India: Indian Subsidiary Of Foreign Public Companies - A Critical Analysis

Last Updated: 9 November 2012
Article by Hemant Goyal

India has vast untapped potentials for foreign companies looking for expansion/investment opportunities. Usually, foreign companies start their Indian operations by setting up a liaison (representative) office in India. The role of liaison office is limited to collecting information about possible market opportunities in India and providing information about the parent company and its products to the prospective Indian customers. A liaison office can undertake the following activities in India:

(a) Representing the parent company / group companies in India.

(b) Promoting export / import from / to India.

(c) Promoting technical/financial collaborations between parent/group companies and companies in India.

(d) Acting as a communication channel between the parent company and Indian companies.

At a later stage, foreign companies start their Indian business operations by incorporating a private limited company under the Companies Act 19562 ("CA1956") either as a joint venture company or a wholly owned subsidiary3. The choice of having a private limited company in India is for various reasons including less compliances and more freedom given to private limited companies to carrying on its operations under the CA1956.

Section 4(1) of the CA1956 defines the holding and subsidiary companies. This section is applicable to Indian subsidiaries of the foreign companies as well. As per this section, a company ("First Company") is said to be a subsidiary of another ("Second Company"), if Second Company:

(a) controls the composition of the board of directors of First Company, or

(b) holds more than half of paid-up equity share capital4 of First Company, or

(c) if the First Company is a subsidiary of any company which is subsidiary of Second Company.

The Second Company is known as the holding company.

In most cases, an Indian company becomes the holding company of the other company by holding more than half of paid-up equity share capital. It is pertinent to note that section 4(6) of the CA1956 has made special additional provisions to determine holding-subsidiary companies relationship in case of foreign companies. According to section 4(6) of the CA1956, if a foreign company is the holding company of the Indian company by applying the law of the country of the foreign company, the foreign company shall be deemed to be the holding company of the Indian company under the CA1956 as well, irrespective of whether the requirements of this section 4 of the CA1956 are fulfilled or not. Illustration: If under the test laid down in the laws of United Kingdom a company, say, A Limited (Indian company) is subsidiary of, say, B Limited (UK company) by applying the laws of United Kingdom, then, A Limited shall be subsidiary of B Limited under the CA1956 as well notwithstanding the test laid down under section 4 of the CA1956 is satisfied or not.

The CA1956 has put restrictions on payment of the remuneration by a public company (and subsidiaries of public companies5) to its directors and other managerial personnel as defined therein. As per section 3(1)(iv) of the CA1956 as amended by the Companies (Amendment) Act, 2000 (w.e.f. 13 December 2000), 'public company' means a company which: (a) is not a private company; or (b) is a private company which is a subsidiary of a company which is not a private company. However, no such restriction on payment of the remuneration to directors is applicable to private companies. Consequently, if any director of a public company draws or receives the remuneration in excess of the prescribed limits (without the prior sanction of the Central Government), he shall refund such sums to the company and until such sum is refunded; such director shall hold such money in trust for the company. More importantly, the said public company cannot waive the recovery of any sum so refundable unless permitted by the Central Government.

Due to this restriction on payment of remuneration to directors by the public companies and their subsidiaries, Indian private limited subsidiaries ("Indian Subsidiaries") of foreign publicly traded companies ("Foreign Public Companies") also faced problems in paying remuneration to their directors. To overcome this problem, section 4(7) was introduced in the CA1956 through the Companies (Amendment) Act, 1960 (w.e.f. 28 December 1960) on the recommendation of the Companies Act Amendment Committee 1957 ("Committee"). The Committee felt that the prime purpose of the CA1956 is to protect the interest of Indian shareholders. Therefore, a distinction was drawn between: (a) private companies which are wholly owned subsidiaries of foreign companies; and (b) private companies which are subsidiaries6 of foreign companies but a portion of their capital is held by Indian nationals or companies. Evidently, it is the interest and protection of Indian shareholders that the Committee then had in mind. The Committee had recommended that:

"Where, Indians having no beneficial shareholding interest, whatsoever in the company, it was felt that there is no necessity for the Indian Legislature to concern itself with the matter. But if any as the Indian capital is involved, there is no reason for any different treatment for the purpose of the Act [CA1956] between such a company and a company which is a subsidiary of an Indian public company."

Accordingly, section 4(7) was inserted in the CA1956 as under:

"(7) A private company, being a subsidiary of a body corporate incorporated outside India, which, if incorporated in India, would be a public company within the meaning of this Act, shall be deemed for the purposes of this Act to be a subsidiary of a public company if the entire share capital in that private company is not held by that body corporate whether alone or together with one or more other bodies corporate incorporated outside India."

