Section 185 & 186 of Companies Act r.w. Section 2(22)(e) of Income Tax – Consequences of non-compliance

Practical application of Section 185 and Section 186 of Companies Act,2013 read with Section 2(22)(e) of Income Tax Act, 1961 and consequences on non- compliance’s of these sections.

Let’s summarise these sections and understand the provision of relevant acts.

Section 186 of Companies Act,2013 – Whether Loan, advance or guarantee is allowed to Directors or other.

Section 2(22)(e) of Income Tax Act, 1961 – Deemed Dividend if condition does not meet.

Section 185 of Companies Act, 2013 – If Loan and investment by company is allowed as per section 185 & Section 2(22)(e) then what will be limit to the extent of which Loan & Investment will be allowed under section 185.

Detail Analysis of these sections

Section 185 – Loan to Directors

Company shall not provide loan to director/ partner or relative of such director/ any firm   in which such director or relative is partner/Director of Its holding co.

(1) No company shall, directly or indirectly, advance any loan, including any loan represented by a book debt to, or give any guarantee or provide any security in connection with any loan taken by,—

a)  any director of company, or

• • Director of a company which is its holding company or
  • any partner or relative of any such director; or

b) any firm in which any such director or relative is a partner.

Note: – What is an indirect loan is not defined in section 185 or elsewhere in the Act. Indirect loan is interpreted in case of Dr. Fredie Ardeshir Mehta v. Union of India [1991] 70 Comp. Cas. 210 (Bom.)

Company may provide loan to borrowing company if some conditions are satisfied

(2) A company may advance any loan including any loan represented by a book debt, or give any guarantee or provide any security in connection with any loan taken by any person in whom any of the director of the company is interested, subject to the condition that—

(a) a special resolution is passed by the company in general meeting:

Provided that…

the explanatory statement to the notice for the relevant general meeting shall disclose the full particulars of the loans given, 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 of the loan or guarantee or security and any other relevant fact; and

(b)  the loans are utilised by the borrowing company (recipient) for its principal business activities.

Note: –In clause (b) of Section 185(2) word “Company” deliberately used because in explanation of any person define itself Applicability on Companies

Explanation —For the purposes of this sub-section, the expression “any person in whom any of the director of the company is interested” means—

(a) any private company of which any such director is a director or member;

(b) any body corporate at a general meeting of which not less than 25%. of the total voting power may be exercised or controlled by any such director, or by two or more such directors, together; or

(c) any body corporate, the Board of directors, managing director or manager, whereof is accustomed to act in accordance with the directions or instructions of the Board, or of any director or directors, of the lending company.

Non- Applicability of Section 185

(3) Nothing contained in sub-sections (1) and (2) shall apply to—

(a) the giving of any loan to a managing or whole-time director—

i) as a part of the conditions of service extended by the company to all its employees; or

ii) pursuant to any scheme approved by the members by a special resolution; or

(b) 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 prevailing yield of one year, three years, five years or ten years Government security closest to the tenor of the loan; or (like Banking Companies, NBFC)

If the loans made under clauses (c) and (d) are utilised by the subsidiary company for its principal business activities, then section will not applicable otherwise will applicable.

(c) 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; or

(d) 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:

Note:- Limitation given above under First proviso to section 185 (3) is applicable for Subsidiary company where loan provided by holding company. However, such limitation is not applicable where loan is providing by Subsidiary company to its Holding company under this sub-section. It is needless to state here that, where loan is providing by Subsidiary company to its Holding company same condition as given in Sub- section (3) is also apply but in Sub-section (2) of section 185 with an additional condition i.e. by passing Special Resolution.

Contravention of this section is a punishable offence

(4) If any loan is advanced or a guarantee or security is given or provided or utilised in contravention of the provisions of this section,—

i) the company shall be punishable with fine

• • Minimum ₹ 5 lakh.
  • Maximum ₹ 20 lakh;

ii) every officer of the company who is in default shall be punishable with

• • Imprisonment for a term Maximum 6 months or
  • with Fine
    •  Minimum ₹ 5 lakh.
    • Maximum ₹ 20 lakh; and

iii) the director or the other person to whom any loan is advanced or guarantee or security is given or provided in connection with any loan taken by him or the other person, shall be punishable with

• • Imprisonment for a term Maximum 6 months or
  • with Fine
    •  Minimum ₹ 5 lakh.
    •  Maximum ₹ 20 lakh; or
  • with Both

Now read Section 2(22)(e) of Income Tax Act, 1961

Section 2(22)(e)

• any payment by a company, not being a company in which the public are substantially interested, of any sum (whether as representing a part of the assets of the company or otherwise) made after the 31st day of May, 1987, by way of advance or loan, to the extent to which the company in either case possesses accumulated profits ;
• a shareholder, being a person who is the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) holding not less than 10% of the voting power, or
• to any concern in which such shareholder is a member or a partner and in which he has a substantial interest (hereafter in this clause referred to as the said concern) or
• any payment by any such company on behalf, or for the individual benefit, of any such shareholder.

Note: – Such Shareholder means a shareholder who is the beneficial owner of share holding not less than 10% voting power.

Note:- The meaning  beneficial owner is not specified under this section but for the purpose of understanding the meaning of Beneficial owner, definition can be borrowed from Explanation 4 to section 139(1) of Income Tax Act, 1961.

Explanation 4.—For the purposes of this section “beneficial owner” in respect of an asset means an individual who has provided, directly or indirectly, consideration for the asset for the immediate or future benefit, direct or indirect, of himself or any other person.

