In today’s globalised economy, Indian companies are increasingly expanding their footprints across borders. Despite the global ambition, the regulatory framework often remains stubbornly local.
One such concern lies with Section 186(7) of the Companies Act, 2013 (“Act”), which prescribes minimum interest rate benchmarks. While this ensures a level-playing field for Indian companies, applying this uniformly to loans given to foreign wholly-owned subsidiaries (“Foreign WOS”) creates unfair interest rates as interest rate norms vary across jurisdictions.
Another hurdle is the interplay between layering restrictions and funding requirement of foreign subsidiaries. To prevent complex corporate structures, the law limits the number of layers (of subsidiary(ies)) a company can have. While this law was brought in to ensure that complex structures are not used to bypass regulatory restrictions, the blanket application of these provisions to foreign subsidiaries may require reconsideration to align with global business realities.
Section 186(7) – Interest rate benchmarks and foreign subsidiaries
Introduction to Section 186(7) of the Act
Section 186(7) requires loans extended by companies to carry interest rates not lower than yields on comparable government securities. This benchmark, while suitable domestically, creates challenges for Indian holding companies lending to Foreign WOS.
When it comes Foreign WOS, Section 186(7) becomes a square peg in a round hole. The practical difficulties can be explained with the following illustrative example:
ABC Ltd, a listed Indian company, has two wholly-owned subsidiaries incorporated abroad – XYZ Ltd in Japan and DEF Ltd in Vietnam. These Foreign WOS may lack access to local credit markets and therefore rely on ABC Ltd for financial support. Any loan extended by ABC Ltd to these entities would attract the provisions of Section 186(7), mandating a minimum interest rate based on Indian government securities. However, this requirement may be in conflict with interest rate regulations in the subsidiaries’ respective jurisdictions, potentially resulting in non-compliance with local laws.
This poses legal challenges as Foreign WOS are governed by the laws of their country of incorporation. The Supreme Court[1] has held that companies incorporated abroad must operate as‘good local citizens’under local laws. Additionally, interest rates in India typically exceed those incountries such as Japan, Vietnam, or the UK, making funding commercially unviable.
Hence, for a Foreign WOS, the law of the country of its incorporation will attain primacy over the requirements of Indian law.
A Blind Spot in Section 186(7)?
One of the key gaps under Section 186(7) is that “government security” is left undefined under the Act, for which we must refer to the definition given in the Securities Contracts Regulation Act, 1956 (‘SCRA’).
SCRA defines “government security” only as securities created or issued by the Central or State Government for raising a public loan, complicating the application of Indian benchmarks to foreign lending scenarios. While the MCA has issued a clarificatory circular[2], which attempts to address yield comparisons on tax free bonds versus prevailing bank rate, they do not resolve the cross-border interest rate dilemma.
Additionally, it is unclear whether zero-coupon OCDs and NCDs come within this section’s purview as it only prescribes the minimum interest rate applicable to loans and does not address the treatment of transactions where no interest is charged. Consequently, it remains unclear whether such interest-free arrangements are valid under the Act or could be deemed as non-compliant.
The Way Forward
To address these legal and practical difficulties, it is proposed that Section 186(7) be amended to provide a specific exemption from complying with the interest rate benchmarks to the loans extended to Foreign WOS. While the Company Law Committee (2016) did not support permitting interest-free loans to WOS, a targeted amendment to Section 186(7) is warranted to exempt such cross-border loans from Indian interest rate benchmarks. This exemption would be limited solely to the interest rate requirement, with all other provisions of Section 186 and applicable regulations under the Foreign Exchange Management Act, 1999, continuing to apply.
Accordingly, Section 186(7) may be amended by adding a proviso as follows:
“… Provided that nothing in this sub-section shall apply to loans given by a holding company to its wholly-owned subsidiary incorporated outside India, whose accounts are consolidated with such holding company and placed before the shareholders at the general meeting for approval.”
