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The dilemma of mandatory interest on inter corporate loans

New Companies Act has made some changes in the rules that govern inter-corporate loans. Here is how it impacts the company.

August 17, 2015 / 05:57 PM IST
Monika Khanna Wadhwa

Companies often find it beneficial to lend excess funds to affiliates. The borrower often benefits from lower borrowing rates and less restrictive credit terms relative to bank borrowings or any other form of fund raising. The lending affiliate may benefit by being able to invest excess funds in a company which is within the same group and is less risky affair than investing in unrelated companies. The low cost of borrowing is one of the significant advantages gained in such mode of funding.

Though inter corporate funding would not be as easy hereon and would come with its own set of frills under the new Company Law regime. Companies Act, 2013 (‘New Act’) has made it mandatory for a company to allot its securities within 60 days from the date of receipt of the application money for such securities, failing which it shall repay the application money within 15 days from the date of completion of 60 days, along with interest @ 12% p.a. from the expiry of the 60th day (in case of failure to repay within 15 days). This restricts the companies from funding their subsidiaries through share application money for unlimited periods.

Traditionally, the other preferred mode used to fund businesses in subsidiaries has been ‘Inter corporate loans’. Section 186 of the New Act restricts a company from providing loans, giving any guarantee or security or acquiring any securities of a body corporate, exceeding (i) 60% of its paid up share capital, free reserves and securities premium account or (i) 100% of its free reserves and securities premium account, whichever is more. However, a company may overcome such restrictions by passing a special resolution at a general meeting.

The erstwhile Section 372A of Companies Act, 1956 (‘Old Act’) provided an umbrella exemption of the applicability of the Section in case of a loan given to a wholly owned subsidiary by the holding company. Thus, allowing the holding companies to give ‘interest free loans’ to their wholly owned subsidiaries. This facilitated the subsidiaries to access funds from their well-established cash rich holding companies at virtually no cost. Section 186 of the New Act, however, does not provide that exemption. The Companies (Meetings of Board and its Powers) Rules, 2014 (‘New rules’) exempt companies from only the requirement of obtaining a special resolution prior to granting a loan to a wholly owned subsidiary.

Section 186 of the New Act makes it mandatory for the lender to charge interest at a rate higher than the prevailing yield of one year, three year, five year or ten year Government Security close to the tenor of the loan. It has now become mandatory for companies to charge interest on even loans given to their wholly owned subsidiaries. While this provides a mandatory cash repatriation strategy for some corporates, on the flip side it heavily burdens the group with the leakage on account of withholding tax on such interest payment and tax deductibility issues under the Income tax Act.

Replacing the existing loans with certain specific securities like equity or preference shares could be explored as an alternate strategy to fund the subsidiaries. Although, this may prove to be a costly affair for the corporates, considering the cost of maintaining higher authorised share capital.

Section 186(7) requires that no interest free ‘loan’ is given by a company. Does that mean that there is no requirement to have interest chargeability on ‘securities’ (which is not loan) subscribed by a holding company in another body corporate? There is no prohibition on a holding company acquiring by way of subscription, purchase or otherwise, the ‘securities’ (defined in Section 2(h) of the Securities Contracts (Regulation) Act, 1956 (‘SCRA’), to include shares, scripts, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature, derivatives, mutual fund units, Government securities) of a body corporate.

The issue of debate that crops up is whether interest free ‘debentures’ can replace the previous interest free loans advanced by companies. That is, whether debentures are to be treated as a ‘loan’ or a ‘security’. Explanation to Section 372A of the Old Act provided that ‘loan’ includes debentures or any deposit of money made by one company with another company, not being a banking company. However, Section 186 of the New Act does not provide any such explanation or definition of the term ‘loan’.

Does the removal of the said explanation show the intent of the Government to treat debentures as securities and not as loans? Considering the SCRA definition and landmark SC judgement in the case of Sahara India Real Estate Corporation Limited, the possibility of debentures being treated as ‘securities’ could be explored. Also, the absence of definition of ‘loan’ in the New Act, could support the argument that debentures may not be treated as ‘loan’ in the New Act, thus making it possible for companies to explore advancing interest free funds to their subsidiaries by way of debentures.

Alternatively, corporates wanting to stay out of the legal debate on the issue of securities vs loans are also opting to either replace the loans with equity / preference shares or folding up their holding-subsidiary structures into a single company thereby eliminating the inter-company loans, subject to of course the commercial viability of the same. Thus, given the potential tax leakages on account of steep interest rates and the legal ambiguity around the issue, inter corporate debt may no longer be an attractive mode of funding and one may expect corporates resorting to other cheaper external funding mechanisms.

That said, the New Act is a new law work product and the legal experts are still trying to figure out its finer aspects. One will only need to wait for the most accurate interpretation of the law as it evolves and clarifications from the Ministry of Corporate Affairs to reach to a conclusion. For now, corporates are busy scouting for solutions to this puzzle that has just surfaced!

Author is Director - Tax & Regulatory Services, EY
Puneet Sachdev, Senior tax professional, contributed to the article
Views expressed are personal

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