Section 185 Exemption: Can an Object Clause Justify an Interest-Free Loan?

Brief: This article examines an illustrative case in which a software company pays ₹18 crore to another private company in which a director’s son holds an indirect 35% interest through two LLPs. The payment is interest-free and recorded as a trade advance, although no goods or services have been supplied against it. The lending company’s memorandum permits financing, but it has never carried on a financing business. An object clause alone cannot establish the ordinary-course lending exemption under Section 185(3)(b) of the Companies Act, 2013. That exemption also requires interest at not less than the applicable Government security yield. Whether Section 185 restricts the payment in the first place depends on the director’s own connection with the recipient, the fund trail and any applicable private-company exemption. If the payment is a loan in substance, Section 186 must also be examined, including its approvals, limits, disclosures and minimum interest requirement. The transaction documents and ownership records, rather than its accounting label or the family relationship alone, determine the final compliance position.

Section 185 Ordinary-Course Lending Exemption: Can a Software Company Rely on Its Object Clause?

The Question

Consider a private company engaged in software development. Its memorandum of association permits financing and lending, but the company has never carried on a financing business. It pays an interest-free, unsecured amount of ₹18 crore to another private company (“Company B”). The son of one of the lending company’s directors holds an indirect 35% interest in Company B through two LLPs. The payment remains unadjusted and is shown as a “trade advance”, although no goods or services have been supplied against it. The Board claims the “ordinary course of business” exemption under Section 185 on the strength of the object clause.

This is an illustrative fact pattern. No disbursement date or period outstanding is assumed. Those details, along with the contractual purpose, intended tenor, ownership arrangements and use of the funds, would have to be established in an actual case.

1. Short Summary

Many companies have wide object clauses permitting activities they do not actually undertake. A permission to lend in a software company’s memorandum does not, without more, establish that it provides loans in the ordinary course of its business. Section 185(3)(b) also requires interest at not less than the specified Government security yield. An interest-free payment therefore cannot qualify for that exemption if it is a loan.

There are two questions before the exemption becomes relevant. First, is the amount a genuine trade advance or a loan in substance? Second, is Company B a person covered by Section 185, or has it acted as a conduit for a loan to a prohibited recipient? The director’s son’s indirect interest in Company B does not automatically answer the second question. The lending company must also check whether it qualifies for the separate conditional exemption from Section 185 available to certain private companies. If the payment is a loan, Section 186 requires an independent review even where Section 185 does not apply.

2. Short Answer

The stated claim under Section 185(3)(b) fails if the payment is a loan. The company has not carried on lending as a business, and it has charged no interest. Either issue defeats reliance on that exemption on the stated facts; the interest-free term is particularly clear.

This does not mean that a Section 185 contravention is established automatically. Company B’s status under Section 185(2), any indirect loan to a person prohibited under Section 185(1), and the lender’s eligibility for the private-company notification exemption must be examined. Separately, an interest-free loan governed by Section 186 would conflict with its minimum interest requirement under Section 186(7).

3. Applicable Legal Provisions

• Section 185(1), Companies Act, 2013: Prohibits specified loans, including loans represented by a book debt, made directly or indirectly to a director or certain other persons identified in that subsection.
• Section 185(2): Permits a loan to a person in whom a director is interested subject to its conditions, including a prior special resolution and use of the loan by the borrowing company for its principal business activities.
• Section 185(3)(b): Exempts qualifying ordinary-course lending from subsections (1) and (2), provided interest is charged at not less than the prevailing yield of the specified Government security closest to the loan’s tenor.
• Section 185(4): Prescribes consequences for contravention of Section 185. These should be assessed against the statutory text applicable when the transaction took place.
• Section 186(2) and (3): Set an aggregate limit for covered loans, investments, guarantees and securities, and require prior member approval by special resolution when applicable limits are exceeded, subject to statutory exceptions.
• Section 186(5): Requires the prescribed Board approval and, in applicable circumstances, approval from a public financial institution from which the company has an outstanding term loan.
• Section 186(7): Sets a minimum interest rate for a loan governed by that section.
• Section 186(4) and (9), read with the applicable rules: Require prescribed financial-statement disclosures and maintenance of a register of loans, guarantees, securities and acquisitions.
• Section 186(11): Provides exclusions for specified classes of companies and transactions. Eligibility must be established from the statutory conditions, not merely from an object clause.
• MCA notification dated 5 June 2015: Provides a separate, conditional exemption from Section 185 for eligible private companies.
• Section 2(77) and the applicable rules: Treat a son as a relative. This does not automatically treat a separate company in which the son holds an interest as the son himself.
• Sections 179 and 184: Address Board powers and directors’ disclosure of interests, as applicable.

