Sundaram Clayton Ltd (SCL), recently rechristened TVS Holdings Ltd, undertook a major corporate restructuring exercise, discussed in detail in an earlier article, and one of its legs was the issue of 9% cumulative nonconvertible redeemable preference shares (NCRPS) of Rs10 each in the ratio of 116 NCRPS each fully paid-up of the company for every one equity share of Rs5 each fully paid-up, by way of bonus to the equity shareholders of the company.
The quantum of the issue is a whopping Rs2,347 crore, perhaps the highest amount ever distributed in this fashion and it involved capitalising the reserves of the company of an equivalent amount. Consequently, the reserves have come down to a modest Rs687 crore from the previous year's figure of Rs2,884 crore.
The company managed to give effect to this part of the restructuring in the latest accounting year, 31 March 2023, as the order of the Tribunal was passed in early March 2023 and the board of the company initiated the follow-on action on 13 March 2023.
The speed at which this process moved and concluded is quite breathtaking. Who said there is delay and red tape in the government?
The company has also advised the stock exchanges that the NCRPS would be available for trading on both exchanges effective from 19 June 2023, being the date of listing. The instrument carries a CRISIL rating of A1+.
These preference shares, under the terms of the issue forming part of the composite scheme of arrangement (SOA), are redeemable within a maximum period of 12 months from the date of such issue, which would mean one year from 24 March 2023, the date which the company mentions as the date of issue of such NCRPS to all its shareholders.
Why would a company issue preference shares as a bonus to its equity-holders?
The reasons given by the company itself in the SOA are reproduced below for academic interest.
"(i)SCL has built up substantial surplus reserves, over the years from its retained profits. The surplus reserves are well above SCL's current and likely future business needs. Further, barring unforeseen circumstances, SCL is confident of generating incremental cash over the next few years. Overall reserves position is expected to improve further even after considering cash requirements for SCL's capex programme and working capital requirements.
"(ii) Further, upon taking into consideration SCL's capability to generate strong cash flow and the surplus reserves being more than what is needed to fund SCL's future growth, SCL is of the view that these excess funds can be optimally utilised to reward its shareholders in such difficult and unprecedented times by way of distribution.
"(iii) At the same time, in keeping with SCL's tradition of conventional cash management and being mindful of the challenging business environment, SCL is of the view that it would be prudent to retain liquidity as well. Accordingly, SCL has proposed, inter alia, to distribute such funds amongst its shareholders by issuing fully paid up nonconvertible redeemable preference shares by way of bonus in terms of this scheme.
"(iv) Nonconvertible redeemable preference shares, while giving near-cash_ (traded, encashable) instrument in the hands of shareholders, give increased flexibility to SCL in managing its liquidity through options like buy back, redemptions, etc.
"(v) In view of the aforesaid factors, SCL has concluded that it can optimally utilise its surplus reserves by distributing a considerable portion of the same to the equity shareholders. In order to maintain high level of corporate governance and transparency, SCL proposes issuance of preference shares by way of bonus under Section 230 of the Act which will be subject to necessary statutory, regulatory and corporate approvals."
SCL is not the first company to adopt this route. A few more have done in the past like Marico Industries, Sun Pharma, etc.
One of the biggest such issues in the past was by Zee Entertainment Enterprises Ltd (Zee), which issued such shares to the tune of Rs2,017 crore in 2014 in the form of 20.17bn (billion) numbers of 6% cumulative redeemable nonconvertible preference shares of Re1 each by way of bonus in the ratio of 21 bonus preference shares of Re1 each fully paid-up for every one equity share of Re1 each fully paid- up, and got it listed on BSE and National Stock Exchange (NSE).
Incidentally, R Gopalan, the independent director and chairman of SCL, is also a director on the board of Zee Entertainment and possibly the inspiration behind this idea pursued by SCL!
Unlike the term of just one year for SCL's issue, Zee had a longer duration of redemption and redeemed at par value, 20% of the total bonus preference shares allotted, every year from the fourth anniversary of the date of allotment.
A legitimate question that can arise for any bystander is if SCL had excess funds beyond its perceived business needs, as stated in the reasons extracted above, why did it have to go through such a convoluted way to reach the money to its investors? More so, when the preference shares come up for redemption within a few months from its listing in the stock exchanges.
The answer to these questions may lie in the scheme of taxation assumed by the company for such bonus preference shares compared to a cash dividend.
Bonus preference shares, when issued, are believed to not constitute a distribution of the company's assets and, therefore, not taxable. At the same time, a cash dividend implies the release of the assets and is immediately taxable.
There is another variant to such deferred distribution which is the issue of bonus debentures. This has been favoured by many companies to commemorate special occasions but such issues also attract immediate taxation like cash dividends and would not have suited the requirement in this case.
Therefore, there is a perceived efficiency in substituting a cash dividend with redeemable preference shares. However, the issue is not adequately tested in terms of precedents in law but the considered view is that the taxable event arises only when the redemption takes place.
