INTRODUCTION
An investor with less than a majority of the voting rights may have rights that are sufficient to give it power and the practical ability to direct the relevant activities of the investee unilaterally: typically known as ‘de facto control’. Concluding whether an entity has de facto control over another entity can at times be highly judgemental and challenging. This article considers the requirements of Ind AS 110 Consolidated Financial Statements, analyses them and lucidly summarizes the principles using live examples of de facto control applied by companies.
Extracts of Ind AS 110 Consolidated Financial Statements
B41 An investor with less than a majority of the voting rights has rights that are sufficient to give it power when the investor has the practical ability to direct the relevant activities unilaterally.
B42 When assessing whether an investor’s voting rights are sufficient to give it power, an investor considers all facts and circumstances, including:
(a) the size of the investor’s holding of voting rights relative to the size and dispersion of holdings of the other vote holders, noting that:
(i) the more voting rights an investor holds, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;
(ii) the more voting rights an investor holds relative to other vote holders, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;
(iii) the more parties that would need to act together to outvote the investor, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;
(b) potential voting rights held by the investor, other vote holders or other parties;
(c) rights arising from other contractual arrangements; and
(d) any additional facts and circumstances that indicate the investor has, or does not have, the current ability to direct the relevant activities at the time that decisions need to be made, including voting patterns at previous shareholders’ meetings.
B43 When the direction of relevant activities is determined by majority vote and an investor holds significantly more voting rights than any other vote holder or organised group of vote holders, and the other shareholdings are widely dispersed, it may be clear, after considering the factors listed in paragraph B42 (a)–(c) alone, that the investor has power over the investee.
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Application examples
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Example 4
An
investor acquires 48 per cent of the voting rights of an investee. The
remaining voting rights are held by thousands of shareholders, none
individually holding more than 1 per cent of the voting rights. None of the
shareholders has any arrangements to consult any of the others or make
collective decisions. When assessing the proportion of voting rights to
acquire, on the basis of the relative size of the other shareholdings, the
investor determined that a 48 per cent interest would be sufficient to give
it control. In this case, on the basis of the absolute size of its holding
and the relative size of the other shareholdings, the investor concludes that
it has a sufficiently dominant voting interest to meet the power criterion
without the need to consider any other evidence of power.
Example 5
Investor A holds 40 per cent of the voting rights of an
investee and
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twelve other investors each hold 5 per cent of the
voting rights of the
investee. A shareholder
agreement grants investor A the right to appoint, remove and set the
remuneration of management responsible for directing the relevant activities.
To change the agreement, a two- thirds majority vote of the shareholders is
required. In this case, investor A concludes that the absolute size of the
investor’s holding and the relative size of the other shareholdings alone are
not conclusive in determining whether the investor has rights sufficient to
give it power. However, investor A determines that its contractual right to
appoint, remove and set the remuneration of management is sufficient to
conclude that it has power over the investee. The fact that investor A might not
have exercised this right or the likelihood of investor A exercising its
right to select, appoint or remove management shall not be considered when
assessing whether investor A has power.
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B44 In other situations, it may be clear after considering the factors listed in paragraph B42 (a)–(c) alone that an investor does not have power.
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Application example
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Example 6
Investor A holds 45 per cent
of the voting rights of an investee. Two other investors each hold 26 per
cent of the voting rights of the investee. The remaining voting rights are
held by three other shareholders, each holding 1 per cent. There are no other
arrangements that affect decision-making. In this case, the size of investor
A’s voting interest and its size relative to the other shareholdings are
sufficient to conclude that investor A does not have power. Only two other
investors would need to co-operate to be able to prevent investor A from
directing the relevant activities of the investee.
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B45 However, the factors listed in paragraph B42 (a)–(c) alone may not be conclusive. If an investor, having considered those factors, is unclear whether it has power, it shall consider additional facts and circumstances, such as whether other shareholders are passive in nature as demonstrated by voting patterns at previous shareholders’ meetings. This includes the assessment of the factors set out in paragraph B18 and the indicators in paragraphs B19 and B20. The fewer voting rights the investor holds, and the fewer parties that would need to act together to outvote the investor, the more reliance would be placed on the additional facts and circumstances to assess whether the investor’s rights are sufficient to give it power. When the facts and circumstances in paragraphs B18–B20 are considered together with the investor’s rights, greater weight shall be given to the evidence of power in paragraph B18 than to the indicators of power in paragraphs B19 and B20.
