Ever since the stock market scam of 2001 (Ketan Parekh Scam) was brought to light, regulators have been vigilant about the use of complex corporate structures to circumvent statutory restrictions and divert company funds. After the magnitude of financial irregularities in the Ketan Parekh Scam came to light, the Joint Parliamentary Committee (“JPC”) and the erstwhile Department of Company Affairs (“DCA”) proposed steps to prevent companies from using the ‘subsidiary route’ to siphon off funds, by providing inter-corporate loans.
The DCA had proposed that all categories of subsidiaries should comply with the discipline of Section 372A of the 1956 Act – which prescribed the compliance requirements for inter-corporate loans and investments. The spirit of this recommendation has been incorporated in Section 186 of the Companies Act, 2013 (“Act”), which does not provide a complete exemption even for loans granted by a parent company to its wholly owned subsidiary (“WOS”).
To prevent the misuse of the ‘subsidiary route’, and to ensure that complex corporate structures are not used to bypass regulatory restrictions, it was proposed that there should be a statutory cap on the number of ‘layers of subsidiaries’ permitted for a holding company. This was the objective behind the introduction of the layering restrictions prescribed under Sections 2(87) and 186(1) of the Act, and the Companies (Restriction on Number of Layers) Rules, 2017 (“Layering Rules”).
Section 2(87) of the Act and the Layering Rules:
Section 2(87) of the Act provides that a subsidiary company, in relation to any other company (that is to say the holding company), means a company in which the holding company:
(a) controls the composition of the Board of Directors; or
(b) exercises or controls more than one-half of the total voting power either at its own or together with one or more of its subsidiary companies.
The proviso to Section 2(87) of the Act provides that such class or classes of holding companies as may be prescribed shall not have layers of subsidiaries beyond such numbers as may be prescribed. Further, the expression “layer” in relation to a holding company means its subsidiary or subsidiaries.
Rule 2(1) of the Layering Rules provides that:
“On and from the date of commencement of these rules, no company, other than a company belonging to a class specified in sub-rule (2), shall have more than two layers of subsidiaries:
Provided that the provisions of this sub-rule shall not affect a company from acquiring a company incorporated outside India with subsidiaries beyond two layers as per the laws of such country:
Provided further that for computing the number of layers under this rule, one layer which consists of one or more wholly owned subsidiary or subsidiaries shall not be taken into account”.
It is pertinent to note that banks, NBFCs, insurance and government companies have been exempted from complying with the layering restrictions prescribed under Rule 2(1).
Under the second proviso to Rule 2(1), for computing the number of layers, one layer which consists of one or more WOS shall not be taken into account (“WOS Exemption”).
Given the express wording of Rule 2(1), there are two intricate issues that India Inc is currently grappling with:
(i) Should the number of layers be computed horizontally or vertically?
(ii) Will the WOS exemption apply exclusively to the first layer of WOS, or can it be extended to any one layer of WOS?
Both these issues have given rise to considerable ambiguity in structuring M&A deals, and different views have been taken in the market. In the analysis below, the authors present an approach that may potentially be adopted for each of these issues.
Should the number of layers be computed horizontally or vertically?
As Section 2(87) of the Act (under which the Layering Rules have been notified) uses the words “layers of subsidiaries”, the said provision refers to each level of the ownership chain, which is ultimately controlled by the holding company. A holding company may have multiple WOS – which are at the same level of the ownership chain. Given that all the WOS present at the same level of the ownership chain should be excluded, the layers must be computed horizontally and not vertically.
Is the WOS Exemption applicable only to the first layer?
The second proviso to Rule 2(1) uses the expression “one layer”, but it does not expressly state that only the first layer of WOS will be exempted while computing the number of layers. However, in this context, it must be noted that the WOS Exemption is contained in the proviso to Rule 2(1) of the Layering Rules, and may be interpreted in consonance with the principles enshrined by the Supreme Court of India (“SC”) for interpreting a proviso to a statutory provision.
The proviso qualifies and creates an exception to the general rule contained in Rule 2(1) and may be considered in relation to the subject-matter covered in the main provision – and cannot extend beyond its intended scope. In this regard, reference may be made to the SC decision in Ram Narain Sons Limited v. Assistant Commissioner of Sales Tax, where the SC held that:
“It is a cardinal Rule of interpretation that a proviso to a particular provision of a statute only embraces the field which is covered by the main provision. It carves out an exception to the main provision to which it has been enacted as a proviso and to no other”.
Further, the SC has held that a proviso should be construed harmoniously with the main provision. Basis the above well-established principles of interpretation, the proviso to Rule 2(1) (which acts as an exception) may be harmoniously interpreted in relation to the principle matter contained in Rule 2(1) – which provides that no company shall have more than two layers of subsidiaries.
