This article has been written by Srejan Gupta Reza, pursuing law at Jagran Lakecity University, School of Law, Bhopal, Madhya Pradesh. The article explains Section 198 of the Companies Act, 2013 and sheds light on the nuances surrounding this section.
This article has been published by Sneha Mahawar.
Table of Contents
Introduction
Section 198 of the Companies Act, 2013 titled “Calculation of profits” provides for a particular method that is used for calculating the net profits of a company in a Financial year. The provision makes use of certain rules and limitations, that are not there in the general Accounting Standards, in order to arrive at the net profit. This particular section corresponds with two other provisions of the act. These are Sections 135 and 197.
Section 135 is titled “Corporate Social Responsibility” and it makes a company responsible for spending atleast 2% of their average net profits in the last three years on CSR activities. This net profit is different from the net profit that is presented in the financial reporting. Thus, this net profit is calculated by the means of Section 198.
Similarly, Section 197 titled “Overall maximum managerial remuneration and managerial remuneration in case of absence or inadequacy of profits” purports an identical condition. As per Section 197, the maximum remuneration that can be paid by a company is restricted to 11 % of the net profit, which has to be computed as per Section 198.
Therefore, it can be determined from the aforementioned that the particular mode of calculation and computation of net profits of a company which is prescribed under Section 198 is used for two purposes:
(i) for identifying the minimum CSR amount which is to be spent by the company in a financial year, under Section 135(5) of the 2013 Act; and
(iI) for determining managerial remuneration under Section 197 and Schedule V.
Origin of Section 198 : Sections 349 and 350 of the Companies Act, 1956
Sections 349 and 350 of the Companies Act of 1956 (the “1956 Act”) are closely related to the provision under Section 198. The fundamental objective of the provisions under Sections 349 and 350 of the 1956 Act was to ensure that a corporation pays managerial compensation out of legitimate operational earnings only and not out of any artificially inflated profits that have been earned by means of the sale of real estate or any kind of investment.
These provisions were included in the 1956 Act, which established stringent restrictions on the amount of managerial compensation that the firm was permitted to offer. There was a need to make sure that businesses do not intentionally inflate their earnings and that such remuneration is paid exclusively out of operating profits because severe limits had been placed by the 1956 Act. When the 1956 Act was passed, there weren’t many “accounting standards” to govern specifics pertaining to calculating net profit. By removing a few unique sources of income and expenses, Sections 349 and 350 aimed to normalise profit.
Section 349 of the 1956 Act brought up a variety of practical problems. In 1960, the Companies Amendment Committee noted that Section 349 had caused “many difficulties in its interpretation and application.” The Committee did not consider the possibility of additional computing methods, albeit making a few minor amendments to Section 349.
In 2005, the J.J. Irani Committee in its report came to the conclusion that the computation techniques outlined in Sections 349 and 350 were no longer necessary because the current provisions of the Companies Act sufficiently ensured the presentation of a genuine and fair image of the company’s earnings. This suggestion of the J.J. Irani Committee was not mentioned in the report of the Parliamentary Standing Committee on Finance, which investigated the Companies Bill, 2011, which was at issue. The computation technique specified under Sections 349 and 350 was kept in Section 198 of the 2013 Act with a few minor changes.
Purpose of Section 198
Section 198 is incorporated into the Companies Act, 2013 for the simple reason of ensuring standardisation of the computation of the net profit for the purposes of Section 135 which provides for corporate social responsibility— and Section 197, which provides for managerial remuneration. Specifying the method of calculation is important as different companies might assume different net profits for the purposes of Sections 135 and 197, which is not good for financial reporting as far as transparency and good corporate governance are concerned. Therefore, we have Section 198 in the Company’s Act, which ensures that all the companies that have to compute the profit do so in a very standard manner.
