Legislative History of Section 186:
Granting of inter-corporate loans, making investments and provisions for guarantees was previously regulated by Sections 370 and 372 of the Companies Act, 1956 (the“1956 Act”), which mandated prior Central Government approval (along with compliance with certain other stringent guidelines prescribed by the Ministry of Corporate Affairs) for giving loans/ guarantee/ security in excess of the limits prescribed under the said sections. This position was subsequently changed with the enactment of Section 372A of the 1956 Act (by the Companies (Amendment) Act, 1999), which replaced the need to obtain prior government approval with a self-regulatory mechanism, which mandated prior shareholder approval by a special resolution before granting inter-corporate loans, guarantees or securities beyond the limits prescribed therein..
It is pertinent to note that a similar legal regime for regulating inter-corporate loans, investments and guarantees is not present in the English company law. This is despite the fact that the 1956 Act was almost entirely borrowed from the English Companies Act, 1948. The genesis of Indian law on this subject was provided under Sections 370 and 372 of the 1956 Act, which was consolidated under Section 372A in 1999, followed by a stricter regime under Section 186 of the 2013 Act.
The genesis of a stricter legal regime under Section 186 can be traced back to the Report of the Joint Parliamentary Committee (“JPC Report”) on ‘Stock Market Scam and Matters related thereto’. After the magnitude of financial irregularities in the “Ketan Parekh scam” was revealed, the JPC and the erstwhile Department of Company Affairs (“DCA”) had proposed steps to ensure that companies do not use the ‘subsidiary route’ to siphon off funds, by providing inter-corporate loans.[1]
The Parliamentary Standing Committee, 2009 (“PSC”), deliberated on whether Section 186 of the 2013 Act should put any restrictions on loans/ guarantee/ security provided to wholly owned subsidiaries (“WOS”) or whether they should simply be done away with on the lines of Section 372A of the 1956 Act. However, given the Satyam saga and other corporate scandals, where the subsidiary route was used to siphon off funds, the PSC ruled against this as it had been observed that companies, especially those with large number of subsidiaries, were misusing the subsidiary route to siphon off funds.
Key issues for a corporate lawyer:
While there are many issues under Section 186, the author would like to highlight two specific issues in this post. Firstly, how to compute the limits for intercorporate investments, etc., and secondly, practical challenges created by interest rate restrictions under Section 186(7) in case of loans to foreign subsidiaries.
Challenge No. 1:
How to compute 60% paid-up share capital, free reserves and securities premium account, or 100% free reserves or securities premium account threshold, whichever is more? How to value the investments already made or guarantees already given for computation of limits? Does one need to deduct investments already written off or reduce the value of guarantee, if the underlying loan is partially repaid by the borrower?
Section 186(2) provides that no company shall either directly or indirectly give loans or provide any guarantee/ security in connection with a loan to any ‘person’ or other ‘body corporate’ or acquire the securities of another body corporate either through the means of subscription, purchase or otherwise in breach of the following limits:
- exceeding 60% of its paid-up share capital, free reserves and securities premium account, or
- 100% of its free reserves and securities premium account, whichever is more.
It is to be noted that this 60% limit is to be calculated on a standalone financial statement basis and not on a consolidated financial statement basis.
The key challenge is to compute the thresholds of 60% paid-up share capital, free reserves and securities premium account or 100% of free reserves or securities premium account, whichever is more? Specifically,
- How to value the investments already made or guarantees already given for computation of limits?
- Does one need to deduct investments already written off or reduce the value of guarantee, if the underlying loan is partially repaid by the borrower?
The answer may, prima facie, appear simple and one may believe that:
Denominator = paid-up share capital + free reserves + securities premium account
Numerator = inter-corporate loans + investments + guarantees
However, there are practical challenges in calculating both numerator and denominator, which is explained below:
“Free reserve” means such resources that as per the latest audited balance sheet of a company are available for distribution as dividend……”
An important issue is that ‘General Reserve’ is included in the definition of Free Reserve. Rule 3 of the Companies (Declaration and Payment of Dividend) Rules, 2014, inter alia provides that in the event of inadequacy or absence of profits in any year, the total amount to be drawn from such accumulated profits shall not exceed 1/10th of the paid-up share capital and free reserves as appearing in the latest audited Financial Statement. Under the circumstances, while computing the aggregate of Free Reserve, should one take the entire accumulated profits, which may be appearing in the balance sheet either as General Reserve or retained earnings or should one take only 10% of such amount for the purpose of calculating such limit under Section 186of the Companies Act, 2013. Such an interpretation could have far reaching ramifications as the expression “free reserves” has been referred to in several provisions including in the provisions relating to buy back of shares.
Further, the qualifier ‘as per the latest audited Balance Sheet of a company’ only appears in the definition of Free Reserve under Section 2(43) of the Act, but no such qualifier appears in the definition of paid-up share capital and securities premium account. As a result, should one take the figure of paid-up capital and securities premium account in the middle of the year in case of issue of share capital at a premium during the financial year?
Even for the numerator, there are a few challenges in calculating the aggregate of inter-corporate loans, investments and guarantees. If a provision is made against a loan or investment, should one take the figure as appearing in the balance sheet or should one deduct the provisions made? Basis some Supreme Court judgments under the Income Tax Act, it is possible to take the view that if the amount is written off from the books of accounts, then it may be possible to take the net figure after such write-offs, but not otherwise as mere provision made in the books of account can always be reversed by an accounting entry.
