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Companies Amendment Act 2017

An overview of key changes

The enactment of the Companies Act, 2013 (the 2013 Act or the Act) was one of the most significant legal reforms in India, aimed at bringing Indian companies law in line with the global standards. The Act introduced significant changes in the companies law in India, especially in relation to accountability, disclosures, investor protection and corporate governance.

On many fronts, constituents faced significant implementation challenges. The Government continued to receive representations from several quarters for further review and simplification of the 2013 Act. Against this background, the Ministry of Corporate Affairs (MCA) constituted a Companies Law Committee (Committee) for addressing these concerns. The Committee had to deal with more than 2,000 comments received from different sources. Given the sheer enormity and complexity of the exercise, it is indeed a commendable feat that the Committee could finalise its report in a little more than six months.

The Government considered many of the suggestions made by the Committee and introduced the Companies (Amendment) Bill 2016 (the 2016 Bill) in the Lok Sabha in March 2016. It was later referred to the Standing Committee on Finance for further examination. After considering the suggestions of the Standing Committee and other related developments, the 2016 Bill renamed as the Companies (Amendment) Bill 2017 (the 2017 Amendment Bill) was reintroduced in Lok Sabha and passed in July 2017. The 2017 Amendment Bill was approved by the Rajya Sabha on 19 December 2017. It got assent from the Honourable President of India on 3 January 2018 and has been notified in the Official Gazette of the same date to be an Amendment to the 2013 Act (the 2017 Amendment Act).

The 2017 Amendment Act addresses difficulties in implementation, facilitates ease of doing business helps achieving better harmonisation with other statutes such as the Reserve Bank of India Act, 1934 and regulations made thereunder, and rectifies inconsistencies in the 2013 Act. We compliment the Government of India for adopting a highly collaborative approach and addressing the various challenges.

Net worth

In accordance with section 2(57) of the 2013 Act, ‘net worth’ means the aggregate value of the paid-up share capital and all reserves created out of the profits and securities premium account, after deducting the aggregate value of the accumulated losses, deferred expenditure and miscellaneous expenditure not written off, as per the audited balance sheet, but does not include reserves created out of revaluation of assets, write-back of depreciation and amalgamation.

Debit or credit balance of the profit andloss account’ will be included in ‘net worth’computation. This is a clarificatory change,one that was important to make.

In the absence of a specific mention, there was a debate as to whether ‘net worth’ included ‘debit or credit balance of the profit and loss account’. The 2017 Amendment Act addresses this debate by specifically including the phrase ‘debit or credit balance of the profit and loss account’ in the definition of ‘net worth’. In our view, the net worth of a company reflects its intrinsic value. Hence, this is a clarificatory change, one that was important to make.

Practical perspective

On transition to Ind AS, companies are typically required to apply Ind AS retrospectively. However, Ind AS 101 First-time Adoption of Ind AS provides specific exemption/exceptions to the retrospective application. The resulting profit or loss impact is adjusted directly in the retained earnings. Under Ind AS, companies also recognise various gains and losses in the other comprehensive income (OCI) on an ongoing basis. Some of these gains and losses are subsequently reclassified to the statement of profit and loss (P&L) and other are not subsequently reclassified to the P&L. Given below are few examples of gains and losses recognised directly in the OCI:

  • Exchange differences on translation of foreign operations(foreign branches), i.e., foreign currency translation reserve(FCTR) – to be recycled to P&L
  • Cash flow hedge reserve – to be recycled to P&L
  • Revaluation surplus on application of revaluation model toproperty, plant and equipment (PPE)/intangible assets – cannotbe recycled to P&L but can be transferred to general reservewhen asset is depreciated/disposed
  • Remeasurement gains and losses of defined benefit plans –cannot be recycled to P&L; rather, they are recognised in OCIand immediately transferred to retained earnings
  • Gains and losses on Fair Value to Other Comprehensive Income(FVTOCI) equity instruments (not held for trading) – cannot berecycled to P&L
  • Gain on bargain purchase arising in a business combination
    • If there is clear evidence for the underlying reasonof bargain purchase, gain is recognised in OCI andaccumulated in capital reserve.
    • If there is no clear evidence for the underlying reason ofbargain purchase, gain is recognised directly in capitalreserve.

It is not absolutely clear whether amountsrecognised in OCI / retained earnings ontransition to Ind AS or subsequently will beincluded in the net worth. Also, it is not clearwhether these amounts will be included in‘net worth’ upfront or on realisation. Weshare our perspectives on these issues.

The definition is not absolutely clear on whether amounts recognised in OCI/retained earnings in this manner on transition to Ind AS or subsequently will be included in the net worth. Also, it is not clear whether these amounts will be included in ‘net worth’ upfront or on realisation, irrespective of whether recycled to P&L or not. For example, fair value as well as subsequent gains or losses on sale of an FVTOCI equity investment are not recycled to P&L. The question therefore is whether gains or losses are included in net worth and, if yes, at what point in time. The following three options are theoretically possible: (a) never included in net worth, (b) included in net worth as the gains or losses are recognised in OCI or (c) included in net worth when the equity investment is eventually disposed of or impaired.

With regard to adjustments arising on first-time adoption of Ind AS, pending clear guidance from the regulator, the following assumptions may be made on the basis that net worth reflects the intrinsic worth of a company:

  • Ind AS are notified under the 2013 Act. The company preparesits first Ind AS financial statements, including the openingInd AS balance sheet, in accordance with Ind AS. Hence, theaccounting treatment adopted by the company has legalbacking of the 2013 Act.
  • The definition of term ‘net worth’ refers to the ‘audited balancesheet’. This further supports the argument that the accountingtreatment adopted in the financial statements should berespected.
  • In accordance with the definition, ‘net worth’ includes ‘allreserves created out of the profits’. The word ‘profit’ is a wideterm and may include even amounts recognised directly inthe retained earnings in accordance with Ind AS 101. Forexample, a first-time adopter measures its investment inmutual funds at fair value on the transition date and recognisesthe resulting fair value gain directly in retained earnings. Suchgain is included in ‘net worth’ as it is a reserve created out ofprofits (which is recognised in retained earnings on first-timeadoption of Ind AS). However, consider another example wherea company decides to use revaluation model for its property,plant and equipment (PPE) at the transition date and on ago forward basis. This is different from the use of fair valueas deemed cost exemption for PPE at transition date (referdiscussion below). In this case, revaluation gain is credited torevaluation reserve. The reserves created out of revaluation ofassets will not be included in the net worth but will be includedin the net worth to the extent and when realised.
  • The 2017 Amendment Act specifically includes debit or creditbalance of the P&L account as part of net worth.
  • The definition excludes ‘reserves created out of revaluation’ from the net worth. It may be argued that the decision on what is revaluation and what is not should be as per the applicable accounting standards. In accordance with Ind AS for PPE, transition date measurement at fair value based on deemed cost option in Ind AS 101 is not revaluation.

With regard to ongoing adjustments recognised directly in the OCI, one may need to consider the nature of adjustments carefully to decide their inclusion or exclusion from net worth. For example, with regard to remeasurement adjustments recognised in OCI in accordance with Ind AS 19 Employee Benefits and transferred to retained earnings, it may be argued that these adjustments are not in the nature of ‘reserves created out of revaluation of assets’ and hence should be included in the net worth determination. However, for OCI adjustments such as gains on fair valuation of FVTOCI equity investments, one argument is that these are ‘reserves created out of revaluation of assets’. Hence, they should be excluded from determination of net worth. However, those gains will be included in net worth to the extent and when realised. In contrast, some may also argue that fair valuation in accordance with the requirements of Ind AS 109 Financial Instruments is not the same as revaluation of assets, for example, revaluation of PPE using the revaluation model. Therefore, the fair valuation gain should be included in the net worth. We believe that in the absense of clear guidance, both the views can be accepted. In either case. any losses on fair valuation of FVTOCI equity investment are deducted from net worth immediately.