Although, Explanation 4 to section 139(1) of Income Tax Act, 1961 is restrict the scope of the definition of Beneficial owner, but this definition can be used to understand the meaning.

There are many case laws which are ambiguous in nature in respect definition of beneficial owner.

but “dividend” does not include—

(i) Distribution made where non-participating of shareholder in surplus of assets – Any distribution made in accordance with sub-clause (c) or sub-clause (d) in respect of any share issued for full cash consideration, where the holder of the share is not entitled in the event of liquidation to participate in the surplus assets ;

(Like Preference shareholder having right to participate in full cash consideration to the extent of Value of its shares at the time of liquidation, in other words he has no right in surplus assets.)

(ia) Distribution is attributable to the capitalised profits by way of bonus share issue to Equity shareholder – a distribution made in accordance with sub-clause (c) or sub-clause (d) in so far as such distribution is attributable to the capitalised profits of the company representing bonus shares allotted to its equity shareholders after the 31st day of March, 1964, and before the 1st day of April, 1965 ; (Now this provision is not in longer use )

(ii) Giving loan & advance is the ordinary course of business of lending company – Any advance or loan made to a shareholder or the said concern by a company in the ordinary course of its business, where the lending of money is a substantial part of the business of the company; (For Ex- Banking Company or NBFC)

(iii)  Dividend is set-off against deemed dividend that was treat as loan earlier – any dividend paid by a company which is set off by the company against the whole or any part of any sum previously paid by it and treated as a dividend within the meaning of sub-clause (e), to the extent to which it is so set off;

(iv) Buy back of share by complying section 77A as define under companies Act, 2013 – any payment made by a company on purchase of its own shares from a shareholder in accordance with the provisions of section 77A of the Companies Act, 1956 (1 of 1956);

(v)  Distribution of share to the shareholder of demerged company –   Any distribution of shares pursuant to a demerger by the resulting company to the shareholders of the demerged company (whether or not there is a reduction of capital in the demerged company).

Explanation 1.—The expression “accumulated profits”, wherever it occurs in this clause, shall not include capital gains arising before the 1st day of April, 1946, or after the 31st day of March, 1948, and before the 1st day of April, 1956. (Now this explanation is not in longer use)

Explanation 2.—The expression “accumulated profits” in sub-clauses (a), (b), (d) and (e), shall include all profits of the company up to the date of distribution or payment referred to in those sub-clauses, and in sub-clause (c) shall include all profits of the company up to the date of liquidation, but shall not, where the liquidation is consequent on the compulsory acquisition of its undertaking by the Government or a corporation owned or controlled by the Government under any law for the time being in force, include any profits of the company prior to three successive previous years immediately preceding the previous year in which such acquisition took place.

Further widen the scope of meaning of accumulated profit for the purpose of Deemed profit an Explanation 2A in clause (22) of section 2 of the Act has been inserted.

Instances have come to light whereby companies are resorting to abusive arrangements in order to escape liability of paying tax on distributed profits. Under such arrangements, companies with large accumulated profits adopt the amalgamation route to reduce capital and circumvent the provisions of sub-clause (d) of clause (22) of section 2 of the Act. With a view to preventing such abusive arrangements and similar other abusive arrangements, act come with the new explanation 2A of Section 2(22)(e). 

Explanation 2A.—In the case of an amalgamated company, the accumulated profits, whether capitalised or not, or loss, as the case may be, shall be increased by the accumulated profits, whether capitalised or not, of the amalgamating company on the date of amalgamation.

Explanation 3.—For the purposes of this clause,—

(a) “concern” means a HUF, or a firm or an AOP or a BOI or a company;

(b) a person shall be deemed to have a substantial interest in a concern, other than a company, if he is, at any time during the previous year, beneficially entitled to not less than 20% of the income of such concern;

Section 186 – Loan and investment by company.

Limit to the extent of which Loan & Investment will be allowed under section 185.

(2) No company shall directly or indirectly—

(a)	give any loan to any person or other body corporate;
(b)	give any guarantee or provide security in connection with a loan to any other body corporate or person; and
(c)	acquire by way of subscription, purchase or otherwise, the securities of any other body corporate,

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

whichever is more.

Explanation.—For the purposes of this sub-section, the word “person” does not include any individual who is in the employment of the company.

Conclusion – From provision to analysis we can conclude that If section 185 of Companies Act, 2013 is invoked i.e. Non-Compliance of this section then such non-compliance have to be report under the notes to account as an Related party transaction of the Financial statements of the company and Statutory Auditor of the company will provide qualified opinion and will disclose in its audit report as well as where CARO, 2020 [Paragraph 3(iv)] will applicable on the company then also such disclosure will be required. Company and their office may also liable for offence by way penalty or imprisonment as the case may be given u/s 185(4) of the Companies Act, 2013. And where section 2(22)(e) of the Income Tax act, 1961 is applicable then deemed dividend will be taxable under the hand beneficial owner will be taxable as.

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Disclaimer: The information given in this document has been made on the basis of the provisions stated in the Companies Act, 2013 & Income Tax Act, 1961. It is based on the analysis and interpretation of applicable laws as on date. The information in this document is for general informational purposes only and is not a legal advice or a legal opinion. You should seek the advice of legal counsel of your choice before acting upon any of the information in this document. Under no circumstances whatsoever, we are not responsible for any loss, claim, liability, damage(s) resulting from the use, omission or inability to use the information provided in the document.