4. The First Question: Trade Advance or Loan?

A genuine trade advance is supported by a commercial arrangement for an identifiable future supply of goods or services. Relevant evidence would include an agreement, purchase orders, correspondence, delivery schedules, invoices, adjustment entries and the parties’ conduct. An amount left unadjusted without any supply calls for closer examination, particularly where the recipient has a connection with a director’s family.

The ledger heading is not decisive. Section 185 refers expressly to a loan “represented by a book debt”, and both Sections 185 and 186 address indirect arrangements. Equally, an unpaid advance does not become a loan merely because supply is delayed. The decisive question is whether the documents and conduct show a genuine commercial advance or, in substance, money placed with Company B on terms requiring repayment.

If there was no genuine supply arrangement and Company B was expected to return the money, describing the ₹18 crore as a trade advance would not avoid loan-related compliance. The company should then correct the accounting classification and assess the position under Sections 185 and 186.

The 365-day deposit rule does not decide the lender’s classification

Rule 2(1)(c)(xii)(a) of the Companies (Acceptance of Deposits) Rules, 2014 addresses an amount received as an advance for goods or services and its appropriation within 365 days, subject to the rule’s terms and exceptions. It operates from Company B’s perspective; it is not an automatic test for classifying the lending company’s payment under Sections 185 and 186.

Further, an amount received by one company from another company is separately excluded from the definition of “deposit” under Rule 2(1)(c)(iv). Company B should consider its applicable reporting in Form DPT-3, but the mere absence of supply for 365 days does not, on these facts alone, establish that it accepted a prohibited deposit.

5. The Second Question: Is Company B Covered by Section 185?

5.1 Section 185(1): Prohibited recipients

Section 185(1) covers loans to a director of the lending company or its holding company, a partner or relative of such director, and a firm in which such director or relative is a partner. Company B is a separate private company. The director’s son’s indirect 35% interest does not, by itself, make a payment to Company B a direct loan to the son.

An indirect loan to a prohibited person requires a separate examination. If evidence shows that Company B received the money merely as a conduit and passed it on for the benefit of the son or another prohibited recipient, Section 185(1) may become relevant. The fund trail, related agreements, repayment obligations and actual use of the ₹18 crore would be important. The father–son relationship alone does not establish such an arrangement.

5.2 Section 185(2): A person in whom a director is interested

Company B may fall within Section 185(2) if, for example:

• a director of the lending company is himself a director or member of Company B;
• that director, alone or together with other directors of the lending company, can exercise or control at least 25% of the voting power in Company B; or
• Company B’s Board, managing director or manager is accustomed to act in accordance with the directions or instructions of the lending company’s Board or any of its directors.

The relevant Explanation refers to the director’s position or control. The son’s interest through two LLPs cannot automatically be attributed to his father. Conversely, an indirect structure cannot be ignored if the director actually controls the votes or directs Company B’s management. The LLP agreements, beneficial ownership records, voting rights, registers of members and directors, and evidence of decision-making should be examined.

If Company B is covered by Section 185(2), the company must assess whether the required special resolution was passed before the loan and whether the borrowing company used the funds for its principal business activities. A subsequent resolution does not retrospectively satisfy a prior-approval requirement.

5.3 The conditional exemption for certain private companies

The lender is itself described as a private company. Under the MCA notification dated 5 June 2015, Section 185 does not apply to a private company meeting the notification’s cumulative conditions. Broadly, these concern the absence of investment by another body corporate in its share capital, a ceiling on specified borrowings, and the absence of a subsisting default in repayment of those borrowings at the time of the transaction.

