Layering of companies and restriction

By Anish Sinha 12 Minutes Read

Introduction

To address black money, the government has consistently pursued various measures (such as demonetization, Goods and Service Tax, and RERA laws) for the promotion of better governance. The Companies Act, 2013 (“2013 Act”) aimed to tackle the misuse of multiple subsidiary layers in two ways. Firstly, by restricting certain holding companies from creating more than a specified number of subsidiary layers. Secondly, prohibiting investments through more than two layers of investment companies. The Companies Law Committee (“CLC”) recommended removing these restrictions, arguing they might obstruct modern business practices and hinder companies’ ability to raise funds.

Despite this, the government decided to keep the provisions in place due to concerns about their misuse for creating shell companies and money laundering. In June 2017, a draft notification for the new rules was opened for public comment. Ultimately, on September 20, 2017, the Ministry of Corporate Affairs (“MCA”) issued the Companies (Restriction on Number of Layers) Rules, 2017 (“Layering Rules”) under Section 2(87) to regulate subsidiary layers and address issues related to fund mismanagement. Additionally, amendments were made to Section 186 of the 2013 Act concerning investment companies.

The current restrictions on company layering have both strengths and shortcomings, which this article aims to explore. The goal is to examine different interpretations of the law on company layering in the context of various committee reports that led to these rules, and to address specific ambiguities where greater clarity could aid the government in effectively addressing the malpractices these rules are designed to combat.

Law defined

The Companies (Restriction on Number of Layers) Rules, 2017, also known as the “Companies Layering Rules,” were notified on September 20, 2017, along with the proviso to Section 2(87) of the Companies Act, 2013. These rules limit Indian companies from establishing structures with more than two layers of subsidiaries.

In contrast, the Foreign Exchange Management (Overseas Investment) Rules, 2022, together with the Foreign Exchange Management (Overseas Investment) Regulations, 2022 (collectively referred to as the “OI Framework”), notified on August 22, 2022, state that individuals residing in India cannot invest in a foreign entity that invests in India through a structure with more than two layers of subsidiaries, as per the “OI Layering Rules.”

The Companies Layering Rules aim to prevent the misuse of complex corporate structures by restricting the number of subsidiaries an Indian entity can have. Meanwhile, the OI Layering Rules enable Indian residents to establish previously prohibited circular investment structures (ODI-FDI structures) through up to two layers of subsidiaries.

Both the Companies Layering Rules and the OI Layering Rules reflect a regulatory preference for investment and operational structures with a maximum of two layers of subsidiaries. However, despite being in effect for several years, these laws still contain ambiguities in their interpretation.

It is important to highlight that the Companies (Restriction on Number of Layers) Rules, 2017, which took effect from September 20, 2017, expanded the scope of the existing layering restrictions under Section 186(1) of the Act to include all subsidiaries, not just “investment subsidiaries.” The legislature’s aim was to broaden the scope of these restrictions through the new Rules without conflicting with the Act, as specified in sub-rule (3) of Rule 2, which states, “The provisions of this rule shall not be in derogation of the proviso to sub-section (1) of Section 186 of the Act.” Additionally, with the implementation of the Rules, the Government established the permissible number of layers mentioned in the first proviso to Section 2(87), which states that “such class or classes of holding companies as may be prescribed shall not have layers of subsidiaries beyond such numbers as may be prescribed.”

Anatomy of company layering rule

Company layering in company law refers to the practice of organizing a company’s structure in multiple tiers or layers of subsidiaries. This involves creating several levels of subsidiary companies, where each subsidiary can have its own subsidiaries, and so on. The concept is often used for various strategic purposes, including tax planning, risk management, regulatory compliance, and operational efficiency.

The Companies Layering Rules stipulate that Indian companies, except those exempted under the “Class Exemption,” are not permitted to establish structures with more than two layers of subsidiaries.[1] The exemptions to this restriction include:

• Excluding one layer that consists of one or more wholly-owned subsidiaries from the calculation of layers (“WOS Exemption”); and
• Acquiring a company incorporated outside India with subsidiaries beyond two layers in accordance with the laws of that country (“Acquisition Exemption”).