In the absence of specific guidance, these views may be challenged. We suggest the MCA should clarify these issues through an appropriate notification/circular.

Reserves

In accordance with the 2013 Act, the term ‘free reserves’ means such reserves which, as per the latest audited balance sheet of a company, are available for distribution as dividend: Provided that

  • Any amount representing unrealised gains, notional gains or revaluation of assets, whether shown as a reserve or otherwise, or
  • Any change in carrying amount of an asset or of a liability recognised in equity, including surplus in P&L on measurement of the asset or the liability at fair value,

Shall not be treated as free reserves.

Determination of free reserves is extremelyonerous and effectively requires companiesto determine profits on cash basis ofaccounting, and losses on accrual basis.

Practical perspective

The 2017 Amendment Act does not prescribe any change with regard to the definition. Consequently, from a practical perspective, the following issues will continue to arise.

  • The definition of the term ‘free reserves’ appears to be basedon the principle that a company should not include unrealisedgains, but unrealised losses are included for computing freereserves. One common example of a reserve that may typicallyget excluded is revaluation surplus forming part of OCI createdon upward revaluation of PPE. A company that is applyinghedge accounting principles will exclude hedging reservefrom the ‘free reserves’ if the hedging reserve has a positive(credit) balance. If the hedging reserve has a negative (debit)balance, it will be deducted from free reserves. Similarly, acompany that has a foreign branch will exclude accumulatedgains on foreign currency translation of the branch. However,accumulated losses on translation will reduce free reserves.
  • The manner in which the term ‘free reserves’ is defined, particularly its proviso (a), suggests that unrealised gains, whether shown as reserves or credited to P&L/OCI, are not free reserves. Thus, if a company has recognised foreign exchange gains on translation of receivable, payables or loans in accordance with Ind AS 21 The Effects of Changes in Foreign Exchange Rates or recognised mark-to market gains on derivative contracts in accordance with Ind AS 109 Financial Instruments, such gains are not treated as free reserves. A company includes these amounts in free reserves upon realisation, e.g., when receivable is realised or derivative is settled. Interestingly, any unrealised losses on them will be treated as a reduction of the free reserves. The application of this principle creates practical challenges. Tracking the unrealised gains and its subsequent realisation on an individual item basis will be a very cumbersome exercise.
  • In accordance with the definition, the term ‘free reserves’ does not include any amount representing unrealised/notional gains, whether shown as a reserve or otherwise (Emphasis added). To apply this principle in practice and determine free reserves correctly, a company will need to track separately and identify when each gain is realised in cash. Till such realisation, gain cannot be included in free reserves. It does not matter whether the gain is recognised in P&L, OCI or directly in reserves. This will make identification of free reserves quite challenging.
  • The above principles will apply with regard to identification of free reserves for adjustments arising on first-time adoption of Ind AS and on-going Ind AS adjustments.

As can be seen from the above, the determination of free reserves is extremely onerous and effectively requires companies to determine profits on cash basis of accounting, and losses on accrual basis. Consequently, adjustments will be required for many more items than what may be apparent. For example, free reserves will be reduced by items such as deferred tax assets, rate regulated assets and fair valuation of defined benefit plan assets.

These matters are not beyond doubt and can be challenged. We recommend that the MCA should consider addressing these issue and provide appropriate guidance on them.

Loans and Investments

Multi-layering of investment companies

Section 186 of the 2013 Act prohibits a company from making investment through more than two layers of investment companies. Many stakeholders have raised concerns that these restrictions are not in line with the requirements of modern business and will be a significant impediment to the ease of doing business. For example, many conglomerates need multi-layer investment structures for reasons such as fundraising, creating sector-specific sub-groups and private equity (PE) investment. Companies also need these structures to raise finance where the PE investor wants to invest in specific businesses or group of entities, instead of making investment

In view of reports suggesting misuse ofmultiple layers of companies for diversion offunds or money laundering, the Governmenthas decided that the 2013 Act should retainrestriction on layers of companies.

at the ultimate parent level. Considering these aspects, the Companies Law Committee, the Standing Committee and the 2016 Bill had recommended for the removal of the provision relating to restriction on layers of companies.

However, subsequently, in view of reports of misuse of multiple layers of companies, where companies create shell companies for diversion of funds or money laundering, the Government has decided to retain these provisions. Accordingly, the 2017 Amendment Act does not contain any change on the matter. This indicates that restrictions on layering contained in the 2013 Act will continue to apply on a go forward basis as well.

In addition, it may be noted that definition of the term ‘subsidiary company’ in section 2(87) of the 2013 Act contains a proviso whereby such class or classes of holding companies as may be prescribed will not have layers of subsidiaries beyond such numbers as may be prescribed. Till sometime back, the MCA had not specified any companies under this proviso. Hence, this restriction was earlier not applicable.

On 28 June 2017, the MCA issued a public notice indicating its intention to enact this proviso in section 2(87) and invited public comment on related draft rules. After considering the comments received, the MCA has recently notified the applicability date for the proviso to section 2(87) of the 2013 Act. The MCA has also notified the Companies (Restriction on number of layers) Rules 2017. The proviso and these rules are applicable from the date of publication in the Official Gazette, viz., 20 September 2017. The rules provide for the following:

  • A holding company is allowed to have up to two layers of subsidiaries. In computing the layers under this rule, one layer that is represented by a wholly owned subsidiary will not be taken into account.
  • These restrictions are in addition to the layering restrictions under section 186(1), which prohibit a company from making investment through more than two layers of investment companies. Investment companies will also be included in the count for the purposes of layer requirements under the new rule.
  • The restriction does not prohibit a holding company from acquiring a subsidiary incorporated in a country outside India if such subsidiary has layers as per the laws of such country.
  • The provisions of this rule do not apply to the following classes of companies, i.e., they can continue to have more than two layers of subsidiaries:
    • A banking company
    • A systemically important non-banking financial company (NBFC) registered with the Reserve Bank of India
    • An insurance company
    • A government company
  • Every company, other than exempt companies referred to in (d) above, existing on or before the commencement of these rules, which has number of layers of subsidiaries in excess of the permitted layers, will comply with the following transitional provisions:
    • The company will file with the Registrar a return in Form CRL-1 disclosing the details specified therein, within 150 days from the date of application of these rules.
    • The company will not, after the date of commencement of these rules, have any additional layer of subsidiaries over and above the layers existing on such date.
    • The company will not, in case one or more layers are reduced by it subsequent to the commencement of these rules, have the number of layers beyond the number of layers it has after such reduction or maximum layers allowed in sub-rule (1), whichever is more.
  • If any company contravenes any provision of these rules, the company and every officer of the company who is in default will be punishable with fine that may extend to INR10,000 and, where the contravention is a continuing one, with a further fine that may extend to INR1,000 for every day after the first during which such contravention continues.

Loans to directors etc.

In accordance with section 185 of the 2013 Act, a company cannot provide loan, guarantee or security to any of its directors or to any other person in whom the director is interested. One of the outcomes of the term ‘person in whom director is interested’ was that a company could not give a loan even to its subsidiary, associate or joint venture companies. This has created significant challenges for many groups, particularly cases where investee companies are significantly dependent on the investor for financing. The MCA tried addressing these concerns through rules/ notifications. However, they were not comprehensive. Also, there was a concern that rules may be overriding the Act.