Despite the fact that the law brings out all the provisions very clearly, many times, for some reason or another, there is bound to be some confusion with regards to certain provisions, and there is also bound to be confusion regarding the application of Section 198. The best thing to do in order to clear any kind of confusion is to go to the root of it. The rationale behind Section 198 is very simple. The rationale behind Section 198 for the purpose of Section 197 is that the managerial remuneration should be linked with the profit that is accruing to the business on account of the efforts of the managerial team. It is also for the purpose of determining the maximum ceiling of managerial remuneration which can be paid by a company. That remuneration must be linked with a profit, which can be credited to the efforts of the managerial team, so if a business is making some profit or loss, it would be incorrect to pass the credit or debit. It would also be unfair to the managerial team to give them less remuneration because of some losses that have occurred in the business which were due to the fault of the managerial team.
If the maximum ceiling of the remuneration that is working out gets reduced, that means the managerial person will get less remuneration or will be eligible for a lesser amount of remuneration, and vice versa. If a profit is accruing to a business on account of the sale of a capital asset, and if this profit is added to the net profit for the purpose of computing the maximum ceiling as per Section 197, the amount of the maximum ceiling is going to increase as a profit has been added on account of the sale of a capital asset. Section 198 operates to ensure that only those incomes are taken into account which can be credited to the efforts of the managerial team and to deduct only those expenses which are related to the income of the managerial team. This same logic is also applicable with regard to spending on corporate social responsibility under Section 135. The profit after Section 197 also becomes a basis for the purpose of deciding the two percent average profit of the last three years for the purpose of spending on CSR activities.
Computation of net profits of a company in a financial year
Section 198 of the Companies Act, 2013 lays down the manner of calculating the net profits of a company in any financial year for purposes of Section 197. Sub-Section (2) specifies the sums for which credit shall be given, and sub-Section (3) specifies the sums for which credit shall not be given while calculating the net profit. Similarly, sub-Section (4)/(5) of Section 198 specifies the sums which shall be deducted/not deducted while calculating the net profit.
The provision under Section 198 of the Act of 2013 prescribes the following method:
Sub-Section (1) prescribes that the amounts specified in sub-Sections (2) and (3) are not eligible for credit when calculating a company’s net profits for any given financial year for the purposes of Section 197. Second, the amounts specified in sub-Sections (4) and (5) are not eligible for deduction when calculating a company’s net profits.
Sub-Section (2) provides that credit will be provided for the bounties and subsidies received from any government, or any public authority established or authorised in this regard by any government, in the computation described above, unless and except in the instances where the Central Government specifies differently.
Sub-Section (3) provides that credit shall not be given for the following amounts in determining the aforementioned calculation:
(a) profits received as a premium on shares, unless the company is an investment company.
(b) profits received from the sale of forfeited shares by the company;
(c) profits of a capital nature;
(d) profits from the sale of immovable property or fixed capital assets of the company unless the company is in the business of purchasing and selling such property or asset as long as the sum for which a fixed asset is sold does not exceed its written-down value, credit will be awarded for the portion of the surplus that does not exceed the difference between the fixed asset’s original cost and its written-down value;
(e) Any modification to the carrying amount of an asset or liability that has been recognised in equity reserves, including any surplus in the profit and loss account following the measurement of the asset or liability at fair value.
(f) Any sum corresponding to unrealized gains, notional gains, or asset revaluation.
Sub-Section (4) prescribes that the amounts such as all usual working expenses; directors’ compensation; any bonus or commission paid; any tax designated by the Central Government as a tax on excess or abnormal profits; any other tax; interests on mortgages, loans, unsecured loans, and advances; expenses on repairs; outgoings; depreciation; excess expenditure; compensation or damages paid in case of legal liability; insurance; and bad debts must not be included in the computation described above:
Finally, Sub-Section (5) prescribes that the amounts such as income-tax and super-tax payable by the company under the Income-tax Act; any compensation, damages or payments made voluntarily; loss of a capital nature; any change in carrying amount of an asset or of a liability recognised in equity reserves shall not be deducted while computation of the net profits.