The interpretation of “layers” in the Companies Layering Rules is indeed subject to debate. While the primary objective of these rules is to prevent opaque ownership structures, which typically involve complex vertical layering of subsidiaries, the current provisions do not explicitly exclude horizontal layers.

Arguments for Vertical Layers

• Purpose Alignment: Vertical layers (step-down subsidiaries) are more likely to contribute to opaque ownership structures, which the rules aim to prevent.
• Practicality: Restricting horizontal layers (sister subsidiaries) could hinder business operations, as companies often need to separate different business verticals into distinct legal entities for operational, financial, or regulatory reasons.
• Common Interpretation: The term “layering” is commonly associated with vertical hierarchies in corporate structures.

Arguments for Inclusion of Horizontal Layers

• Technical Reading: The broad language of the rules could be interpreted to include any form of layering, whether vertical or horizontal.
• Regulatory Intent: Without explicit regulatory clarification, both vertical and horizontal layers might be considered within the scope to ensure comprehensive compliance and transparency.
• Pending Clarification: Until the regulatory authorities provide specific guidance, it remains arguable whether horizontal layers are included. Companies should carefully consider both interpretations and, if necessary, seek legal counsel to ensure compliance.

Ultimately, the intent of the Companies Layering Rules is to promote transparency and prevent complex structures that obscure true ownership and control. In the absence of explicit regulatory clarification, a conservative approach that considers both vertical and horizontal layers might be prudent.

General exemption

The general exemption from the applicability of the restrictions under the layering rule, as specified under Rule 2 of the Rules, is granted to the following classes of companies:

• Banking Companies: Defined under clause (c) of Section 514 of the Banking Regulation Act, 1949 (10 of 1949).
• Non-Banking Financial Companies (NBFCs): Defined under clause (f) of Section 45(I) of the Reserve Bank of India Act, 1934 (2 of 1934), which are registered with the Reserve Bank of India and considered as systemically important non-banking financial companies by the Reserve Bank of India.
• Insurance Companies: Companies that carry on the business of insurance in accordance with the provisions of the Insurance Act, 1938 (4 of 1938) and the Insurance Regulatory and Development Authority Act, 1999 (41 of 1999).
• Government Companies: Referred to in clause (45) of Section 218 of the Companies Act.

These exemptions are similar to those provided against the applicability of Section 186 layering restriction to the aforementioned classes of companies under Section 186(11) of the Companies Act.

The penal provision for contravention of the Rules, as per Rule 2(5), includes a fine that may extend to ten thousand rupees for the company and every officer of the company who is in default. If the contravention is a continuing one, an additional fine may extend to one thousand rupees for every day after the first during which such contravention continues.

Way forward

The OI Layering Rules, mentioned above state that no person resident in India can make a financial commitment in a foreign entity if that investment creates a structure with more than two layers of subsidiaries. However, it is not explicitly clarified whether this restriction applies only to the offshore entities or if it also includes the layers below the Indian entity receiving the foreign investment.

The prevalent market view suggests that the restriction is typically interpreted to apply only to the offshore entities and not to the subsidiaries of the Indian entity at the end of the investment loop. This would imply that the two-layer restriction is concerned with the foreign investment structure rather than the domestic structure below the Indian entity.

Conclusion

In nutshell, the concept of layering under company law is a critical aspect of regulatory compliance and corporate governance. The rules governing layering, such as those outlined in the OI Layering Rules, are designed to prevent complex structures that obscure financial commitments and potentially facilitate undesirable practices. Understanding these rules is essential for ensuring transparency and accountability within corporate structures.

The two-layer restriction on subsidiaries, as seen in the OI Layering Rules, highlights the need for careful structuring of investments and operations, especially when dealing with foreign entities. While the prevalent view suggests that the restriction primarily targets offshore layers, the intricacies of these regulations underscore the importance of seeking explicit clarifications from regulatory bodies like the Reserve Bank of India (RBI) for comprehensive compliance.

By adhering to these regulations, companies can not only avoid penalties but also foster a more transparent and trustworthy corporate environment. As regulatory frameworks continue to evolve, staying informed and proactive in compliance efforts will be crucial for navigating the complexities of corporate layering and ensuring sustained corporate integrity.

[1] The Companies Act, 2013, s. 2(87).

Anish Sinha