Two’s cute, three’s a crowd?

Layer restrictions under Section 186(1) of Companies Act, 2013

Simrat Singh, Executive | corplaw@vinodkothari.com

Regulations often attempt to curb opacity in corporate structures, transactions and arrangements. Opacity may quite often be the breeding ground for ulterior designs. Opaque corporate structures may be used for hiding the identity of real owners, or to shift  corporate funds from entities. Section 186(1) of the Companies Act (‘Act’) is one such provision which restricts companies to make investments through more than two layers of investment companies. While the objective of removing opacity through several layers of entities becomes clear through this provision, however it also creates a tricky situation for several corporate houses which have a long vertical stretch of investments in entities. This restriction in itself raises several questions, such as:

• What is covered under the ambit of ‘investments’?
• What is meant by ‘investment through’?
• Does this section relate to investment subsidiaries or investment companies in general?  and so on. 

Before we delve into the intent and implication of interpreting this section, it will be interesting to note that a similar provision exists under section 2(87) of the Act which only talks about putting a limit on the number of subsidiaries a company may have. Our detailed write up and FAQs on the same can be referred to. 

Rationale behind 186(1)

When companies invest through multiple entities, the primary challenge for a lawmaker is the inherent lack of transparency that such structures can create. The topmost entity may try to route its investments through several layers to invest in a business in which investing directly may not be possible or even legal. This issue is succinctly captured by the Latin maxim “quando aliquid prohibetur ex directo, prohibetur et per obliquum” meaning “what you cannot do directly, you cannot do indirectly.” The concern here is that by using a series of interconnected entities, investors may circumvent regulatory intent, thus undermining the transparency and oversight that the law seeks to ensure. To address this, legislators have generally focused on two main mechanisms: enhancing disclosure requirements and limiting the number of entities through which investments can be made. Section 186(1) adopts the latter approach and restricts a company from making investments through more than 2 investment companies. 

The JJ Irani Committee, [Pg 17, Para 8.1 to 8.6] in its deliberations, recommended against prescribing rigid group structures or limiting the number of subsidiaries, arguing that such restrictions could place Indian companies at a disadvantage relative to their global counterparts. Instead, the Committee advocated for a focus on transparency and governance, emphasizing robust disclosure requirements and greater supervision of subsidiaries through clear and accountable board processes.

However, the Joint Parliamentary Committee [Pg. 21, Para 4.10 (1)], which investigated the Stock Market Scam of 2008, had its reservations regarding use of a multi-layered approach for investment as this can make it difficult to trace the origin of the fund. The Department of Corporate Affairs also considered putting a cap on the number of investment companies that can be set up by an individual. In line with this, the Ministry of Corporate Affairs (MCA) at one point considered restricting investments to a single investment company [Pg. 254 para 11.8 (a)]. This suggestion, however, was not accepted, as it could stifle legitimate business structures and limit operational flexibility.

In 2016, the Companies Law Committee Report [Pg 60, Para 12.16] further explored this issue and proposed dispensing with certain restrictions under Section 186(1) of the Act. The Committee acknowledged that a multi-layered investment structure could be justified for legitimate business purposes. Despite this, the recommendation was not incorporated into the final amendment bill. As a result, the restriction limiting investments through no more than two investment companies remains in effect.

Similar restrictions were made applicable by the RBI on Core Investment Companies (‘CICs’) by way of para 7 of Master Directions on CICs wherein the number of layers of CICs within a Group (including the parent CIC) shall be restricted to two, irrespective of the extent of direct or indirect holding/ control exercised by a CIC in the other CIC. Further, if a CIC makes any direct/ indirect equity investment in another CIC, it will be deemed as a layer for the investing CIC.

Deciphering the language of section 186(1)

The provisions of the said sub-section reads as under – 

“Without prejudice to the provisions contained in this Act, a company shall unless otherwise prescribed, make investment through not more than two layers of investment companies:

Provided that the provisions of this sub-section shall not affect,—

(i) a company from acquiring any other company incorporated in a country outside India if such other company has investment subsidiaries beyond two layers as per the laws of such country;

(ii) a subsidiary company from having any investment subsidiary for the purposes of meeting the requirements under any law or under any rule or regulation framed under any law for the time being in force.”

On the basis of the language used above, let us understand few terms and its implications in the instant context

What is an ‘investment company’ ?

As per the explanation to Section 186, an “investment company” for the purpose of this section means a company whose main business is investing in shares, debentures or other securities. A company is considered to be primarily engaged in this business if:

1. at least 50% of its total assets consist of investments in shares, debentures, or other securities, or
2. at least 50% of its total income comes from such investments.

Note that unlike the 50-50 test for determining an NBFC, an investment company has to fulfil either of the above conditions and not both at the same time. 

What is an ‘investment’?

It is important to understand what ‘investment’ is, since 186(1) restricts investments being made by a company through another company(ies). Common examples of investment include subscription or purchase of shares, warrants, debentures or similar securities. However, purchase of trade receivables, extending credit facilities or making of loans would not count as investment. 

‘Not more than two investment companies’?

What is prohibited is routing of investments through more than 2 investment companies. Note that Section 2(87) of the Act read with the Companies (Restriction on Number of Layer) Rules, 2017 restricts creation of more than 2 layers of subsidiaries. On a combined reading of the above, let’s examine whether the following structures are feasible or not.

In the above example, A is investing through 1 investment company (B Ltd.) into another company (D Ltd.) and therefore this structure is permissible.

A is investing through 2 investing companies (B and C Ltd.) into D and therefore the structure is permissible.

In the above example A is investing in E through more than 2 investment companies i.e. through B, C and D. Therefore, the above structure is not permissible as per law

When can it be established that a company has made investment ‘through’ another company? 

