Choice of Law Clause in International Outsourcing Contracts: Some key considerations

By Harshvardhan Tripathi, for Legal Corner LLP. Harsh is a fourth year student of NALSAR University of Law and will be graduating in 2022. 

The views expressed here are not to be considered as legal opinion. You may not rely on this article as legal advice. You should reach out to me (chetana@legalcornerllp.com) if you are planning to consider incorporate or expand your existing business in the US so as to get legal advice that is specific to your business needs. 

With the growth of cross-border trade, more and more business entities are entering into international agreements. While negotiating terms of international contracts, customers and service providers must pay special attention to the choice of law clause. This clause assumes special importance because it specifies which governing law would regulate the legal relationship between the parties, determines their rights and liabilities under the legal regime and provides them legal remedies in case of a potential breach of the contract.

Generally, parties to the contract have autonomy and enjoy flexibility with respect to the naming the governing law of the contract, subject to some exceptions. Talking in the specific context of an international outsourcing contract between a US based entity or person and Indian entity or person, the parties are free to choose the governing law, except when the choice of law has no connection to either the parties of the contract or to the performance of the contract. However, notably New York allows the even non-domiciliaries of the state (which would include American citizens not from New York and other foreigners) to choose the NY local law to govern their contracts for transactions above $250,000. The conflict of law rules of India are well recognized by the India Courts and the judiciary generally enforces the choice of law decided by the parties in the contract, except in the rare circumstances where the chosen governing law violates India’s public Policy in some manner.

The parties must seek reliable quality legal advice while negotiating the choice of law clause to fully appreciate the legal implications and avoid future risks. In order to assess which legal regime would be best suited to regulate their contract, the parties must consider the following factors:

• Predictability: It must be remembered that legal systems prevailing in other jurisdictions might have divergent positions of law on the same issue. For parties about to choose a governing law, it is important to consider whether the legal system under consideration has followed a uniform standard or approach in dealing with a legal issue. This is essential because if the legal system is predictable, in case of a dispute arising, the parties can determine their legal positions and possible options under that legal system with reasonable certainty.

• Insulation: When parties decide upon their governing law of the contract, they accept the risk that any changes in this law will affect their rights and obligations. Depending upon the nature of the international contract, the parties need to negotiate a choice of law clause based upon the consideration that whether they are adequately insulated against such changes in the law. For instance in a case where the contract involves debt, the debtor would prefer a governing law that is more protective of its position while the creditor would want a governing law that ensures quick and effective enforcement. Hence, negotiation of governing law between parties should be done keeping in mind insulation from risk as an essential factor.

• Creditor Orientation: The public policy of legal systems is inclined more towards protecting the interests of either the debtor or the creditor; or it could be neutral. Depending upon which recourse is preferable to both in case of a potential insolvency, the governing law of the contract should be chosen reflecting either pro-debtor, pro-creditor or a neutral orientation.

• Nullification of transactions on formal grounds: Some legal systems have the approach of upholding the validity of a transaction when some formal requirements have not been satisfied. Other jurisdictions however, adopt a strict approach requiring complete compliance, and would not hesitate nullifying transactions based on lapse to meet the formal requirements. Governing law of the contract should be chosen keeping in mind this key factor of consideration.

• Ease of enforcement of judgments abroad: From a practical point of view, before choosing a governing law for the international contract, the overall record of enforceability of that legal system’s judgement in other jurisdictions should be considered. Judgements from certain legal jurisdictions have a higher rate of acceptability in foreign jurisdictions as compared to others. For parties looking to have a speedy and effective recovery of debts, effective enforcement of judgements becomes a priority, and the choice of governing law should reflect this priority.

• Extent of freedom of contract: Parties might want to consider the relative extent of freedom granted by different legal systems in allowing freedom of contract and choose the governing law of contract accordingly.

• Language: Parties to the contract must keep in mind that it is hard to conduct litigation or to know one’s rights and protect oneself when statutes, case law and court proceedings are in a foreign language. Hence ideally, the governing law of the contract should be chosen in a language familiar to the parties.

