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This article is written by Raghav Madan, pursuing Diploma in Law Firm Practice: Research, Drafting, Briefing and Client Management from LawSikho.

Introduction

One of the most important questions before a business is how it will raise money to run its business. There are various sources such as raising funds through the public, taking a loan from a bank, etc. However, taking a loan from the bank can be a very tedious task. Followed by a large number of financial scams in recent times, banks now ask for various compliance and conditional requirements which could be quite detrimental for a business. So how will a company raise a large sum of money without the lender asking for too much comfort? Are there any such sources?

The most commonly used source for raising funds in this situation is taking a loan from group companies themselves. Companies Act, 2013 deals with transactions between large corporates and group companies by way of Related Party Transactions and Inter-Corporate Loans. However, subject to the tendency of their misuse, these transactions are strictly regulated and involve a lot of intricacies. 

This article aims to decode all such intricacies and provide you with an overview of all the transactions within the purview of corporate relations, large corporates, group companies, etc. along with their latest amendments and a step-wise guide as to how to use them practically. 

Decoding the corporate relations

Before we dive deep into different forms of inter-corporate transactions, let us first understand the different types of relations under corporate law transactions. These relations can broadly be divided into two categories:

  1. Relation between companies,
  2. Relation between parties.

Relation between companies

It deals with the relationship between different types of entities in a Group Structure. Once a company grows and starts generating revenue on a larger scale, they diversify and separate their operations from one another. To focus on their separate functions, they form separate companies. This concept is commonly known as ring-fencing.

Ring-fencing leads to the formation of a Group Structure and the companies within a Group Structure become related to each other in the following manner:

  • A holding company as per Section 2 (46) of the Companies Act 2013, is a company whose business form is registered to control other companies. The holding company may own another legal entity through the ownership of shares or by controlling its management. In the above diagram, Company A can be called a holding company.
  • A subsidiary company is a company that belongs to another company, which is usually referred to as the parent company/holding company. The parent holds a controlling interest in the subsidiary company, meaning it has or controls more than half of its stock. From the structure diagram, Company B and Company C can be termed as subsidiaries to Company A.

To become a subsidiary, the holding company must control more than 50% of the total voting power or power to appoint or remove the majority of the Directors of such a subsidiary as per Section 2(87) of Companies Act, 2013.

  • A Wholly-Owned Subsidiary (WOS), similar to a holding company, holds 100% shares of its subsidiary. A WOS allows the parent company to mitigate its risk. In the given diagram, Company B can be called a Wholly-Owned Subsidiary of Company A. 

For forming a WOS company,  a nominee shareholder is appointed to fulfil the minimum of the requirement of the shareholder of Section 3(1)(b) of the Companies Act, 2013.

  • A Sister Company is a company where two companies are controlled by a common parent. In the given diagram, Company B and Company C can be termed as sister companies as they are controlled by a common parent (Company A). They can have cross-holdings in each other but it must not exceed 50%.
  • An Investing Company is a company that derives more than half of its income from investment activities i.e., more than 50% of the gross income comes from investment activities. It is governed by Section 186(13) of the Companies Act, 2013. It can be any company whether parent, holding or a subsidiary.
  • An “Associate Company” (as per Section 2(6) of the Companies Act, 2013), is a company in which another company has a “significant influence” (at least 20% control), but which is not a subsidiary company (not more than 50% holding) of the company. For better clarity, in the given diagram it can be Company E. It can also be a Joint Venture Company till the time the Joint Venture Company has more than 20% holding.
  • A Joint Venture Company (JVC) is a form of business arrangement where two or more parties agree to pool their resources to accomplish a specific task. This task can be a new project or any other business activity. They are typically formed by way of a Joint Venture Agreement (JVA). In the above diagram, Company B and Company C may form Company D for a certain strategic alliance, mutual benefit, etc. through a common understanding (via JVA). 
  • An Unrelated Company, as the name suggests, is completely unrelated to the other group of companies. For instance, Company F in the following diagram can be termed as an Unrelated Company.