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Application example
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Example 7
An investor holds 45 per cent of the voting rights of
an investee. Eleven
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other shareholders each hold 5 per cent of the voting
rights of the investee. None of the shareholders has contractual arrangements
to consult any of the others or make collective decisions. In this case, the
absolute size of the investor’s holding and the relative size of the other
shareholdings alone are not conclusive in determining whether the investor
has rights sufficient to give it power over the investee. Additional facts
and circumstances that may provide evidence that the investor has, or does
not have, power shall be considered.
Example 8
An investor holds 35 per
cent of the voting rights of an investee. Three other shareholders each hold
5 per cent of the voting rights of the investee. The remaining voting rights
are held by numerous other shareholders, none individually holding more than
1 per cent of the voting rights. None of the shareholders has arrangements to
consult any of the others or make collective decisions. Decisions about the
relevant activities of the investee require the approval of a majority of
votes cast at relevant shareholders’ meetings—75 per cent of the voting
rights of the investee have been cast at recent relevant shareholders’
meetings. In this case, the active participation of the other shareholders at
recent shareholders’ meetings indicates that the investor would not have the
practical ability to direct the relevant activities unilaterally, regardless
of whether the investor has directed the relevant activities because a
sufficient number of other shareholders voted in the same way as the
investor.
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B46 If it is not clear, having considered the factors listed in paragraph B42 (a)–(d), that the investor has power, the investor does not control the investee.
ANALYSIS OF THE DE FACTO CONTROL EXAMPLES
As can be seen from the above provisions, the requirements are set out more like principles, and there are no bright-line tests, making the decision on de facto control extremely judgemental. When it is not clear whether the investor has de facto control, the default position is that the investor does not control the investee.
The following conclusions can be drawn from the examples provided under Ind AS 110:
• In Example 4, the investor holds 48% voting rights, and the remaining 52% is widely spread. Here, the conclusion is straightforward. In practice, the starting point for determining de facto control is 45% voting rights, when the remaining 55% is widely spread. However, that does not mean that a 40% voting right with the remaining 60% voting rights widely spread will straight-away disqualify. A 40% voting right may qualify as de facto control if other facts and circumstances indicate that the investor has the practical ability to direct the relevant activities unilaterally of the other entity. For example, the investor may have some formal agreements of support from other major investors, or it may have contractual rights to appoint, remove and remunerate the key management personnel. Here, the emphasis is on contractual rights and not that the investor appoints, removes or remunerates the key management personnel, even without those contractual rights.
• In Example 5, the investor has 40% voting rights, with the remaining 60% voting rights held by 12 investors equally, i.e. 5% each. Typically, the investor in such circumstances will not have de facto control. However, in this example, the investor has contractual rights to appoint, remove and remunerate the decision-makers of the investee and therefore exercises control through a combination of 40% voting rights and contractual rights. Sometimes, contractual rights may be to appoint and remove a majority of the board of directors that drive the relevant activities of the company, which would certainly provide the investor with control. Those contractual rights may either be entered into with all other investors or embedded in the articles of association or other constitutional documents, such as the shareholder’s agreement.
• In Example 6, the investor has 45% voting rights, with two other investors having 26% voting right each. If these two investors get together, the investors voting rights of 45% will not be sufficient to trump the 52% combined voting rights of the other two investors. It does not matter whether the two investors have an agreement or not between themselves to vote against the 45% investor. However, if the 45% investor has an agreement with one of the 26% investors to act in concert, then either the 45% investor or the 26% investor would have control which will depend upon which investor has agreed to support which other investor.
• In Example 7, an investor has 45% voting rights, and the remaining voting rights are held 5% each by 11 other investors. Additionally, there are no other contractual arrangements or matters that change the fact pattern. Here, the 45% investor cannot assume that two other investors holding 5% voting rights each may co-operate with him or have co-operated with him in the past, and as a result, the 45% investor has de facto control. In this example, the 45% investor would not have de facto control, despite a significant size of the investment, absent other facts and circumstances that may change the decision. Although the 45% size is large enough, it cannot be seen in isolation. When seen in the context of the shareholding of the other investors, and the dispersion, and absent any contractual arrangements, the accounting conclusion is that the 45% investor does not have control.
• In Example 8, the investors voting rights of 35% is considered to be of a small size in the context of significant participation by other shareholders in the general body meetings, as well as the existence of three major investors holding 5% each, with which the investor does not have any contractual arrangements. It does not matter that the investor has been able to exercise his voting powers to his advantage for several years; but that alone will not mean that the investor can consolidate the investee as a subsidiary. If this example was extended such that 34% other investors vote at general body meetings, it may indicate the 35% investor exercising control (35% > 34%, total voting is 69%). However, it is highly unlikely that the investee would qualify as a subsidiary for the 35% investor, given that the size of the investment is relatively very low and the presence of other significant investors. Even if the significant investors did not exist, the 35% investor would not qualify for de facto control, unless for example, there is absolutely poor participation at the general body meeting, say other investors holding not more than 10% voting rights vote, and there is no precedence in the past, of that having exceeded 15%.