Effect of the 2017 Amendment
The Ministry of Corporate Affairs introduced the Companies (Amendment) Act, 2017 on 3rd January, 2018. The main objective behind this amendment act was to simplify the compliance process and do away with unnecessary procedures, to ensure lesser regulatory interference and promote greater self-regulation, to bring clarity to the provisions of the act. to encourage startups, and to strengthen the corporate governance standard.
This 2017 Amendment, in pursuance of these objectives, removed the stringent restrictions on managerial compensation that were established under the provisions of Section 197 and Schedule V. This step was taken as a result of the recommendations made by the Company Law Committee, 2016 (the “CLC 2016”) and the Standing Committee on Finance. The obligation to obtain the permission of the Central Government for the payment of compensation above the permissible levels was eliminated by the 2017 Amendment.
Now, after the amendment has been effected, a corporation may pay remuneration that is greater than the permitted criteria with the consent of the shareholders by presenting a special resolution. Accordingly, the 2017 Amendment has essentially abolished the severe control on managerial compensation that had been placed upon Indian companies for the past 61 years. The government’s objective of making India an appealing environment to do business and making it easier by eliminating superfluous restrictions is highlighted by this significant adjustment in manager compensation.
Fading relevance of Section 198
There had been several instances where a company would inflate its profits and therefore, Section 198 was incorporated in order to prevent the companies from doing so by requiring them to pay managerial compensation entirely from their actual operational earnings. After the 2017 amendment came along, there was a removal of the stringent controls that had been placed on managerial compensation since 1956, as they were no longer required. The major contention against the provision under Section 198 is that it is completely out of date and incompatible with Indian Accounting Standards (AS). The provisions on which Section 198 is based, i.e., Sections 349 and 350 of the 1956 Act, were passed into law in a period where the socioeconomic environment of the country was entirely different. The needs and circumstances of the present do not align with the provision, and therefore, it is no longer required.
The Indian Accounting Standards (AS), which is considered to be the Indian counterpart of the International Financial Reporting Standards (IFRS) has thoroughly covered all aspects of “net profits” accounting. The Ministry of Corporate Affairs has notified 39 Indian AS Accounting Standards in compliance with Section 133 of the 2013 Act. Therefore, even in the absence of Section 198 of the 2013 Act, the Accounting Standards have provided sufficient safeguards which guarantee that profits made by companies are not exaggerated or reported incorrectly. Since the Ind AS properly covers every area of net profit accounting, Section 198 does not need to be used to prescribe a different approach.
Conclusion
The provision under Section 198 of the Companies Act, 2013 Act has lost its relevance. The major reasons behind this are the withdrawal of severe controls over managerial compensation and the notification of Indian AS Accounting Standards under Section 133 of the Act. Furthermore, the provisions under Sections 349 and 350 of the 1956 Act have also been struck as irrelevant by the Irani Committee’s assessment, because sufficient safeguards are in place to guarantee an accurate depiction of the company’s revenue in the financial statements.
This makes up for an interesting argument in favour of omitting the provision under Section 198 of the Act entirely. The omission would spare Indian businesses from having to do separate individual calculations in order to calculate their net profits separately for managerial compensation and CSR. The elimination of Section 198 will result in the removal from the Act of an antiquated provision that is no longer necessary. It would increase consistency in calculating net profits and make doing business in India easier.
Frequently Asked Questions (FAQs)
What is the maximum limit of managerial remuneration according to Section 198 of the Companies Act?
The remuneration is computed as per Section 198 and the maximum limit for managerial remuneration exceeds 11% of the net profits for the financial year.
References
- https://ibclaw.in/Section-198-of-the-companies-act-2013-calculation-of-profits/.
- https://www.lexology.com/library/detail.aspx?g=82196215-35be-4def-8246-372b184234bc.
- https://www.mca.gov.in/Ministry/circulars/cir2001/cir_27122001.html.
- https://taxguru.in/company-law/computation-net-profit-csr-contribution-Section-198.html.
- https://www.icsi.edu/media/webmodules/JULYCOMPANY_LAW_CORNER.pdf
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