Recommendations of the Task force
on
Knowledge-Based Industries

Annexure I : Foreign Exchange Issues

1) EEFC ACCOUNT SHOULD BE MADE FULLY CONVERTIBLE ON CURRENT ACCOUNT

As per Para 14D.4 of the ECM, "The funds held in EEFC accounts may be permitted to be utilised by the account holder for all bonafide payments of the account holder subject to the limits and conditions and on verification of documents prescribed in the manual and/or against permits issued by the RBI. Authorised dealers may also permit utilisation of the funds held in EEFC accounts for making bonafide payments of the account holders in foreign exchange connected with their trade and business related transactions which are of a current account nature without any restriction except in the case of remittance of agency commission on exports".

At present, the ECM places limits on the amounts that can be paid for various transactions. For example, remittances up to a limit of US$ 25,000 towards cost of services rendered by overseas parties to companies in India is permitted to be made without approval of the RBI (RBI circular AD/MA 8/1997). Specific approval of the RBI is required for payments exceeding this limit.

The EEFC account should be made fully convertible on current account. Para 14D.4 should therefore be amended as follows:

"Authorised dealers may permit utilisation of the funds held in EEFC accounts for making bonafide payments of the account holders in foreign exchange connected with their trade and business related transactions which are of a current account nature without any restriction."

2) EEFC ACCOUNT TO BE FREELY CONVERTIBLE ON CAPITAL ACCOUNT

Indian software companies are granted blanket investment approval up to 50% of their cumulative export/ foreign exchange earnings in the preceding three years subject to a maximum of US$ 25 million under the fast track route of the RBI. This ceiling is inclusive of the US$ 15 million under the EEFC fast track window.

The following amendment should be made in Circular No.35:

"KBCs are allowed to invest in Joint ventures/ Wholly owned subsidiaries abroad without any limit provided the investment is made from out of the balances held in their EEFC accounts without any reference to the RBI. The Board of Directors of the Indian promoter company is permitted to change the equity structure of subsidiaries, divest the equity of subsidiary in favour of new investors/Venture Capitalists, re-structure the equity of subsidiaries, issue stock options to employees of JVs/WOS etc., without any reference to the RBI".

3) INVESTMENT IN START-UPS ABROAD

KBCs like software companies need to invest in start-ups in the US which will place Indian companies at par with its counterparts in other parts of the world and will also ensure that they have access to newer technologies and will enable them to make it a profitable investment, in case the start-ups succeed. At present, the setting up of a wholly owned subsidiary or Joint Venture abroad is covered under the notification No. 4/1/93-EP(01) dated 17th August 1995 as amended from time to time, issued by the Ministry of Commerce, Government of India. The RBI has also issued guidelines based on the above vide ADMA series No.35 dated 28th August 1997. As per para 2.2 of the above notification, "the guideline is applicable to investment in a foreign concern in the nature of a wholly owned subsidiary or a joint venture engaged in industrial, commercial, trading or service activity including hotel or tourism industry. This includes financial services such as insurance, mutual funds etc.,

The Ministry of Commerce, Government of India should issue the following amendment to the notification:

"This guideline applies to investment in a wholly owned subsidiary or Joint Venture abroad whose principal activity is in the nature of financial services in the area of venture capital funding.

The wholly owned subsidiary or Joint Venture whose main activity is in the areas of financial services as defined above can invest in companies located in USA and other countries without any limit on the investee company’s capital.

The direct investment out of India to fund start-up ventures in the software technology field outside India is allowed under the existing guideline on "setting up of a wholly owned subsidiary or Joint Venture abroad".

 

4) DOWNLOADING OF SOFTWARE FROM THE INTERNET

The RBI vide Circular No. AD (MA Series) No.51 has permitted authorised dealers to allow remittances towards import of software through datacom channels or Internet. However, the absence of a Customs notification in this regard is preventing the RBI intent from being carried out in practice.

The Customs should immediately come out with a notification facilitating import of software through datacom channels and Internet.

5) RESTRICTIONS ON ISSUE OF PERFORMANCE GUARANTEES

The Memorandum PEM (Project Exporters Manual) permits guarantees up to a limit of Rs.5 crores to be issued by authorised dealers. The guarantees for amounts ranging between Rs. 5 crores to Rs.10 crores is required to be approved by EXIM Bank and approvals for guarantees above Rs. 10 crores is required to be approved by the Working Group. This delays the issue of such guarantees and unnecessarily increases costs.

