Layering of Subsidiaries: The Phoenix Rises Again?

[The following guest post is contributed by Siddharth Raja, Senior Partner & National Executive Director, Argus Partners, Solicitors & Advocates.  Monica Umesh and Divya Mirlay, Associates of the Firm, assisted in the preparation of the “Note on Objections” referred to below.  Views are personal and do not reflect or incorporate the views or positions of the Firm. Comments are welcome.]

On 28 June 2017, the Ministry of Corporate Affairs (“MCA”) issued Public Notice No. 3/3/2017-CL-I, containing a draft notification proposing amendments – chiefly, the insertion of Rule 5 (the “Proposed Amendments”) – to the Companies (Specification of Definitions Details) Rules, 2014 (the “Rules”). 

The Proposed Amendments restrict the prescribed class or classes of holding companies from having subsidiaries beyond two layers.  In other words, as the Public Notice states, “[b]ased on suggestions received, the [MCA] is considering commencing” the proviso to Section 2(87) of the Companies Act, 2013 (the “Companies Act”).  The Public Notice, which also contains a background or explanatory note, invites suggestions and comments on the Proposed Amendments from stakeholders. 

The authors of this post have prepared and submitted to the MCA a detailed note of their objections to the Proposed Amendments.  This post is a summary of their “Note on Objections”.  The issue of the layering of subsidiaries had first caught critical attention at the time such a restriction was first suggested in the Companies Bill, 2011 (here).

The thrust of the objections to the Proposed Amendments in their entirety is a principled one. In other words, the proposed amendments ought not to be implemented in full as, at the very threshold, we believe they are destructive of the ability of companies to structure their affairs entirely from a commercial perspective, while still maintaining their compliance with anti-abuse, prevention of the siphoning-off of funds or money laundering objectives or other legal provisions.  We believe that the Proposed Amendments are neither salutary nor necessary to achieve the MCA’s principal objective stated in paragraph 4 of the “Background / Explanatory Note” accompanying the Public Notice: namely, the creation of shell companies for the diversion of funds or money laundering.

In 2005, the J Irani Committee Report on a proposed new companies’ legislation for India strongly opposed the move to have any restrictions on the number of subsidiaries that a holding company may have.  This opposition was principally founded on two threads of analysis: firstly, as the Irani Committee Report itself very succinctly states, in paragraph 8.1 of its Report (emphasis added): 

The Companies Act should not pre-empt the decision as to what structure is appropriate for controlling businesses.  Such prescriptions will make the environment rigid and put Indian companies at a disadvantage vis-a-vis their competitors internationally. Such restrictions would also not facilitate sound corporate planning, formation of joint ventures, international operations or restructuring of companies.”

Secondly, while recognising the need to control the misuse of funds through multiple layers of subsidiaries, the Irani Committee had also opined in paragraph 8.3 of its report that “the phenomenon of siphoning off funds may not be caused solely on account of holding-subsidiary structure” and went on to observe (emphasis added): 

“[I]solated instances of misuse of the holding-subsidiary structure should not result in doing away with this very important business model [namely, the holding-subsidiary structure] for investment and corporate planning.  Instead of prohibiting formation of subsidiaries, there should be adequate disclosure obligations as to utilisation of the funds raised or loans and advances given by the coming to other entities.  Strict disclosure and compliance norms in respect of holding and subsidiary company structures should be provided for.

Indeed, the Companies Act has proper and strict disclosure requirements as suggested in the Irani Committee Report, including the mandatory consolidation of financial statements.  All such existing provisions address the concerns (principally, the diversion of funds) attendant to the purported lack of transparency in the holding-subsidiary structure.  Directed by the need for financial transparency and to root out misuse, the Companies Act has stringent requirements with respect to disclosures and related party transactions to snuff out any such potential abuse.

Even assuming, for a moment, that the situation of the Indian economy in general, and the corporate world in India in particular, is vastly different from what existed when the Irani Committee submitted its report, despite the passage of time and drastic changes in circumstances, two subsequent learned and distinguished official committees of experts have underscored and endorsed (or, in any event, not entirely gone against) the views and approaches of the Irani Committee on this issue of the layering of subsidiaries under a holding company structure.

The Companies Law Committee Report of February 2016 (the “CLC Report”) that formed the basis of the Companies Amendment Bill, 2016, presently pending before Parliament, was especially clear in reiterating the objection to having any stipulation as to such layers; so much so, that the Companies Amendment Bill, 2016 based on the CLC Report, expressly and specifically suggests the removal of the proviso to Section 2(87) of the Companies Act.  Paragraph 1.24 of the CLC Report states as follows (emphasis added):

The Committee noted that this provision [Section 186(1)] was included to address practices of creating subsidiaries aimed at making it difficult to trace the source of funds and their ultimate use, and reduce the usage of multiple layers of structuring for siphoning off of funds and that the same was incorporated in the [Companies Act] in the wake of various scams in the country……..The Committee, therefore, felt that while the proviso to Section 2(87) has not yet been notified, it was likely to have a substantial bearing on the functioning, structuring and the ability of companies to raise funds when so notified and hence recommended that the proviso be omitted.

