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MCA Notifies Restriction on Layers of Subsidiary – Is It Too Restrictive?

The Central Government has been very active in bringing about measures for prevention of money laundering. As to what has been perceived as a new step in this regard, the Ministry of Corporate Affairs (MCA) has, on 20th September, 2017, notified the Companies (Restriction on number of layers) Rules, 2017 and the proviso to Section 2 (87) of the Companies Act, 2013 (hereafter ‘2013 Act”), which has placed certain restrictions on the number of layers of investments by a company. Layering restriction on investment subsidiaries were incorporated in the Companies Act, 2013 “with a view to check misuse of multiple layers of subsidiaries for diversion of funds/siphoning off funds as a measure of minority investor protection,” the ministry had said while issuing the draft rules in June.

Earlier Position on Investments by a Company

Under the Companies Act, 1956 (hereafter ‘1956 Act’), the Sections 372  and 372A primarily dealt with the investments in other ‘body corporates’, of which Section 372A corresponds to the present Section 186 of the 2013 Act. Under the said provision of Section 372A of the 1956 Act, a company was allowed to invest in the security(ies) of another ‘body corporate’ in excess of 60% of the paid-up capital and free reserves or 100% percent of its free reserves (whichever is more) subject to a previous authorization by a special resolution passed at a general meeting. Further, a resolution sanctioning the investment must be passed at a meeting of the Board with the consent of all directors present at the meeting and prior approval of public financial institution where any term loan is subsisting. However, it is to be noted that the permission of the public financial institution was not required if (i) the investment proposed to be made did not exceed the limit of sixty per cent and (ii) there was no default in repayment of the loan or its interest.

What does the 2013 Act say?

Under the present 2013 Act, Section 186 (1) and Section 2(87) largely deals with the provisions to prevent diversification of funds of a company through multiple layers of companies. Section 186 of the 2013 Act provides for ‘Loan and investment by company’ wherein sub-section (1) states that a company shall not make an investment through more than 2 (two) layers of investment companies, unless otherwise specified. However, this restriction is not applicable in two cases viz.

(i) a company from acquiring any other company incorporated in a country outside India if such other company has investment subsidiaries beyond two layers as per the laws of such country;

(ii) a subsidiary company from having any investment subsidiary for the purposes of meeting the requirements under any law or under any rule or regulation framed under any law for the time being in force.

Section 2 (87) of the 2013 Act, provides for the definition of a ‘subsidiary company’ which defines a subsidiary company in relation to any other company (that is to say the holding company), to mean a company in which the holding company— (i) controls the composition of the Board of Directors; or (ii) exercises or controls more than one-half of the total share capital either at its own or together with one or more of its subsidiary companies.

The Change under 2013 Act

While, the 2013 Act states that companies can make investments only through two layers of investment companies, subject to exceptions provided thereunder, there were no such restrictions on the number of layers of investments under the 1956 Act. Further, the exemption available from the provisions of section 372A of the 1956 Act to private companies, is no longer available under the 2013 Act. Apart from these, most other compliance requirements such as special resolution of general meeting, consent of all directors at Board meeting and maintenance of Registers etc. are still applicable. However, the Section 186 further imposes a restriction on a company which has defaulted in repayment of its deposits from making any acquisitions till such deposit is subsisting.

Effect of the Notifications

The said Notifications have brought into effect the proviso to Section 2 (87) (“Proviso”) and the Companies (Restriction on number of layers) Rules, 2017 (“Rules”) with effect from 20th September, 2017. The proviso to Section 2(87) stipulates that ‘such class or classes of holding companies as may be prescribed shall not have layers of subsidiaries beyond such numbers as may be prescribed’. The Rules prescribe that a company is not permitted to have more than two layers of subsidiaries.

However, the said Rules also stipulates some exemptions and relaxation, which are as follows:

(i) The restrictions will not apply in case of (i) a company acquiring a company incorporated outside India with subsidiaries beyond two layers as per the laws of that country; (ii) a banking company; (iii) a registered non-banking financial company (NBFC) which is considered as systematically important NBFC by the Reserve Bank of India (RBI);(iv) insurance company; and (v) Government Company.

(ii) In case of computing the number of layers, one layer (i.e. a subsidiary) which consists of one or more wholly owned subsidiary or subsidiaries will not be taken in to account;

(iii) The said Rules stipulates that the provisions contained therein shall not be in derogation of the proviso to Section 186 of the 2013 Act. As such the exemptions to acquire a foreign company and for ensuring compliances under applicable laws are still available.

A company (other than the exempted companies), existing before the notification and which has more than 2 layers of subsidiary has to make necessary disclosures with the Registrar of Companies (in Form CRL-1) giving the details of the subsidiaries within 150 (one hundred and fifty) days from the date of Notification of the Rules. Thereafter, such a company cannot have any additional layer over and above the existing layers. Further, if in the event it has reduced its number of layers after the notification, it cannot have more than such reduced number of layers or 2 layers, whichever is more.

The Rules also prescribe for penalty of up to Rs. 10,000 (Rupees Ten Thousand) on the company and every officer of the company in case of any contravention with the provisions of the Rules. Further, if the contravention is a continuing one, a further fine which may extend up to Rs. 1000 (Rupees One Thousand) for every day after the first during which the contravention continues.

Conclusion

As such, with the enforcement of the said Notifications, a company is not allowed to have more than two layers of subsidiaries. Though the Rules will be applicable prospectively, companies in existence would be required to comply with the disclosure norms. Apart from banks, financial institutions etc., the only exemption provided to an operational company is (i) for acquiring a company outside India which has two or more subsidiaries; and (ii) a layer of wholly-owned subsidiary. The MCA has attempted to bring the provision in line with the restrictions imposed in case of an investment company with the result being that, now a company cannot have multiple layers even for its operation companies. In case of investment companies, at the least a relaxation was permitted for an investment company to have subsidiary to meet purposes of law, however, even such a flexibility has not been provided to an operational company. This might pose various operational challenges to big conglomerates which would need to structure its business through multiple layers purely for its operational flexibility. Further, merger and acquisitions within India would now require to be structured such that with the acquisition, the layers would remain within the restriction permitted. However, with the proposed Companies (Amendment) Bill, 2016 (Bill No. 73 of 2016) proposing to remove the proviso to Section 2 (87), we will need to wait and watch as to what would be the final amendment passed by the legislature in this regard.

Anjali Haridas is a Senior Associate in Fox Mandal & Associates. All the Views are Personal.

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