IndiaCorpLaw

A Question of Interpretation in Identifying Significant Beneficial Owners

[Aditi Tomar is a 4th Year B.A.LLB (Hons.) Student at NALSAR University of Law, Hyderabad]

The Ministry of Corporate Affairs notified the Companies (Significant Beneficial Owners) Rules, 2018 (“Rules”) in the official gazette on 14 June 2018. The power to formulate these Rules is derived from section 90 of the Companies Act, 2013 (“Act”). These Rules cast an obligation on both public and private companies to disclose information regarding their significant beneficial owners (“SBO”). However, as the revised form (BEN- 1) in which the disclosure has to be made is yet to be notified, the implementation of these Rules has been suspended until further notification.

Definition of SBO

The definition of SBO under the Rules can be divided into two parts. The first part of rule 2(e) provides for a three-pronged test for identifying SBO, namely: (i) SBO should be an individual or natural person under section 90(1) of the Act, (ii) holding ultimate beneficial interest of 10% or more, and (iii) the name not having been entered in the register of members of the company as holder of such shares. The second part of the rule 2(e) is in the form of an explanation which provides for a method to determine SBO when the registered member is a company, partnership firm or trust.

The explanation prescribes three criteria to identify SBO of the target company, i.e. (i) materiality threshold (10%), (ii) significant influence or (iii) control. However, in absence of any of these criteria, the senior managing official of that company would be identified as its SBO.  Thus, to identify SBO, a company has to look through its structure and identify the ultimate natural person who is fulfilling the materiality threshold or exercising significant influence or control over the target company.

Interpretational issue in calculating materiality threshold

The interpretational issue that arises is how many layers along the corporate structure should one look through to identify the natural person who is a SBO of the target company. According to the explanation to rule 2(e), if the member of the target company is a partnership firm then the 10% has to be calculated as per the profits of the partnership firm (which is an intermediate entity) rather than the ultimate interest in the target company:

Rule 2(e), Explanation (ii) where the member is a partnership firm, the significant beneficial owner is the natural person, who, whether acting alone or together with other natural persons, or through one or more other persons or trusts, holds not less than ten per cent. of capital or has entitlement of not less than ten per cent. of profits of the partnership;

For instance, A Ltd is a target company, whose SBO is to be identified. Y, a partnership firm is a registered member of A Ltd holding 11% of its share capital. Further, D is a partner at Y who is entitled to 11% of the profits of the partnership firm.

A Ltd (target company) ← 11% Y (partnership firm, intermediary entity) ← 11% D (partner, natural person)

In this situation, D will be the SBO of A Ltd because she holds 11% of the profits of the partnership firm (which is above the materiality threshold) even though her ultimate interest in A Ltd, the target company is merely 1.21% (11 % of 11) and that too if computed on a proportionate basis. According to the explanation, in order to identify the natural person who is a SBO, the 10% requirement has to be considered only at the intermediary entity level and there is no need to further look through.

This situation gets more complicated when the registered member of the target company is a company having complex corporate structure. The explanation to rule 2(e) states:

Explanation (i) where the member is a company, the significant beneficial owner is the natural person, who, whether acting alone or together with other natural persons, or through one or more other persons or trusts, holds not less than ten per cent. share capital of the company or who exercises significant influence or control in the company through other means;

On a plain reading of this explanation in light of other explanations, it appears that the phrase “holds not less than ten percent share capital of the company” refers to the intermediary company which is the registered member and not the target company. For instance, X Ltd is a target company of which Y Ltd is a registered member holding 20% of its share capital. Further A is a natural person holding 15% of the share capital of Y Ltd.

X Ltd (target company) ← (20%) Y Ltd ← (15%) A (natural person)

In this situation, if the 10% threshold be applied at the intermediary level, then A will be the SBO of X Ltd as she holds 15% of the share capital of Y Ltd which is an intermediary entity. This is despite the fact that A’s ultimate interest in X Ltd is 3% (15% of 20%), again if computed on a proportionate basis.

However, such an interpretation might defeat the purpose of the Rules which, while defining SBO, state that she is a natural person holding ultimate interest in the company. Thus, if one stops the enquiry at the intermediary level itself, then it will not serve the purpose of identifying only the persons holding ultimate interest or significant interest.

The proposition of identifying the SBO not merely at the intermediary level but at the level of the target company is supported by the SEBI Know Your Client requirements for Foreign Portfolio Investors (FPIs), which also mentions the criteria for identifying beneficial owners. Here, a look through approach is adopted. According to these requirements, the materiality threshold to identify the beneficial owners should be applied first at the level of the foreign portfolio investor and, next, look through basis shall be applied to identify the beneficial owner of the intermediate shareholder. Beneficial owner and the intermediate shareholder with holding equal to and above the materiality threshold in the FPI need to be identified through look through basis. This approach is explained through an example in the aforementioned circular.

Referring back to the above example, by applying the look through approach, A would not be the SBO of X Ltd as she ultimately holds only 3% of the share capital in X Ltd, even though she holds 15 % in the intermediary entity.

Conclusion

A clarification in regards to the applicability of the materiality threshold is needed from the Ministry of Corporate Affairs. In my view, if the threshold is applied merely at the intermediary level and the look through approach is not adopted, then the target company would need to disclose even the interests of the natural persons indirectly holding 3% of the interest in its capital (as discussed in the aforesaid example). Such interpretation would not be in consonance with the idea of disclosure of “significant” beneficial owners and will cast an onerous disclosure requirement on the companies.

Aditi Tomar