The Hindu Business Line : Jarring notes in the sweat equity regime

EXPLANATION II to Section 79A of the Companies Act, 1956 defines `sweat equity shares' to mean "equity shares issued by the company to employees or directors at a discount or for consideration other than cash for providing know-how or making available right in the nature of intellectual property rights or value additions, by whatever name called."

So, one of the touchstones of judging whether shares belong to the genre of `sweat equity' is whether it was issued at a discount. Discount with reference to what? Is it with reference to the prevailing market price? The answer seems to be in the negative as evident from the opening line of Section 79A — the section overrides the provisions of Section 79 which prescribes the regime for issuance of shares at a discount with reference to face value.

It follows from this that a company can issue shares to its employees and directors at discount to face value without complying with the provisions of Section 79. But this view is belied by the SEBI Regulations on sweat equity dated September 24, 2002, which stipulates that sweat equity shares have to be priced at the higher of the six months average preceding the relevant date or the average for the two weeks preceding the relevant date.

This then precludes issuance of shares at a discount to directors or employees unless the share was quoting below par throughout during these periods. The SEBI regulations thus effectively and partially negates the definition of sweat equity insofar as it permits issuance of shares at discount to employees and directors.

What survives in the definition is issuance of shares to employees and directors for non-cash consideration. And such non-cash considerations should be either providing knowhow or making available intellectual property rights or value additions. Pray what is a value addition? This is too cryptic a term. What sort of value addition is contemplated? Can a director, under this dispensation, provide advertising services in his professional capacity and take shares in the company he is the director of instead of cash? Can a director or employee supply machinery or materials to the company and take shares in the company as recompense? It seems he cannot, because the accent of the definition in this context is on making available right in the nature of intellectual property rights or value additions. Supply of material or machinery thus seems to be out. This is a trifle curious. The merchant banker who, under the SEBI regulations, is required to do the relatively more demanding job of valuing the intellectual property rights or knowhow or other value addition, certainly would not be out of his depths when it comes to materials and machinery.

The regulations require the value of the sweat equity shares to be treated as a part of managerial remuneration with attendant restrictions on its quantum if such shares have been issued to a director and if they have been issued in consideration of providing services that cannot be carried in the balance sheet as an asset.

If shares have been issued for providing advertising services, how can the value thereof be booked as `salary' while in truth it must be booked as `advertising expenses'?

Block torn as under

WHEN the block concept in respect of depreciable assets was ushered in with effect from the assessment year (AY) 1988-89, one thought that calculation of depreciation had indeed been simplified. For the raison d'etre of the move — bundling assets of same description qualifying for the same rate of depreciation — was to do away with the tedium of accounting for each and every piece of asset howsoever small.

If there were one hundred items of machinery qualifying for 25 per cent depreciation on the written-down value (WDV), earlier one had to keep track of each single item, provide for depreciation on each one of them and compute short-term or long-term capital gain if and when any of them were sold. Bundling promised to make this a thing of past.

Assets, merging as they do seamlessly into one homogenous mass, apparently lose their individual identity under the new dispensation. When individual items belonging to the block are sold albeit for a hefty profit, all that has to be done is to credit the sale proceeds to the block account without having to compute profit or loss from such transaction. The resultant loss of capital gains tax to the exchequer is amply made up by the lesser grant of depreciation that ratchets up the business profit giving rise to a greater tax liability on business income. In other words, what is lost in the swing is gained in the roundabout by the exchequer. All this is fine. But the need to keep track of individual assets has not been done away with after all.

When there is a `slump sale' — sale of one of the undertakings of a company — the depreciable assets belonging to such undertaking have to be ferreted out of the block. This is for two purposes. One, to compute the resultant capital gains by taking the WDV of the assets so ferreted out as cost. And, two, to enable the company to claim depreciation correctly in future — on assets sans those disposed of.

When there is a demerger — spinning off a division of a company into a separate company — once again the assets of the demerging and resultant companies have to be dug out of the heap, as it were. Because in future, the two companies would claim depreciation with reference to the WDV of the assets inherited.

For shipping companies, the block will not remain immutable, especially if they opt for the proposed tonnage tax system [by the Finance (No. 2) Bill, 2004] and have other businesses outside of such system. In such a scenario, assets belonging to the shipping business governed by the tonnage tax regime have to be once again ferreted out of the heap.

The short point is that the idea of block, laudable as it was, has refused to remain sacrosanct. Change is the only constant feature of a business. Business restructuring is inevitable. In the event, every business has to keep track of individual assets not because the taxman demands it during normal times but because in the aftermath of business restructuring it would find it difficult otherwise. One may contend that one need not maintain individual account of depreciable assets because if and when there is an episodic event, such amalgamation or demerger, things can be managed. In other words, we will cross the bridge when we come to it. This, perhaps, can be done by scanning the fixed assets register mandated to be maintained by the company law in which details of individual assets, including their location, must be recorded. But this would call for some heavy rearguard action. One can minimise workload in the aftermath of such episodic events by maintaining individual account of assets whether they are asked for or not during normal times.

(The author is a Delhi-based chartered accountant.)