Applying the above principles, it appears that the WOS Exemption will only cover a WOS of a holding company (which is at the first layer), and may not include a WOS of a subsidiary company – which is at the second or third level of the ownership chain.
The difficulty arises in scenarios where the WOS is positioned at the intermediate or the third layer of the ownership chain. In many situations, a subsidiary of a holding company (that is not 100% owned by the holding company) sets up one or more WOS in India or abroad. Such a WOS will be a step-down subsidiary placed in the second or third level of the ownership chain. Although such a WOS will be ultimately controlled by the holding company at the top of the ownership chain, it will only be a subsidiary of the holding company in question – and will not be a WOS of the ultimate holding company.
Given that the WOS Exemption may only apply to a WOS of the ultimate holding company (that exists at the top of the ownership chain), the regulators may not permit the ultimate holding company to claim this exemption in situations where the WOS is present at the second or the third layer of the ownership chain.
Section 186(1) – The ‘Investment Company’ Conundrum:
Section 186(1) provides that without prejudice to the provisions contained in the Act, a company shall unless otherwise prescribed, make investment through not more than two layersof ‘investment companies’.
Section 186 provides that for the purposes of the said section – “the expression “investment company” means a company whose principal business is the acquisition of shares, debentures or other securities and a company will be deemed to be principally engaged in the business of acquisition of shares, debentures or other securities, if its assets in the form of investment in shares, debentures or other securities constitute not less than fifty per cent of its total assets, or if its income derived from investment business constitutes not less than fifty per cent as a proportion of its gross income”.
On the other hand, the RBI Guidelines for NBFCs provide that acompany will be treated as an NBFC if its financial assets are more than 50% of its total assets (netted off by intangible assets) and income from financial assets is more than 50% of the gross income. Both these tests are required to be satisfied as the determinant factor for ‘principal business’ of a company”.
Unlike the RBI Guidelines for NBFCs, Section 186(1) requires a company to satisfy eitherthe asset-based test or the income-based test only, and a company need not satisfy both of these tests. Companies should keep note of this material distinction, while structuring their domestic and cross-border M&A transactions.
Another interesting development relates to the way the RBI has linked ODI-FDI structures (round tripping transactions) with the layering restrictions, under the Foreign Exchange Management (Overseas Investment) Rules, 2022 (“New ODI Rules”).
While the erstwhile regime under FEMA 120 did not explicitly mention round tripping in the text of the law, RBI’s ODI FAQs effectively enacted substantive law by mandating prior RBI approval for round-tripping transactions (ODI-FDI structures).
ODI-FDI structures are now permitted subject to compliance with the layering restrictions set out under Rule 19(3) of the New ODI Rules, which provides that “no person resident in India shall make financial commitment in a foreign entity that has invested or invests into India, at the time of making such financial commitment or at any time thereafter, either directly or indirectly, resulting in a structure with more than two layers of subsidiaries.”
The New ODI Rules have legalised round-tripping by recognising that ODI-FDI structures are legitimate, subject to compliance with the two-layer restriction. However, greater clarity is needed on how to compute the layers – to remain within the overall limit of two layers. RBI clarification on this vital aspect will facilitate structuring of ODI-FDI deals, with greater clarity on the validity of the proposed structure.
In this context, it is interesting to note that the two-layer restriction under Rule 19(3) of the New ODI Rules is premised on the same principle as the Layering Rules, however, the WOS Exemption has not been incorporated.
As the Layering Rules were framed with the objective of preventing companies from diverting their funds and circumventing regulatory requirements, courts and regulators may look into the “mischief that was sought to be remedied” while interpreting these provisions. However, the wording of the WOS Exemption exhibits an inherent ambiguity, leading to conflicting interpretations. Given that such ambiguity exerts significant impact on the structuring of M&A deals (both inbound and outbound), it behoves the Regulators to swiftly settle this long pending debate.
 Report of the Joint Parliamentary Committee on the Stock Market Scam and Matters relating thereto, 13th Lok Sabha, Volume-I.
 Rule 2(2), Layering Rules.
 (1955) 2 SCR 483
 CIT Mysore v. Indo Mercantile Bank, 1959 Supp. (2) SCR 256 & Abdul Jabar Butt v. State of Jammu & Kashmir AIR 1957 SC 281.
 See RBI Press Release 1998-99/1269, dated April 8, 1999.
 The New ODI Rules were notified on August 22, 2022.
 FAQ No. 64 of the RBI’s FAQs on Overseas Direct Investments.
 Rule 19(3) of the New ODI Rules.