Introduction

Section 185 of the Companies Act, 2013 has been incorporated to prevent higher management in the company from abusing their authority. This Section categorizes such transactions as prohibitive, conditional, and exempted, with the dual goal of keeping a check on such transactions while also making it easier to conduct business.

The article discusses the various amendments made in the Companies Act, 2013 regarding the provisions related to advancing loan by the Companies to their directors and tries to conclude the current scenario while dealing with the question of such transaction concerning private companies, as well as the issue of taxation and the effect of recent amendments in the taxation law on such transactions. 

What is a Private Company?

Section 2(68) of the Companies Act, 2013 (hereafter referred to as the 'Act') defines Private Companies.

A cursory reading of this section leads to the following conclusions:

1. Private companies are owned by a small number of people, and their shares are not freely transferable like those of public corporations, hence they are not listed on the stock exchange.
2. Private companies are not permitted to encourage the public to subscribe to their securities; instead, investments are made through private placements.
3. The minimum number of shareholders necessary for this Company is "two," with a maximum of "200."
4. At the moment, there is no minimum restriction for its paid-up share capital (previously it was 1 lakh).
5. For the purposes of accounting for company members, two people who jointly own one or more shares in the firm are treated as one single member.

Can Private Companies Grant a loan to its directors?

The limitations on such transactions were considerably less stringent under the old Companies Act of 1956, but with the introduction of the Companies Act of 2013, a blanket prohibition on providing loans to directors, their partners, or family was introduced u/s 185 of the Act. [4]

Since the enactment of this Act, the complete prohibition on these types of transactions has been deemed unacceptable by companies across the country because the provisions were contradictory to those in other countries. The companies' argument was that businesses in India are promoter-driven, and where promoters have invested in the company's business, they should have the freedom to use those funds as they see fit with the approval of the shareholders.

To address this issue, the Ministry of Corporate Affairs declared in a Notification dated 5th June 2015 [6] that Private Companies are exempt from Section 185 if they meet the following conditions: “in whose share capital no other body corporate has invested any money;

• provided such a firm's borrowings from banks, financial institutions, or other corporate are less than twice its paid-up capital or fifty crore rupees, whichever is less; and
• such a company has no default in repayment of such borrowings subsisting at the time of undertaking transactions under this section." [7]

However, these transactions that were exempted from Section185 must nonetheless conform to Section 186 and be approved by board resolution as stipulated by it, as well as adhere to the limit provided by it, i.e.

• 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.

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Companies (Amendment) Act, 2017

The aforementioned notification provided some relief to private companies, but for the sake of furthering the ease of business transactions, Section 185 was entirely replaced by new Section 185 by the Companies (Amendment) Act, 2017 which still prohibited directly advancing loan to individuals such as directors, their partners, relatives, and the partnership firm, but it has widened its scope in respect of advancing loan and guarantees to persons in whom directors are involved.

Additionally, a few exceptions to the applicability of this rule have been specified. Before the modification, Section 185 of the Code made it expressly unlawful to advance loans, securities, or guarantees to directors or to persons or entities in which directors have an interest.

Exemption to Section 185 after Companies (Amendment) Act,2017

Managing director or full-time director is awarded a loan(as part of conditions of employment also extended towards its other employees by the company or any scheme approved by members through special resolution).

The corporation provides a loan, a guarantee, or a security to its wholly owned subsidiary.

Given as a loan, security, or guarantee in the normal course of business.

On behalf of its subsidiary, the corporation provides a financial institution with a guarantee or security in exchange for a loan.

Penalties for Non-Compliances

Penalties are outlined in Section 185(4) in the event that its restrictions are violated. "A fine of Rs.5 lakh, which may go as high as Rs.25 lakh, will be imposed on the contravening company.

Officers of the company who commit a violation are subject to a fine of up to Rs.25 lakhs and a maximum sentence of 6 months in prison.

If the director or any other person to whom a loan guarantee, or security is granted violates the terms of this section, they maybe punished with up to six months in jail or a fine of up to 25 lakh rupees, or a combination of the two.

The big question that remains after reviewing the legislative developments throughout the years is whether private firms can lend to their directors. The answer to this is affirmative, although even with the introduction of Section 185's change, this transaction will only be allowed in circumstances where the company fits the description provided in the MCA notification dated June 5th, 2015.

Issues Related to Grant of such Loans

Since private companies that were exempted from Section 185 prohibitions by MCA notification of 2015 can lend to their directors. If the same meets the criteria outlined in the aforementioned Section, it will be classified as a "Deemed Dividend" under Section 2(22)(e) of the Income Tax Act of 1961:

"Dividend" refers to any payment made after May31, 1987, to a shareholder 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 outstanding shares of a company in which the public does not have a substantial interest (hereafter in this clause referred to as the said concern) or any payment made by any such company to any such shareholder on their behalf or for their personal benefit, to the degree that either instance involves the firm having accrued profits.

The director must have 10% or more voting power in the company (i.e., the director in the present case is also a shareholder) or have a substantial beneficial interest in the company's shares in order for this section to apply. Closely held companies, such as private companies, may make payments by way of advancing loans.

What happens if the Loan advanced is considered as "Deemed Dividend"?

Now, the legislative goal in creating this section was to close a loophole that firms were using to avoid paying the 15% TDS that was applied to the distribution of dividends since they used to issue the payout in the form of a loan and the shareholder never used to pay it back. [10] Later in 2018, the law changed and the regulations tightened, making the firm responsible for paying Dividend Distribution Tax (DDT) @ 30% and Section 10(34)of the Income Tax Act, 1961 exempting the beneficiary from paying tax on the distribution.

In this case, the Company is still obligated to pay DDT@ 30%in the fiscal year in which the loan is advanced, even if the Shareholder repays the loan amount to the Company.

The "Finance Act, 2020" changed the legal framework governing the taxability of dividend payments once more. According to the memo outlining the amendment, the dividend is income received that belongs to shareholders rather than the company, so the recipient should be made liable for paying tax rather than the company. This amendment altered a lot of the dynamics of taxation in the dividend distribution space.

Conclusion

When private companies advance loans to their directors, care must be taken to determine if Section 2(22)(e) of the Income Tax Act, 1961 is relevant or not. If it is, the director will not benefit because the majority of the loan will be taxable. In such circumstances, it would be in the director's best interest to obtain a loan from a reputable financial institution.

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