Layering Restrictions – Exemption for one layer of WOS
The proviso to Section 2(87) restricts the number of subsidiary layers a company may have, with ‘layer’ defined as a subsidiary or subsidiaries of a holding company.
Thus, the law restricts the number of subsidiary layers a company may establish, aiming to prevent the creation of complex corporate structures that could circumvent regulatory restrictions.
Intricacies and challenges with Layering Rules
According to Rule 2(1) of the Companies (Restriction on Number of Layers) Rules, 2017 (“Layering Rules”), a company cannot have more than two layers of subsidiaries.
Rule 2(1) provides for two key exemptions:
- Foreign subsidiary exemption, wherein companies may acquire foreign subsidiaries with more than two layers, if such structuring is permitted under the laws of the foreign jurisdiction; and
- Wholly-owned Subsidiary Exemption (“WOS Exemption”), wherein one layer consisting one or more WOS or subsidiary is not counted while computing the number of layers under this rule.
This Rule 2(1) does not expressly clarify whether the WOS Exemption can only be availed by one or more WOS at the first layer of the ownership chain, or whether it can also be availed if the WOS is at the second or the third layer of the ownership chain, which results in ambiguity while structuring M&A transactions and while assessing group structures, limiting the utility of the exemption.
However, there is no express guidance on whether the layering restriction applies only to vertical chains or also to horizontal structures. It remains uncertain whether indirect holdings qualify for WOS Exemption. Clarification is needed on whether both direct and indirect ownership structures are considered when evaluating WOS status.
Limits on Investment Layers and Ambiguities in Acquisition Transactions
Section 186 deals with loans and investment by company. Accordingly, Section 186(1) provides that a company shall not invest through more than two layers of investment company unless prescribed. However, there is an exception to this, where an Indian company can acquire a foreign company that has more than two layers of subsidiaries and comply with the laws of the foreign country. Also, a subsidiary company in India can create investment subsidiaries if required by law or any regulation in force.
An “investment company” is defined under Section 186 to mean one whose main business is acquiring shares, debentures, or securities. It qualifies as such if 50% or more of its assets or gross income come from investments in these financial instruments.
In contrast, the RBI’s NBFC guidelines require both 50% asset and income conditions to be met, creating different tests under each framework for M&A transactions.
Moreover, the provision does not define the term “acquisition” within the definition of “investment”, resulting in uncertainty over whether transactions such as business transfer agreements, fall within the scope of layering restrictions. Thus, this creates ambiguity around which types of acquisitions or investments may trigger layering concerns and potentially violate Section 186(1).
Proposed Amendment
The MCA should clarify whether the WOS Exemption applies only to the first layer or extends to deeper layers. The second proviso to Rule 2(1) could be amended as follows:
Accordingly, the second proviso to Rule 2(1) may be amended in either of the following ways:
Option 1 – WOS Exemption applies only to the first layer
Provided further that for computing the number of layers under this rule, the first layer of the ownership chain which consists of one or more wholly-owned subsidiary or subsidiaries shall not be taken into account.
Option 2 – The WOS Exemption applies to any one layer of the ownership chain, i.e. either the first, second or the third layer
Provided further that for computing the number of layers under this rule, any one layer of the ownership chain which consists of one or more wholly owned subsidiary or subsidiaries shall not be taken into account.
Conclusion
As Indian companies expand globally, rigid application of domestic regulations like Section 186(7) and layering restrictions create significant operational and legal challenges.
To foster a more globally competitive and compliant corporate environment, targeted amendments are essential. Exempting loans to Foreign WOS from interest rate benchmarks and clarifying the scope of the WOS Exemption in layering rules would provide much-needed flexibility, without compromising regulatory oversight. These reforms would not only align Indian corporate law with international business practices, but also empower Indian companies to structure their global operations more efficiently and compliantly.
[1] Vodafone International Holdings BV v. Union of India (2012) 6 SCC 613
[2] MCA General Circular No. 06/2015 (April 9, 2015).