Relation between parties

Relation between the parties (also known as Related Party Transactions) is governed by Section 188 of the Companies Act, 2013.

Let us first understand who are related parties.

Who are “related parties”?

Related parties (as per Section 2(76) of the companies act, 2013) includes:

  1. A director or his relative (includes HUF, husband, wife, father, stepfather, mother, stepmother, son, stepson, son’s wife, daughter, daughter’s husband, brother, stepbrother, sister, step-sister);
  2. Key Managerial Personnel (KMP) or his relative (defined under Section 2(51) of the Companies Act, 2013);
  3. A partner who is a director, manager, or relative in a firm;
  4. A private company in which a director, manager, or relative is a member or director;
  5. A public company in which a director or manager is a director and holds collectively along with its relatives more than 2% of its paid-up capital;
  6. Any Body Corporate whose board of directors, MD, or manager is required to act under the advice, directions, or instructions of a director or manager (N/A in cases when these directions are followed in a professional capacity);
  7. Any person on whose directions a director or manager is required to act (not applicable when done in the professional capacity);
  8. Holding, Subsidiary or Associate of such company;
  9. When a company is a subsidiary of a holding company to which it is also a subsidiary.
  10. Additionally, SEBI’s recent Board Meeting held on 28th September 2021 states that a Related Party would further include:
  1. all persons or entities forming part of promoter or promoter group irrespective of their shareholding;
  2. any person/entity holding equity shares in the listed entity, as below, either directly or on a beneficial interest basis at any time during the immediately preceding financial year:
  1. to the extent of 20 % or more. 
  2. to the extent of 10% or more w.e.f. April 1, 2023. 

When these parties enter into a transaction with each other, it is called a Related Party Transaction.

What transactions constitute a “related party transaction”?

As per Section 188(1) of the Companies Act 2013, the following constitutes a Related Party Transaction:

  1. Sale, purchase, or supply of any movable goods or materials by a company to its related party;
  2. Selling and otherwise disposing of any immovable goods to a related party or any purchase or buying of such property from a related party;
  3. Lease of a property to a related party;
  4. Consultancy services or any such similar service to and from a related party;
  5. Appointment of agent for making sale or purchase of any good, material, service, or property;
  6. Appointment of a related party to any office or place of profit (where the director is occupying a position of receiving remuneration or any such similar benefit; and
  7. If there is an underwriting agreement for the subscription of securities between a company and its related party.

Exceptions:

The above-stated transactions do not include:

  1. Transactions that are undertaken in the ordinary course of business at an “arm’s length” basis (where independent parties act like unrelated third parties);
  2. Transactions arising out of mergers, acquisitions, or restructuring;
  3. Transactions entered between a holding company and its Wholly-Owned Subsidiary whose accounts are consolidated with such holding company (subject to approval by shareholders in the General Meeting);
  4. Transactions between a holding company, subsidiaries, associates, and fellow subsidiaries provided they are private companies.

How to undertake a valid related party transaction?

The understanding of related parties, the transactions under related parties is important so that you know how to undertake a valid Related Party Transaction. It can be undertaken in the following manner:

  1. Relation between the Parties. Suppose you want to find out whether a related party transaction is valid or not, the first thing you have to do is analyze whether parties entering into a transaction fall within the definition of a Related Party;
  2. Then, you must check the nature of the transaction if the parties are falling within the ambit of a Related Party Transaction or not. Check whether any exception is applicable or not. Any exception would not require the following compliances;
  3. Board Approval. Every Related Party Transaction would require a Board Approval along with a clear reason for undertaking those transactions (unless falling within the exceptions);
  4. Audit committee approval. Only those companies which are required to form an audit committee will first take the approval of the audit committee before entering into a transaction with a Related Party. (To know the requirements, click here);
  5. Check the threshold limits of the transaction. Any transaction beyond the threshold limit would require the approval of the shareholder through a resolution. The threshold limit of the Related Party transactions are as follows:
Type of TransactionThreshold
Sale or purchase of goodsExceeding 10% of turnover or 100 INR crore (whichever less).
Sale, PurchaseExceeding 10% of net-worth or 100 INR crore (whichever less).
Leasing of PropertyExceeding 10% of turnover, Exceeding 10% of net-worth or 100 INR crore (whichever less).
Service ContractsExceeding 10% of turnover or 50 INR crore (whichever less).
Appointment to the office of profit in the company or its sister concernsIf the remuneration exceeds INR 2.5 lakhs per month.
Remuneration for underwriting security or derivative issuanceExceeding 1% of the net worth.

