Utilisation of Accumulated Surplus by Section 8 Companies

[Pammy Jaiswal is a Partner and Shraddha Shivani an Executive at Vinod Kothari and Company]

Section 8 of the Companies Act, 2013 provides for the formation of companies with specific objects. The profits earned by such companies necessarily get redeployed to pursue the very same objects for which the company is formed and cannot be distributed to the shareholders. There are several restraints to ensure that special status granted by the law to such companies is not misused for any personal gain or that of its promoters, shareholders or management of the company. 

Rule 22(4) of the Companies (Incorporation) Rules, 2014 (the “Incorporation Rules”) requires a declaration from the board of directors that “no portion of the income or property of the company has been or shall be paid or transferred directly or indirectly by way of dividend or bonus or otherwise to persons who are or have been members of the company or to any one or more of them or to any person claiming through any one or more of them”. [emphasis supplied]

In this post, we discuss some of the potential modes of utilising the income (including accumulated profits) earned by a section 8 company and the consequences of violating the conditions laid under the Companies Act.

Issue of Redeemable Preference Shares

Preference shares have preference over equity shares with regards to payment of dividends, and return of surplus in the event of winding up. As discussed above, section 8 of the Companies Act prohibits such a company from paying dividend to its members. Moreover, it also prohibits returning the surplus assets of such a company to its members in the event of winding up. Therefore, the entire reasoning behind issue of redeemable preference shares becomes futile and therefore, section 8 companies cannot issue such securities.

Issue of Bonus Shares

As we discussed earlier, any profit or gain earned by a section 8 company needs to be used for and in furtherance of its objects. Accordingly, it becomes clear that the issuance of bonus shares to the members of a section 8 company has been prohibited by law.

Buy-back of Shares

Buy-back of shares by a section 8 company has not been expressly prohibited under the Companies Act. However, there is abundant clarity on the fact that repayment of capital or its worth to the shareholders of a section 8 company can never be expected. Where payment of any dividend or bonus itself has been strictly prohibited under the Companies Act, buying back its shares by paying fair consideration out of the specified sources cannot be considered at all.

It is also important to note that section 115QA of Income Tax Act treats the consideration amount paid for repurchase of shares as reduced by the consideration received for allotment of such shares as distributed income of the company. Therefore, in our view, it is very clear that the buying back of shares by a section 8 company will violate the terms on which it was capable of being incorporated under the Companies Act.

Global Scenario

United Kingdom (UK)

The Office of the Regulator of Community Interest Companies in the UK has clarified that repurchase of shares is in effect a distribution of assets to members, particularly where the member receives a premium over the paid up value of the shares. Further regulation 24 of the Community Interest Company Regulations 2005 (“CIC Regulations”) provides that community interest companies (“CICs”) may not distribute assets to its members by way of the redemption or purchase of the company’s own shares, unless the amount to be paid by the company in respect of any such share does not exceed the paid up value of the share.

Japan

Japanese law has similar provisions to that of their Indian counterpart on the regulation of charitable companies. Article 32 of the Japanese Law to Promote Specified Non-profit Activities provides that the remaining assets of a dissolved specified non-profit corporation shall, except in the cases of merger and bankruptcy, be assigned to the entity stipulated by the articles of incorporation at the time of notifying the government agency with jurisdiction of the completion of liquidation. Further, if there is no provision in the articles regarding assignment of remaining assets, the liquidator may, upon receipt of approval by the government agency with jurisdiction, transfer them to the national government or a local public organization. Any assets that are not so disposed of shall be assigned to the national treasury.

Entering into Related Party Transactions (RPTs)

Just like any other company, a section 8 company also earns profits and, moreover, the same is necessary for meeting its objectives. Similarly, such companies may also enter into transactions with their related parties, provided they adhere to the standards laid down to regulate such transactions and the same is in the ordinary course of business and on an arm’s length basis.

Having said that, simply stating that an RPT is satisfying both the conditions as aforesaid will fall short of justifying the same. Obtaining external valuations or expert opinion, wherever needed, is always suggested to support or substantiate the stand of the company for entering into RPTs. 

Global Scenario

Interestingly, this fact of growing concerns over self-dealing and passing on benefits privately in not-for profit organisations has been discussed in details around the globe.

