This article has been written by Md Farhan Saquib pursuing a Diploma in Corporate Law & Practice: Transactions, Governance and Disputes course from LawSikho.

This article has been edited and published by Shashwat Kaushik.

Introduction

Section 2 (20) of the Companies Act, 2013 defines a company as any company that is incorporated under this law or any previous law. It is a legal entity formed by associations of individuals to engage in business. A company has its own rights, duties, liabilities, and obligations; it can sue and be sued, which means that it has a separate legal identity that is distinct from the other members of the company. 

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In the case of Salomon vs. A. Salomon Co. Ltd. (1897), the concept of a separate legal entity of the company was deduced and it was held that the company is independent from its members and shareholders and has an identity of its own. Once a company is incorporated, it becomes an ‘artificial person’, and the veil is used to protect the interests of the owner and members of the company. This corporate personality rule of company law has an exception known as the lifting of the corporate veil. The term lifting of the veil means to remove the imaginary barriers between the company and its members and hold the person who is accountable for the illegal activity conducted under the veil of the company. 

Evolution of the concept

In the case of Bacha F. Guzdar vs. CIT, Bombay (1952), the Supreme Court of India accepted the fact that the company has a juristic personality and has a distinct identity from its shareholders.

The company, after its incorporation, enjoyed several rights, such as perpetual succession, the right to sue, transferable shares, limited liability and, above all, separate legal entities. Since a company is an artificial person and it can not practise any illegal activity on its own, if a member of the company commits fraudulent activity and uses the rule of corporate personality to refrain from legal action to convict the real culprit, the adjudicating authority, in some exceptional circumstances, lifts this corporate veil to punish the real accused.

The concept of a corporate veil distinguishes the shareholders from the company and allows the owner to work without any unforeseeable liabilities. The veil protects the shareholders from any mishaps, and the cost is paid by the assets of the company. But when the shareholders misuse the rule of corporate personality, for personal benefits and limit the liabilities to the company, then the court has the power to pierce the corporate veil to decipher the real person hidden behind in the name of the company and will be tried for his fraudulent or undue benefits as per the procedure established by law.

Elements required for lifting the veil

There are three major elements that need to be established by the aggrieved party in court in order to lift the corporate veil:

  1. Control and domination: The party has to prove that the shareholder has complete control and dominance in the company, which is not only confined to “finance but also in its policy and business practice regarding the transaction that has caused the grievances in the party, and the corporate entity as to this transaction has no separate mind, will or existence of its own.”
  2. Improper purpose or use: The second test for lifting the corporate veil is to prove that the stakeholder used its dominant position to commit fraud or deceive the person or any action that was in contravention of the laid provision and has affected the legal rights of such person. The plaintiff has to establish that the corporation has infringed on his rights by their misconduct beyond the fact that the corporation was controlled and dominated. 
  3. Resulting damage or harm: In the final test, the aggrieved party has to establish that the dominant stakeholder’s wrong or illegal act has caused damages to the plaintiff. However, if the damage has not been caused by the corporation, then in such cases, the defendant will not be liable. “The fact that the corporate veil could be disregarded for some purposes does not mean that it must be disregarded for all purposes.”

The Supreme Court of India in the case of L.I.C. India vs. Escorts Ltd. & Others (1985) enshrined that though the company is a separate corporate personality, the court, under certain exceptional circumstances, can pierce the corporate veil. The circumstances under which the corporate veil can be lifted are:

  • Statutory provisions, and 
  • Judicial Interpretations.

Grounds for lifting of corporate veil

Statutory provisions

The Companies Act, 2013 (here and after referred to as the Act) explicitly provides several specific provisions that allow the adjudicating authority to pierce the corporate veil. Section 2 (60) of the Act defines ‘officer in default’ as the person who acts in contravention of any provision of this Act and will be held liable for penalty or imprisonment as per the given law.

According to Section 7 of the Act, if a company is incorporated by “presenting any false or misrepresenting information or intentionally concealing relevant facts or information in filing the documents for the incorporation of the company,”  the promoters, the first directors of the company, and the persons making declarations under clause (b) of subsection (1) shall each be liable for action under Section 447. Provided the Tribunal also has the jurisdiction to take appropriate action on sufficient grounds where the Tribunal can pass an order for changes in the management of the company, remove the name of the company from the register of the companies, or direct the winding up of the company. 

Criminal and civil liability for misstatement in prospectus are provided under Sections 34 and 35, respectively, of the Act. It states that if the prospectus of the company contains any misleading or untrue information that can confuse the public and cause damage based on such statements, then every person who knowingly issued such a prospectus will be held liable. Whereas under Section 36 of the Act, if any person knowingly induces any other person by making a false or fraudulent statement or concealing any facts for the investment of money by such person, then he will be liable for fraud under Section 447 of the Act. 

