Section 198 of the Companies Act, 2013 (‘2013 Act’), prescribes a special method for computation of ‘net profits’ of a company in a financial year — which has different rules for arriving at net profit than the one prescribed under Accounting Standards.
The special methodology for computation of net profits prescribed under Section 198 is used for two purposes – (i) for determining managerial remuneration under Section 197 and Schedule V; and (ii) for determining the minimum CSR amount to be spent by the company in a financial year, under Section 135(5) of the 2013 Act.
Section 198(3) provides items of income for which no credit shall be given while calculating net profit, which includes items like profit on sale of investments, profits of a capital nature, including profits from the sale of undertaking, and profit from sale of any immovable property.
Section 198(4) provides for various items of expenditure, which shall be deducted while calculating net profit, which includes usual working charges, directors’ remuneration, etc.
Section 198(5) provides for four specific items, which shall not be deducted — which includes items like loss of capital nature on sale of undertaking, income tax, any voluntary payments of compensation, etc.
Through the Companies (Amendment) Act, 2017 (‘2017 Amendment’), sub-clause (f) was inserted to Section 198(3). In accordance with Section 198(3)(f), while calculating ‘net profit’ — credit shall not be given for “any amount representing unrealised gains, notional gains or revaluation of assets”. This amendment was required to take care of Ind AS Accounting Standards. There was also an amendment made to allow an investment company to include profit on sale of investments, which is not allowed for other companies.
The origin of Section 198
Section 198 broadly corresponds to Sections 349 and 350 of the Companies Act, 1956 (‘1956 Act’). The objective of Section 349 and 350 of the 1956 Act was to ensure that a company pays managerial remuneration only out of genuine operating profits, and not out of artificially inflated profits – due to sale of real estate or investments.
This provision was introduced in the 1956 Act, which had for the first time introduced strict controls over the extent of managerial remuneration that could be paid by the company – which was in line with the then prevalent political and economic ideology of the Nehruvian era-socialistic pattern of society. As strict limits had been imposed by the 1956 Act, there was a need to ensure that companies do not artificially inflate their profits, and such remuneration is paid only out of operating profits.
The 1956 Act was enacted at a time when there were very few “accounting standards” to regulate aspects relating to the computation of net profit. The objective of Sections 349 and 350 was to normalise the profit, by excluding certain special items of income and expenditure.
For example, profit on sale of investment was not allowed to be added to net profit. This provision had created practical challenges for investment companies in compensating their managerial personnel, as their main income was from the profits made on trading in stock. Further, the arrears of depreciation of the previous years are not required to be deducted from the net profit as depreciation is not an expenditure but only a notional charge.
After the passing of the 1956 Act, India became one of the few countries in the world, which had imposed statutory restrictions on the extent of managerial remuneration that could be paid by the company. Other jurisdictions such as the UK have never imposed similar statutory restrictions on managerial remuneration. The English Companies Act, 1948, did not contain any provision that was analogous with Sections 349 and 350 — although our 1956 Act was substantially derived from the said Act.
Section 349 of the 1956 Act brought about multiple practical difficulties after it was brought into force. In 1960, the Companies Amendment Committee noted that Section 349 had given rise to a “number of difficulties in its interpretation and application”. While the Committee proposed minor amendments to Section 349, it did not evaluate whether any alternate computation method could be formulated.
In 2005, the J.J. Irani Committee took the view that there was no longer any necessity to retain the computation methods prescribed under Sections 349 and 350. The J.J. Irani Committee Report opined as follows –
“Though the Committee has separately recommended that the issue of managerial remuneration should be determined by the shareholders only, the Committee also felt that the existing method of computation of net profit for the purpose of managerial remuneration, in the manner laid down in Sections 349 and 350 of the Act, should be done away with since the current provisions of the Companies Act adequately ensure that a true and fair picture of the company’s profit is presented”.
The Report of the Parliamentary Standing Committee on Finance, which examined the Companies Bill, 2011, did not make any reference to this recommendation of the J.J. Irani Committee. With a few minor modifications, the computation method prescribed under Sections 349 and Section 350 was retained in Section 198 of the 2013 Act.
While the objective behind Section 198 has not been mentioned in the Standing Committee Report, we may infer that a provision corresponding to Sections 349 and 350 was retained as the 2013 Act also did not initially remove the strict controls placed on managerial remuneration. Section 197 and Schedule V of the 2013 Act continued to impose limits on managerial remuneration, which were substantially similar to the limits that were earlier imposed under Sections 198 and 309 of the 1956 Act — though the absurd restrictions on managerial remuneration of the1980s era were significantly liberalised over time.
2017 Amendment – dismantling of strict controls on managerial remuneration.
Following the recommendations of the Company Law Committee, 2016 (‘CLC 2016’), and the Standing Committee on Finance, the 2017 Amendment dismantled the strict controls imposed on managerial remuneration under Section 197 and Schedule V. The 2017 Amendment repealed the requirement of obtaining Central Government approval for payment of remuneration beyond the permitted thresholds.
Post the 2017 Amendment, a company can pay remuneration exceeding the prescribed thresholds, after obtaining shareholder approval through a special resolution. The 2017 Amendment has accordingly repealed the 61-year long strict control imposed on managerial remuneration in India. This fundamental shift in the approach towards managerial remuneration reflects the new policy of the Government — of making India an attractive destination to do business, and facilitate ease of doing business in the country by removing unnecessary controls.
Has Section 198 lost its relevance now?
The objective of Section 198 was to ensure that a company pays managerial remuneration only out of genuine operating profits and does not artificially inflate its profits. This objective is no longer relevant now, as the 2017 Amendment has dismantled the strict control imposed on managerial remuneration since 1956. The central criticism of Section 198 has been that it is anachronistic and totally out of sync with Ind AS Accounting Standards. The socio-economic context in which Sections 349 and 350 of the 1956 Act were enacted was completely different and are no longer relevant.
The Ministry of Corporate Affairs (“MCA”) has, till date, notified 39 Ind AS Accounting Standards under Section 133 of the 2013 Act. The Ind AS Accounting Standards, which are the Indian version of International Financial Reporting Standards (IFRS), comprehensively covers all aspects relating to accounting of “net profits”. Hence, even without Section 198 of the 2013 Act, there are adequate safeguards in the Accounting Standards that would ensure that profits are not artificially inflated or inaccurately reported.
As the Ind AS adequately covers all aspects relating to accounting of net profits, there arises no requirement for prescribing a separate methodology under Section 198.
Following the dismantling of the strict control over managerial remuneration, and the notification of Ind AS Accounting Standards under Section 133 of the 2013 Act – Section 198 has lost its relevance in the statute book. As opined by the Irani Committee in 2005 – even Section 349 and 350 of the 1956 Act had lost its relevance, as there were sufficient provisions for ensuring that the financial statements reflect a true and fair view of the profits of the company.
A strong case can accordingly be made for the repeal of Section 198, which will save the companies in India from doing separate calculation of net profit for managerial remuneration and CSR. The deletion of Section 198 will lead to the removal of an anachronistic provision from the Act, which has lost its relevance. It will bring greater uniformity in computing net profits and will further facilitate ease of doing business in India.
While repeal of Section 198 would require Parliamentary approval, the MCA can grant general exemption under Section 462 of the Act to all public companies from this provision, if such companies are abiding by the applicable Accounting Standards prescribed under Section 133 of the Act.