• Acceptability in the market: Certain governing laws are widely accepted in international markets due to their proven efficacy over the period of time, familiarity of concepts and wide range of legal authorities. A transaction can be strengthened by adopting a widely acceptable governing law of contact.

• Stability of the law: Before choosing a governing law of contract, parties must examine the extent to which that legal system adheres to the rule of law and whether it has sound and efficient legal infrastructure. This is an important indicator for a stable legal system alongside a uniform approach in the legal direction. The parties can substantially lower their legal risks by investigating the stability of a legal system before choosing their governing law of contract.

If you have any questions on choice of law, please email me at chetana@legalcornerllp.com . I will be happy to set up a free consultation.

Disgorgement proceedings in India: Takeaways from Liu v. SEC

 

By Akash Kumar Prasad, for Legal Corner LLP. Akash is a final year student of NALSAR University of Law and will be graduating in 2021. 

The views expressed here are not to be considered as legal opinion. You may not rely on this article as legal advice. You should reach out to me (chetana@legalcornerllp.com) for any legal advice that is specific to your business needs. 

In layman’s language, disgorgement implies legally mandated repayment of ill-gotten gains imposed on wrongdoers by the courts. The Black’s Law Dictionary defines disgorgement as ‘the act of giving up something (such as profits illegally obtained) on-demand or by legal compulsion’. To understand it more simply, let’s suppose that Mr. X makes a profit of Rs. 1000 in an illegal manner. The court can now direct Mr. X to ‘disgorge’ the amount of Rs. 1000. This recovery of the profit earned through illegal means is termed as ‘disgorgement’. In India, after the enactment of the Securities and Exchange Board of India Act, 1992, this process has been used to recover the unlawful and unethical profit made by the participants in the capital markets. Initially, it was considered to be an equitable remedy, but with the passage of time it has been observed that the understanding has shaken a bit.

In the securities market, to preserve the interests of the stakeholders, this tool has proved to be a potent tool for the regulatory authorities worldwide. Even though the concept of disgorgement finds a place in the SEBI Act, 1992, specifically speaking, Section 11B  of the Act (added by an amendment in 2013), it has been observed that the Indian regulatory authorities have not been able to enforce such powers smoothly due to the lack of clarity in the legislation itself and precedents thereof as to how the computation of disgorgement amount must be done. As a result, the courts and tribunals in India look up to the foreign judgements on the matter.

The Indian regulatory law has been influenced by the US securities law; hence any development in the US securities market becomes very pertinent to the Indian regulatory regime. Recently, the US Supreme Court, in the case of Liu v. SEC [2020], stated that the tool of disgorgement has its roots in the equity principles and that the disgorgement awards are an equitable remedy provided to the wronged investors. It further redefined the computation of the disgorgement amount. Considering the fact that the Indian securities regime takes inspiration from the US securities law, this has initiated discussions regarding its impact on the Indian disgorgement regime.

Takeaways from Liu v. SEC

The first and foremost significant point in the observation was acknowledging the tool of disgorgement as an equitable remedy rather than a punitive measure which should be computed on the basis of net profit earned i.e. the same must be meant to make better the wrong and not to punish the wrongdoer. The Court held: “A disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is equitable relief permissible” under 15 U.S.C. § 78 u (d)(5). Same principle was observed by the Securities Appellate Tribunal (SAT) in the case of Gagan Rastogi v. SEBI [2019] and Shadilal Chopra v. SEBI [2009].

Further, another important takeaway from the US ruling is the restitution of amount to the victims of the wrongdoing. It is often observed that the regulatory authorities disgorge the amount and then preach that justice is served. The US Supreme Court has deviated from this practice and held that the purpose would only be served if the amount would be restituted and not if the disgorged amount would be deposited in the government treasury. The court said that doing the latter would amount to a penalty and thus the restitution principle should be followed taking into consideration the number of stakeholders and passing appropriate orders to protect the interests of the victims. SAT in the case of Ram Kishori Gupta v. SEBI [2019] has observed similarly remarking “disgorgement without restitution does not serve any purpose” which further shows the influence of the US security jurisprudence on the Indian securities regime.