To address these issues comprehensively, the 2017 Amendment Act replaces the current requirement of section with a completely new section 185. Given below is an overview of the key requirements in the new section:

  • A company will not provide loan, guarantee or security in connection with a loan to any director, director of the holding company or any partner or relative of any such director or any firm in which any such director or relative is a partner.
  • Loan to other persons or parties in whom the director is interested can be given if both the following conditions are met:
    • A special resolution is passed by the company in the general meeting. The explanatory statement to the notice for the relevant general meeting should disclose the full particulars of the loans or guarantee given or security provided and the purpose for which the loan or guarantee or security is proposed to be utilised by the recipient and any other relevant facts.
    • The loans are utilised by the borrowing company for its principal business activities.

The new section 185 states that the above prohibitions/ restrictions will not apply in the following cases . However, the loans made under clauses (c) and (d) below should be utilised by the subsidiary company for its principal business activities:

  • A loan given by a company to a managing or whole-time director either as part of the conditions of service extended by the company to all its employees, or pursuant to a scheme approved by the members by a special resolution
  • A company which in the ordinary course of its business provides loans or gives guarantees or securities for the due repayment of any loan and in respect of such loans an interest is charged at a rate not less than the rate of the prevailing yield of one-year, three-year, five-year or ten-year Government security closest to the tenor of the loan
  • Any loan made by a holding company to its wholly owned subsidiary company or any guarantee given or security provided by a holding company in respect of any loan made to its wholly owned subsidiary company
  • Any guarantee given or security provided by a holding company in respect of loan made by any bank or financial institution to its subsidiary company

We welcome the revision of section 185. It is likely to address many practical issues which had arisen on the application of the 2013 Act.

Loans to employees

Section 186(2) of the 2013 Act contains specific prohibitions/ restriction on provision of loan/guarantee/security etc. to a person or body corporate. The occurrence of the word ‘person’ in the section unwittingly seemed to cover employees. The Companies Law Committee was of the view that loans which are given to employees as part of service conditions or pursuant to an approved scheme for all employees by the company should not be covered under this section. This section was meant to cover intercorporate loans and not loans to employees.

The 2017 Amendment Act clarifies that for the purposes of this sub-section, the word ‘person’ does not include any individual who is in the employment of the company. Consequently, loans to employees will not be subject to restrictions under section 186(2).

Loans and investments by holding company

Section 186 of the 2013 Act requires that a company will not (i) give loans to any person/other body corporate, (ii) give guarantee or provide security in connection with a loan to any person/other body corporate and (iii) acquire securities of any other body corporate, exceeding the higher of:

  • 60% of its paid-up share capital, free reserves and securities premium, or
  • 100% of its free reserves and securities premium.

The 2017 Amendment Act has includedrelaxations, which were earlier availablein rules, as part of the Act itself. This willaddress concerns that rules were overridingthe 2013 Act.

The 2013 Act states that for providing loan/giving guarantee/ security or acquiring security exceeding the above limit, a company will need to take prior approval by means of a special resolution passed at the general meeting. The 2013 Act did not contain any exemption for loan made/guarantee given/ security provided by a holding company to its wholly owned subsidiary companies. Consequently, it was required that a company will include the amount of loan/guarantee/security to its wholly owned subsidiary as well in the 60%/ 100% limit. This was likely to create hardship for many subsidiary companies, which are significantly dependent on their parent for financing.

To address the above challenge, the rules notified under the 2013 Act provided that where a loan or guarantee is given or where a security has been provided by a company to its wholly owned subsidiary company or a joint venture company, or acquisition is made by a holding company of the securities of its wholly owned subsidiary company, the requirement concerning special resolution at the general meeting will not apply. However, the company will disclose details of such loans or guarantee or security or acquisition in the financial statements.

The changes made in the rules were helpful to address the practical challenges faced by companies. However, there was a concern that the rules were overriding the requirements of the 2013 Act. To address this concern, the 2017 Amendment Act has included relaxations, which were available in rules, as part of the Act itself. The changes made in the 2017 Amendment Act state that where a loan or guarantee is given or where a security has been provided by a company to its wholly owned subsidiary company or a joint venture company, or acquisition is made by a holding company, by way of subscription, purchase or otherwise of, the securities of its wholly owned subsidiary company, the requirement related to approval by special resolution at the shareholders’ meeting will not apply. However, the company will disclose the details of such loans or guarantee or security or acquisition in the financial statements.

Section 186(7) of the 2013 Act requires that no loan will be given under section 186 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. On the lines of rules notified under the 2013 Act, the 2017 Amendment Act does not contain any relaxation in this regard. Hence, a company needs to charge interest at the specified rate on all its loans, including loans given to wholly owned subsidiaries, other subsidiaries and joint ventures.

Restrictions on powers of the board

Section 180(1)(c) of the 2013 Act requires that if money proposed to be borrowed together with the money already borrowed by the company exceeds the aggregate of its paid-up share capital and free reserves, a special resolution should be passed by the company for borrowing money. Hence, the securities premium amount is not included in this computation. The 2017 Amendment Act amends section 180(1)(c) so that it includes securities premium along with paid-up share capital and free reserves for the calculation of maximum limits on the borrowing powers of the board.

Related party transactions

The requirements concerning RPTs have been a matter of significant debate since their introduction in the 2013 Act. The 2017 Amendment Act contains the following key changes primarily aimed at addressing practical difficulties in the application:

Definition of ‘related party’

Company vs. body corporate

The definition of the term ‘related party’ in section 2(76) of the 2013 Act used the word ‘company’, e.g., it used the words ‘holding’, ‘subsidiary’ or associate’ company. Foreign company is not a company under the 2013 Act; rather, it is a body corporate. Thus, some may have interpreted the definition of the term ‘related party’ to include only companies/entities incorporated in India within its purview. Such an interpretation will have a consequence that companies/entities incorporated outside India, such as foreign holding/subsidiary/associate/ fellow subsidiary of an Indian company, were excluded from the purview of related party requirements for an Indian company. This was not the intention of the government and such an interpretation may have seriously diluted compliance with related party requirements under the 2013 Act.

To address this issue beyond any doubt, the 2017 Amendment Act substitutes the word ‘company’ with the word ‘body corporate.’ Hence, upon enactment of the 2017 Amendment Act, it is now absolutely clear that a body corporate that is a holding/subsidiary/associate /fellow subsidiary of an Indian company should be treated as related party.

A body corporate (foreign company) whichis a holding/subsidiary/associate /fellowsubsidiary of an Indian company will betreated as related party under the 2013 Act.This is clarificatory change.

Investor in associate company

Under the existing definition of the term ‘related party’ given in section 2(76) of 2013 Act, associate company is a related party for the investor in that company. However, for the associate company itself, investor is not a related party. The 2017 Amendment Act fixes this anomaly and requires that both associate company and investor should be treated as related to each other.

Both associate company and investor willnow be treated as related to each other.

Voting rights

The second proviso to Section 188(1) of the 2013 Act states that a member who is a related party will not be entitled to vote on special resolutions or approve any contract or arrangement that may be entered into by the company. Since section 47 of the 2013 Act is the primary section dealing with members that are entitled to vote and the proportion of their voting rights, the 2017 Amendment Act clarifies that the requirement of section 47 will be subject to section 188(1). In other words, the right of every member holding equity shares to vote on all resolutions placed before the shareholders meeting would not be applicable to members who are related parties and prohibited from voting under section 188.

Section 47 of the 2013 Act dealing withmembers’ right to vote has been aligned withsection 188, which restricts related parties’right to vote on ordinary/ special resolutionto approve RPTs.

Approval of related party transactions

Section 188 of the 2013 Act requires RPTs to be approved by an ordinary resolution of disinterested shareholders if they do not meet the prescribed exemption criteria. The 2013 Act states that no member of the company will vote on such ordinary resolution if such member is a related party. Compliance with this requirement may be particularly challenging in certain cases. For example, compliance with this requirement will be challenging for companies that are closely held or are a joint venture between 2-3 shareholders since all shareholders will be related parties. To address this issue, the 2017 Amendment Act states that a company wherein 90% or more members in number are relatives of the promoter or are related parties, all shareholders will be entitled to vote on the ordinary resolution.