Thus, an exemption was provided to Indian Subsidiaries of Foreign Public Companies by inserting section 4(7) in the CA1956, wherein it is provided that an Indian Subsidiary of Foreign Public Company is not treated as 'public company' under the CA1956, if entire share capital of such an Indian Subsidiary is held by foreign companies incorporated outside India. The reason for such an exemption was that there was no Indian shareholder in such Indian Subsidiaries. This exemption is continuing even after the Companies (Amendment) Act, 2000 came into effect.

As per prevailing practice, it is however noticed that the provision to determine the holding-subsidiary companies relationship as stated in section 4(1) and section 4(6) are usually ignored by Indian Subsidiaries of Foreign Public Companies and the provisions of section 4(7) which is an exemption provision were used to determine the holding-subsidiary companies relationship. As per this practice, it is argued that the phrase "A private company, being a subsidiary of a body corporate incorporated outside India, which, if incorporated in India, would be a public company within the meaning of this Act" as used in section 4(7) of the CA1956 should consider only the intermediate parent company to determine the holding-subsidiary companies relationship under the CA1956. In most of such cases, the intermediate holding company (which is a private company formed in tax beneficial jurisdiction) is considered for determining the holding-subsidiary companies relationship and the ultimate parent company which is often a Foreign Public Company is ignored7. Further, the cases in which the provisions of sections 4(6) of the CA1956 are applied to determine the holding-subsidiary companies relationship are negligible.

It is inferred that the practice of using section 4(7) of the CA1956 to determine the holding-subsidiary companies relationship will make the provisions of section 4(1)(c) and section 4(6) of the CA1956 (as stated above) redundant and cannot be accepted at all. Even in the Vodafone case8, it was ultimate parent company, i.e., Vodafone International Holdings B.V. against which proceedings were initiated and not against the intermediate parent companies. Further, as and when the violations of remuneration to directors in excess of limits under the CA1956 are known, the proceedings could be initiated against the directors of such Indian Subsidiaries of Foreign Public Companies. In such cases, a director who received remuneration in excess of such limits from the Indian Subsidiary of Foreign Public Companies (under the impression that remuneration so paid to him is in compliance with provision of the CA1956) continues to hold such remuneration in trust for the employer company though such director is paying taxes on this remuneration as his income under Indian tax laws.

In view of above, a Foreign Public Company going to set up private limited company in India should ensure that entire paid-up share capital of its Indian Subsidiary is owned by two or more bodies corporate outside India. Further, if an individual (in or outside India) or an Indian company (in both cases either as a nominee or otherwise of Foreign Public Company) holds even a single share of Indian Subsidiary of Foreign Public Company, the provisions to avail the exemption under section 4(7) of the CA1956 are not complied with because as per said section the entire paid-up share capital of Indian Subsidiary must be held by "bodies corporate incorporated outside India".

Going forward, the new Companies Bill has no exemption provision similar to section 4(7) of the CA1956. Though the reason for this omission is unknown, but it is assumed that keeping in view the globalisation it would be unfair on the part of Indian Government not to protect interest of the global investors by granting such an exemption to Indian Subsidiaries of Foreign Public Companies and allowing the directors of such private companies to draw remuneration without any restriction.

Footnotes

Author is partner of Global Jurix LLP, Advocates & Solicitors, India (www.globaljurix.com ) providing legal services in the fields of the corporate & commercial laws, intellectual property rights and corporate litigation & arbitration.

2 The CA1956 is proposed to be replaced by new Companies Bill which is under consideration.

3 The CA1956 requires that in case of private limited company the minimum number of shareholders should be two otherwise the liability of member shall be unlimited. Therefore, normally the parent company holds few shares (most of the times only one) either through another subsidiary company or jointly with another subsidiary company to meet the requirement of minimum two members under the CA1956.

4 In case of companies having differential voting rights, to determine the holding-subsidiary companies relationship the amount of paid-up capital is to be considered under this clause.

5 Due to amendment in the definition of the 'public company' by the Companies (Amendment) Act, 2000 (w.e.f. 13 December 2000), now a private company which is a subsidiary of a company other than a private company is also a "public company'.

6 By virtue of owning majority paid-up share capital.

7 It is interesting to note that name of Foreign Public company is though disclosed as ultimate parent company by some of the Indian private limited companies in their annual accounts.

8 Vodafone International Holdings B.V. Vs. Union of India (2012)

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