The US court further noted that mostly the entire amount from the wrongdoing is disgorged without deducting the legitimate expenses incurred during the wrongdoing. The same has been observed in Indian scenario too. The US court acknowledged the same and directed that the amount to be disgorged should be decided after taking into account the facts and circumstances of every case as then only it would mean that the remedy is truly equitable in nature.

Lastly, the court directed cautioned usage of the “jointly and severally liable” principle. As much as it acknowledged the necessity of its usage, it also directed that there must not arise a case wherein, a person is being asked to disgorge the amount, when actually such person is not in possession of the unlawful gains, thereby making it difficult for him to disgorge the amount.

Conclusion

The understanding of disgorgement is still at a nascent stage and it can be expected that the US ruling would throw some light on the development of the subject in India. It has definitely paved the way for formulating a mechanism and effectively execute the same while pronouncing the judgements. While it might be argued that Indian and US securities markets are different, the principles enunciated by the court form the basic structure and can help develop a better understanding of the subject, thereby showing Indian securities regime a way forward.  If you have any questions on choice of law, please email me at chetana@legalcornerllp.com . I will be happy to set up a free consultation.

A Guide to Simple Agreements for Future Equity (SAFEs)

 

By Shreya Kalidindi, for Legal Corner LLP. Shreya is a fourth-year student of NALSAR University of Law and will be graduating in 2022. 

The views expressed here are not to be considered as legal opinion. You may not rely on this article as legal advice. You should reach out to me (chetana@legalcornerllp.com) if you are seeking advice on structuring SAFEs or other investment agreements tailored to your business needs. 

What are SAFEs?

A Simple Agreement for Future Equity (SAFE) agreement is one made between a company (generally in its seed financing round) and an investor wherein the company agrees to provide an investor with potential future equity in return for immediate cash. They have been introduced by American startup accelerator Y Combinator in 2013 and have since gained popularity among both founders and investors, mostly owing to their simplicity.

How do SAFEs convert?

The future equity – or the SAFE – eventually converts to equity during a subsequent round of financing, provided that a particular trigger event (previously agreed upon and outlined in the SAFE Agreement) takes place. Trigger events can include subsequent rounds of equity financing, the sale of a majority of the company’s shares, or the acquisition of the company. The size of equity investment is not material.

Following the trigger event, the investor has a choice between receiving the investment amount back or converting it into shares in the company. The number of shares receivable upon such conversion depends on where the share price stands during either the priced equity round or the trigger event (as applicable). Prior to the SAFE maturing in this manner, it is treated like any other convertible security (for instance, options or warrants).

How do SAFEs differ from Convertible Notes?

The primary difference between the two is that Convertible Notes have a maturity date, upon which the amount given by the investor is either converted into equity at a predetermined rate or is returned. Furthermore, investments under Convertible Notes are considered to be loans, and involve more negotiation than SAFEs, seeing as the notes convert after a specific period, and can accrue interest during this period.

What makes SAFEs a distinctive form of raising funds?

Maturity – SAFEs do not have an expiry date. They remain valid and continue to exist in the issued state until a trigger/ liquidation event occurs, upon which they convert into shares.

Interest – A SAFE is not a debt instrument, and thus a SAFE investment does not accrue interest, regardless of how long it takes for it to convert into shares.

Deferred Valuation – Similar to other forms of convertible debt, there is no requirement for the company and its investors to agree upon a valuation price at the time of entering into the SAFE Agreement. This can be ascertained at a later date and is usually done when the company has more revenue.

Why are startups opting for SAFEs?

In the previous year, the number of SAFEs and other similar notes (such as the Keep It Simple Securities, also known as KISS) that have been used by pre-funding companies was 58%, thus making them equally prevalent as convertible notes. This is largely owing to the fact that they are seen as a simple and risk-free method of raising money.

