Interpreting the Restriction on Layering of Subsidiaries

[Mayank Labh is a 4th year student at NALSAR University of Law]

The Ministry of Corporate Affairs recently notified the Companies (Restriction on Number of Layers) Rules, 2017 (the “Rules”) on 20 September 2017. Much has been debated (here, here and here) on how the Rules affect genuine business structuring of companies and the unnecessary burden and costs it imposes on companies. In this post, I seek to add further to the existing discourse by elaborating on the issues related to the manner in which the Rules are to be interpreted and its effect on the structuring of companies.

Rule 2(1) of the Rules states that no company, with few exceptions, can have more than two layers of subsidiaries. First of all, to clear any doubts, it is pertinent to note that the Rule applies only to vertical subsidiaries and not horizontal subsidiaries. To elaborate, what the Rule restricts is not the number of subsidiaries of a holding company itself, but the number of layers of subsidiaries (i.e. subsidiary of a subsidiary and so on) a holding company can have.

It is also important to clarify that the Rules apply to a company that has been incorporated under the Companies Act, 2013 (the “2013 Act”) or under any previous company law. There is an element of misconception that the Rules also apply to a “body-corporate”, which includes a company incorporated outside India. It is pertinent to discuss the applicability of the Rules to bodies corporate, for it will help determine how beneficial it would be to have an overseas holding company in the structuring of companies. 

Now, the above misconception arises because one of the explanations to section 2(87) of 2013 Act states that a company includes a body corporate. However, it is important to understand that such an explanatory meaning of a “company” under the explanation applies only in relation to “subsidiary company” and not the “holding company” since section 2(87) of the 2013 Act deals only with the definition of “subsidiary company”. The usage of the term holding company in section 2(87) of 2013 Act is only for the purpose of determining the circumstances under which a company becomes its subsidiary. 

To better appreciate this point, it is pertinent to refer to section 4 of the Companies Act, 1956, which provides the definition of both a holding company and a subsidiary company. There, the explanation to a company meaning body corporate applies equally for a holding company as well as a subsidiary company.[1] However, under the 2013 Act, separate definitions have been provided for holding company and subsidiary company and the clause defining holding company refers only to a “company” and not a “body corporate”.[2] Therefore, since section 2(87) of the 2013 Act is meant for a “subsidiary company” and not “holding company”, the term body corporate would apply only to a subsidiary company and not to a holding company, notwithstanding the fact that the said clause mentions “holding company”.

Speaking of body-corporate, it brings me to the next point of consideration. One of the provisos to the Rules states that the Rules shall not affect a company from acquiring a company incorporated outside India with subsidiaries beyond two layers, as long as it complies with the laws of such country in which the company incorporated outside India is situated.[3]

It is clear that an Indian company can acquire overseas companies which already have more than two layers of subsidiaries. But what about a situation wherein an Indian company acquires an overseas company with no subsidiaries, but which wants to further acquire layers of subsidiaries outside India at a later stage?  If we strictly go by the literal interpretation then it seems that such overseas subsidiary of an Indian company cannot acquire further layers of subsidiaries at a later stage which seems to be an unnecessary restriction. It is particularly so when the local laws allow overseas subsidiary of an Indian company to acquire as many layers of subsidiaries as it can.

However, one of the justifications for such a literal interpretation could be that the intention behind such proviso is to not let the Rules affect cross-border merger activity of an Indian holding company, given that an Indian company cannot control how many subsidiaries its foreign counterparts might have. However, once an Indian company acquires and exercises control over the foreign subsidiary, there does not seem to be any reason why the restriction on the layers of subsidiaries should not apply to such foreign subsidiaries who are under the control of an Indian company. Such restriction does not affect the cross-border merger activities of an Indian company and at the same time it prevents multiple layers of subsidiaries which is the supposed objective of the Rules.

There is scope for considerable debate as to the interpretation of another proviso in the Rules. The relevant proviso states that one layer which consists of one or more wholly owned subsidiaries shall not be counted when computing the number of layers of subsidiaries.[4] There is a view that the literal interpretation of such a rule would be that any layer which consists of one or more wholly owned subsidiaries shall not be counted, which means that one can have as many layers of wholly-owned subsidiaries as possible without falling afoul of the Rules.

Assuming that such a literal interpretation represents the actual legislative intent, arguably it is still not the proper way to interpret the rules in light of the rules of the interpretation. It is pertinent to note the golden rule of the interpretation, which states that a statute has to be given its literal and natural meaning. However, there is an exception to the rule. If the literal meaning defeats the very objective of the law, then one can use appropriate interpretative tools to give effect to the intention of the legislature (for example, the mischief rule). Considering the fact that the objective behind the rule is to prevent the creation of shell companies for diversion of funds or money laundering, such exclusion of any layer consisting of wholly owned subsidiary or subsidiaries might defeat the very  purpose of the creation of Rules.

Furthermore, there is also some ambiguity with regard to whether the proviso excluding wholly-owned subsidiaries shall be extended to section 186(1) of 2013 Act which restricts the layering of subsidiaries for investment companies. It is important to note that Rule 3 of the Rules states that the Rules shall not be in derogation of the proviso to section 186(1) of 2013 Act and not section 186(1) of 2013 Act per se. The effect would be that the Rules in their entirety apply equally well to investment company as long as they are not in derogation of proviso to section 186(1) of 2013 Act.  In such a situation, the proviso excluding the layer consisting of wholly-owned subsidiaries shall also be applicable to section 186(1) of 2013 Act in as much as such proviso is an integral part of the Rules and is not in derogation of proviso to Section 186(1) of 2013 Act. Therefore, in light of the above discussion, it emerges that there is no need to count the layer consisting of wholly-owned subsidiaries when counting the layers of subsidiaries for investment companies. 

Last but not the least, there are also few doubts with regard to grandfathering clause, which exempts the existing companies with more than two layers of subsidiaries from reducing the number of layers of subsidiaries to two. It is not clear what will happen to an agreement to acquire multiple layers of subsidiaries which has been concluded before the date of notification of the Rule.  What about such a situation wherein an agreement to acquire multiple layers of subsidiaries is pending before the regulatory authorities or adjudicatory bodies prior to the publication of the notice?

Such questions assume relevance particularly in light of the rationale behind the grandfathering clause. The underlying idea behind such grandfathering clause traces its roots from the doctrine of legitimate expectation. Under the doctrine of legitimate expectation, the government, inter alia, must not deprive someone of a benefit or advantage which he has in the past been permitted to enjoy and which he can legitimately expect to be permitted to continue to do.[5]  Such a doctrine of legitimate expectation can then equally well apply to the aforementioned situations for such an agreement to acquire multiple layers of subsidiaries, in the legitimate expectation that there would not be any restriction on their layering of subsidiaries. It is not to forget that even an agreement to acquire a subsidiary might entail considerable amount of back-end investment to give effect to the purposes for which the subsidiary has been acquired. It would be curious to see how regulators decide such cases in the face of a rule which says that the exemption is only applicable for existing companies which have more than multiple layers of subsidiaries.

– Mayank Labh

[1] See Section 4(5) of Companies Act, 1956.

[2] See Section 2(46) of Companies Act, 2013.

[3] See the First proviso to Rule 2(1) of Companies (Restriction on Number of Layers) Rules, 2017.

[4] See the First proviso to Rule 2(1) of Companies (Restriction on Number of Layers) Rules, 2017.

[5] Sethi Auto Service Station vs Delhi Development Authority & Ors, AIR 2009 SC 904.

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