Companies Act: Operation Delyening

Introduction

A bariatric surgeon is one who cuts away layers of fat from an obese person in order to have a slimmer structure. The Ministry of Corporate Affairs (“MCA”) has also donned the role of such a surgeon by trimming away vertical layers of subsidiaries (or step-down subsidiaries) in order to present a leaner and clearer corporate structure. Its scalpel for this highly impactful operation was the Companies (Amendment Act), 2017 to the Companies Act, 2013 (“the Act”) coupled with the Rules issued under the Act. The Amendment Act has introduced several changes to the Act but the one which had the most disruptive effect is in fact not a part of the Amendment Act. Initially, the Amendment Bill had decided against restricting vertical layers of subsidiaries but subsequently on account of the action against shell firms and other similar events, the MCA decided to retain the restriction in the Amendment Act. Thus, the Amendment Act does not amend the existing position in the Companies Act, 2013 of restricting the number of layers of vertical subsidiaries.

Amendment

The original definition of  section 2(87) of the Act which defined the term “subsidiary” provided that a subsidiary in relation to a company, which was the holding company, meant one in which the holding company controlled the composition of the board of directors or exercised or controlled more than half the total share capital either on its own or together with its subsidiaries. The definition as it stood had generated several problems since even a passive investor, e.g., a private equity investor, who owned more than 50% of the total share capital but not 50% of the total voting power was treated as the holding company of the investee company. This created unique problems for several investors and investees alike.

This definition was amended by the Amendment Act to replace total share capital with total voting power. Hence, the Amendment restores the old position, i.e., in order to be treated as a subsidiary, the holding company must control more than 50% of the total voting power and not merely 50% of the total capital. Accordingly, all shares not carrying voting rights, e.g., non-voting shares, preference shares, etc., would be ignored while determining whether there is a holding-subsidiary relationship between 2 companies.

The proviso to this definition provides that such classes of holding companies as may be prescribed by the MCA shall not have more than the prescribed number of layers of subsidiaries. The Companies (Amendment) Bill, 2016 sought to delete this proviso and permit holding companies to have as many layers as they desired. However, when the Bill was passed by the Lok Sabha this deletion was dropped, i.e., the original position of restriction in number of layers of subsidiaries, was retained. 

Rules

Pursuant to the proviso being retained, the MCA notified the Companies (Restriction on Number of Layers) Rules, 2017 (“the Rules”) on 20^th September 2017. The Rules provide that on and from 20^th September 2017, a company cannot have more than 2 layers of subsidiaries. A layer in relation to a holding company has been defined to mean one or more subsidiaries. A layer thus, is a vertical layer of a subsidiary. However, in computing the limit of 2 layers, 1 layer comprising of one or more wholly owned subsidiaries is excluded. Thus, the total number of layers which a company can have is 1 + 2 = 3, i.e., 1 layer of wholly owned subsidiaries + 2 layers of other subsidiaries which may or may not be wholly owned. For instance, HCo has 5 wholly owned subsidiaries – A to E. All of these would constitute 1 layer which would be exempted. Each of these wholly owned subsidiaries can now incorporate 2 vertical layers, e.g., A can incorporate A1 and A1, in turn, can have A2. A1 and A2 would constitute 2 vertical layers in relation to HCo. However, A2 cannot incorporate A3 since that would mean that HCo would violate the prescribed limits. It may be noted that the restriction is on vertical layers and not horizontal subsidiaries. Thus, in the above example, instead of 5 subsidiaries, A to E, HCo can have many more direct subsidiaries (whether 100% or less), say, A to Z. However, the number of step-down subsidiaries would be limited as per the Rules.

Section 2(87) provides that company includes a body corporate and hence, the definition of subsidiary would even encompass a foreign body corporate which is a subsidiary of the Indian holding company. Also, a subsidiary in the form of a Limited Liability Partnership, being a body corporate, would be covered.

Gateways

The Rules do not apply to the following types of companies:

(a)    a Bank

(b)    a Systemically Important Non-Banking Finance Company, i.e., NBFCs whose asset size is of Rs. 500 cr. or more as per its last audited balance sheet.

(c)    an Insurance Company

(d)    a Government Company

The Rules provide grandfathering to existing layers of subsidiaries even if they are in excess of the limits prescribed by the Rules. For availing of this protection, holding companies were required to file a prescribed return with the Registrar of Companies latest by 17^th February 2018. The protection further provided that after the commencement of the Rules, such a holding company cannot have any additional layers over and above those which have been grandfathered. Further, if the existing layers are reduced after the commencement of the Rules, then it cannot have new layers over and above the limit prescribed by the Rules. To give an illustration, HCo had 5 layers of subsidiaries prior to the enactment of the Rules. These layers would be protected by the grandfathering provisions and can continue. However, HCo cannot incorporate any fresh 6^th layer of subsidiary.If HCo were to sell the shares of one of the subsidiaries and be left with 4 layers then it cannot now incorporate any fresh layer of subsidiaries since that would again violate the provisions of the Rules, but it can continue with the 4 layers which have been grandfathered.

