While the crackdown is a major step in combating tax evasion and improving transparency, it might also impact the flexibility and genuine corporate structures created to achieve legitimate objectives, says Suresh Surana.
The ministry of corporate affairs in September took stricter measures against more than 100,000 shell companies and their directors.
On September 5 banks were issued instructions by the department of financial services to ensure that all the directors (ex) or their authorised signatories are restricted from operating the bank accounts of such companies and that they cannot siphon off money from these accounts.
There is also concerted action by the MCA and the Central Board of Direct Taxes to unearth unreported income or use of such companies during demonetisation for depositing demonetised currency.
Some of these companies might have been used for the above purposes.
However, in a vast majority of cases, there are companies that have not been carrying on business for the past few years and have merely not complied with the company law filing requirements such as annual return or their financial statements are also covered.
It would be appropriate for the MCA to permit such companies to avail the option of being struck off or a fast-track exit with a limited time window of three months.
This would avert unwarranted hardships in genuine cases of only procedural lapse.
With a view to check misuse of multiple layers of subsidiaries, the MCA on September 20 notified the proviso to Section 2(87) of the Companies Act, 2013, and the Companies (Restriction on number of layers) Rules, 2017 (Layering Rules).
It restricts all the operating and investment companies, other than those belonging to the exempted class, from having more than two layers of subsidiaries.
The purpose of the notification seems to be to improve transparency regarding financial transactions and real ownership.
Layers of subsidiary would have the same meaning as specified in Clause (d) to explanation of Section 2(87)(d) of the Companies Act.
One holding-subsidiary relation shall constitute as one layer.
A company holding more than one parallel subsidiary company shall be considered as one layer.
The rule only restricts “vertical” expansion. There is no restriction on “horizontal” expansion of a group.
Hence, a company can still hold any number of horizontal subsidiaries as well as horizontal step-down subsidiaries.
Some companies have been exempted from this rule, viz a banking company; a systemically important non-banking financial company (NBFC) registered with the Reserve Bank of India; an insurance company; and a government company.
Rule vis-à-vis Section 186(1)
Section 186(1) of the Companies Act already had the provision that a holding company cannot invest through more than two layers of investment subsidiaries.
However, companies could still make more than two layers of investment through non-investment subsidiaries (that is, operating subsidiaries).
The rule plugs the gap by restricting the creation of non-investment subsidiaries, too, which suggests that this amendment is more restrictive in nature then Section 186(1).
The rule specifically states that it will not derogate proviso to Section 186(1). Proviso to Section 186(1) contains exceptions where 186(1) shall not apply.
Hence this rule shall also not apply to such exceptions mentioned in the proviso.
One of the exceptions is a subsidiary company having any investment subsidiaries to meet the requirements of any law or regulation.
Hence, a company may hold more than two layers of investment subsidiaries, if required, by any other law.
Prospective in nature
The notification will be applicable prospectively, to save the companies from hardships of disinvestment.
Hence, existing holding companies having more than two layers of subsidiaries before the commencement of these rules need not reduce their layers of subsidiaries.
However, they cannot add any additional layer of subsidiary henceforth.
They need to file a return to the registrar furnishing details of the layers of subsidiaries in Form CRL-1.
If subsequently, such companies do reduce their layers, they cannot have more than two layers of subsidiaries.
The notification overlooks the business exigencies that may warrant a multi-layered corporate structure.
This could be due to several reasons:
- Need for intermediate holding companies for different business segments to facilitate business segment-wise consolidation, funding, ownership and borrowings
- A different ownership structure at each layer
- Ring-fencing business carried on by one entity with other entities due to guarantees, high risk projects etc.
It is due to these reasons that in most countries, there is no restriction on the number of layers and, in fact, several multinational corporations have multi-layered and complex structures to meet their business needs.
This restriction needs to exempt genuine corporate structures as long as the financial statements of the entities involved are consolidated and the names of all the entities constituting part of the group with ownership patters are disclosed.
The Layering Rules and the crackdown on shell companies and their directors are major steps in combating tax evasion and improving transparency.
However, such steps impact the business flexibility and genuine corporate structures created to achieve legitimate business objectives.
Suresh Surana is founder, RSM Astute Consulting Group.