The primary intent of 186(1) is to capture the conscious call of the investor to route the investment through several intermediary entities and then reach its destination. This has to be seen factually whether the intermediate entity is acting as an investment vehicle for its shareholders or is it making its own independent investment decisions. One may also look at the stake of investment in the investee company to determine whether the investor is using the investee company as a conduit for its own investments. In case an investment company has a diversified portfolio of shareholders, it becomes difficult to establish that the investment company is acting on the instructions of its shareholders. Purpose of the investment can also be used to determine whether the transaction is a bonafide one or not.

In the above example, will A be charged for violation of section 186? 

It is the holding company which will be held as having violated the section. The section is applicable to such a scenario where A makes investment through more than 2 layers of subsidiaries. The idea is to trace the investments made by A and thereby keep the structure easy. Thus, when D makes an investment in E, the section will be attracted.

This can serve as an impediment for the other loops in the layers from making further investments out of their own funds. The applicability of this section under such circumstances can be mitigated if it can be proved that the investment in E was out of the own funds of D and not out of the investment made by A. 

Ambiguous proviso?

The proviso to Section 186(1) contains two clauses that provide exemptions from its restrictions:

1. Foreign Company acquisition: If a company acquires a foreign entity that already has investment subsidiaries beyond two layers, the restrictions of Section 186(1) will not apply, provided that such a structure is permitted under the laws of the host country.
2. Mandatory investment subsidiary: If a company has a subsidiary that is legally required—by any law, rule, or regulation—to establish an investment subsidiary, the restrictions of Section 186(1) will not apply in this case either

Note that in both the above clauses, the word ‘investment subsidiary’ is used and not investment company as used in 186(1). This creates ambiguity regarding the scope of the sub-section. Whether 186(1) is applicable on only investment companies which are subsidiaries? Or is it to extend even to those investment companies which are not subsidiaries? Seemingly restricting the scope of 186(1) only to investment subsidiaries would somewhat defeat the purpose of 186(1) since tracking of funds in a holding-subsidiary structure is far easier than in a non holding-subsidiary relationship. 

Rule 3 of the Companies (Restriction on Number of Layers) Rules, 2017 provides a little guidance on the inter-play between 186(1) and 2(87) by providing that the provisions of the rules are not in derogation to the proviso to 186(1). Which means that the so-called exemptions in clause i) and ii) of proviso to Section 186(1) will not get affected by the restriction of 2(87). In other words, restrictions of section 2(87) will not extend to exemptions claimed under clause i) and ii). 

The above structure is exempt as per clause i) of proviso to 186(1) and is also permissible under 2(87) since restrictions of 2(87) do not apply to the exemptions of 186(1).

The above structure is breaching the limit of 2 layers of subsidiaries as laid down in 2(87), however since the above is allowed as per clause ii) of proviso to 186(1), the same is permissible under 2(87) as well.

Note that the term ‘not in derogation of’ is not used in the context of 186(1) but only for its proviso. This raises the question whether an investment company which is not a subsidiary will be counted for determining the number of layers under section 2(87) and whether an alternate arrangement of investment companies and subsidiaries can be utilized to create a complex group structure which is seemingly legal.

The above structure is legal as per law since A is investing in E through not more than 2 investment companies. Further, there is no violation of 2(87) since B, C and D are not subsidiaries of A 

Similarly, the above structure, which is complicated and may induce diversion of funds, is legal as per law. Since there are only 2 investment companies in the structure and the number of subsidiaries for C is not more than 2.

If we factor in the exemption given to the first layer of WOS, then the above structure is also permissible. All we have to see is whether there are more than 2 investment companies in the structure and whether any one holding company has more than 2 subsidiaries or not.

No restriction on horizontal investments

It is to be noted that 186(1) does not restrict horizontal investments i.e. a company can invest in multiple entities and those entities can further invest in one single entity.

In the above example, there is no restriction on A investing capital through B and C into D since the investment is flowing through a horizontal set of entities. There can be more entities on the level of B and C and it will not be a violation of 186(1) even if those entities are investment companies and/or subsidiary companies of A. What is restricted is the vertical proliferation of investment entities to route funds. 

Difference between 186(1) and 2(87)

While the intent of Section 2(87) aligns with that of Section 186(1) in terms of curbing opaque investment structures, the distinction lies in the specific mechanisms each provision seeks to regulate. Section 186(1) aims to restrict the creation of more than two investment companies, whereas Section 2(87) focuses on limiting the formation of more than two subsidiaries. It is clear that an investment company, which is also a subsidiary, would fall under the purview of both of these provisions. However, there are certain differences between the 2 as tabulated below:

Criteria	2(87)	186(1)
Applicability	On all companies except Banking company; Non-banking financial company, Insurance company,a Government company	On all companies.
Restriction on	Holding companies having more than 2 layers of subsidiaries	Investing through more than 2 investment companies
Entity at the end of the loop of the layer	Can be a body corporate	Has to be a company
Criteria of establishing relationship	Subsidiary can be either by way of control of composition of board of directors or by way of investment in total share capital of company	Holding company has to invest through investment companies. Investment can be in any security.

Conclusion

While the intention behind 186(1) is clear – to ensure greater accountability and prevent the concealment of ownership or the diversion of funds through complex, multi-layered corporate setups – the practical implications of this restriction present challenges, especially for businesses with long-established and legitimate vertical investment structures. Additionally, the distinction between Section 186(1) and Section 2(87) of the Act further complicates the regulatory landscape, particularly in terms of the relationship between subsidiaries and investment companies. Clearer guidelines and more specific interpretations of the law will be essential to ensuring its effective implementation without stifling operational flexibility.