SAFEs terms are not standardized to a large extent, and thus can be negotiated – often to the benefit of the startup. These include terms relating to conversion, dissolution and repurchase rights. Furthermore, seeing as SAFEs only conditionally convert into shares on a later date, voting rights are not immediately given to the investors. This enables many startups to retain a larger degree of control during their initial stages and inculcate practices that help materialize their vision.

Apart from the benefits of flexibility and control, SAFEs are also preferred because their implementation involves a lesser degree of paperwork and legal costs.

Important terms to be established in a SAFE agreement  

Valuation Cap – this is the maximum valuation at which a SAFE can convert to equity upon maturing. For instance, if the valuation cap is $6 Million and the company raises money at a valuation of $10 Million, then the investor is entitled to convert their SAFE at a share price equivalent to the former amount.

Discount – this is the valuation discount given to a SAFE investor and is relative to the investors in the subsequent financing round. These discounts range between 10% to 30%, and are usually implemented to entice early investors. For instance, a SAFE is issued with a 20% discount, and the investor puts in $60,000. If the future investment is $15, the price per share after discount will be $12. Thus owing to the discount, the investor ends up with 5,000 shares instead of 4,000 shares.

A SAFE can come with either of these provisions, both of them, or a Most Favored Nation (MFN) clause instead of the discount or valuation cap.

Risks associated with issuing SAFEs

While SAFEs offer benefits such as expediency and simplicity, using them as financing options can also be one of the reasons for the failure of an issuing company. One of the largest issues that SAFEs can create for a company is unintended dilution of ownership. Seeing as SAFE dilution is not reflected in the capitalization table till the point of maturity, many issuers may lose sight of how much dilution they are taking on. If due consideration is not taken, issuing SAFEs in such a manner may even lead to a loss of control in the company.

Even before future equity rounds, another risk posed by SAFEs is improper valuation. Often, the valuation cap is seen as the actual valuation of the company, which in turn makes any price below this cap an undesirable ‘down round’ in subsequent priced financing rounds.

Additionally, while one of the advantages of issuing SAFEs is their flexibility, this also allows for the insertion of one-sided and onerous clauses (such as guaranteed board seats) being put in favor of the investor. Such terms make it difficult for investors in future equity rounds to provide funds for the company, seeing as more than the expected degree of company control has been relinquished.

However, these inherent risks can be combatted through measures such as creation of dynamic capitalization tables to track SAFE dilution, putting a hold on company valuation during the SAFE stage, and ensuring that the non-standard terms of a SAFE Agreement are well balanced and negotiated.

If you have any questions on SAFEs, please email me at chetana@legalcornerllp.com . I will be happy to set up a free consultation.

Equalisation Levy: Extra Territoriality an obstacle

 

By Akash Kumar Prasad, for Legal Corner LLP. Akash is a fifth year student of NALSAR University of Law and will be graduating in 2021. 

The views expressed here are not to be considered as legal opinion. You may not rely on this article as legal advice. You should reach out to me (chetana@legalcornerllp.com) to get legal advice that is specific to your business needs. 

The Finance Act 2020 was passed on March 27, 2020 and created a lot of confusion as it amended the position of Equalisation Levy (EL), a type of digital service tax (DST). The Equalisation Levy was first introduced pursuant to the Finance Act, 2016 wherein a non-resident service provider, providing service to the resident are required to withhold at the rate of 6% of the gross amount of fee payable by the resident in lieu of such service. After the amendment of Equalisation Levy, the legal position related to it has changed drastically. Post amendment, the non-residential e-commerce operators are required to withhold at the rate of 2% of the gross amount received/receivable in lieu of the e-commerce supply and service. The Act has extra-territorial application as it attempts to tax the income earned from the advertisements (directed at Indian customers), or even accessed through Indian IP addresses and income earned from the sales of goods and services to anyone using any Indian IP address. Furthermore, EL has now been made applicable on both supplies of goods and services and on both B2B and B2C transactions. This article engages with the extra-territorial aspect of EL and aims to highlight both the practical and technical issues that arise/are being faced due to its implementation in its present state in India.