Is there adequate wisdom in such a step where the tax would anyway arise when the shareholder receives the redemption proceeds?
It is most unlikely that the company would have assumed no tax liability to arise on the redemption as well. The promoters hold 74.46% of the shares and, being the main beneficiary of this arrangement, carry the highest risk if any part of the planning goes awry.
To set the larger context, the TVS parent company had earlier undergone a major realignment of the shareholdings of the various investee companies as part of a family arrangement and a major part of the value actually resided in the companies under SCL. There could be potential questions on the taxability of the said family arrangement itself.
Thus, in the current environment of a highly motivated tax department that does the assessments 'faceless' but overly compensates with frequent and unwelcome visits to the business premises in the guise of a survey, a company with the pedigree of SCL would be most guarded!
As a matter of fact, Zee, while redeeming the annual quota of the preference shares, paid the tax under the DDT system prevalent then. The investors did receive the amount free of tax but that was not on account of the redemption being exempt but because of a different tax system prevailing then!
If so, why all this fuss? Why go through such a complex scheme that actually delays the cash reaching the shareholders, carries some key tax uncertainties and with a bullet redemption within such a short tenure the advantage of cash management is also absent for the company.
Additionally, the company has to create an equivalent amount that it pays on the redemption as a special reserve. Based on the latest numbers, the available amount falls far short and only the next year's annual report may reveal how the circle gets squared!
While the tax liability as dividend arises at the time of redemption, if the shares exchange hands before such redemption and the value is cashed, there is no question of dividend distribution resulting in a taxable event. However, such a sale is like the sale of any capital asset and the gain would be classified as capital gains.
Whether such gains are to be reckoned by taking the cost of the preference shares as zero, or attributing a notional cost equivalent to the face value is a subject for some tax expert to comment on!
The tax rate applicable to gains arising on shares that are listed is much lower even if the asset is held for less than a year. Thus, a clear arbitrage exists for the persons cashing through a market sale. The difference can be about 20% for an individual in the highest tax bracket.
A logical follow-on question is: can all the investors sell in that fashion and just pay the lower tax and the dividend tax is fully avoided?
Any buyer in the secondary market would become liable to tax on the redemption proceeds when it is redeemed by the company. The company would be compelled to deduct tax classifying the payment as dividend and the tax authorities assessing the secondary holders (assuming a first sale) would bring the entire receipts to tax as dividend.
Isn't this unfair as the secondary-holders have bought the share paying the full price and the redemption proceeds are only a reimbursement of the capital invested?
There is ambiguity in the position. In the case of ZEE, the question of taxing the investor did not arise as the tax regime was different but the company paid the tax assuming the full amount as taxable. Since the investor was fully exempt there was no occasion to test this issue.
The principal objective of this article is to caution the secondary buyers of the potential danger of getting into a trap when their wealth adviser or the bank relationship manager touts this as a wonderful short-term investment opportunity that is being exclusively offered to handpicked clients!
The only consolation for such investors who pay the tax on the entire redemption amount may be to make a claim for allowing the amount invested as a loss from a short-term capital asset and trust the tax officer would be at least considerate not to levy a penalty for a wrong claim even if the basic claim is not sustained!
If a layman sees so many issues, what merit would the promoter, being the biggest beneficiary, have seen in this structure? Did they take an ill-advised route with no proper professional guidance? Certainly not, as seen from the annual report, they have spent a significant amount on legal fees and must have made sure that all the ground was duly covered!
What could be such an artifice available to the promoter which a small investor may not have the luxury of accessing?
The redemption amount is taxable in the hands of the receiver of the proceeds as dividends in the present law. Therefore, if the receiver has a tax-exempt status, then such amounts cannot be taxed. For example, mutual funds are not subject to tax on dividends or capital gains.
Given the above scenario, the promoters could have negotiated with one or more such entities to buy their quota and escape the tax on the redemption proceeds. One such fund is within the larger TVS group and can be a captive buyer!
It is difficult to calculate the amount of the possible tax heist but assuming a 20% arbitrage on 75% of the total payout, it is a smart Rs370 crore! An interested reader may work out over how many years the company paid a cumulative tax equalling the above number!
To conclude, the money spent on the lawyers and the tax consultants would have a good payback if the tax authorities don't treat the scheme as a case of tax evasion under the anti-avoidance rules or if the government, sensing the potential, makes a retrospective change to the law!
Postscript: Someone can raise a mischievous query about whether the tax can be fully avoided if the issuer were to buy back the entire issue a few days before the redemption!
(Ranganathan V is a CA and CS. He has over 43 years of experience in the corporate sector and in consultancy. For 17 years, he worked as Director and Partner in Ernst & Young LLP and three years as senior advisor post-retirement handling the task of building the Chennai and Hyderabad practice of E&Y in tax and regulatory space. Currently, he serves as an independent director on the board of four companies).