This article is written by Hritika Jannawar who is pursuing a Diploma in Companies Act, Corporate Governance and SEBI Regulations from LawSikho.
Table of Contents
Introduction
When the question comes of granting loans or providing guarantee or security to directors or parties in whom the directors are interested, there always comes lingering doubt of nepotism and favoritism bred in all the persons and if such transaction is easily carried out it encourages the undue advantage and malpractices among the persons who has fiduciary obligation towards the company and all the persons interested in it. To avoid the misuse of their authority by higher management in the company, Section 185 has been incorporated in the Companies Act, this Section categorizes such transactions as prohibitive, conditional and exempted; to attain the twofold objective of keeping check on such transactions as well as providing ease to carry out the business.
The article discusses the various amendments made in the Companies Act, 2013 regarding the provisions related to advancing loan by the Companies to their directors and tries to conclude the present scenario while dealing with the question of such transaction concerning private companies, furthermore the article dives into the issue of taxation and effect of recent amendments in the taxation law on such transactions.
What is a Private Company?
A Private Company is a separate legal entity owned by a small group of individuals with few restrictions defined under the Companies Act, 2013.
Section 2(68) of the Companies Act, 2013 (hereinafter referred to as ‘Act’) provides for the definition of Private Companies.
A bare perusal of this section concludes that,
1) Private Company is held by few members and the shares of these types of Companies are not freely transferable like public companies and hence never listed on the stock exchange.
2) Private Companies are prohibited to invite the public to subscribe to their securities; they bring the investments through private placements.
3) The minimum number of shareholders required for this Company is ‘two’ up to a limit of maximum ‘200’.
4) There is no minimum limit for its paid-up share capital at present (previously it was 1 lakh).
5) For the accounting for the members of the company, two persons jointly holding one or more shares in the company will be accounted as one single member.
6) Who will be not accounted as a member:
i) Employee of the company.
ii) A person who has ceased to be an employee of the company but use to hold securities of the company in course of employment and still does after the employment has been ceased.
Furthermore, the Act defines the types of companies that can be incorporated and registered under it. Section 3(2) provides that the company can be following types
i) A company limited by shares (members liability is limited up to its share capital invested in a company which is also recorded in Memorandum of Association and that member cannot be held liable beyond that limit);[1]
ii) A company limited by liability (in case of companies with shareholding members liability is limited to the unpaid capital on subscribed shares, in case of without shareholding the amount for liability is decided in MoA of the Company);[2]
iii) An unlimited company ( No restrictions on the member’s liability, each member’s liability will extend over companies entire debt; despite not having limited liability in case debts the members cannot be sued individually, this type of company is still regarded as a separate legal entity);[3]
iv) One Person Company is s new category of Private Company introduces in the Companies Act, 2013 in Section 2(62) of the Act whereas, there is only one shareholder in the company and it is still eligible for registration as a company under this Act.
Can Private Companies grant a loan to its directors?
In the old Companies Act that of 1956, the restrictions were relatively less in such type of transactions but with the advent of the Companies Act, 2013 a blanket prohibition was imposed on advancing loans to directors, their partners, or relatives u/s 185 of the Act.[4]
Since the enactment of this Act, the complete ban on this type of transactions was unacceptable by the companies across the country as these provisions were contradictory to that of in other countries and the argument put forward by the companies was the businesses in India are promoter-driven and where the promoters have invested in the business of the company, they should have freedom of utilization of those funds in the manner they want with the approval of the shareholders [5] because this prohibition would handicap the private companies to utilize their funds.
To resolve this issue the Ministry of Corporate Affairs vide Notification dated 5th June 2015 [6] declared that the Private Companies were exempted from the purview of Section. 185 if they fulfill the following conditions:
- “in whose share capital no other body corporate has invested any money;
- if the borrowings of such a company from the banks or financial institutions or anybody corporate is less than twice of its paid-up capital or fifty crore rupees, whichever is lower; and
- such a company has no default in repayment of such borrowings subsisting at the time of making transactions under this section.” [7]
But, these transactions which were exempted from Section 185 still have to adhere to Section 186 and accordingly get approved by board resolution as prescribed under it and also adhere to limit provided by it i.e:
- 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.