The Project Exports Manual should be amended as follows:

"KBCs are excluded from the provisions of the Memorandum PEM and authorised dealers are permitted to issue such guarantees on merit based on their approval."

6) OPENING OF BANK ACCOUNTS ABROAD

Section 8 (1) of the Foreign Exchange Regulation Act, 1973 prohibits companies in India from opening an account expressed in foreign currency abroad without prior approval of the RBI. KBCs therefore have to approach the RBI every time a new marketing office is set up seeking permission to open bank accounts abroad.

The RBI should issue a general notification as follows:

"KBCs who are EEFC account holders or otherwise are allowed to open foreign currency accounts abroad for the purpose of transacting the operations of overseas non-trading marketing offices without approval of the RBI."

7) OPENING OF NON-TRADING MARKETING OFFICES ABROAD

At present, companies desiring to set up non-trading offices abroad are required (vide AD M.A. Series circular No.42) to make an application to the authorised dealers in Form. OBR for each proposed office along with details of remittances proposed to be made and the particulars of their turnover duly certified by their auditors.

The RBI should issue the following notification:

"KBCs who are EEFC account holders are allowed to open non-trading marketing offices abroad without the requirement to file Form OBR with authorised dealers."

8) FEDAI RULES

The Foreign Exchange Dealers Association of India (FEDAI) prohibits banks in India from charging rates for various foreign exchange related services that are below the rates approved by FEDAI. The rates are fixed by FEDAI for various foreign exchange transactions including export transactions, import transactions, guarantees, forward contracts etc., This restrictions placed on the authorised dealers deprives KBCs from the benefits they would otherwise be eligible for based on the volumes of transactions.

The FEDAI rules should be amended permitting banks to fix the rates for various foreign exchange transactions on the basis of negotiations with individual companies. This would result in KBCs getting the best rates from the banks and will be on par with the rates available to competitors in the US and other parts of the world.

9) INTER-BANK FOREIGN EXCHANGE SETTLEMENTS

The settlement of foreign currency transactions between banks in India is routed through their respective nostro accounts maintained abroad resulting in delay in settling inter-bank related transactions of companies.

The RBI should permit settlement of inter-bank foreign exchange transactions through balances maintained in India.

10) CASH-LESS EXERCISE OF STOCK OPTIONS

The RBI vide circular. A.D.(M.A.Series) Circular No.25 permits resident employees of Indian software companies to remit on exercise of stock options up to US$ 50,000 in a block of five years to acquire ADRs/GDRs. An up front payment is therefore required to be made for exercise of the options. The limit also places a restriction on the amount that an employee can pay to exercise the stock options in a given block of years.

The RBI should permit cash-less exercise of stock options. Cash–less exercise of stock options would enable employees holding ADR/GDR linked stock options to remit from India in foreign currency up to the limit specified over the block of years towards the cost of the options. At the time of exercise, the employees will have to approach designated brokers abroad for funding the exercise. The designated broker will sell stock arising from the exercise of the option and remit the balance, after adjusting the amount advanced to the employee for exercising the option. This ensures that there is no huge foreign exchange outflow from India.

The RBI should amend circular No.25 as follows:

"Resident employees of Indian software companies who are granted dollar denominated stock options linked to the issue of ADRs/GDRs are permitted the facility of cash-less exercise of stock options.

Cash-less exercise of stock option means that the resident employees of Indian software companies who are granted dollar denominated stock options linked to the issue of ADRs/GDRs are permitted to approach designated brokers abroad for funding the exercise. Such funding will have to be repaid from out of the sale proceeds of stock arising out of the stock options."

11) DECLARATION OF SOFTWARE EXPORTS

The paras 6D.1 and 6D.2 of the ECM requires export of computer software in non-physical form to be declared on SOFTEX form. The SOFTEX form in triplicate along with relevant documents is required to be submitted for purpose of valuation by the Department of Electronics. The exporter is required to designate a single branch of an authorised dealer to whom export documents will be submitted for all export of software in non-physical form.

The RBI should issue a notification making the following amendment to paras 6D.1 and 6D.2 of the ECM thereby eliminating the need of filing SOFTEX forms:

"Software companies are required to submit to the RBI, a Chartered Accountant’s certificate on a quarterly basis certifying the amount invoiced and amount received against each invoice in lieu of filing GR/SOFTEX forms."

12) EXTENSION OF TIME LIMIT FOR REALIZING EXPORT PROCEEDS

The para 6D.3 of the ECM requires that the amount representing the full value of each export of software be realised on the due date for payment or within six months from the date of export, whichever is earlier. The para 6C.16 requires exporters who are not able to realise export proceeds within six months from the date of shipment to seek extension of time by making an application in Form ETX to the RBI.