Section 188 (3) of the 2013 Act deals with a scenario where any contract or arrangement is entered into by a director or any other employee without obtaining the consent of the board and/ or approval by an ordinary resolution in the general meeting. The section states that if the contract/arrangement is not ratified by the board or, as the case may be, by the shareholders at a meeting within three months from the date on which such contract or arrangement was entered into, then such contract or arrangement will be voidable at the option of the board. Further, if the contract or arrangement is with a related party to any director, or is authorised by any other director, the directors concerned will indemnify the company against any loss incurred by it. The 2017 Amendment Act states that apart from being voidable at the option of the board, the contract/arrangement would also be voidable at the option of the shareholders.

The third proviso to Section 188(1) has reference to the terms ‘ordinary course of business’ and ‘arm’s length basis’. The Companies Law Committee had considered a suggestion that these terms may be clarified/defined. The Committee was of the view that these terms are known in general commercial parlance and enough accounting guidance is available. The Committee therefore did not recommend any change in the 2013 Act/ Rules on these matter. Rather, it was suggested that the ICAI may consider issuing suitable guidance notes on these matters to guide its members. In line with the Committee’s recommendations, the 2017 Amendment Act does not contain any change on this matter.

Audit Committee pre-approval of RPT

Under section 177 of the 2013 Act, the Audit Committee is required to pre-approve all RPTs and subsequent modifications thereto. In contrast, section 188 requires the board and/ or shareholders to pre-approve only specific RPT’s. Also, section 188 contains two exemptions from the approval process, viz., transactions are entered into by the company in its ordinary course of business and on an arm’s length basis, or they do not exceed prescribed materiality threshold.

The 2017 Amendment Act does not prescribe changes to align the Audit Committee pre-approval requirements with the RPT approval requirements under section 188. However, it clarifies that if the Audit Committee does not approve transactions not covered under section 188, the Audit Committee will make its recommendations to the board. This will require the board to consider and approve these RPTs even if they were otherwise not covered under the approval requirement of section 188.

The 2017 Amendment Act clarifies that RPTs between a holding company and its wholly owned subsidiaries will not require the approval of the Audit Committee. However, if these transactions require board approval under section 188, then they will also require approval of the Audit Committee.

If Audit Committee does not approve RPT notcovered under section 188, the Committee willmake its recommendations to the board. The boardwill need to consider and approve such RPTs.

The 2017 Amendment Act somewhat relaxes Audit Committee pre-approval requirements for RPTs. Based on the relaxation given, a director or officer of the company may enter into a related transaction for an amount not exceeding INR1 crore, without obtaining prior approval of the Audit Committee. However, such transaction should be ratified by the Audit Committee within three months from the date of the transaction. In the absence of such ratification, the transaction will be voidable at the option of the Audit Committee. Also, if the transaction is with a related party to any director or is authorised by any other director, the director concerned will indemnify the company against any loss incurred by it.

We welcome most of the changes above. However, with regard to Audit Committee pre-approval of RPT’s, we continue to believe that the Audit Committee and independent directors (IDs) should not have executive responsibility to approve RPT’s. They should be responsible for reviewing RPT’s and not approving the same.

Declaration and payment of dividend

Distributable profits

The 2013 Act permits a company to pay dividend from current year’s profits or from ‘free reserves’ (in case of inadequacy of current year’s profits). As mentioned in the ‘Free reserves’ heading of this publication, the definition of ‘free reserves’ excludes unrealised/notional gains arising on fair valuation or revaluation of assets and liabilities. However, the 2013 Act appears to permit payment of dividend out of current year’s profits without adjustment in respect of notional/unrealised gains.

The 2013 Act permits dividend payment outof current year’s profits without adjustmentfor notional/ unrealised gains. The auditcommittee and board of companies applyingInd AS should ensure that prudent policiesare followed for dividend distribution.

There is no clarity as to how Ind AS adjustment recognised in P&L will impact distributable profits recognised in P&L. Under Ind AS, an infrastructure company accounting for service concession arrangement recognises significant revenue and margins upfront, though the cash is received in the form of toll revenue over the next several years. A prudent policy would be to not distribute the accounting profits that will be realised over several future years. However, in the absence of clear legislation, this may not be enforceable.

The MCA may consider addressing these issues appropriately. In any case, the audit committee and board of companies applying Ind AS should ensure that prudent policies are followed with regard to dividend distribution

Interim dividend

In accordance with section 123(3) of the 2013 Act, a company may declare interim dividend during any financial year out of the surplus in the P&L account and out of profits of the financial year in which such interim dividend is sought to be declared.

From a plain reading of the paragraph, it appears that the interim dividend for a particular financial year could only be declared before the close of financial year and not thereafter. For example, a company has 31 March year-end and its annual general meeting (AGM) for the year ended 31 March 2017 is held in September 2017. From a literal reading of the section, the company can declare interim dividend only till 31 March 2017 and not thereafter, say, in May or June 2017.

Further, the use of the words “out of the surplus in the P&L account and out of profits of the financial year” indicate that a company may declare interim dividend only if it has at least some profit for the current financial year. Consider the following two scenarios:

  • Company A has accumulated profit of INR100 million at the beginning of the financial year. It earned an additional profit of INR0.1 million during the first six months of the financial year. Its accumulated profit at the end of six months is INR100.1 million.
  • Company B has accumulated profit of INR101 million at the beginning of the financial year. It incurred a loss of INR0.9 million during the first six months of the financial year. Its accumulated profit at the end of six months is INR100.1 million.

A company can declare interim dividendduring any financial year or at any timeduring the period from the closure offinancial year till holding of the AGM. Also,interim dividend can be declared out ofsurplus in the P&L account or out of profitsfor the financial year for which interimdividend is being declared.

Since Company A has earned a profit in the first six months, it can declare an interim dividend out of the accumulated profits of INR100.1 million. However, Company B with the same amount of accumulated profits cannot declare a dividend since it has incurred losses in the first six months.

The Companies Law Committee expressed the view that the above cannot be the intention of the law. To resolve the above issues, the 2017 Amendment Act allows declaration of interim dividend during any financial year or at any time during the period from the closure of financial year till the holding of the AGM. It also clarifies that interim dividend can be declared out of surplus in the P&L account or out of profits for the financial year for which interim dividend is sought to be declared or out of profits generated in the financial year till the quarter preceding the date of declaration of the interim dividend. However, if a company has incurred losses during the current financial year up to the end of the quarter immediately preceding the date of declaration of interim dividend, the rate of interim dividend cannot be higher than the average dividends declared by the company during the immediately preceding three financial years.

Final dividend

The second proviso of Section 123 (1) of the Act states as below:

“Provided that where, owing to inadequacy or absence of profits in any financial year, any company proposes to declare dividend out of the accumulated profits earned by it in previous years and transferred by it to the reserves, such declaration of dividend shall not be made except in accordance with such rules as may be prescribed in this behalf.”

The wordings used in the 2013 Act suggest that compliance with the Companies (Declaration and Payment of Dividend) Rules, 2014 will be required only when dividend is declared out of amounts already transferred to ‘reserves’. However, in contrast, rule 3 of the Companies (Declaration and Payment of Dividend) Rules, 2014 allows companies to declare dividend out of ‘free reserves’ only if the conditions laid in the rule have been complied with (Emphasis added). Since ‘surplus in the profit and loss account’ is also a free reserve, it is not clear whether a company will be required to comply with the said rules even when it declares dividend out of surplus in the P&L account. The surplus balance (i.e., carried forward balance of the P&L account) is a part of ‘free reserves’ but it does not represent an amount ‘transferred’ to reserves.

Companies will have freedom of utilising thebalance standing in the P&L account (and nottransferred to the reserves) for payment ofdividend. Appropriate change can be made inDividend Rules to clarify this further.