Companies (Amendment) Act, 2017
The aforementioned notification brought about somewhat relief in the private companies but for the further ease of business transactions the Section 185 was wholly substituted by new Section 185 by the 2017 Companies (Amendment) Act, where directly advancing loan to individuals like directors, their partners, relatives, the partnership firm was still prohibited, but it has widened its scope in respect of advancing loan and guarantees to the persons in whom directors are interested (elaborates in explanation attached to Section. 185(2) of the Act) by putting few restrictions on them, for instance, to seek approval of shareholders by special resolution in the general meeting and the amount will be used for the purposes of principal business only, making the new provisions restrictive rather rendering it prohibitive in all spheres.
And have also provided few exceptions for applicability of this provision. Whereas in the earlier Section 185 i.e. before the amendment advancing loan/security/guarantee to directors and the persons/entity in whom directors are interested was strictly prohibited altogether.
Exemption to Section 185 after Companies (Amendment) Act, 2017
- Loan given to managing director or Whole-time Director (as part of conditions of employment also extended towards its other employees by the company or any scheme approved by members through special resolution).
- Loan/guarantee/ security by the company to its wholly-owned subsidiary.
- Loan/security/guarantee given in its ordinary course of business.
- Guarantee/security by the company to a financial institution on behalf of its subsidiary to seek loan.
Penalties
Section 185(4) provides for the penalties in event of contravention of the provisions under it.
- “Contravening company will be punishable with a fine of Rs. 5 lakhs which can extend upto Rs. 25 lakhs.
- Officers of company at default shall be punishable by imprisonment which may extend up to 6 months and fine not less than Rs. 5 lakhs but may extend to Rs. 25 lakhs.
- The director or any other person to whom loan/guarantee/security is advanced contravening the provisions under this section shall be punishable with imprisonment which may extend to six monts or fine which shall not be less than 5 lakh rupees but which may extend to Rs. 25 lakhs, or with both.”[8]
After perusing all the legal development in past years the million-dollar question that remains is whether private companies can provide loans to their Directors? To this question, the answer is yes, but then this transaction will be permissible only in cases where the company falls under the category mentioned in the notification of MCA dated 5th June, 2015 even after the emergence of amendment in Section 185.
Issues related to grant of such loans
Since the private Companies exempted from the Prohibitions of Section 185 vide MCA notification of 2015 can grant loan to its director. The same will come under the fiction of dividend i.e. ‘Deemed Dividend’ u/s 2 (22)(e) of Income Tax Act, 1961 if it fulfills the conditions laid down in the aforementioned Section:
“dividend” includes -(e) any payment by a company, not being a company in which the public are substantially interested, of any sum (whether as representing a part of the assets of the company or otherwise) made after the 31st day of May 1987, by way of advance or loan to a shareholder, being a person who is the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) holding not less than ten percent of the voting power, or to any concern in which such shareholder is a member or a partner and in which he has a substantial interest (hereafter in this clause referred to as the said concern) or any payment by any such company on behalf, or for the individual benefit, of any such shareholder, to the extent to which the company, in either case, possesses accumulated profits.”[9]
In a nutshell for application of this section, there should be a payment made by the company which is closely held for instance like private companies in a way of advancing loan; the director should have 10% or more voting power in the company (i.e. the director in the present case is also a shareholder) or have a substantial beneficial interest in the shares of the company.
What happens if the loan advanced is considered as ‘deemed dividend?
Now the legislative intent behind drawing up this section was to overcome the loophole which was misused by the companies to evade 15% TDS applicable on the distribution of dividend as they used to give the dividend in form of the loan and the shareholder never used to return the same. [10] Later in the year 2018, the law underwent a change and the provisions had become more stringent making the company liable to pay Dividend Distribution Tax (DDT) @ 30% and Section 10(34) Income Tax Act, 1961 exempted the taxation of the same in the hands of the recipient.