The RBI should issue a notification substituting the following amendment to the present requirement of filing Form ETX for each overdue invoice:

"KBCs are required to submit a statement of invoices not realised within the prescribed period on a quarterly basis duly certified by a Chartered Accountant"

13) REDUCTION IN VALUE / WRITE-OFF OF UNREALISED EXPORT BILLS

The paras 6C.13 and 6C.14 of the ECM govern the procedures to be followed for seeking reduction in invoice value and write–off of unrealised export bills respectively. Reduction in value is allowed subject to the same not exceeding 10% of invoice value. Authorised dealers are allowed to permit write-off of unrealised export bills subject to the condition that the aggregate amount of write-off allowed by any branch during a calendar year should not exceed 5% of the total export proceeds realised by the exporter through its medium during the previous calendar year. As this is a business decision, the Board of Directors should be the final arbitrator. There should be no need for a reference to the Enforcement Directorate or any other authority.

The RBI should issue a notification substituting the following amendment to the one existing at present :

"KBCs are given general permission for reduction in invoice value and automatic permission to write-off unrealised export bills without approval of Authorised dealers and without any reference to the RBI provided the aggregate of the reduction in invoice value and write-offs during any financial year does not exceed 5% of the exports of the KBC in the preceding financial year. Such a decision shall not be subject to any reference or proceedings by the Enforcement Directorate".

14) EXPORTS OF GOODS BY COURIER

As per ECM , exports through Courier are not permitted. Para 6B (ii) details the procedure for exports through posts by complying with the PP procedure instead of GR forms. Exports through courier, of small consignments is more economical, speedy and in line with the international customers expectations.

Exports of consignments up to certain prescribed value to be permitted through certain designated courier companies

15) SUBMISSION OF POSTAL WRAPPERS FOR IMPORTS THROUGH POSTS - BOOKS

Para 7A.22 of ECM requires submission of postal wrapper for imports through posts within three months from the date of import. As purchase of books, is presently treated as imports it is obligatory on the part of the importer to provide postal wrapper evidencing proof of import. A large company operating in an multi-locational environment where books are sourced by numerous departments, the practical difficulties in collection, understanding the importance of postal wrapper etc. are very difficult to be spelt out and this leads to unproductive correspondence between banks and importers.

Evidence of import of books, samples etc. up to a certain prescribed value through posts need to be accepted based on the declaration of the importer duly certified by a Chartered Accountant.

16) CEILING ON AGENCY COMMISSION PAYABLE ON EXPORTS

As per Para 6E.2 of ECM, agency commission is permitted up to 12.50% of the FOB value subject to compliance of certain conditions. In view of the growing competitiveness and increased cost of marketing infrastructure & expenditure, this limit needs to be revised upwards.

Limit on commission payable to be increased to 20% of the FOB value of exports on individual sales subject to an overall ceiling of 12.50% of average of annual export value during the preceding three years to be duly certified by a Chartered accountant.

17) EXPORT ON EXTENDED CREDIT TERMS

Para 6A.7 stipulates that export proceeds need to be realised on the due date or within six months from the date of export of shipment, whichever is earlier. Exports to CIS countries, particularly after devaluation of Rouble have been affected and there is a likelihood of further delays in realisation of proceeds due to the continued economic recession in Russia. The ECM stipulates specific approval for exports on extended credit terms ( i.e., on credit terms beyond six month from the date of export) This constrains the ability to accept orders and conduct business during the period when such approvals are being processed.

Exports on extended credit period to be made subject to the condition that overall export outstanding of the exporter is less than specified limit of the average realisations during the preceding three years as duly certified by a chartered accountant, every quarter.

18) CONSIGNMENT EXPORTS

Currently, maximum credit terms for conducting business on consignments sales basis is restricted up to the prescribed period for realisation of export proceeds i.e. within 180 days from the date of export. However, para 6C.8 of ECM provides that prior approval of RBI is required for extending credit terms beyond 180 days. As consignment sale involves stock transfer of goods, (subsequent to procurement of order) & dispatch of the same and the involvement of several parties in the transaction, the period of 180 days is not sufficient to conclude business transactions.

Consignment sales be permitted on credit terms beyond 180 days and may extend up to 365 days from the date of export of consignment for exporters with satisfactory track record.