Inter-corporate loans and guarantees

Inter-corporate loans refer to loans taken by large corporate groups amongst one another. This includes four types of transactions:

  1. One company providing a loan to the other;
  2. One company guaranteeing a loan repayment condition for another;
  3. One company providing a loan repayment under security to another;
  4. One company acquiring shares or debentures of another.

Why prefer taking a loan from a company rather than a bank?

Followed by a large number of scams in recent years, banks in India always look for a certain kind of security or comfort whenever providing a loan. From a company’s point of view, this becomes a challenge especially if you have not paid your past loans on time. As a result, a loan from a company is much more efficient because:

  1. You can raise a large capital with lesser compliances;
  2. You get a loan at a much lesser rate of interest;
  3. If you still want a bank loan for some reason, you can even use some other company as a guarantor for loan repayment in case of any default (known as a corporate guarantee). This is a very common practice in the project finance industry.

However, inter-corporate loans have a high tendency to be abused for personal motives (especially in a Group Structure where the promoters of two companies are the same). As a result, there have been restrictions imposed on such transactions under:

  1. Section 185 (for loans to directors, etc.) of the Companies Act, 2013; and 
  2. Section 186 (for loans to another company) of Companies Act, 2013. 

Let us discuss these regulations in more detail.

Loans to Directors

Section 185(1) states that no loan can be granted to:

  1. any director of a company, or of a company which is its holding company or any partner or relative of any such director; or
  2. any firm in which any such director or relative is a partner.

However, there are certain exceptions to this rule.

Exceptions

  1. A company can provide any loan to “any person in whom any of the Directors of the company is interested” on the condition:
  1. A Special Resolution is passed by the company in its General Meeting (Resolution must include all necessary particulars of a loan including particulars of the loan/guarantee/security, purpose, tenure, and any other relevant fact);
  2. The loans are utilized by the borrowing company for its principal business activities.
In this context, “any person in whom any of the Directors of the company is interested” includes: Any private company of which a person is a director or member; Such director, or two or more such directors, together with control at least 25% of the total voting power at a general meeting of the other company; Company in which the Board of Directors, Managing Director or Manager is accustomed to act by the directions of the Board, or of any Director or Directors, of the other company. If a person is not falling within this definition, then the a) point will not be applicable.
  1. The whole section is completely exempted from:
  1. The giving of any loan to a managing or whole-time director is a part of conditions of service extended by the company to all its employees;
  2. The giving of any loan to a managing or whole-time director provided it is approved by the members by a Special Resolution;
  3. A company which in the ordinary course of its business provides loans/ guarantees/ securities for the due repayment of any loan. These loans must have an interest which is charged at a rate not less than the rate of prevailing yield of one year, three years, five years, or ten years of the Government security tenor (whichever is the closest);
  4. Any loan made by a holding company to its WOS or any guarantee/security provided by a holding company in respect of any loan made to its WOS. This condition is only applicable if the subsidiary is going to use its loan for its principal business activities;
  5. Any guarantee/security provided by a holding company in respect of loan made by any bank or financial institution to its subsidiary company. This condition is only applicable if the subsidiary is going to use its loan for its principal business activities.

