The Ministry of Corporate Affairs (MCA) vide Notification S.O. 3086(E), dated September 20, 2017 notified proviso to Section 2(87) of Companies Act, 2013 (Act). The notified clause provides for the definition of ‘Subsidiary company’ and specifies that such classes of holding companies, as prescribed, shall not have layers of subsidiaries beyond the numbers as may be specified. In furtherance to the notification bringing in force the said proviso, the MCA vide Notification G.S.R. 1176 (E) (Notification) notified the Companies (Restriction on number of layers) Rules, 2017 (Rules).

The Notification provides for restriction on layers of companies and the MCA has notified that any company, post commencement of these Rules, shall not have more than two layers of subsidiaries. However, it has been clarified that this rule will not affect a company acquiring another company incorporated outside India with subsidiaries beyond two layers as per the laws of those countries. For the purpose of calculating the number of layers under this rule, it has been specified that one layer consisting of one or more wholly owned subsidiaries shall not be taken into account. This Notification seems to have a negative connotation on the workings of the corporates as it has stated that no company can have more than two layers of subsidiaries. Thus, even if such subsidiaries are formed for legitimate reasons such as genuine ease of doing business, operational flexibility etc., they shall not be allowed.

Section 186 of the Act also provides a similar restriction wherein a company is restricted to make investment through more than two layers of investment companies. The Report of the Companies Law Committee [see endnote 1] (CLC Report) states the reasoning for adding this provision. It states that this was included to address practices of creating subsidiaries aimed at making it difficult to trace the source of funds and their ultimate use, and to reduce the usage of multiple layers of structuring for siphoning off funds.

The JJ Irani Committee Report (JJ Irani Report) on Company Law, which formed the basis for drafting the Act, had recommended that the Act should not impose severe restrictions on corporate structuring as these prescriptions would be disadvantageous to Indian companies vis-à-vis their international counterparts. JJ Irani Report, while acknowledging the concerns relating to lack of transparency, noted that these concerns can be curbed through disclosures accompanied by mandatory consolidation of financial statements and a proper implementation of these disclosures shall be sufficient. It further noted that siphoning off of funds could take place through other routes, and therefore imposing a blanket restriction on the number of layer of subsidiaries will not be the best way to deal with such concerns. Thus it had expressed a view that there should not be any restriction to a company having any number of subsidiaries, or to such subsidiaries having further subsidiaries. The Parliamentary Standing Committee, that was created to review the Companies Bill, 2012, had stated in its report that various stakeholders had represented that imposing restrictions on layers could be construed as restrictive for conduct of businesses. Therefore, The CLC Report had recommending omitting the proviso by noting that though the proviso to section 2(87) had not been notified, it was likely to have a substantial bearing on the functioning, structuring and the ability of companies to raise funds when so notified.

CLC Report in relation to the layering restrictions on investment companies under Section 186(1) stated that such restriction will become too obtrusive and impractical in the modern business world while noting the regulatory concerns arising out of earlier scams. It acknowledged that there might be several legitimate business justifications for use of a multi layered structure and such a restriction would hamper the ability of a company to structure its business. CLC Report provided that sufficient safeguards have been built into the oversight mechanism of SEBI and stock exchanges, and thus this restriction should be omitted.

Interestingly, the Central Government in Companies Amendment Bill, 2016 (Bill) had proposed to omit this restriction in Section 186 as well as the proviso in Section 2(87), altogether.[see endnote 2] However, during the course of debates in the Lok Sabha while considering the Bill, a number of parties raised objections for removal of these restrictions. It was stated that removal of such a restriction will aid in creating shell companies which will in a way promote the conversion of black money. Thus, the Bill as passed by Lok Sabha on July 27, 2017 rejected these amendments.

The Rules however specify that these provisions shall not apply to the following companies:

1. Banking Company; 2. A Non-Banking Financial Company which is registered with the Reserve Bank of India and is considered as systemically important by them. i.e. NBFC whose asset size is of Rs. 500 Crore or more; 3. Insurance Company; and 4. Government Company

The Rules further provide that every company which has more than two layers of subsidiaries, existing on or before September 20, 2017 should intimate the registrar of companies, in the notified form, disclosing the details of such companies within 150 days from the commencement of these rules. It also specifies that such companies shall not have any additional layer of subsidiaries over and above the layers existing and in case it removes one of the layers of the companies, it shall maintain such reduced number of layers or two, whichever is more. If a company is found contravening the provisions of these Rules, it shall be liable to a fine which can extend up to Rs. 10,000 (ten thousand rupees) and if the contravention is a continuing one, a further fine up to Rs. 1000 (one thousand rupees) shall be levied every day till the time the contravention continues.

From this Notification, it can be inferred that the Central Government has changed its stance with regards to removal of such restrictions as it had put forward in the Bill and is now of the opinion that such a restriction is required. Even though the CLC Report as well as the JJ Irani Report had recommended that such a restriction should be removed as it will create hindrances in the legitimate functioning of the companies, the Central Government has decided to disregard such recommendations. It will be interesting to see how the Notification impacts the functioning of companies with a genuine need to create subsidiaries because of the large involvement of the resources as well as diverse areas of practice. It can only be hoped that Companies Amendment Bill, 2016, when it is passed by the Rajya Sabha, considers the concerns of the various stakeholders and omits these restrictions, as was proposed previously.