Australia and the UK

A review by the Australian Charities and Not-for-Profits Commission has been accepted by the Australian government which provides for disclosure of RPTs and abstention by related parties for voting on RPTs. Similarly, the UK has a specified guidance on managing conflict of interest. Further, as stated by the UK charities regulators, a decision by a charity to enter into any transaction must be made in the charity’s own interests and for the benefit of its beneficiaries. The disclosure of RPTs is an important element of transparency in financial reporting because:

  • related parties may enter into transactions that unrelated parties would not;
  • transactions between related parties may not be made at the same amounts or on the same terms as those between unrelated parties; and
  • the existence of the relationship may be sufficient to affect the transactions of the charity with other parties.

Loans from Members and Issue of Debentures

There is no restriction on a section 8 company from borrowing funds for its business. However, due to their restrictive nature with regards to application of income, such companies are often kept out of the lending portfolios of commercial financial institutions. As a result, these companies look for other methods of raising funds.

As a result, section 8 companies may look upon their members for the purpose of borrowing funds and pay interest thereupon. Such companies may even issue debentures to the public, including their own members. However, any interest or redemption of such debentures must be purely compensatory in nature and done on an arm’s length basis. Redemption of debentures on a premium to its members might be seen as being in contravention of rule 22(4) of the Incorporation Rules.

Sale of Property

A section 8 company, being a separate legal entity, can acquire, own, and dispose of its property in its own name in the ordinary course of its business (where the sale of property becomes the only option available or the disposal is the only way to drive value out of such assets). A  question then arises: can the sale of its property below fair market value be used as a loophole to distribute its accumulated wealth hidden in the intrinsic value of the property to its shareholders?

Holding of any asset or property of the company may sometimes no longer be feasible and it may have to sell off its property below the fair market value. While we agree that a company should not be penalized for what every business experiences during its lifetime, but since a section 8 company often acquires its property at a subsidized value, it may either be required to pay back the amount of subsidy it received on such acquisition or to sell such property only to another section 8 company having similar objectives. 

Entering into a Scheme of Arrangement

The licence issued to a Section 8 company, according to the provisions of rule 20 of the Incorporation Rules, allows amalgamation with another section 8 company having similar objects. There is no restriction on the demerger of a section 8 company; however, keeping in mind the prohibition regarding amalgamation, it can be inferred that the resulting entity out of the demerger or an existing resulting company must also be an entity registered under section 8 of the Companies Act.

Global Scenario

Japan

Article 33 of the Japanese Law to Promote Specified Non-profit Activities provides that a specified non-profit corporation may only merge with another specified non-profit corporation.

UK

According to the FAQs issued by the Office of the Regulator of the CIC, such companies may only sell their assets subject to the specified conditions, which include transferring the assets at full value only, i.e. the market value; transfer to an asset locked body specified in the CIC’s articles of association; transfer to any other asset locked body with the consent of the regulator; or transfer for the benefit of the community.

Conversion into a Non-section 8 Company

A section 8 company desirous of converting itself into a company of any other form must not only obtain no-objection certificate from every regulatory authority from which it had obtained any benefit owing to its special status, but in terms of rule 22(4) of the Incorporation Rules it must also be able to prove that it has not transferred any part of its income or property to its members.

Where any asset or property was acquired free of cost or at a concessional rate by the company, it may be required to pay the difference between the cost at which it acquired such property and the market price of such property at the time of conversion. Any profit or income left over with the company after repayment of all dues are to be transferred to the Investor Education and Protection Fund within 30 days of approval of the date of conversion. 

Winding up of the Company

Any asset that remains after the satisfaction of its debts and liabilities should be transferred to another similar company, subject to such conditions as the National Company Law Tribunal may impose, or may be sold and proceeds thereof credited to Insolvency and Bankruptcy Fund formed under section 224 of the Insolvency and Bankruptcy Code, 2016.

Conclusion

The points as discussed above seek to demonstrate how the utilization of the income of a section 8 company is comprehensively governed by the provisions of law, since its inception and as a going-concern entity and until the dissolution of the company. At any point of time the profits or any other income of a section 8 company cannot flow back to the members of the company in any form or manner. In the event such a company tries to transfer its profits, several provisions under the Income Tax Act also come into picture (sections 13, 115TD, etc) which either take away the exemption or impose tax on accredited income.

– Pammy Jaiswal & Shraddha Shivani

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