The Companies Law Committee discussed the issue and was of the view that companies must have the freedom of utilising the balance standing in the P&L account (and not transferred to the reserves) for payment of dividend in case of inadequacy of profit in a year. The Committee was of the view that once rule 3 is aligned with the provisions of the 2013 Act, this aspect will be clear. The Committee suggested that to avoid any legal challenges in application, the requirements of the Rule and the section should be harmonised appropriately.

The 2017 Amendment Act does not contain any change on this matter. It is important that the Government make appropriate changes in the rules to align the same with the requirements of the 2013 Act. Also, it appears that companies will have freedom of utilising the balance standing in the P&L account (and not transferred to the reserves) for payment of dividend in case of inadequacy of profit in a year. Specifically they will not be required to comply with the Companies (Declaration and Payment of Dividend) Rules, 2014 in such cases.

Net worth

In accordance with section 2(57) of the 2013 Act, ‘net worth’ means the aggregate value of the paid-up share capital and all reserves created out of the profits and securities premium account, after deducting the aggregate value of the accumulated losses, deferred expenditure and miscellaneous expenditure not written off, as per the audited balance sheet, but does not include reserves created out of revaluation of assets, write-back of depreciation and amalgamation.

Debit or credit balance of the profit andloss account’ will be included in ‘net worth’computation. This is a clarificatory change,one that was important to make.

In the absence of a specific mention, there was a debate as to whether ‘net worth’ included ‘debit or credit balance of the profit and loss account’. The 2017 Amendment Act addresses this debate by specifically including the phrase ‘debit or credit balance of the profit and loss account’ in the definition of ‘net worth’. In our view, the net worth of a company reflects its intrinsic value. Hence, this is a clarificatory change, one that was important to make.

Practical perspective

On transition to Ind AS, companies are typically required to apply Ind AS retrospectively. However, Ind AS 101 First-time Adoption of Ind AS provides specific exemption/exceptions to the retrospective application. The resulting profit or loss impact is adjusted directly in the retained earnings. Under Ind AS, companies also recognise various gains and losses in the other comprehensive income (OCI) on an ongoing basis. Some of these gains and losses are subsequently reclassified to the statement of profit and loss (P&L) and other are not subsequently reclassified to the P&L. Given below are few examples of gains and losses recognised directly in the OCI:

  • Exchange differences on translation of foreign operations(foreign branches), i.e., foreign currency translation reserve(FCTR) – to be recycled to P&L
  • Cash flow hedge reserve – to be recycled to P&L
  • Revaluation surplus on application of revaluation model toproperty, plant and equipment (PPE)/intangible assets – cannotbe recycled to P&L but can be transferred to general reservewhen asset is depreciated/disposed
  • Remeasurement gains and losses of defined benefit plans –cannot be recycled to P&L; rather, they are recognised in OCIand immediately transferred to retained earnings
  • Gains and losses on Fair Value to Other Comprehensive Income(FVTOCI) equity instruments (not held for trading) – cannot berecycled to P&L
  • Gain on bargain purchase arising in a business combination
    • If there is clear evidence for the underlying reasonof bargain purchase, gain is recognised in OCI andaccumulated in capital reserve.
    • If there is no clear evidence for the underlying reason ofbargain purchase, gain is recognised directly in capitalreserve.

It is not absolutely clear whether amountsrecognised in OCI / retained earnings ontransition to Ind AS or subsequently will beincluded in the net worth. Also, it is not clearwhether these amounts will be included in‘net worth’ upfront or on realisation. Weshare our perspectives on these issues.

The definition is not absolutely clear on whether amounts recognised in OCI/retained earnings in this manner on transition to Ind AS or subsequently will be included in the net worth. Also, it is not clear whether these amounts will be included in ‘net worth’ upfront or on realisation, irrespective of whether recycled to P&L or not. For example, fair value as well as subsequent gains or losses on sale of an FVTOCI equity investment are not recycled to P&L. The question therefore is whether gains or losses are included in net worth and, if yes, at what point in time. The following three options are theoretically possible: (a) never included in net worth, (b) included in net worth as the gains or losses are recognised in OCI or (c) included in net worth when the equity investment is eventually disposed of or impaired.

With regard to adjustments arising on first-time adoption of Ind AS, pending clear guidance from the regulator, the following assumptions may be made on the basis that net worth reflects the intrinsic worth of a company:

  • Ind AS are notified under the 2013 Act. The company preparesits first Ind AS financial statements, including the openingInd AS balance sheet, in accordance with Ind AS. Hence, theaccounting treatment adopted by the company has legalbacking of the 2013 Act.
  • The definition of term ‘net worth’ refers to the ‘audited balancesheet’. This further supports the argument that the accountingtreatment adopted in the financial statements should berespected.
  • In accordance with the definition, ‘net worth’ includes ‘allreserves created out of the profits’. The word ‘profit’ is a wideterm and may include even amounts recognised directly inthe retained earnings in accordance with Ind AS 101. Forexample, a first-time adopter measures its investment inmutual funds at fair value on the transition date and recognisesthe resulting fair value gain directly in retained earnings. Suchgain is included in ‘net worth’ as it is a reserve created out ofprofits (which is recognised in retained earnings on first-timeadoption of Ind AS). However, consider another example wherea company decides to use revaluation model for its property,plant and equipment (PPE) at the transition date and on ago forward basis. This is different from the use of fair valueas deemed cost exemption for PPE at transition date (referdiscussion below). In this case, revaluation gain is credited torevaluation reserve. The reserves created out of revaluation ofassets will not be included in the net worth but will be includedin the net worth to the extent and when realised.
  • The 2017 Amendment Act specifically includes debit or creditbalance of the P&L account as part of net worth.
  • The definition excludes ‘reserves created out of revaluation’ from the net worth. It may be argued that the decision on what is revaluation and what is not should be as per the applicable accounting standards. In accordance with Ind AS for PPE, transition date measurement at fair value based on deemed cost option in Ind AS 101 is not revaluation.

With regard to ongoing adjustments recognised directly in the OCI, one may need to consider the nature of adjustments carefully to decide their inclusion or exclusion from net worth. For example, with regard to remeasurement adjustments recognised in OCI in accordance with Ind AS 19 Employee Benefits and transferred to retained earnings, it may be argued that these adjustments are not in the nature of ‘reserves created out of revaluation of assets’ and hence should be included in the net worth determination. However, for OCI adjustments such as gains on fair valuation of FVTOCI equity investments, one argument is that these are ‘reserves created out of revaluation of assets’. Hence, they should be excluded from determination of net worth. However, those gains will be included in net worth to the extent and when realised. In contrast, some may also argue that fair valuation in accordance with the requirements of Ind AS 109 Financial Instruments is not the same as revaluation of assets, for example, revaluation of PPE using the revaluation model. Therefore, the fair valuation gain should be included in the net worth. We believe that in the absense of clear guidance, both the views can be accepted. In either case. any losses on fair valuation of FVTOCI equity investment are deducted from net worth immediately.

In the absence of specific guidance, these views may be challenged. We suggest the MCA should clarify these issues through an appropriate notification/circular.

Reserves

In accordance with the 2013 Act, the term ‘free reserves’ means such reserves which, as per the latest audited balance sheet of a company, are available for distribution as dividend: Provided that

  • Any amount representing unrealised gains, notional gains or revaluation of assets, whether shown as a reserve or otherwise, or
  • Any change in carrying amount of an asset or of a liability recognised in equity, including surplus in P&L on measurement of the asset or the liability at fair value,

Shall not be treated as free reserves.

Determination of free reserves is extremelyonerous and effectively requires companiesto determine profits on cash basis ofaccounting, and losses on accrual basis.