Those conditions require verification from the lending company’s shareholding, borrowing and repayment records. The exemption cannot be assumed merely because the lender is privately held. If it applies, the company must still examine its obligations under Section 186.

6. Why the Ordinary-Course Exemption Is Unavailable on These Facts

Section 185(3)(b) has two cumulative requirements:

The memorandum sets out what the company is authorised to undertake. It does not establish what the company actually does in the ordinary course. A company may have more than one business, and a new line of business is not ruled out merely because its existing operations are in software. It must, however, support an ordinary-course claim with its real activities and records. On the stated facts, there is no lending activity to support that claim.

The company’s accounting treatment also calls for an explanation. It cannot simply describe the payment as a trade advance in its books while asserting, without supporting evidence, that it was a loan made in the ordinary course of a lending business. Most decisively, an interest-free loan cannot satisfy the exemption’s express minimum-interest condition.

7. Section 186 Applies Independently

The Section 185 inquiry does not dispose of Section 186. If the ₹18 crore is a loan, Section 186 must be considered unless the lender establishes a relevant exclusion under that section. A software company does not become a company engaged in the business of financing companies solely because its memorandum contains a lending object.

The compliance review should cover the following:

• Aggregate limit: Section 186(2) compares the company’s aggregate covered exposures with the higher of 60% of its paid-up share capital, free reserves and securities premium, or 100% of its free reserves and securities premium. Existing exposures must be included.
• Special resolution: If the applicable limit is exceeded, a prior special resolution under Section 186(3) may be required, subject to the section’s exceptions.
• Board approval: Section 186(5) requires approval at a Board meeting with the consent of all directors present.
• Public financial institution: Any requirement for prior approval from a public financial institution with which the company has an outstanding term loan must be checked against Section 186(5) and its proviso.
• Interest: Section 186(7) prohibits a loan governed by the section at a rate lower than the prevailing yield of the one-, three-, five- or ten-year Government security closest to its tenor.
• Records and disclosures: The company must assess the disclosure requirements under Section 186(4) and the register requirement under Section 186(9) and the applicable rules.

An interest-free loan would breach Section 186(7) even if Company B is outside Section 185. The numerical approval limit and minimum interest rate cannot be calculated from the ₹18 crore amount alone. The lender’s financial figures, existing exposures, actual disbursement date and loan tenor are required.

8. Interest, NBFC Registration and Other Arguments

8.1 Can an advance be interest-free?

A genuine commercial advance against goods or services need not carry interest merely because payment precedes supply. If the arrangement is a loan governed by Section 186, however, its agreed interest rate must meet Section 186(7). Interest at or above the statutory floor is also an express condition of the Section 185(3)(b) ordinary-course exemption.

The applicable Government security yield should be determined by reference to the loan’s actual date and tenor. An assumed three-year term or a current yield cannot safely be substituted for the transaction documents.

8.2 Does lending require NBFC registration?

A company is not prohibited from having both software and financial activities. RBI registration becomes a separate question where financial activity is its principal business under the applicable regulatory framework. RBI’s principal-business assessment examines both the financial-assets and financial-income pattern. An ₹18 crore advance may be significant for the asset assessment, but that figure alone does not establish that the company meets the income criterion or must register as an NBFC.

The Board should review the company’s overall assets, income and activities if financing is becoming a substantial line of business. An object clause is neither proof of an ordinary-course lending business for Section 185 nor a substitute for any RBI registration that is actually required.

8.3 Is an incidental lending power enough?

No. Authority under the memorandum and eligibility for a statutory exemption answer different questions. A company may be authorised to make a particular payment without being a company that provides loans in the ordinary course of its business. The factual pattern of lending and the interest charged must support the Section 185(3)(b) claim.

9. Accounting, Audit and Tax Implications

If the transaction documents establish a loan, continuing to present the amount as a trade advance would obscure its nature. The company should assess the correct recognition, measurement and presentation under its applicable accounting framework, including Ind AS or Accounting Standards, as relevant. It should also examine recoverability, expected credit loss or impairment requirements where applicable, repayment terms, related-party disclosures and Schedule III presentation.