When a company fails to repay the deposit, part thereof, or interest within the time specified by the tribunal, then every officer of the company responsible for such default will be held liable under Section 74(3) of the Act.

According to Section 239 of the Act, the central government can appoint an investigating officer for an inquiry about the management of the affairs of the company or the amalgamation or acquisition of its shares and if there has been any offence regarding such activity.

The Registrar of the Company has the power to strike off the name of the company from the Register of the Companies on the application of the company under Section 242(2) of the Act, provided that such company must extinguish all its liabilities and obligations before such application. The officers of the companies misuse the provision to avoid liabilities, defraud the creditors, or evade tax. In such circumstances, the officer in charge of the company will be jointly liable for the  fraudulent application for removal of name under Section 251 of the Act.

When the company is in the process of winding up and it appears that the company carried out business to defraud the creditor or any other person, then on the application from the official liquidator, the company liquidator or the creditor, any officer of the company who intentionally tries to defraud shall be held personally liable by the National Company Law Tribunal as per Section 339 of the Act.

Judicial interpretations

The concept of the corporate veil emerged after the landmark case of Soloaman. The courts in India, beside the statutory provisions, have over time laid down certain grounds for lifting the corporate veil by carefully analysing the provisions but these criteria are not exhaustive and change according to the facts and circumstances of the case.

Fraud

The courts have consistently invoked the doctrine of lifting the corporate veil in cases where the officers of the company use the veil to conduct their fraudulent activities and protect themselves from liabilities. In Commissioner of Income-tax vs. Associated Clothiers Ltd. (1963), the Calcutta High Court held that the veil should only be lifted in exceptional circumstances where the statutory provisions are expressly stated, such as lifting the veil in cases of fraudulent activity or misdescription of the company by the shareholders for deceiving the creditors.

Additionally, in the case of Jones vs. Lipman (1962), a person formed a contract to sell his property but after some change of mind, he transferred the property in the name of a company to avoid specific performance under the contract. The court in the case held that the company is only the mask that Lipman holds to avoid liability and performance as per contract; therefore, the court lifted the veil to avoid fraud and misuse of the doctrine and awarded specific performance against the company and Mr. Lipman.

Sham company

When there are multiple corporate bodies but they are majority owned by one person or group of people, these corporate bodies are mere cloaks, and the main purpose for the incorporation of the company was to commit illegal activity. In the landmark judgement of Delhi Development Authority vs. Skipper Construction Company (P) Ltd. and.. (1996), the Supreme Court held that when a director and member of his family incorporate several corporate bodies for illegal activity, then the court can consider them as one single entity owned by the director and their family. Though there is no bar to holding a subsidiary company and the law identifies them as separate legal entities, when there are instances of illegal activity, it can be considered one economic entity.

Tax evasion

The company is a separate legal entity and has the same liabilities as any other legal person. One such liability is to pay tax to the government, and as we know, a company is an artificial person and can do no wrong on their own. The officers of the company use the mechanism of a separate legal entity to evade taxes; therefore, in such circumstances, the court pierces through the veil to hold the person responsible for failure to pay tax. In the case of  Vodafone International Holdings BV vs. Union of India (2012), the Supreme Court held that the income tax department has the power to lift the corporate veil if they can establish that the company uses the doctrine of a separate legal entity to evade taxes and to exempt themselves from any liability.

Mere agency of the holding company

When the company uses its subsidiary company as an agency for undue benefits, the court can lift the corporate veil to hold the person accountable for such action. In the case of Smith Stone & Knight Ltd. vs. Birmingham Corporation (1939), the company transferred its asset to a subsidiary company for waiving its liability, stating that they are not the owners of the property. The court lifted the corporate veil and held that the subsidiary company is just an agent of the parent company and the transaction was made to benefit the parent company.

Landmark cases which helped shape the doctrine

In recent times, the courts have pronounced several landmark judgements shaping the doctrine of piercing the corporate veil. Over time, the judiciary has taken new approach in piercing 

Singer India Ltd. vs. Chander Mohan Chadha and Ors. (2004)

In the case of Singer India Ltd. vs. Chander Mohan Chadha and Ors. (2004), it was held that the doctrine of separate entity was evolved for the purpose of development in trade and commerce and not to conduct illegal and fraudulent activity to deceive the creditor or any other person. Therefore, the court, under such circumstances, will lift the veil of a separate entity to do justice for the aggrieved party. The court observed that the primary purpose of the doctrine of separate entities is to facilitate the development of trade and commerce. It enables businesses to operate independently, make decisions, and assume risks without exposing their owners to unlimited personal liability. However, this privilege should not be abused to engage in unlawful or unethical practices.