As can be seen from the above, the principles of de facto control have to be applied to each fact pattern very carefully. Just because an investor is able to exercise his voting powers to his advantage, it does not on its own suggest that the investor should treat the investee as its subsidiary.
EXAMPLES OF DE FACTO CONTROL
A perusal of the examples below suggests that the investors holding should be significant to reach the de facto threshold; in most cases, it is around 45% or more. Other facts and circumstances would have also played a critical role in deciding on de facto control. In the absence of that information, it may not be appropriate to conclude basis the examples exhibited below.
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CHOLAMANDALAM
FINANCIAL HOLDINGS LIMITED
The Company holds 45.47% of
the total shareholding in CIFCL as at March 31, 2021 (45.50% as at March 31,
2020) and has de-facto control as per the principles of Ind AS 110 and
accordingly CIFCL has been considered as a subsidiary in Ind AS Financial
Statements.
(Source:
2020-21 Annual Report)
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TATA
COMMUNICATIONS
Tata Sons Pvt Limited is
controlling Tata Communication by virtue of holding 48.90%.
On 28 May 2018, Tata Sons
Private Limited (‘TSPL’) and its wholly owned subsidiary, Panatone Finvest
Limited (‘Panatone’), increased their combined stake in the Company to 48.90%
there by gaining de-facto control as per Ind-AS. Accordingly, the Company has
classified TSPL and Panatone as “Controlling Entities” and disclosed
subsidiaries, joint ventures and associates of Controlling Entities and their
subsidiaries as the ‘Affiliates’ of the Controlling entities, effective this
date.
(Source:
2019-20 Annual Report)
GODREJ
INDUSTRIES LIMITED
During the year, Godrej
Properties Limited has allotted 25,862,068 equity shares (Previous Year:
22,629,310 equity shares) of face value of Rs 5 each through Qualified
Institutions Placement. This has resulted in the dilution of equity holding
of the Company from 49.36% to 44.76%. The Company (GIL) has power and de
facto control over Godrej Properties Limited (GPL) (even without overall
majority of shareholding and voting power). Accordingly, there is no loss of
control of GIL over GPL post the QIP and GIL continues to consolidate GPL as
a subsidiary.
(Source:
2020-21 Annual Report)
RPSG
VENTURES
Parent- under de facto
control as defined in Ind-AS 110
(Source:
2020-21 Annual Report)
BOMBAY
BURMAH TRADING CORPORATION LIMITED
The Company along with its
Subsidiaries holds 39.67% of the paid up Equity Share Capital of Bombay
Dyeing & Manufacturing Corporation (BMDC), a Company listed on the Bombay
Stock Exchange. Based on legal opinion and further based on internal
evaluation made by the Company, there is no de facto control of the Company
over BDMC.
(Source:
2019-20 Annual Report)
BRITISH
AMERICAN TOBACCO
Investments in associates
and joint ventures – On 30 July 2004, the Group completed the agreement to
combine the US domestic business of Brown & Williamson (B&W), one of
its subsidiaries, with R.J. Reynolds. This combination resulted in the
formation of RAI, which was 58% owned by R.J. Reynolds’ shareholders and 42%
owned by the Group. The Group has concluded that it does not have de facto
control of RAI because of the operation of the governance agreement between
the Group and RAI which ensures that the Group does not have the practical
ability to direct the relevant activities of RAI; in particular, the Group
cannot nominate more than five of the Directors (out of 13 or proportionally
less if there are less than 13 Directors) unless it owns 100% of RAI or some
other party owns more than 50%. In addition, there are no other contractual
arrangements which would give the Group the ability to direct RAI’s
operations. Manufacturing and cooperation agreements between RAI and the
Group have been agreed on an arm’s length basis.
(Source:
2015 Annual Report)
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CONCLUSION
In India, several companies have significant promoter ownership, though the promoters may not hold a clear absolute majority, such as a shareholding greater than 50%. Therefore, the concept of de facto control becomes all the more important. As can be seen from the above discussion, even if a promoter is able to exercise his voting powers to his advantage, it may not be appropriate to conclude that the investee is a subsidiary with respect to that promoter unless the absolute and relative size of the holding held by the promoter is substantial, and there are other facts and circumstances including the extent of dispersion of other holdings or contractual arrangements, that suggest that the promoter has control over the investee.