Loan and investment by a company

Section 186 of the Companies Act, 2013 deals with situations under which companies can grant loans to another company. For the sake of simplicity, the meaning of the section is decoded as follows:

SectionMeaningException/Not Applicable
186(1)No loan to any “Investment Company” for more than two layers of investment.Not applicable if it is an: Investment or acquisition of a foreign company (including off-shore companies) where the laws of that company allow investment beyond two layers; Investment in a subsidiary if it is required for meeting requirements under any law.
186(2)No loan/guarantee/investment to any person or body corporate if the loan amount (whichever more): Exceeds 60% of (Paid-up share capital + free reserves + security premium account) ORExceeds 100% of (Free reserves + Securities Premium Account)If the loan is within the limit; Obtained Special Resolution [186(3)]; Unanimous consent of all the Directors in a Board Meeting [186(5)].
186 (3)Even if the loan amount exceeds as per 186(2), it can be granted if Special Resolution is passed provided the loan has all the material information related to the loan has been disclosed.Not applicable if: A company giving loan/ investment/ guarantee to its Wholly-Owned Subsidiary/ Joint Venture Company;
All material details regarding the transaction are not disclosed.
186(4)The company must disclose to the members in the financial statement the full particulars of the loans/ investment/ guarantee. Not applicable if all material details regarding the transaction are not disclosed.
186(5)Loan exceeding the limit specified in Section 186(2) can only be taken with the consent of all the Directors in a Board meeting;
If there is a prior pending loan/ prior default, then the consent of such a Public Financial Institution (where such loan is pending) will also be required. 
No prior approval of all directors if within the limit specified under Section 186 (2);No prior approval of the Public Financial Institution is required if no pending loan or prior default.
186 (6)No loan for companies that exceed the limit of 186(2) and are registered under Section 12 of SEBI by any method (Not even after passing Special Resolution)Not applicable if they are within the limit of 186(2).
186(7)The rate of loan must be equal to or higher than the prevailing yield of one year, three years, five years, or ten years Government Security closest to the tenor of the loan.
186 (8)If there is any default in repayment of any deposit or any payment of interest, then no loan can be given under any condition.No prior default in repayment of any deposit or payment of any interest.
186(9)Every company giving loan/ guarantee/ security/ acquisition under this section has to keep a register which shall contain such particulars and shall be maintained in such manner as may be prescribed.
186(10)The register referred under 186(9) shall be open to inspection at such office
186(11)Lays down restrictions on certain forms of companies on which this section is not applicable. (discussed in detail later)Applicable to every other category of company.

The layering of investment companies

The layering of companies basically means limiting the number of entities a loan, investment or a guarantee could be advanced to amongst the group of companies. 

Why is there a need for layering?

You might wonder why we even need to restrict the circulation of loans? Isn’t it better if a company is free to circulate the money amongst its sister companies, subsidiaries, etc. so that it can allocate according to where it is needed the most? The reason is that if you do not layer these transactions, it would lead to the two problems:

  1. Difficulty in identifying the real promoters of the group (especially if the structuring is done to create confusion);
  2. Difficulty in tracing the money-trail of financial transactions. 

Thus, to avoid this and keep a track of the loan, Section 186(1) was introduced to prohibit a company from making more than two layers of “Investment Companies”.

Why only investment companies?

As discussed before, any investment company is a form of a company whose income derived from gross investment is more than 50%. This implies that an investment company is less focused on daily business operations and more on the investment to generate income. Therefore, there is a tendency that a loan given to an investment company may be subject to further investment (circulation) and not for business operations. This will result in difficulty in keeping track of the transactions and may lead to fraud.

As a result, the layering of loans, investments, or guarantees applies only to those companies that fall in the category of Investment Company under, Section 186(13) of the Companies Act, 2013.

This excludes a banking company, a systemically important non-banking financial company, an insurance company, and a government company, which are permitted to have more than two layers of subsidiaries under the Layering Rules. 

Exceptions

Even within an Investment Company, this provision is exempted from:

  1. Investment or acquisition of a foreign company (including off-shore companies) where the laws of that company allow investment beyond two layers;
  2. Investment in a subsidiary if it is required for meeting requirements under any law.

Along with the nature of the companies, there are a lot of other facets that are required to be considered before taking an inter-corporate loan. Let us understand how to undertake them using Section 185 and 186

How to undertake a valid inter-corporate loan/investment/guarantee/acquisition?