In the present case, the court found that the defendants, Chander Mohan Chadha and Ors., had incorporated multiple companies with the sole intention of syphoning off assets and defrauding creditors. The defendants had used these companies as mere facades to conceal their wrongdoing and evade legal responsibility.

Recognising the need to prevent such misuse of corporate structures, the court lifted the veil of separate entities and held the defendants personally liable for the debts and liabilities of the companies they controlled. The court reasoned that allowing the defendants to hide behind the corporate veil would undermine the principles of justice and fair play and grant them an unfair advantage over their creditors.

The decision in Singer India Ltd. serves as a reminder that the doctrine of separate entities is not absolute. Courts have the authority to pierce the corporate veil and impose personal liability on individuals who abuse this doctrine to engage in illegal or fraudulent activities. This principle ensures that individuals cannot use corporate structures as a means to evade their legal obligations and harm innocent parties.

Richter Holding Ltd. vs. The Assistant Director of Income Tax (2011)

In the case of Richter Holding Ltd. vs. The Assistant Director of Income Tax (2011), the Karnataka High Court held that the income tax department, being the fact finding authority, may lift the veil to find the true nature of the transaction. At the heart of the dispute was the interpretation of Section 2(22)(e) of the Income Tax Act, which empowers the income tax department to disregard the separate legal entity of a company if it finds that the company was formed or is being used for the purpose of avoiding or reducing tax liability. The department argued that this provision granted it the authority to lift the corporate veil and examine the true nature of the transaction in question.

The assessee, Richter Holding Ltd., contended that the income tax department could not disregard the separate legal entity of a company unless it could establish that the company was a sham or a mere facade. The assessee relied on the principle of corporate personality, which recognises a company as a separate legal entity distinct from its shareholders.

The Karnataka High Court, after considering the arguments of both parties, held that the income tax department, being the fact-finding authority, does have the power to lift the corporate veil to find the true nature of the transaction. The court observed that the purpose of Section 2(22)(e) is to prevent tax avoidance and evasion by artificial or contrived arrangements. To achieve this objective, the court held that the department must be able to look beyond the formal structure of a company and examine the underlying substance of the transaction.

The court emphasised that the power to lift the corporate veil is not absolute and must be exercised judiciously. The court laid down certain safeguards to prevent the arbitrary use of this power. For instance, the court held that the department must have reasonable grounds to believe that the company was formed or is being used for the purpose of tax avoidance or evasion. Additionally, the court held that the department must follow due process and provide the assessee with an opportunity to be heard before lifting the corporate veil.

The decision of the Karnataka High Court in Richter Holding Ltd. vs. The Assistant Director of Income Tax (2011) is a significant development in the area of corporate taxation. It clarifies the income tax department’s power to lift the corporate veil and provides important safeguards to protect the rights of taxpayers. This decision serves as a reminder that, while corporate personality is a fundamental principle of the law, it cannot be used as a shield for tax avoidance or evasion.

State of Rajasthan and Ors. vs. Gotan Lime Stone Khanji Udyog Pvt. Ltd. and Ors. (2016)

In the case of the State of Rajasthan and Ors. vs. Gotan Lime Stone Khanji Udyog Pvt. Ltd. and Ors. (2016), the Supreme Court held that the veil can be lifted if the company acts against public interest. The Gotan Lime decision is a significant development in Indian corporate law. It sends a clear message that companies cannot use the corporate veil to shield themselves from liability for wrongdoing. The decision also provides a valuable tool for regulators and law enforcement agencies to pursue companies that engage in illegal or unethical conduct.

Here are some of the key implications of the Gotan Lime decision:

  • Increased accountability for shareholders and directors: The decision makes it clear that shareholders and directors can be held personally liable for the debts and obligations of a company if the company is used to perpetrate fraud or to evade legal obligations. This increased accountability is likely to make shareholders and directors more cautious about the activities of the companies they own and manage.
  • Greater scrutiny of corporate conduct: The decision is also likely to lead to greater scrutiny of corporate conduct by regulators and law enforcement agencies. Companies will need to be more careful to comply with all applicable laws and regulations, as they may be held accountable for any wrongdoing.
  • Potential for more lawsuits: The decision may also lead to an increase in lawsuits against companies and their shareholders and directors. Shareholders and directors who are concerned about their personal liability may be more likely to file lawsuits against companies that they believe are engaging in illegal or unethical conduct.

Conclusion

In conclusion, the corporate veil protects the shareholders and officers of the company but when the concept of a separate entity is misused and any fraudulent or illegal activity takes place, under such circumstances, the veil is lifted to punish the actual offender. The courts in India have given several landmark judgements laying down conditions and circumstances under which the veil can be lifted. The doctrine was laid down to establish the fact that incorporating a company does not waive off all the liabilities of the shareholders and personal liability arises whenever the officers of the company act in contravention of the law of the land.

References

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