Technical difficulties that arise with the imposition of EL in its current state 

The first technical issue is the absence of a global tax collection system. In the context of a fragile global economy, the requirement of the same becomes necessary because any unilateral actions by different nations have the potential to impair the investments and economic growth on a global level. The Organisation for Economic Co-operation and Development (OECD) an intergovernmental economic organisation which deliberates the policies on digital taxation is still in the process of developing a common system and arriving at a consensus on taxable nexus and allocation of taxing rights.

Another issue is that the OECD has recommended the idea of ‘Significant Economic Presence’ (SEP) to be the basis of taxable nexus. Hence, it is highly possible that, a company’s permanent establishment, which is a taxable presence of the company outside its state of residence, may be in one country and the SEP in another country. Now, this is problematic because this gives rise to the issue of double taxation and hence defeats the purpose of Double Tax Avoidance Agreements (DTAAs) which aims to avoid international double taxation. The Akhilesh Ranjan Committee had also observed this as an inherent limitation of EL.

Furthermore, another technical concern is the lack of explanation to the technical terms such as ‘systematic, continuous soliciting’, and ‘users’ as mentioned in the explanation 2A (b) to S.9 of the amended Act. For instance, there is not much statutory guidance as to who would qualify as an Indian IP address user. It is not clear whether the threshold is merely visiting a website via an Indian IP address or that of browsing through links therein. Such lack of interpretation could be highly chaotic and lead to confusion among the litigators and the taxpayers alike.

 Practical difficulties that arise with the imposition of EL in its current state

The first practical concern is that the States normally charge taxes from non-resident entities that have no physical presence in their own territory, by taxing the domestic source of their revenue. The same had been followed until the scope was widened. The concern now is that the present EL regime aims to charge under S. 165A of Finance Act, 2016 directly and it is still not clear how the Indian government aims to achieve the same. There are high costs involved in tracking and storing the location of all the users and it is unlikely that the foreign businesses would want to incur such costs. Thus, it becomes difficult for such businesses to assess and pay the taxes owed.

Another issue is the absence of compliance and penalising mechanism in the event of non-payment of EL, by a non-resident entity. Although the Act provides for the attraction on unpaid taxes, penalisation and prosecution for non-compliance, such provisions aren’t enough to deter foreign businesses which have no tangible assets in India. Furthermore, there is an issue relating to the ‘revenue rule’ (general principle of international taxation) which states that the courts of a country can refuse enforcement of foreign revenue or tax laws. Thus, if any foreign country is unsatisfied with EL’s applicability on their domestic businesses, it may refuse EL’s enforcement on their resident businesses. It is highly possible that the foreign countries might raise an issue due to the above-mentioned concerns. For instance, the United States Trade Representatives raised an issue recently saying India’s DST (Digital Service Tax, referred as Equalisation Levy in India) is discriminatory, unreasonable, and burdens or restricts US commerce, and thus, is actionable under Section 301 (of Trade Act, 1974). The investigation, initiated by the USTR on June 2 last year, said that this tax explicitly exempts Indian companies and only ‘non-residents’ must pay the tax.

Conclusion

The objective and intention behind the expansion of the scope of EL is appreciative and it might have appeared to be effective to address the challenges of permanent establishment principle, but has surely caused confusion and significant predicaments as explained above. It seems that there was no proper deliberation and discussion before amending the position and hence the inevitable result is an adverse effect on free flow cross border transaction and India’s reputation as business-friendly jurisdiction. It is clear that the Indian government is aiming to further its revenue from all ways possible as it too has faced a heavy blow due to pandemic, but at the same time, there is an urgent requirement of issuing clarifications and supplementary rules to remove the surrounding ambiguity on the implementation of EL.