Practical perspective

The 2017 Amendment Act does not prescribe any change with regard to the definition. Consequently, from a practical perspective, the following issues will continue to arise.

  • The definition of the term ‘free reserves’ appears to be basedon the principle that a company should not include unrealisedgains, but unrealised losses are included for computing freereserves. One common example of a reserve that may typicallyget excluded is revaluation surplus forming part of OCI createdon upward revaluation of PPE. A company that is applyinghedge accounting principles will exclude hedging reservefrom the ‘free reserves’ if the hedging reserve has a positive(credit) balance. If the hedging reserve has a negative (debit)balance, it will be deducted from free reserves. Similarly, acompany that has a foreign branch will exclude accumulatedgains on foreign currency translation of the branch. However,accumulated losses on translation will reduce free reserves.
  • The manner in which the term ‘free reserves’ is defined, particularly its proviso (a), suggests that unrealised gains, whether shown as reserves or credited to P&L/OCI, are not free reserves. Thus, if a company has recognised foreign exchange gains on translation of receivable, payables or loans in accordance with Ind AS 21 The Effects of Changes in Foreign Exchange Rates or recognised mark-to market gains on derivative contracts in accordance with Ind AS 109 Financial Instruments, such gains are not treated as free reserves. A company includes these amounts in free reserves upon realisation, e.g., when receivable is realised or derivative is settled. Interestingly, any unrealised losses on them will be treated as a reduction of the free reserves. The application of this principle creates practical challenges. Tracking the unrealised gains and its subsequent realisation on an individual item basis will be a very cumbersome exercise.
  • In accordance with the definition, the term ‘free reserves’ does not include any amount representing unrealised/notional gains, whether shown as a reserve or otherwise (Emphasis added). To apply this principle in practice and determine free reserves correctly, a company will need to track separately and identify when each gain is realised in cash. Till such realisation, gain cannot be included in free reserves. It does not matter whether the gain is recognised in P&L, OCI or directly in reserves. This will make identification of free reserves quite challenging.
  • The above principles will apply with regard to identification of free reserves for adjustments arising on first-time adoption of Ind AS and on-going Ind AS adjustments.

As can be seen from the above, the determination of free reserves is extremely onerous and effectively requires companies to determine profits on cash basis of accounting, and losses on accrual basis. Consequently, adjustments will be required for many more items than what may be apparent. For example, free reserves will be reduced by items such as deferred tax assets, rate regulated assets and fair valuation of defined benefit plan assets.

These matters are not beyond doubt and can be challenged. We recommend that the MCA should consider addressing these issue and provide appropriate guidance on them.

Loans and Investments

Multi-layering of investment companies

Section 186 of the 2013 Act prohibits a company from making investment through more than two layers of investment companies. Many stakeholders have raised concerns that these restrictions are not in line with the requirements of modern business and will be a significant impediment to the ease of doing business. For example, many conglomerates need multi-layer investment structures for reasons such as fundraising, creating sector-specific sub-groups and private equity (PE) investment. Companies also need these structures to raise finance where the PE investor wants to invest in specific businesses or group of entities, instead of making investment

In view of reports suggesting misuse ofmultiple layers of companies for diversion offunds or money laundering, the Governmenthas decided that the 2013 Act should retainrestriction on layers of companies.

at the ultimate parent level. Considering these aspects, the Companies Law Committee, the Standing Committee and the 2016 Bill had recommended for the removal of the provision relating to restriction on layers of companies.

However, subsequently, in view of reports of misuse of multiple layers of companies, where companies create shell companies for diversion of funds or money laundering, the Government has decided to retain these provisions. Accordingly, the 2017 Amendment Act does not contain any change on the matter. This indicates that restrictions on layering contained in the 2013 Act will continue to apply on a go forward basis as well.

In addition, it may be noted that definition of the term ‘subsidiary company’ in section 2(87) of the 2013 Act contains a proviso whereby such class or classes of holding companies as may be prescribed will not have layers of subsidiaries beyond such numbers as may be prescribed. Till sometime back, the MCA had not specified any companies under this proviso. Hence, this restriction was earlier not applicable.

On 28 June 2017, the MCA issued a public notice indicating its intention to enact this proviso in section 2(87) and invited public comment on related draft rules. After considering the comments received, the MCA has recently notified the applicability date for the proviso to section 2(87) of the 2013 Act. The MCA has also notified the Companies (Restriction on number of layers) Rules 2017. The proviso and these rules are applicable from the date of publication in the Official Gazette, viz., 20 September 2017. The rules provide for the following:

  • A holding company is allowed to have up to two layers of subsidiaries. In computing the layers under this rule, one layer that is represented by a wholly owned subsidiary will not be taken into account.
  • These restrictions are in addition to the layering restrictions under section 186(1), which prohibit a company from making investment through more than two layers of investment companies. Investment companies will also be included in the count for the purposes of layer requirements under the new rule.
  • The restriction does not prohibit a holding company from acquiring a subsidiary incorporated in a country outside India if such subsidiary has layers as per the laws of such country.
  • The provisions of this rule do not apply to the following classes of companies, i.e., they can continue to have more than two layers of subsidiaries:
    • A banking company
    • A systemically important non-banking financial company (NBFC) registered with the Reserve Bank of India
    • An insurance company
    • A government company
  • Every company, other than exempt companies referred to in (d) above, existing on or before the commencement of these rules, which has number of layers of subsidiaries in excess of the permitted layers, will comply with the following transitional provisions:
    • The company will file with the Registrar a return in Form CRL-1 disclosing the details specified therein, within 150 days from the date of application of these rules.
    • The company will not, after the date of commencement of these rules, have any additional layer of subsidiaries over and above the layers existing on such date.
    • The company will not, in case one or more layers are reduced by it subsequent to the commencement of these rules, have the number of layers beyond the number of layers it has after such reduction or maximum layers allowed in sub-rule (1), whichever is more.
  • If any company contravenes any provision of these rules, the company and every officer of the company who is in default will be punishable with fine that may extend to INR10,000 and, where the contravention is a continuing one, with a further fine that may extend to INR1,000 for every day after the first during which such contravention continues.

Loans to directors etc.

In accordance with section 185 of the 2013 Act, a company cannot provide loan, guarantee or security to any of its directors or to any other person in whom the director is interested. One of the outcomes of the term ‘person in whom director is interested’ was that a company could not give a loan even to its subsidiary, associate or joint venture companies. This has created significant challenges for many groups, particularly cases where investee companies are significantly dependent on the investor for financing. The MCA tried addressing these concerns through rules/ notifications. However, they were not comprehensive. Also, there was a concern that rules may be overriding the Act.

To address these issues comprehensively, the 2017 Amendment Act replaces the current requirement of section with a completely new section 185. Given below is an overview of the key requirements in the new section:

  • A company will not provide loan, guarantee or security in connection with a loan to any director, director of the holding company or any partner or relative of any such director or any firm in which any such director or relative is a partner.
  • Loan to other persons or parties in whom the director is interested can be given if both the following conditions are met:
    • A special resolution is passed by the company in the general meeting. The explanatory statement to the notice for the relevant general meeting should disclose the full particulars of the loans or guarantee given or security provided and the purpose for which the loan or guarantee or security is proposed to be utilised by the recipient and any other relevant facts.
    • The loans are utilised by the borrowing company for its principal business activities.

The new section 185 states that the above prohibitions/ restrictions will not apply in the following cases . However, the loans made under clauses (c) and (d) below should be utilised by the subsidiary company for its principal business activities:

  • A loan given by a company to a managing or whole-time director either as part of the conditions of service extended by the company to all its employees, or pursuant to a scheme approved by the members by a special resolution
  • A company which in the ordinary course of its business provides loans or gives guarantees or securities for the due repayment of any loan and in respect of such loans an interest is charged at a rate not less than the rate of the prevailing yield of one-year, three-year, five-year or ten-year Government security closest to the tenor of the loan
  • Any loan made by a holding company to its wholly owned subsidiary company or any guarantee given or security provided by a holding company in respect of any loan made to its wholly owned subsidiary company
  • Any guarantee given or security provided by a holding company in respect of loan made by any bank or financial institution to its subsidiary company

We welcome the revision of section 185. It is likely to address many practical issues which had arisen on the application of the 2013 Act.