From Section 185 and 186, we conclude that the procedure to undertake a loan/ investment/ guarantee/ acquisition includes:

  1. Identifying a valid party for a loan transaction
    1. This includes identifying the party under Section 185 that is eligible to take a loan.
    2. Exempted parties to the transaction have also to be kept in mind
  2. Identifying the nature of the company

An Investment Company has certain layer requirements. Similarly, a Wholly-Owned Subsidiary has certain exemptions. Therefore, it is important to identify the nature of a company and find out its eligibility, exemptions, thresholds, etc.

Following is a list of companies on which Section 186 is not applicable

With regards to Government CompanyWith regards to the Acquisition of sharesWith regards to loans, guarantee or securityWith regards to the acquisition of shares and loan
A Government company engaged in defence production;
A Government company, other than a listed company, in case such a company obtains approval of the Ministry or Department of CG which is administratively in charge of the company or State Government, as the case may be.
Any acquisition of shares allotted in pursuance of right shares;
Any acquisition made by a company whose principal business is the acquisition of securities (i.e. investment company).
A banking company in the ordinary course of its business; An insurance company in the ordinary course of its business; A housing finance company in the ordinary course of its business; A company engaged in the business of financing companies or of providing infrastructural facilities.Any acquisition made by a non-banking financial company whose principal business is the acquisition of securities;
The exemption to NBFC shall be concerning investment and lending activities.
  1. Approval of board
    1. The approval of the Board is required in all cases irrespective of the amount of loan, investment, guarantee, or security;
    2. The approval of the Board shall be obtained by consent of all the directors at a Board meeting with the consent of all the directors present at the meeting;
  2. Approval of the members by passing a special resolution
  1. When the aggregate of the loan, investment, guarantee, or security already made together with the loan, investment, guarantee, or security proposed to be made exceeds the limit specified u/s 186(2), prior approval through a Special Resolution is necessary.
  2. If limit under 186(2) if higher than:
    1. 60% of (paid-up share capital + free reserves + securities premium); or
    2. 100% of (free reserves + securities premium).
  1. The contents of the Special resolution shall contain the total amount up to which the Board is authorized to make loans, guarantees, investment, or security. 
  2. No approval by way of Special Resolution is needed if loan/ guarantee/ acquisition of security by a company to its Wholly-Owned Subsidiary or Joint Venture Company.
  3. Approval of public financial institution [PFI]
  1. The company must obtain the prior consent of the PFI from which it has taken a term loan.
  2. This approval of PFI is not required if –
    1. The aggregate limit under Section 186(2) does not exceed;
    2. No prior default on repayment of loan/loan instalments.
  3. Rate of interest

The rate of interest chargeable should be more than the prevailing yield of Government Security closest to the period of the loan.

  1. No subsisting default concerning deposits

A company with any past default in repayment of any deposits or payment of interest on deposits, cannot make any inter-corporate transaction till such default is not cleared.

  1. Disclosures in financial statements
    1. The company must disclose to the members in the financial statement the full particulars of the loan and the purpose of obtaining such loan.

Conclusion

Taking loans from a related party or a company within a group structure is widely used to shift cash to a business unit to avoid the shortfall in cash and where the funds are aggregated for investment purposes. However, subject to their easy misuse, they have to be strictly regulated and looked after carefully whenever used for conducting due diligence, legal advisory, researching, etc. Hence, to be in a position to give such advice as a Corporate Lawyer, it is important that they must first understand this concept themselves. This article attempts to decode all the relevant concepts of financial transactions between large corporations and group companies. It deals with decoding the relations between companies in a Group Structure and parties which deal with the parties that come under the purview of “Related Parties” under Section 2(76) of the Companies Act. It includes the scope of such parties and such transactions, and their threshold limit.  It further deals with Inter-Corporate Loans which regulate the layers of investment, type of loans (along with the exemptions), and manner of undertaking them within a Group Structure. Lastly, it also provides a practical approach to these transactions through legal routes by a step-wise guide for every transaction. 

References


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