Similarly, if a guarantee is given in favour of a subsidiary, and the subsidiary has repaid the entire loan, should the guarantee amount be reduced to that extent or is there a need to have a formal amendment to the contract of guarantee, which is an independent contract between the guarantor and the debtor, pursuant to Section 126 of the Indian Contract Act, 1872?
There is no MCA clarification on any of these aspects.
Challenge No. 2
Minimum interest rate requirement for inter-corporate loans under Section 186(7) and practical difficulties it poses for loans to foreign subsidiaries.
Section 186(7) provides that no loan shall be given under Section 186 at a rate of interest lower than the prevailing yield of 1 year, 3 years, 5 years, or 10 years’ government security, closest to the tenor of the loan. The expression “Government security” is not defined in the Companies Act, but is defined in Section 2(b) of the SCRA, 1956, as the security issued by the Central Government or a State Government for the purpose of raising a public loan.
As Section 186(2)(a) uses the words – “give any loan to any person or other body corporate” – even inter-corporate loans given to any company incorporated outside India shall fall within the regulatory ambit of Section 186. Section 186(7) would accordingly include loans granted by a holding company to its foreign subsidiaries (incorporated outside India).
The 2013 Act does not define “government security”. However, Section 2(95) of the 2013 Act states that if a word or expression is not defined in the Act, the definition given in the Securities Contracts Regulation Act, 1956 (‘SCRA’), may be applied.
Section 2(b) of the SCRA defines “government security” as “a security created and issued, whether before or after the commencement of this Act, by the Central Government or a State Government for the purpose of raising a public loan and having one of the forms specified in clause (2) of Section 2 of the Public Debt Act, 1944.” Only securities issued by the Central or State Government (for the purpose of raising public loan) fall within the ambit of this provision.
This leads to multiple practical difficulties, particularly when a holding company wishes to grant a loan to a WOS incorporated outside India (i.e. a foreign WOS). The practical issues that arise in this situation are explained below with an illustrative example.
Practical difficulties
Let us take an example of a company – ABC Ltd – which is a public listed company incorporated in India. XYZ Ltd is a WOS of ABC Ltd and is incorporated in the UK. A WOS such as XYZ may not be capable of borrowing directly from the market and is therefore dependent on the holding company (ABC) for funding.
Now, if ABC grants a loan to XYZ, Section 186(7) shall apply. In accordance with Section 186(7), the rate of interest on the loan cannot be lower than the prevailing yield of one-year, three-year, five-year, or ten-year Government Security rate closest to the tenor of the loan.
Under Indian law i.e., Section 186(7), the rate of interest cannot be below a particular threshold. The laws applicable in the foreign jurisdiction may provide that the rate of interest cannot be above a prescribed threshold.
The foreign WOS shall also have a mandate of complying with the English law. Applying Indian interest rate benchmarks may hence create a conflict of law situation as it may conflict with fiduciary duty of director under Section 173 of the English Companies Act, 2006 to exercise independent judgment before making any decision.
Furthermore, the interest rates in India are likely to be significantly higher than the rates prevalent in the UK. Such rate restrictions may also create transfer pricing issues under the laws of the jurisdiction of the host country where the subsidiary is located. The Board of the subsidiary will have to justify borrowing at such a high interest rate, to the Tax Authorities in such foreign jurisdiction.
Even for legitimate business transactions, holding companies are facing difficulties in providing funding to their foreign WOS, due to the interest rate requirement of Section 186(7). The law as laid down in Section 186(7)surely is not in tune with the market reality. Moreover, there is no need to regulate interest rates under the Companies Act for cross-border lending as FEMA regulations have adequate provisions for safeguarding India’s economic interests.
One possible argument that can be used is for a transaction, where the borrower has agreed to bear the foreign exchange risk arising out of the exchange rate fluctuation. In such cases, one may look at the effective ROI to the lender, viz. interest rate plus the benefit of extra rupees received due to rupee depreciation vis-a-vis the foreign currency, say USD.
Through a clarificatory circular issued on April 9, 2015, the Ministry of Corporate Affairs (‘MCA’) has clarified that in cases where the effective yield(effective rate of return) on tax free bonds is greater than the prevailing yield of one-year, three-year, five-year or ten-year government security closest to the tenor of the loan, there shall be no violation of Section 186(7) of the Act.[2] One could possibly argue that this view of looking at the effective yield on the loan and not just the rate of interest is perhaps supported by the MCA’s circular of April 9, 2015.
Concluding thoughts:
Inter-corporate loans, investments and guarantees are the life blood of trade and commerce. Holding companies are required to support their subsidiaries till they reach a maturity level of borrowing on the strength of their own balance sheets. Most countries have not put any restrictions on such inter-corporate financial transactions. These provisions are of day-to-day use for the treasury function of large corporates. These interpretative challenges in such vital provisions of our Act damage our reputation as a favoured destination for making investments. At the minimum, loan restrictions should not apply to cross-border lending (which is already regulated under the FEMA regulations) and it can be easily achieved by issuing an exemption notification under Section 462 of the Act. For facilitating ease of doing business in India, the MCA will do well to issue clarifications related to these contentious issues at the earliest and preferably make suitable amendments to Section 186 in the next round of amendments to the Act.
[1] Report of the Joint Parliamentary Committee on the Stock Market Scam and Matters relating thereto, 13th Lok Sabha, Volume-I.
[2] MCA General Circular No. 06/2015 (April 9, 2015).