Another exemption provided by the Rules is that the limit of 2 layers would not affect a company from acquiring a company incorporated abroad which already has subsidiaries beyond 2 layers and these are allowed under the laws of such foreign country. However,  this exemption is not provided if such a foreign company desires to subsequently set up multiple layers of foreign subsidiaries. Thus, it would not be possible to have multiple foreign layers even if the foreign laws were to permit them.

Impact Analysis

The Rules would severely impact the creation of Special Purpose Vehicles (“SPVs”) which are very prevalent especially in sectors such as, infrastructure, real estate, roads, etc. In these sectors, it is a common practice to have multiple layers for different projects. For instance, a real estate company may have 2 subsidiaries, one for commercial projects and one for residential. Within each of them, there may be holding companies for different regions, e.g., one for Mumbai, one for Delhi, one for Chennai, etc. Under each regional holding company, there may be an SPV for a specific project. The benefit of a layered structure is that it facilitates value unlocking at multiple levels. A strategic investor/project partner can invest at the SPV level. A financial investor who is interested only in residential projects in Mumbai can invest at the Mumbai layer level since he would then get access to all the projects in Mumbai. Similarly, investors could invest at the residential level or even at the corporate level.Such structuring would be constrained by the limit on the layers. Also, in a case where the 1^st layer is not of wholly owned subsidiaries, the limit would be of only 2 layers and not 1+2 =3.

Another area which would be affected is that of outbound investment. It is quite common for Indian companies to have multiple layers when investing abroad. For instance, an Indian company may have an Intermediate Holding Company (IHC) in a tax haven, followed by a Regional Holding Company (RHC) say, one in a European country for housing all European ventures and another in an African country for all African ventures. Under the RHC would be the countrywise SPVs. These layers would now also have to toe the line laid down under the Rules. However, on a related note, the Reserve Bank of India also does not easily approve of multi-layered structures for outbound investments involving the use of multiple layers of foreign SPVs. Thus, the Companies Act restrictions and the RBI’s views under the Foreign Exchange Management Act are now similar. 

Same Difference

A similar restriction already existed in section186 (similar to section 372/372A of the Companies Act, 1956) of the Act. According to this section, a company cannot make an investment through more than two layers of investment companies. Thus, any company, desiring to make an investment, can do so either directly or through an investment company or through one investment company followed by a 2^nd layer of investment company. However, it cannot have a 3^rd layer of investment company under the 2^nd layer of the investment company.

It may be noted that the prohibition is on having more than 2 layers of investment companies and hence, we need to ascertain what constitutes an investment company? The section defines an ‘investment company’ to mean a company whose principal business is acquisition of shares, debentures or securities.

Secondly, it must be a company whose principal business is acquisition of securities. What is principal business has now been defined by the Amendment Act. According to these tests, a principal business is defined if it satisfies the following conditions as per its audited accounts:

(i)  Its assets in the form of investment in shares, debentures or other securities constitute not less than 50% of its total assets; OR

(ii) Its income from investment business constitutes not less than 50% of its gross income.

The Act expressly provides that the restriction on two layers of investment companies even applies to an NBFC whose principal business is acquisition of securities.

The investor company could be an investment or an operating company, but it cannot route its investment via more than 2 layers of investment companies. If the investment is routed through an operating company or one whose principal business is not acquisition of securities, then the restriction u/s. 186 on 2 layers would not apply.

The prohibition on making investments only through a maximum of two layers of investment companies will not affect the following two cases:

(i) a company from acquiring any other company incorporated in a country outside India if such other company has investment subsidiaries beyond two layers as per the laws of such country; or

(ii) a subsidiary company from having any investment subsidiary for the purposes of meeting the requirements under any law or under any rule or regulation framed under any law for the time being in force.

Certain Government companies have also been exempted from this provision.

The Rules u/s. 2(87) provide that they are not in derogation to the exemptions contained u/s. 186(1). Thus, the Rules would apply equally to an investment company as long as they are not in derogation of the proviso to section 186(1).

One may compare the restrictions contained in section 186 vs. section 2(87) as follows:

Conclusion

India Inc. is going to find it tough to grapple with these provisions more so when it is used to having multiple layers. The objective seems to be to cut through the opacity haze of multiple layers and provide more transparency to the regulators to find out who is the real investor. Clearly, thin is in!! _