Loans to employees

Section 186(2) of the 2013 Act contains specific prohibitions/ restriction on provision of loan/guarantee/security etc. to a person or body corporate. The occurrence of the word ‘person’ in the section unwittingly seemed to cover employees. The Companies Law Committee was of the view that loans which are given to employees as part of service conditions or pursuant to an approved scheme for all employees by the company should not be covered under this section. This section was meant to cover intercorporate loans and not loans to employees.

The 2017 Amendment Act clarifies that for the purposes of this sub-section, the word ‘person’ does not include any individual who is in the employment of the company. Consequently, loans to employees will not be subject to restrictions under section 186(2).

Loans and investments by holding company

Section 186 of the 2013 Act requires that a company will not (i) give loans to any person/other body corporate, (ii) give guarantee or provide security in connection with a loan to any person/other body corporate and (iii) acquire securities of any other body corporate, exceeding the higher of:

  • 60% of its paid-up share capital, free reserves and securities premium, or
  • 100% of its free reserves and securities premium.

The 2017 Amendment Act has includedrelaxations, which were earlier availablein rules, as part of the Act itself. This willaddress concerns that rules were overridingthe 2013 Act.

The 2013 Act states that for providing loan/giving guarantee/ security or acquiring security exceeding the above limit, a company will need to take prior approval by means of a special resolution passed at the general meeting. The 2013 Act did not contain any exemption for loan made/guarantee given/ security provided by a holding company to its wholly owned subsidiary companies. Consequently, it was required that a company will include the amount of loan/guarantee/security to its wholly owned subsidiary as well in the 60%/ 100% limit. This was likely to create hardship for many subsidiary companies, which are significantly dependent on their parent for financing.

To address the above challenge, the rules notified under the 2013 Act provided that where a loan or guarantee is given or where a security has been provided by a company to its wholly owned subsidiary company or a joint venture company, or acquisition is made by a holding company of the securities of its wholly owned subsidiary company, the requirement concerning special resolution at the general meeting will not apply. However, the company will disclose details of such loans or guarantee or security or acquisition in the financial statements.

The changes made in the rules were helpful to address the practical challenges faced by companies. However, there was a concern that the rules were overriding the requirements of the 2013 Act. To address this concern, the 2017 Amendment Act has included relaxations, which were available in rules, as part of the Act itself. The changes made in the 2017 Amendment Act state that where a loan or guarantee is given or where a security has been provided by a company to its wholly owned subsidiary company or a joint venture company, or acquisition is made by a holding company, by way of subscription, purchase or otherwise of, the securities of its wholly owned subsidiary company, the requirement related to approval by special resolution at the shareholders’ meeting will not apply. However, the company will disclose the details of such loans or guarantee or security or acquisition in the financial statements.

Section 186(7) of the 2013 Act requires that no loan will be given under section 186 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. On the lines of rules notified under the 2013 Act, the 2017 Amendment Act does not contain any relaxation in this regard. Hence, a company needs to charge interest at the specified rate on all its loans, including loans given to wholly owned subsidiaries, other subsidiaries and joint ventures.

Restrictions on powers of the board

Section 180(1)(c) of the 2013 Act requires that if money proposed to be borrowed together with the money already borrowed by the company exceeds the aggregate of its paid-up share capital and free reserves, a special resolution should be passed by the company for borrowing money. Hence, the securities premium amount is not included in this computation. The 2017 Amendment Act amends section 180(1)(c) so that it includes securities premium along with paid-up share capital and free reserves for the calculation of maximum limits on the borrowing powers of the board.

Related party transactions

The requirements concerning RPTs have been a matter of significant debate since their introduction in the 2013 Act. The 2017 Amendment Act contains the following key changes primarily aimed at addressing practical difficulties in the application:

Definition of ‘related party’

Company vs. body corporate

The definition of the term ‘related party’ in section 2(76) of the 2013 Act used the word ‘company’, e.g., it used the words ‘holding’, ‘subsidiary’ or associate’ company. Foreign company is not a company under the 2013 Act; rather, it is a body corporate. Thus, some may have interpreted the definition of the term ‘related party’ to include only companies/entities incorporated in India within its purview. Such an interpretation will have a consequence that companies/entities incorporated outside India, such as foreign holding/subsidiary/associate/ fellow subsidiary of an Indian company, were excluded from the purview of related party requirements for an Indian company. This was not the intention of the government and such an interpretation may have seriously diluted compliance with related party requirements under the 2013 Act.

To address this issue beyond any doubt, the 2017 Amendment Act substitutes the word ‘company’ with the word ‘body corporate.’ Hence, upon enactment of the 2017 Amendment Act, it is now absolutely clear that a body corporate that is a holding/subsidiary/associate /fellow subsidiary of an Indian company should be treated as related party.

A body corporate (foreign company) whichis a holding/subsidiary/associate /fellowsubsidiary of an Indian company will betreated as related party under the 2013 Act.This is clarificatory change.

Investor in associate company

Under the existing definition of the term ‘related party’ given in section 2(76) of 2013 Act, associate company is a related party for the investor in that company. However, for the associate company itself, investor is not a related party. The 2017 Amendment Act fixes this anomaly and requires that both associate company and investor should be treated as related to each other.

Both associate company and investor willnow be treated as related to each other.

Voting rights

The second proviso to Section 188(1) of the 2013 Act states that a member who is a related party will not be entitled to vote on special resolutions or approve any contract or arrangement that may be entered into by the company. Since section 47 of the 2013 Act is the primary section dealing with members that are entitled to vote and the proportion of their voting rights, the 2017 Amendment Act clarifies that the requirement of section 47 will be subject to section 188(1). In other words, the right of every member holding equity shares to vote on all resolutions placed before the shareholders meeting would not be applicable to members who are related parties and prohibited from voting under section 188.

Section 47 of the 2013 Act dealing withmembers’ right to vote has been aligned withsection 188, which restricts related parties’right to vote on ordinary/ special resolutionto approve RPTs.

Approval of related party transactions

Section 188 of the 2013 Act requires RPTs to be approved by an ordinary resolution of disinterested shareholders if they do not meet the prescribed exemption criteria. The 2013 Act states that no member of the company will vote on such ordinary resolution if such member is a related party. Compliance with this requirement may be particularly challenging in certain cases. For example, compliance with this requirement will be challenging for companies that are closely held or are a joint venture between 2-3 shareholders since all shareholders will be related parties. To address this issue, the 2017 Amendment Act states that a company wherein 90% or more members in number are relatives of the promoter or are related parties, all shareholders will be entitled to vote on the ordinary resolution.

Section 188 (3) of the 2013 Act deals with a scenario where any contract or arrangement is entered into by a director or any other employee without obtaining the consent of the board and/ or approval by an ordinary resolution in the general meeting. The section states that if the contract/arrangement is not ratified by the board or, as the case may be, by the shareholders at a meeting within three months from the date on which such contract or arrangement was entered into, then such contract or arrangement will be voidable at the option of the board. Further, if the contract or arrangement is with a related party to any director, or is authorised by any other director, the directors concerned will indemnify the company against any loss incurred by it. The 2017 Amendment Act states that apart from being voidable at the option of the board, the contract/arrangement would also be voidable at the option of the shareholders.