On merits, Section 186(1) of the Companies Act already effectively restricts the layering of subsidiaries, in particular investment companies, so as to prevent the siphoning-off of funds through such multiple layers – thereby making it clear that the introduction of genuine, operational subsidiaries, which are not principally mere investment vehicles, is a permitted exercise of corporate investment structuring between holding companies and as many layers of operating subsidiary companies as may be commercially justified.  That latter structuring is, on a reading of the scheme of the Companies Act, entirely legal and ought not to be subject to the unnecessary restrictions currently proposed. 

It is, therefore, clear that the CLC Report was mindful of the issue of abuse and siphoning-off of funds, but agreed with the Irani Committee so strongly that they recommended the very omission of the enabling power to make rules in that behalf contained in Section 2(87) proviso.  

In these circumstances, we argue that while the Companies Amendment Bill, 2016 which contains the suggested omission of the proviso to Section 2(87) is pending in Parliament, this attempt to enforce such proviso by these Proposed Amendments to the Rules, would be tantamount to flying in the face of legislative wisdom, should the omission of the proviso be passed by Parliament.   The Companies Amendment Bill, 2016, however, appears to be floundering in Parliament and may well have been put into cold storage, as a result of a change in the MCA’s mind, as the current proposal seems to suggest.  At the very least it appears that the MCA is less than enthusiastic in moving ahead with that amendment bill in its current form.

That said, the Companies Amendment Bill 2016 would need to change if this proposal from the MCA comes through and it insists on it. Otherwise, any “commencement” of the said proviso in the interregnum (such as currently proposed) may lead to the anomalous position that some companies would have been impacted by the proscription on having more than the permitted layers of subsidiaries, while those who acted in a situation without, or in the absence, of such a proscription would not be under any such disadvantage. It would potentially lead to a situation where two equal and similarly situated holding companies would be placed under dissimilar legal requirements leading to the infringement of the equality of treatment among them.  Any such position, apart from being potentially legally untenable, would also be patently disingenuous and disadvantageous to some companies merely because they had acted at a time when the rules may have proscribed such layering of subsidiaries.

Even assuming that the Companies Amendment Bill, 2016 is amended in Parliament to omit the deletion of the proviso to Section 2(87), the very making of the Proposed Amendments, would run contrary to learned and well-held opinion that such a restriction is not warranted in law as well as in genuine, legally compliant commercial practice, given business realities. 

Even the Parliamentary Standing Committee Report on the Companies Bill, 2011 (that eventually became the Companies Act) reveals that while stakeholders (primarily, the MCA) had represented the need for a restriction on layering of subsidiaries on the basis of prevention of abuse, other stakeholders had emphasised that imposing such restrictions could be construed as restrictive of the conduct of business, a point elegantly stated by the Irani Committee, as noted above.  The Parliamentary Standing Committee’s proposal to introduce a register of beneficial owners of a company to address the need to know the ultimate beneficial owners in complex corporate structures is all the more reason that all such considered opinions from the various committees recommend not having such layering restrictions in place.

The Proposed Amendments are both untenable as well as improperly timed. Improperly timed because assuming there is a felt need for such layering restrictions to be in place, the proper approach would have been first to seek the continuing retention of the proviso to Section 2(87)).  The stand of the MCA appears untenable because to seek the introduction of these Proposed Amendments to the Rules not only goes against the grain of the various committees that have examined this matter threadbare, it also exposes companies to the very real possibility of prejudice if the layering restrictions were subsequently to be entirely done away with by Parliament.  It is however clear that the MCA’s approach seems to be in line with the apparent push from the Government to crack down on shell companies; it remains to be seen whether the MCA’s view will prevail and the Companies Amendment Bill, 2016 changed to accommodate the MCA’s and, indeed, the Government of India’s perceived perspective on this matter.

While the objective of preventing abuse and siphoning-off continues to be capable of being achieved through other provisions that have more than ample strength and teeth in law and in practice, the other very real and stated objective of Government to promote Indian industry, including the “Make In India” programme, ought not to suffer by such unnecessary and unwarranted restrictions, which in our view, fetters Indian companies to their detriment and that of the Indian economy, including as regards overseas entities who may not be subject to any such restrictive layering stipulations.  That last aspect is a moot and important issue, requiring further analysis: would any such restriction on the layering of subsidiaries apply to overseas holding companies on a proper interpretation of the (existing and proposed) definitions of “holding company” and “subsidiary”?  This interpretational aspect is made all the more nuanced because the Companies Amendment Bill, 2016 proposes to clarify that for the purposes of the definition of “holding company” the expression company includes anybody corporate.

– Siddharth Raja (assisted by Monica Umesh and Divya Mirlay)

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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