid at the time of the transaction and INR 25 per share will be deferred for a period of 18 months.  However, this will fall foul of the current Notification and Mr R will compulsorily have to pay INR 56.25 ie 75 percent of the total agreed consideration of INR 75 per share, as against a lower current outflow of INR 50 per share as commercially agreed between the parties.  This leads to a higher cash outflow by the resident seller, and seems to be anti-intuitive, as it leads to a higher foreign exchange outflow from the country because of the regulations.

-          Time period for deferment/ escrow

Typically, the deferred consideration is commercially agreed between the parties ranging from a period of 2 to 3 years (to assess the performance of the company, and hence determine the potential for the total consideration).  It could be worthwhile for the RBI to extend the time period of 18 months marginally to give more leeway to the parties to the transactions.

-          Earn-outs & contingent consideration as against just “deferred consideration”

Typically, “earn-outs” and “contingent” considerations are different than “deferred” consideration, wherein the former could be contingent and could materialize only where certain conditions are met, whereas, payouts under the latter would mostly be certain and are just deferred over a period of time.  The language of the Notification somewhere seems to suggest that the RBI wants to cover “contingent-like” situations, however, the term “deferred” used in the Notification casts a doubt. 

-          Indemnity

The Notification suggests that where the seller (either R or NR) has received the “total” consideration, it may furnish indemnity for 25 percent of such consideration.  This seems to suggest the “contingency” portion of the total consideration which needs to be re-paid back to the buyer by the seller where the conditions are not met.  To give an example, in case where the commercial understanding between the buyer and the seller is such, that the consideration should be INR 100 per share; however INR 25 would accrue to the seller only in case where certain conditions are met in the future.  In terms of cash flows, the buyer may pay entire INR 100 per share to the seller only with a condition that if the “conditionalities” are not met, then the seller would re-pay INR 25 per share to the buyer.  In such cases, the seller can provide an indemnity favoring the buyer albeit only with the 25 percent cap mandated under the Notification.

An interesting point to note in this context is that the parties, especially the sellers, generally provide for indemnities qua title of the shares, any misstatements / misrepresentation in the transaction documents, taxation related aspects and the like which could very well be upto 100 percent of the consideration or even beyond.  It doesn’t seem that the RBI is looking to cover such situations within the 25 percent cap; however, a clarification in this regard would help.

To sum up, the Notification is a welcome move by the RBI, which seems to be working in line with the Government objective of ease of doing business and making India a preferred Investment jurisdiction.

With the introduction of the flexibility of having deferred purchase consideration mechanism or an indemnity / escrow arrangement in Indian cross-border transactions, the RBI has taken a significant step to boost investment and M&A environment in India.  Clarifications qua few aspects discussed above would be icing on the cake.