The third proviso to Section 188(1) has reference to the terms ‘ordinary course of business’ and ‘arm’s length basis’. The Companies Law Committee had considered a suggestion that these terms may be clarified/defined. The Committee was of the view that these terms are known in general commercial parlance and enough accounting guidance is available. The Committee therefore did not recommend any change in the 2013 Act/ Rules on these matter. Rather, it was suggested that the ICAI may consider issuing suitable guidance notes on these matters to guide its members. In line with the Committee’s recommendations, the 2017 Amendment Act does not contain any change on this matter.

Audit Committee pre-approval of RPT

Under section 177 of the 2013 Act, the Audit Committee is required to pre-approve all RPTs and subsequent modifications thereto. In contrast, section 188 requires the board and/ or shareholders to pre-approve only specific RPT’s. Also, section 188 contains two exemptions from the approval process, viz., transactions are entered into by the company in its ordinary course of business and on an arm’s length basis, or they do not exceed prescribed materiality threshold.

The 2017 Amendment Act does not prescribe changes to align the Audit Committee pre-approval requirements with the RPT approval requirements under section 188. However, it clarifies that if the Audit Committee does not approve transactions not covered under section 188, the Audit Committee will make its recommendations to the board. This will require the board to consider and approve these RPTs even if they were otherwise not covered under the approval requirement of section 188.

The 2017 Amendment Act clarifies that RPTs between a holding company and its wholly owned subsidiaries will not require the approval of the Audit Committee. However, if these transactions require board approval under section 188, then they will also require approval of the Audit Committee.

If Audit Committee does not approve RPT notcovered under section 188, the Committee willmake its recommendations to the board. The boardwill need to consider and approve such RPTs.

The 2017 Amendment Act somewhat relaxes Audit Committee pre-approval requirements for RPTs. Based on the relaxation given, a director or officer of the company may enter into a related transaction for an amount not exceeding INR1 crore, without obtaining prior approval of the Audit Committee. However, such transaction should be ratified by the Audit Committee within three months from the date of the transaction. In the absence of such ratification, the transaction will be voidable at the option of the Audit Committee. Also, if the transaction is with a related party to any director or is authorised by any other director, the director concerned will indemnify the company against any loss incurred by it.

We welcome most of the changes above. However, with regard to Audit Committee pre-approval of RPT’s, we continue to believe that the Audit Committee and independent directors (IDs) should not have executive responsibility to approve RPT’s. They should be responsible for reviewing RPT’s and not approving the same.

Declaration and payment of dividend

Distributable profits

The 2013 Act permits a company to pay dividend from current year’s profits or from ‘free reserves’ (in case of inadequacy of current year’s profits). As mentioned in the ‘Free reserves’ heading of this publication, the definition of ‘free reserves’ excludes unrealised/notional gains arising on fair valuation or revaluation of assets and liabilities. However, the 2013 Act appears to permit payment of dividend out of current year’s profits without adjustment in respect of notional/unrealised gains.

The 2013 Act permits dividend payment outof current year’s profits without adjustmentfor notional/ unrealised gains. The auditcommittee and board of companies applyingInd AS should ensure that prudent policiesare followed for dividend distribution.

There is no clarity as to how Ind AS adjustment recognised in P&L will impact distributable profits recognised in P&L. Under Ind AS, an infrastructure company accounting for service concession arrangement recognises significant revenue and margins upfront, though the cash is received in the form of toll revenue over the next several years. A prudent policy would be to not distribute the accounting profits that will be realised over several future years. However, in the absence of clear legislation, this may not be enforceable.

The MCA may consider addressing these issues appropriately. In any case, the audit committee and board of companies applying Ind AS should ensure that prudent policies are followed with regard to dividend distribution

Interim dividend

In accordance with section 123(3) of the 2013 Act, a company may declare interim dividend during any financial year out of the surplus in the P&L account and out of profits of the financial year in which such interim dividend is sought to be declared.

From a plain reading of the paragraph, it appears that the interim dividend for a particular financial year could only be declared before the close of financial year and not thereafter. For example, a company has 31 March year-end and its annual general meeting (AGM) for the year ended 31 March 2017 is held in September 2017. From a literal reading of the section, the company can declare interim dividend only till 31 March 2017 and not thereafter, say, in May or June 2017.

Further, the use of the words “out of the surplus in the P&L account and out of profits of the financial year” indicate that a company may declare interim dividend only if it has at least some profit for the current financial year. Consider the following two scenarios:

  • Company A has accumulated profit of INR100 million at the beginning of the financial year. It earned an additional profit of INR0.1 million during the first six months of the financial year. Its accumulated profit at the end of six months is INR100.1 million.
  • Company B has accumulated profit of INR101 million at the beginning of the financial year. It incurred a loss of INR0.9 million during the first six months of the financial year. Its accumulated profit at the end of six months is INR100.1 million.

A company can declare interim dividendduring any financial year or at any timeduring the period from the closure offinancial year till holding of the AGM. Also,interim dividend can be declared out ofsurplus in the P&L account or out of profitsfor the financial year for which interimdividend is being declared.

Since Company A has earned a profit in the first six months, it can declare an interim dividend out of the accumulated profits of INR100.1 million. However, Company B with the same amount of accumulated profits cannot declare a dividend since it has incurred losses in the first six months.

The Companies Law Committee expressed the view that the above cannot be the intention of the law. To resolve the above issues, the 2017 Amendment Act allows declaration of interim dividend during any financial year or at any time during the period from the closure of financial year till the holding of the AGM. It also clarifies that interim dividend can be declared out of surplus in the P&L account or out of profits for the financial year for which interim dividend is sought to be declared or out of profits generated in the financial year till the quarter preceding the date of declaration of the interim dividend. However, if a company has incurred losses during the current financial year up to the end of the quarter immediately preceding the date of declaration of interim dividend, the rate of interim dividend cannot be higher than the average dividends declared by the company during the immediately preceding three financial years.

Final dividend

The second proviso of Section 123 (1) of the Act states as below:

“Provided that where, owing to inadequacy or absence of profits in any financial year, any company proposes to declare dividend out of the accumulated profits earned by it in previous years and transferred by it to the reserves, such declaration of dividend shall not be made except in accordance with such rules as may be prescribed in this behalf.”

The wordings used in the 2013 Act suggest that compliance with the Companies (Declaration and Payment of Dividend) Rules, 2014 will be required only when dividend is declared out of amounts already transferred to ‘reserves’. However, in contrast, rule 3 of the Companies (Declaration and Payment of Dividend) Rules, 2014 allows companies to declare dividend out of ‘free reserves’ only if the conditions laid in the rule have been complied with (Emphasis added). Since ‘surplus in the profit and loss account’ is also a free reserve, it is not clear whether a company will be required to comply with the said rules even when it declares dividend out of surplus in the P&L account. The surplus balance (i.e., carried forward balance of the P&L account) is a part of ‘free reserves’ but it does not represent an amount ‘transferred’ to reserves.

Companies will have freedom of utilising thebalance standing in the P&L account (and nottransferred to the reserves) for payment ofdividend. Appropriate change can be made inDividend Rules to clarify this further.

The Companies Law Committee discussed the issue and was of the view that companies must have the freedom of utilising the balance standing in the P&L account (and not transferred to the reserves) for payment of dividend in case of inadequacy of profit in a year. The Committee was of the view that once rule 3 is aligned with the provisions of the 2013 Act, this aspect will be clear. The Committee suggested that to avoid any legal challenges in application, the requirements of the Rule and the section should be harmonised appropriately.

The 2017 Amendment Act does not contain any change on this matter. It is important that the Government make appropriate changes in the rules to align the same with the requirements of the 2013 Act. Also, it appears that companies will have freedom of utilising the balance standing in the P&L account (and not transferred to the reserves) for payment of dividend in case of inadequacy of profit in a year. Specifically they will not be required to comply with the Companies (Declaration and Payment of Dividend) Rules, 2014 in such cases.