Annexure II : Employee Stock Option Plans

1) TAXATION OF EMPLOYEE STOCK OPTIONS

The CBDT has, in its circular No. 710 dated July 24,1995 issued certain instructions on the taxability of ESOPs in India. They are:

Where the employer offers shares only to its employees at a price less than the market value, the difference between market value on the date of acceptance and the issue price is taxable as perquisite.

In the event the government transfers shares to the employee, there will be no perquisite because there is no employer-employee relationship between the government and the employees.

In the event a company offers shares to employees at the same price as has been offered to other shareholders or the general public, there will be no perquisite.

In the event the employer has offered shares to its employees at a price lower than the one offered to other shareholders/public, the difference between the two will be taxable as perquisite.

The above circular discriminates between public sector and private sector employees. It also discriminates between issue of shares on a stand-alone basis to employees and issue to employees accompanied by a public/rights issue. The circular does not take into account:

Lock-in which prevents an immediate sale and use of sale proceeds for payment of any tax.

Use of warrants which do not give an absolute right to shares but a contingent right which crystallises only upon performance of minimum service

Situations where physical custody of the instrument will not be with the employee till the performance of all conditions associated with the award of such instruments.

Non-possibility of determining the market price at the time of the issue due to lock-in, lack of physical custody and only a contingent right.

The incidence of tax on stock options should arise only on the sale of the shares arising out of exercise of stock options. Such income should be taxed as capital gains, either short term or long term, depending upon the holding period and should not be taxed as salaries.

2) ISSUE OF EMPLOYEE STOCK OPTIONS

Section 73 of the Companies Act should be amended so that:

An offer can be made to employees only not being promoters or a person holding more than 10% of the issued capital under an ESOP duly approved by the Board and the shareholders of the company. As such, the price may be decided under the scheme.

The ESOP shall contain the details of the total number of shares to be issued, the pricing mechanism, payment terms, choice of instrument and the terms and conditions of the scheme.

The Companies Act should not restrict the Board from issuing shares, pricing the issue or the terms and conditions nor should there be rules or guidelines for the same under the Act.

Presently, according to SEBI guidelines, the issue of shares under an ESOP should be at market related prices. The guidelines as regards pricing have been issued in the background of preferential allotment of shares at a price unrelated to the prevailing market price for such instruments as was in vogue at the time the guidelines were issued. These guidelines were framed so as to prevent promoters or persons for the time being in charge of the affairs of the management of a company from enriching themselves at the cost of the shareholders and to protect the interests of the investors. The guidelines, by providing for the same manner of pricing for ESOP, have sought to equate the employees participating in an ESOP with the promoters or persons in charge of the affairs of management. It is therefore suggested that the pricing be determined at the lower of the book value of the share at the time of grant or the market value of the share on the date of the grant.

Currently, SEBI restricts the quantum of shares of shares/ convertible instruments by a company under an ESOP to not more than 5% of the paid up capital of the company in any one year. This provision retards the growth of Stock Option Plans since either the number of employees who can be covered under the stock option plan gets restricted or the quantum of issue of stock options to each employee gets restricted. The Board of Directors of the company should have the discretion to determine the percentage of shares to be issued under the Stock Option Plan. This would however be subject to the approval of shareholders.

Annexure III : CBDT Guidelines

Section 10(23)F of the Income Tax Act introduced in 1995 and the related CBDT guidelines have many shortcomings. The following modifications need to be made to correct them.

Section 10(23)F of the Act permit VC funds to invest only through the equity route. This is highly restrictive in the present economic milieu.

Venture capital firms carry out substantial financial engineering to provide enough flexibility to meet the requirements of investee companies, which vary from case to case. Throughout the world, convertible instruments such as convertible preference shares, convertible debentures and fully / partly convertible debentures are frequently used as instruments of financing. SEBI has taken this into account and permits investment through both equity and equity-like instruments. However, CBDT guidelines need to be modified to permit this.

Section 10(23)F and the allied rules and circulars envisage that the benefits of Section 10(23)F are available only if VC funds provide assistance to companies in the manufacturing sector. These benefits are not available to investments in service sector enterprises (except for Computer Software). Given the increasingly important role of the services sector in the economy, this anomaly should be corrected. In case the benefits cannot be immediately extended to the services sector at large, investments in the following areas should be considered eligible for exemption under Section 10(23)F.

Rule 2D of the Income Tax Rules, 1962, stipulates that investment in unlisted securities should be as per the following schedule:

At least twenty percent in the initial year,

At least fifty percent in the second year, and

At least eighty percent in the third year.