The ₹18 crore payment affects the lender’s liquidity and working capital while it remains outstanding. Any interest required under a properly documented prospective arrangement would affect income and the borrower’s cash flows. The actual financial effect cannot be quantified without the dates, terms, financial statements and recovery assessment.

Auditors should examine the underlying records and consider their reporting obligations under Section 143 and CARO 2020, including clauses 3(iii) and 3(iv), where applicable. The nature of any audit qualification or CARO remark depends on the evidence, materiality and contraventions actually identified; it is not automatic.

Interested directors should make the disclosures required under Section 184. The company should assess their participation in the relevant Board proceedings under the applicable provisions and its governance requirements.

Section 2(22)(e) of the Income-tax Act, 1961 may also require examination if the payment is a loan or advance and the relevant shareholder, voting-right and accumulated-profit conditions are met. The son’s indirect interest in Company B alone does not establish deemed dividend. The shareholding in the lending company, the recipient’s status and the other statutory conditions must be established before drawing a tax conclusion.

10. Practical Compliance Review

1. Identify the payment’s purpose: Obtain the agreements, purchase orders, invoices, correspondence, Board papers, ledger entries and repayment communications. Establish whether any supply was genuinely contemplated.
2. Trace the funds: Review Company B’s use of the ₹18 crore and any onward payment to the director, his son, either LLP or another connected person.
3. Establish control: Check Company B’s membership, directorship and voting records, together with the LLP agreements and beneficial ownership arrangements.
4. Check the private-company notification: Verify all conditions of the 5 June 2015 exemption against the lender’s records as at the transaction date.
5. Test Section 186: Calculate aggregate exposures and the applicable approval limit. Confirm the Board and member approvals, disclosure, register entries and minimum interest rate.
6. Correct the accounting: If the amount is a loan, present and disclose it accordingly and assess its recoverability under the applicable accounting standards.
7. Address any default identified: Consider recovery or a properly approved and documented prospective arrangement. Obtain advice on the applicable adjudication or compounding route for any established past contravention. Later repayment, approval or interest does not automatically validate an earlier breach.

11. Conclusion

A software company cannot establish the Section 185(3)(b) ordinary-course lending exemption merely by pointing to a financing object in its memorandum. On the stated facts, it has not carried on a lending business and the payment is interest-free. If the ₹18 crore is a loan, the claimed exemption is unavailable.

That conclusion must be kept separate from whether Section 185 restricts a payment to Company B at all. The son’s indirect holding alone does not establish the director’s interest or an indirect loan to a prohibited person. The ownership records, control arrangements, fund trail and conditional private-company exemption must be checked. The “trade advance” description likewise depends on evidence of a genuine supply arrangement. If the payment is a loan in substance, Section 186 requires its own compliance review, including the minimum interest condition.

12. FAQs

Q1. Can the company amend its memorandum to add lending as a main object and then claim the exemption?
An amendment cannot retrospectively establish that an earlier loan was made in the ordinary course of a lending business. For any future loan, the company must still establish its actual business activity and satisfy the statutory interest condition.

Q2. Can interest be charged now?
The parties may document compliant terms for the future, subject to the approvals and other requirements applicable to the transaction. This does not automatically cure any contravention when an earlier interest-free loan was made.

Q3. Does the son’s indirect 35% holding automatically make Company B a person covered by Section 185(2)?
No. The director’s own membership, directorship or voting control, or the statutory test concerning Company B’s management acting on directions, must be established from evidence.

Q4. Does Section 188 apply to the loan?
A loan, merely as a loan, is not among the transactions listed in Section 188(1). Sections 185 and 186 must be examined, along with applicable related-party accounting disclosures.

Q5. If Company B repays the ₹18 crore, is the matter closed?
Repayment removes the outstanding exposure but does not, by itself, erase a contravention that occurred when the loan was made.

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Author: CS Divesh Goyal, GOYAL DIVESH & ASSOCIATES, Company Secretary in Practice, Delhi. Email: [email protected]