Introduction
Within a structure with a parent and subsidiary companies this is often within the form of investment being given by the members of the parent company to its subsidiaries. Such loans are meant to cover working capital needs, investments or expansion plans. The question which frequently comes up is whether such loans can be granted interest-free and if so, under which basis would it be legal. Borrowing and investing by companies in India are regulated by the Companies Act, 2013 (“CA 2013”). This research note analyses the permissible liquidity provided by parent to WOS under CA 2013 in the form of interest-free loans and the conditions and approvals required in this regard and the exceptions warranting such security. The article also discusses other regulatory and tax factors that play a role in these transactions.
Section 186 of Companies Act, 2013: An introduction & Provisions Applicability Section 186 of the Companies Act, 2013 – Overview, Rules & Procedure with PPT.
The key section that deals with inter- corporate loans and investments is section 186 of CA 2013. It limits the quantity that a company may lend to other companies or body corporates. In particular, comporting with the latter, Section 186(2) provides for a prohibition against a company directly or indirectly making (i.e., both giving and taking) loans, or providing guarantees or security in excess of 60% of its paid-up share capital, free reserves and its securities premium account or 100% of its free reserves and securities premium account—whichever is greater. Should this limit be exceeded, shareholder consent by way of a special resolution is necessary.
Although this section is of general application, some exceptions for subsidiaries and joint ventures are included. Where the loan/guarantee/investment is to a WOS or a joint venture and is being utilised in normal courses of its business, there is no need to pass SR under Section 186(3). Board approval, however is still required.
Interest Rate Restrictions and Exemptions
However, one major condition under Section 186(7) is that the interest rate on such a loan given by a Company shall not be less than the prevailing yield (which must be re-discount rate published by the Reserve Bank of India) on one year, three years, five years or ten years Government securities closest to the tenor of the loan. This phrase in fact, making interest free loans in most cases, prohibited. But certain waiver has been given for WOS companies to provide interest free loans also.
Accordingly, loans for WOS would not be strictly subject to the interest tests, even though as a general rule, loans should be interest-bearing at market rates, they just simply would be exempt. The exception is based on general principle, that WOS form part of the core business of a parent company and may need financial assistance particularly in its initial phase of operation. It enables groups to fund subsidiaries without the artificial requirement of interest, which will particularly squeeze a new subsidiary financially.
Board and Shareholder Approvals
A loan to a subsidiary (whether interest free or not) requires unanimous resolution of the board of directors (at a properly convened meeting) to authorise. This may not be done by circulation or by a committee of the board. And so, the steps are put in place to assure that all directors are fully informed about, and consent to, such financial risk.
Loans which fall outside the financial limits in Section 186(2) and which do not fall within the fold of the exemption (i.e., if it is given to a non- WOS) require majority approval of the shareholders by way of a special resolution. In case the lending company is an existing borrower of term loans from any public financial institution, and the total of all such loans, term loan and obligations exceed the limit, then prior consent of such institution is necessary unless the company has not defaulted on repayments.
Disclosure, Documentation, and Compliance Requirements
All corporate bodies which, in pursuance of section 186 makes loans, gives guarantees or, provides security or, makes an investment must give full particulars of the loans, guarantees, security and investments given or made in their accounts. The disclosure shall contain a description of the extent and character, amount and purpose of the transaction, and the terms thereof. This promotes transparency and allows the investors to gauge the risk exposure and corporate governance practices of the company.
Also, company has been mandated to keep a register in Form MBP-2 of all such loans, guarantees, securities and investments. The entire register must be kept at the registered office of the Company, be kept permanently and be made available for inspection by members during normal business hours.
Proper documentation is also critical. The conditions, repayment schedule, collateral (if any) and object of loan shall be well defined in the loan agreement. Even if WOS is permitted to receive interest free loans or quasi-equity investments, a formal loan agreement and board resolution should exist in order to give the transaction substance and shield the company from subsequent regulator challenges.
