Most companies (foreign or Indian) provide funding to their subsidiary through equity. This is first as initial capital and then rounds of subsequent capital until the subsidiary becomes self-sustaining. However the problems of equity funding become apparent at a later stage, when for all practical purposes, the money is locked in. Problems of equity funding include:
1. Restrictions and taxes on dividend
The Companies Act 2013 restricts the payment of dividend and the Income Tax Act 1961 applies taxes on dividend paid. The company issuing dividend also pays Dividend Distribution Tax (DDT).
The Companies Act places a limit on the amount that can be paid as dividend in a year (as a % of net worth). This is to ensure value is not eroded. The Income Tax Act applies a stated tax rate of 15% which translates to an effective tax rate of over 20% on the dividend amount (on applying the grossing-up provisions). So, when considering cash reserves available for dividend, ~17% should be set aside for tax and the balance (c.83%) can be paid out.
2. Restrictions and taxes on buyback
The Companies Act has an even more stringent list of requirements for a buyback. These test the company's post-buyback financial stability – debt-equity ratios, buyback history, loan payment history, etc. Only financially sound and very stable companies are able to execute buybacks. In addition, the tax authorities have introduced a buyback tax (under Section 115QA). This tax is at a rate of 20-21% on buyback amount (no grossing-up).
The taxes on dividend and buyback can make it unattractive for owners to get returns even when the company has stabilised. Shareholders are acutely aware of the fact that an additional 20% tax is paid to distribute income (which is already post-tax). Overseas shareholders also pay tax on dividend and buyback amounts in their home country and then claim double-taxation relief.
3. Problems of equity funding among shareholders
Typically, subsequent rounds of capital require shareholders to contribute equally. However often in joint ventures, partners have different risk appetites and capital limitations. If only one partner invests, each round of investment requires a valuation to assess the correct additional stake for the investor. There are also issues of one investor gaining additional control in the company via subsequent investments. All partners may not agree with the valuation, voting rights, board seats, etc. making this a time-consuming process.
More on valuations and joint venture issues:
Valuations – a changing landscape
Joint Ventures – Promises and Pitfalls
4. Lowest level in the hierarchy of claims
In case the venture does not meet its targets and requires liquidation, the shareholder will likely have to write off its entire investment. Equity is the last among the claims, after paying all other creditors. The "next best" option for a fixed return (preference shares) is similar in terms of claim hierarchy and taxation.
In summary
Does this mean that companies should avoid equity entirely? Of course not. Equity is popular because of its risk-reward profile as well as its flexibility because it allows the business to stabilise instead of putting the pressure of immediate returns. But a combination of funding methods can often be much more appropriate than 100% equity funding. In the next part of our post, we will discuss the methods that corporates use to optimise holding company return and subsidiary stability without over-complicated corporate structures.
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