The percentages are reckoned on the funds raised. The foregoing schedule for completing investments is a major handicap given the fact that VC investments typically take some time to consummate. It is, therefore, urged that the schedule for completing investments be dropped and only an overall cap of eighty percent be retained. Further, a time period of three years should be granted to reach the eighty percent limit. This time period of three years should commence from the end of the financial year in which an application in form 56A is made. Additionally, computation of the eighty percent limit will be on the basis of gross original investment. Divestment made by the Fund should not be taken into account, because it would generally not be possible to reinvest the funds-thus received on divestment, on account of the fact that the close-ended funds have a pre-determined short life span.

The section 10(23)F of the Act does not cover capital gains arising out of bonus and right shares. This should be also included in the guidelines.

Annexure IV : Regulatory Problems under Customs and Excise

1) CUSTOMS BONDING FOR STPs

Companies operating under the STP scheme are required to get their premises customs bonded (Paras 9.18 and 9.25 of the Handbook of Procedures) necessitating multiple approvals from DoE-STP and also the Customs and the Excise departments. This results in delay in movement of computer and other equipment from one STP to another especially when software companies are setting up STPs at different parts of the country.

The following amendment is required to be made in the Handbook of Procedures:

"Companies operating under the STP scheme are allowed to operate without the requirement of customs bonding.

Companies operating under the STP scheme are allowed to import duty free goods without prior approval from government agencies."

 

2) ISSUE OF EPCG LICENSES

At present, EPCG licenses (Para 7.7 of the Handbook of Procedures) are being issued by the office of the DGFT either at the regional office or the head office at Delhi based on the investment limits. The issue is approved by a committee and recommendations from the nominee of the DoE is necessary before the grant of the license. This results in considerable delay in obtaining the licenses.

The following amendment is required to be made in the Handbook of Procedures:

"STP will issue EPCG licenses to companies operating under the STP scheme and such licenses shall be issued within 2 days of receiving a valid application from the applicant unit".

3) ISSUE OF SPECIAL IMPORT LICENSES

Special Import Licenses are issued by the office of the DGFT (Paras 12.7 and 12.8 of the Handbook of Procedures). Considerable documentation is involved in making an application for issue of Special Import License. The lead-time in obtaining the licenses runs into several months.

The following amendment is required to be made in the Handbook of Procedures:

"STP shall issue Special Import Licenses to companies operating under the STP scheme."

4) IMSC APPROVAL

Any investment by companies operating under the STP scheme exceeding Rs.10 crores needs the approval by an Inter-Ministerial Standing Committee (Para 9.2 of the Handbook of Procedures). The committee meets once a month to review and approve proposals resulting in considerable lead-time in setting up of projects under the STP scheme.

The following amendment is required to be made in the Handbook of Procedures:

"STP shall approve all investment proposals of companies for setting up of units under the STP scheme without any monetary limit."

5) GRANTS FOR SETTING UP CYBER PARKS

Large companies are able to invest substantially in infrastructure for their own use. However, the rapid growth in revenues at 70-80% per annum making it imperative that infrastructure be set up at a very fast pace in advance. This problem becomes acute for small and medium companies (SMEs) who do not have the capacity to invest in the future.

It is recommended that STPs set up Cyber Parks at various locations all over the country with fully furnished space, power, connectivity and other infrastructure on a rental basis for use by SMEs. Facility should also be provided for taking computer equipment on lease at Cyber Parks. This would bring in the facility of "Plug and Play" in a large manner. It would allow SMEs to grow rapidly without the need to invest time and energy in infrastructure. It would also allow faster recycling of funds. "Plug and Play" facility would reduce the need for capital for SMEs as funding would be minimised initially and earnings would pay for the rentals. This would also reduce the risk involved in financing the SMEs by Banks/FIs. The government should provide grants to DoE-STPs for this purpose.

6) EXPORT OBLIGATIONS

The export obligation on software companies operating under the STP scheme is calculated at 1.5 times the CIF value of hardware imported and the wage bill. The obligation on the hardware part has to be fulfilled over a period of four years and the obligation on the wage bill has to be fulfilled on an annual basis.

The following amendment is suggested:

"The export obligation shall be on the imported hardware only.

The period of export obligation should be five years without any minimum in any year.

The export obligation shall be monitored on a company-wide basis and any shortfall in meeting the export obligation by one unit of a company may be set-off against the excess net foreign exchange of another unit."

 

7) OTHER RECOMMENDATIONS