Inter-corporate loans granted by a company are regulated under Section 186 of the Companies Act, 2013 (‘2013 Act’). One important pre-condition relates to the interest rate thresholds prescribed under sub-section (7). Section 186(7) of the Act states that – “No loan shall be given under this Section at a rate of interest lower than the prevailing yield of one-year, three-year, five-year or ten-year Government Security closest to the tenor of the loan.”
Section 186(7) effectively prevents a company from giving an inter-corporate loan at a rate of interest lower than the prescribed thresholds, i.e. the prevailing yield of one-year, three-year, five-year or ten-year government security closest to the tenor of the loan. This leads to multiple practical difficulties, especially in situations where a holding company wishes to provide funds to its foreign wholly owned subsidiaries (‘WOS’).
In this blog, we have analysed Section 186(7), and have examined the practical difficulties brought about by the interest-rate requirement prescribed under this provision.
Scope of Section 186(7)
As Section 186(2)(a) uses the words – “give any loan to any person or other body corporate” – even inter-corporate loans given to any company incorporated outside India shall fall within the regulatory ambit of Section 186. Section 186(7) would accordingly include loans granted by a holding company to its foreign subsidiaries (incorporated outside India).
The definition of the term “government security” is not given in the 2013 Act. Section 2(95) of the 2013 Act states that if a word or expression is not defined in the Act, the definition given in the Securities Contracts Regulation Act, 1956 (‘SCRA’) may be applied.
Section 2(b) of the SCRA defines “government security” as “a security created and issued, whether before or after the commencement of this Act, by the Central Government or a State Government for the purpose of raising a public loan and having one of the forms specified in clause (2) of Section 2 of the Public Debt Act, 1944.” Only securities issued by the Central or State Government (for the purpose of raising a public loan) fall within the ambit of this provision.
Under the Companies Act, 1956 (‘1956 Act’), the provision that corresponds with Section 186(7) is Section 372A(3). Section 372A(3) of the 1956 Act stated that – “No loan to any body corporate shall be made at a rate of interest lower than the prevailing bank rate, being the standard rate made public under Section 49 of the Reserve Bank of India Act, 1934.”
Through a clarificatory circular issued on April 9, 2015, the Ministry of Corporate Affairs (‘MCA’) clarified that in cases where the effective yield (effective rate of return) on tax free bonds is greater than the prevailing yield of one-year, three-year, five-year or ten-year government security closest to the tenor of the loan, there shall be no violation of Section 186(7) of the Act.
This clarificatory circular brought Section 186(7) in consonance with the earlier legal position under Section 372A(3) of the 1956 Act. Through General Circular No. 06/2013 dated March 14, 2013, the MCA had clarified that in cases where the effective yield (effective rate of return) on tax-free bonds is greater than the yield on the prevailing bank rate, there shall be no violation of Section 372A(3) of the 1956 Act. The same position of law now also exists under Section 186(7) of the 2013 Act.
Exemption for loans granted to WOS – the distinction between the 2013 Act and the 1956 Act
Under Section 372A(8) of the 1956 Act, a loan given by the holding company to its WOS was exempted from complying with all requirements of Section 372A. The interest rate requirements provided under Section 372A(3) did not apply when a loan was given by a holding company to its WOS.
But, the legal position under the 2013 Act is different – and no blanket exemption is provided. The first proviso to Section 186(3) states that a loan provided by a holding company to its WOS shall be exempted from complying with only Section 186(3), and shall have to comply with all the other provisions of Section 186. Hence, a loan granted by the holding company to its WOS shall have to comply with Section 186(7).
This leads to multiple practical difficulties, particularly in a situation where a holding company wishes to grant a loan to a WOS incorporated outside India (i.e. a foreign WOS). The practical issues that arise in this situation are explained below with an illustrative example.
Let us take an example of a company – ABC Ltd – which is a public listed company incorporated in India. XYZ Ltd is a WOS of ABC Ltd that is incorporated in Japan. DEF Ltd is another WOS of ABC Ltd, that is incorporated in Vietnam. In many situations, a WOS such as XYZ or DEF may not be capable of borrowing directly from the market, and shall accordingly be dependent on the holding company (ABC) for funding.
Now, if ABC grants a loan to either XYZ or DEF, Section 186(7) shall apply. In accordance with Section 186(7), the rate of interest on the loan cannot be lower than the prevailing yield of one-year, three-year, five-year or ten-year Government Security closest to the tenor of the loan.
As the loan is being provided by ABC Ltd to its foreign WOS (which is incorporated in Japan/Vietnam) there may arise a conflict of applicable law. Under Indian law i.e. Section 186(7), the rate of interest cannot be below a particular threshold. The laws applicable in the foreign jurisdiction may provide that the rate of interest cannot be above a prescribed threshold.
The foreign WOS shall also have a mandate of complying with the local company law of Japan/Vietnam. Applying Indian interest rate benchmarks may hence create a conflict of applicable law, especially in situations where the foreign jurisdiction contains different interest rate benchmarks. Furthermore, the interest rates in India are likely to be significantly higher than the rates prevalent in jurisdictions such as Japan or Vietnam.
This creates practical difficulties where holding companies are unable to fund their foreign WOS. Companies are hence finding innovative ways to bypass the requirement of Section 186(7) – through methods such as issuing redeemable preference shares, or optionally convertible debentures. Another method is also being employed – where the foreign WOS borrows in the local currency, and the parent company incorporated in India provides a guarantee in accordance with the FEMA regulations.
Even for legitimate business transactions, holding companies are facing difficulties in providing funding to their foreign WOS, due to the interest rate requirement of Section 186(7). The law as laid down in Section 186(7) is hence not in tune with the market reality.
As the law is not in consonance with market realities, there is a need for a suitable amendment to Section 186(7) – through which loans granted by the holding company to its foreign WOS are exempted from complying with Indian interest-rate thresholds.
It is pertinent to note here that the loans granted by a holding company to its foreign WOS shall also have to comply with the FEMA framework. Even if Section 186(7) is amended and the interest rate thresholds are removed, the loans granted to a foreign WOS shall have to continue complying with the FEMA regulations. Hence, sufficient safeguards shall continue to exist.
In its Report, the Company Law Committee, 2016 had also examined whether holding companies should be allowed to grant interest-free loans to their WOS. The Committee took the view that it shall not be desirable to permit a WOS to accept interest-free loans from their parent company. While grant of interest-free loans may not be permitted, Section 186(7) should be amended to ensure that Indian interest rate benchmarks are not applied for loans granted to a foreign WOS.
 MCA General Circular No. 06/2015 (April 9, 2015).
 Report of the Company Law Committee, submitted on February 1, 2016, Pg. 61.