The NDA government has taken significant strides to curb the menace of benami transactions and shell companies. Post-demonetisation, with one stroke of the pen, the government deregistered more than 220,000 companies and disqualified around 300,000 directors from holding positions on the board of any company. There are reports that the government proposes to deregister another 120,000 companies that have not filed their annual reports for the last two years or have not started conducting their business.

The government also notified the Companies Restriction on Number of Layers Rules (Layering Rules) on September 20, 2017, restricting the number of layers of subsidiaries that may be created. In addition, the government also amended the provisions of Section 186 the Companies Act in relation to investments by companies (which are yet to be notified). The government’s stated reason for notifying the Layering Rules is that companies create multiple layers of subsidiaries for diversion/siphoning of funds, and it proposes to check this malpractice.

The Layering Rules provide that no company shall create more than two layers of companies. While badly drafted, the Layering Rules exclude the wholly-owned subsidiaries (WOS) in counting the layers of subsidiaries. The exclusion seems to be on the premise that as long as the source of capital is clear and not blurred with the presence of another party, a company may create layers of WOS plus two layers of subsidiaries for genuine business purposes.

The Layering Rules will, however, require a relook into business structures created for genuine business reasons as well. For example, infrastructure companies—including power generation companies—create a separate special purpose vehicle (SPV) for each project and seek separate financing and funding for them. Even the project bidding rules mostly allow creation and execution of projects through SPVs. The rules for captive consumption of electricity even require captive users to hold a minimum 26% equity in the company owning captive generating plant. While these are legal structures permitted under law and driven by genuine business requirements, the moment certain capital is infused at the holding company level or at the level of the SPV through a third party funding, such subsidiaries will get counted towards layers of subsidiaries.

As a good measure, the Layering Rules provide for the grand-fathering of existing structures with more than two layers of subsidiaries, provided the companies with excess layers file the requisite return with the Registrar of Companies. The grand-fathering is, however, limited to existing entities in the structure and does not permit the layer in itself. This is to say that if the company has three layers of subsidiaries as on September 20, 2017, the existing third layer subsidiaries may continue to survive. However, a company will not be permitted to create new subsidiaries horizontally in the same layer after September 20, 2017.

The Layering Rules also do not restrict a company from acquiring a foreign body corporate with subsidiaries in excess of two layers. While the language is extremely devoid of clarity and literal interpretation would only permit acquisition by way of purchase of a foreign company with existing structure of more than two layers, a constructive and purposeful interpretation would permit setting up and establishing foreign companies beyond two layers, if the same is permitted as per the laws of such country. It is unclear that if such foreign company has an Indian subsidiary in its fold, whether the foreign layers will be counted or excluded for the purpose of counting total number of layers.

The provisions are going to get further compounded by the definition of investment companies sought to be introduced by the Companies Amendment Act, 2017 (yet to be notified). Something like the Layering Rules, Section 186, also prohibits an investment through more than two layers of investment companies. The present provision under the Companies Act considers a company to be an investment company if its principal business is acquisition of shares or securities. The amendment, however, clarifies that if the value of investment exceeds 50% of total assets or income from investment in a particular year exceeds the 50% of total income (due to dividend/capital gains on sale of shares, etc.), a company will be considered an investment company. The proposed test is more stringent than the usual RBI test, which requires that a company will be treated as an investment company/NBFC if both the value of assets comprising of financial assets as well as the financial income is more than 50% of its total assets and the total income of such company. Thus, even if layers of WOS (in excess of two layers) are permitted under Layering Rules, it will not be permitted if such WOS qualify as investment companies.

The existing business structures would thus be required to be re-evaluated and restructured in view of proposed changes to Section 186 of the Companies Act and the Layering Rules, keeping in view the income and asset position, exemption to the WOS and existing structures and the also the proposed amendment to the definition of subsidiary.

Views expressed are personal.

Manvinder Singh
Manvinder Singh

The author is a partner at J. Sagar Associates. His practice covers diverse areas of corporate commercial law including foreign investment, joint ventures, private equity and matters involving asset purchase/business transfer. He has advised Indian and foreign companies in structuring the acquisition or investment and has rendered advice on corporate restructuring.