In this scenario, even if the Shareholder repays the loan amount to the company, the Company is still liable to pay DDT@ 30% in that financial year when the loan is advanced.
The legal regime concerning the taxability on payment of dividends again underwent a change in the year 2020 by the ‘Finance Act, 2020’, where the memorandum explaining the amendment stated that the dividend is the income received is in the hands of shareholders and not the company and hence, the recipient should be made liable to pay tax and not the company, this amendment changed a whole lot of dynamics of the taxation in the sphere of dividend distribution
- By abolishing DDT liability on companies and mutual funds.
- Imposed TDS 10% on dividend income paid more than Rs. 5000.
- The dividend income further received by the recipient will be taxed as per their tax bracket. [11]
Now, for example, Mr. Shankar is a director of XYZ Pvt. Ltd. Company and who fulfills the conditions of MCA Notification of 2015 as well as Section 2(22)(e) [i.e. he is also a shareholder having 10% or more voting right in the company]. XYZ Pvt. Ltd. Company advances loan of Rs. 5 Lakh to Mr. Shankar, due to applicability of Section 2(22)(e) the said loan will be considered as ‘deemed dividend’ and all the liabilities of the taxation for dividend income will be applicable on Mr. Shankar i.e. Since the dividend amount exceeds Rs. 5000, the company will deduct TDS @ 10% on the dividend which will be Rs. 50,000 Mr. Shankar will receive only Rs. 4,50,000 which will be further taxed at the slab rates applicable to him as the dividend received always becomes part of the income of a taxpayer.
When the loans are received from recognized financial institutions there are many tax exemptions available under Income Tax Act, 1961 as such loans are not considered as income. But in the case of loans advanced by the Private Companies to its shareholder they are considered as deemed dividends which brings them under the purview of income robbing a person of all the exemptions.
Furthermore, Section 2(22)(e) will not be applicable in case of loans advanced by the companies who are in the business of lending or if the company does not possess accumulated profits on the advance of loans or in the case where the director is not a shareholder.
Conclusion
In case of advancing loans by Private Companies to their directors’ caution has to be taken to see whether Section 2(22)(e) of Income Tax Act, 1961 is applicable or not, if it is applicable the director will be not benefitted as most of it will be taxable. In such cases, taking a Loan from a recognized financial Institute will be in the interest of such a director.
References
[1] Private Limited Company, Clear Tax, available at https://cleartax.in/g/terms/private-limited-company last seen on 11/04/2021
[2] What is a Private Limited Company? LegalWiz, available at https://www.legalwiz.in/blog/what-is-a-private-limited-company-in-india last seen on 11/04/2021
[3] Supra. 1
[4] Loans to directors by Private Limited Company, The Company Ninja, https://thecompany.ninja/loans-to-directors-by-a-private-limited-company/#_ftn1 last seen on 12/11/2021.
[5] Loans to directors under Section 185, Tax guru, https://taxguru.in/company-law/loans-director-section-185.html last seen on 12/04/2021.
[6] Notification dated G.S.R 464(E) 5th June 2015 by Ministry of Corporate affairs, available at http://www.mca.gov.in/Ministry/pdf/Exemptions_to_private_companies_05062015.pdf last seen on 10/04/2021.
[7] Ibid.
[8] S.185 (4), Companies Act, 2013.
[9] S. 2(22) (e), Income Tax Act, 1961.
[10] Understanding Deemed Dividend Section 2 (22)(e), Tax Guru, available at https://taxguru.in/income-tax/understanding-deemed-dividend-section-222e.html last seen on 13/04/2021.
[11] Do I need to pay tax on dividend income? Clear Tax, available at https://cleartax.in/s/how-dividendstaxable#:~:text=Answer%3A%20In%20India%2C%20a%20company,introduced%20the%20provisions%20of%20DDT.&text=Domestic%20companies%20have%20to%20pay,any%20tax%20on%20their%20income. Last seen on 14/04/2021
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