Special Rule for 100-Percent Owned Subsidiaries
The relief for interest-free loans to WOS can be traced to both Section 185 and 186 of the Act. Section 185 is generally not to advance loans to directors and related concerns. But it does have a carve-out for WOS. According to the revised Section 185(1), loans, guarantees and securities can be provided to a WOS provided the financial assistance is utilised for the principal business of the subsidiary.
It is worth pausing here because the statute does not define “principal business activities” and it is unclear, then, to what it refers. In practice, however, this has been taken to refer to activities which would be disclosed as being the subsidiary’s core or primary activities in the subsidiary’s memorandum of association, or for which the subsidiary derives most of its income.
This exception recognizes the pragmatic reality that holding companies must, at least initially or during capital-intensive periods of business development, support their subsidiaries by providing money. It also makes intra corporate funding between group companies easier, subject to such support being for genuine business requirements and not a subterfuge to circumvent regulatory norms.
Limitations for Non-WOS and Associates
The law is different when the receiver is not a full subsidiary. Interest-free loans: agency-branch; Elimination From consideration offer the facility to deduct interest in the income statement on participating interests and on associate companies where the holding company’s interest in the subsidiary is less than 100%, but control authority is still retained. In those cases, the company will be bound by the interest-rate stipulations prescribed in s 186(7) and will not be able to grant interest-free loans. Also, if the amount of loan exceeds the threshold for advance, the company has to pass a special resolution along with seeking specific disclosures and approvals.
As such, companies must take care in determining if the recipient is a WOS. Even a single outside shareholder can disqualify a subsidiary from it, and the interest-free feature of the loan will result the loan as not meeting the ACT.
Interaction with Tax Laws and Transfer Price
BESIDES CA 2013, THE COS ALSO NEED TO REFER THE INCOME TAX ACT, 1961. A main concern lies in applicability Section 2(22)(e), which deems dividends in respect of loans provided by a company to its shareholders or concerns where in the shareholders have a substantial interest and are taxed in the hands of the recipient. This is true in most cases in respect of individual shareholders; however, group companies need to be vigilant if there is cross or common shareholding between group companies.
In case of cross-border loans between associated enterprises, the transfer pricing provisions contained in Sections 92 to 92F of the Income Tax Act (Act) stage their entry. In these circumstances, although Indian company law may allow an interest free loan to the foreign subsidiary, the Indian tax officer may nonetheless impute notional interest income by reference to the arm’s length standard. This can lead to tax offsets and fines.
As such, even where under the Companies Act a WOS can be lent money at nil interest rate, the tax implications should be analysed and if charging nominal interest can eliminate risk of transfer pricing then it should be charged.
Amendments Impacting Related Party Lending
Lending under Sections 185 and 186 got a substantial flip with the Companies (Amendment) Act, 2015 along with other amendments. Section 185(1) was amended in 2015 to create an exception for loans granted to WOS on condition that such loans were utilized for their principal business activities. It also rationalised authorization systems on related party transactions and harmonised them with international best practices.
The 2017 amendment reiterated the definitions of related party, control and subsidiary and also consolidated the penalties falling under CA 2013. These changes bring much-needed clarification and flexibility for intra-group dealings, such as loans. But the general rule is that any loan must be in the company’s best interest and not otherwise unlawful.
Conclusion
Indian Companies Act 2013 allows Indian companies to provide interest-free loans to their 100% owned subsidiaries under certain constraints. Most importantly, however, the subsidiary is required to use the loan for its primary business operations. No interest at the government securities rate is required on such loans, and they are less complicated to effect because of the shareholder-approval thresholds that do not apply.
This exemption does not apply for non-wholly owned subsidiaries or associate companies, and interest must be payable and necessary clearances secured. Monetising may also pose challenges from a tax perspective, including in the areas of deemed dividend exposure and transfer pricing.
Though there is some leeway in the legislation, rigorous documentation, approval process, and full transparency are necessary for companies to be compliant. Under the changing regulations, it is now imperative to view inter-corporate lending not just as a business necessity but as a transaction to be managed with strategic legal and financial prudence.