Equalisation Levy in India: The issues and the silence continues

 

By Akash Kumar Prasad, for Legal Corner LLP. Akash is a fifth year student of NALSAR University of Law and will be graduating in 2021. 

The views expressed here are not to be considered as legal opinion. You may not rely on this article as legal advice. You should reach out to me (chetana@legalcornerllp.com) to get legal advice that is specific to your business needs. 

Equalisation Levy was introduced in India in 2016, with the goal of taxing the digital transactions i.e. the income accruing to foreign e-commerce companies from India. Digitalization is one of the most important developments since the Industrial Revolution, which has virtually changed the way in which businesses are carried out, across the globe. Some studies have assessed that the worldwide digital economy was worth $11.5 trillion in 2016 (Digital economy report–Value creation and capture: implications for developing countries) and for India, it was assessed to be $200 billion annually (Report of ministry of electronics and information technology-India’s Trillion Dollar Digital Opportunity, February 2019). However, it has been observed that taxation laws which are based on the conventional business models have been battling to keep pace with these changes. This has brought about many transactions completely getting away from the tax net. Hence, the need was felt to address the challenges presented by the digital economy.

A joint effort to address the requirement for tax reform is being taken by OECD/ G-20 since 2015-2016 under the “Inclusive Framework on BEPS”. Base Erosion and Profit Shifting (“BEPS”), as defined by the OECD, refers to tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity or to erode tax bases through deductible payments such as interest or royalties.

While the OECD is working towards creating consensus on an inclusive framework to address tax challenges from digitalization of the economy, several countries have introduced unilateral measures to tax the digital economy. In 2016, India introduced an Equalization Levy on revenue earned by non-residents from online advertising and related services. In 2019, the Indian Income tax law was amended to introduce the idea of ‘significant economic presence’. However, while passing the Finance Act 2020, the Indian government deferred its implementation, citing the absence of effective measures in the tax treaties. What came as astonishment to everyone was the introduction of an Equalisation Levy on sales of goods and services in India by overseas e-commerce operators, which was originally not part of the original Union Budget proposals of 2020-21. This levy has been effective from April 1, 2020 and in its current form, has wide-ranging coverage.

The Issues Involved

This levy was added as a last-minute amendment to the Finance Act day before the entire nation went into the first phase of lockdown in March. However, due to the rush in this decision-making, the provision enabling the levy was ambiguously worded and could cover several transactions which may be unintended. Moreover, it also covers transactions between two non-resident companies in case of sale of advertisement concerning Indian citizens or sale of data collected from Indian residents or if the IP address is located in India. The process transactions tracking on the basis of IP addresses may not be a viable option. With the use of bypass tools such as VPN, proxy sites etc, accurately tracking the transactions might prove to be a difficult task for the entities.

A study conducted by The Dialogue, a Delhi based think-tank proposes to rather look at the billing address or sales location to determine the residents. Moreover, the provision additionally doesn’t clear the tax base for the levy. It is unclear whether the tax has to be paid on the gross amount of the product or the commission received by the e-commerce entities.

There are also other issues such as the impact of this levy on inter-group or inter-company transactions and its interplay with the Digital Services Tax (DST) levied in other countries, which might lead to double taxation. However, due to the lack of clarifications, these issues still remain unaddressed.

Further, (Online Information Database Access and Retrieval Services) OIDAR tax and equalisation levy will create extra burden for the companies who may pass on these tax to the end consumers. Despite the fact that the levy targets non-resident companies, transferring of such cost to the Indian companies who utilize international platforms for their operations may come as an added burden to the Indian startups.

Conclusion

It is important that India maintains an investment friendly climate and such unilateral actions might impact it. Taxation of the digital economy is a sensitive and complicated matter. With multiple jurisdictions involved including India, there is a need for a multilateral consensus rather than a unilateral action and definitely not a rushed through levy such as the present one. There is an urgent requirement for issuing clarifications on the present levy in order to avoid taxing unintended business and narrow its scope.If you have any questions, please email me at chetana@legalcornerllp.com . I will be happy to set up a free consultation.