Minimum Interest Rate on Loans to Foreign WOSs – Need for Review
Intercompany loans granted by an enterprise are governed by Article 186 of the Companies Act 2013 (‘Law of 2013‘). An important prerequisite is the interest rate thresholds prescribed in subsection (7). Section 186 (7) of the Act states that – “No loan shall be made under this section at an interest rate lower than the return in effect on a government guarantee of one year, three years, five years or ten years whichever is closest to the term of the loan. .“
Section 186 (7) effectively prevents a company from granting an intercompany loan at an interest rate below the prescribed thresholds, i.e. the running yield on a government guarantee at one year, three years, five years or ten years closest to the term of the loan. This leads to multiple practical difficulties, especially in situations where a holding company wishes to provide funds to its 100% owned foreign subsidiaries (‘WOS‘).
In this blog, we have analyzed section 186 (7) and discussed the practical difficulties caused by the interest rate requirement prescribed under that provision.
Scope of subsection 186 (7)
As Article 186 (2) (a) uses the words – “grant a loan to any person or other legal person”- even intercompany loans granted to any company incorporated outside India will fall within the regulatory scope of section 186. Section 186 (7) would therefore include loans made by a holding company to its foreign subsidiaries. (incorporated outside India).
The definition of the term “public security” is not given in the law of 2013. Section 2 (95) of the law of 2013 states that if a word or expression is not defined in the law, the definition given in the Securities Contracts Regulation Act, 1956 (‘SCRA‘) can be applied.
Section 2 (b) of the SCRA defines “government security” as “a security created and issued, whether before or after the entry into force of this Law, by the central government or a state government for the purpose of contracting a public loan and having one of the forms specified in paragraph (2) of Article 2 of the Public Law Debt Act, 1944.”Only securities issued by the central or state government (for the purpose of contracting a public loan) fall within the scope of this provision.
Under the Companies Act, 1956 (‘1956 Law‘), the provision which corresponds to Article 186 (7) is Article 372A (3). Section 372A (3) of the 1956 Act provided that – “No loan to a legal person shall be made at an interest rate lower than the prevailing bank rate, which is the standard rate made public under section 49 of the Reserve Bank of India Act, 1934.“
By a clarifying circular issued on April 9, 2015, the Ministry of Social Affairs (‘MCA‘) clarified that in cases where the effective yield (effective rate of return) on tax-free bonds is greater than the current yield of a one-year, three-year, five-year or the nearest ten-year public security of the term of the loan, there will be no violation of section 186 (7) of the Act.
This clarification circular brought article 186 (7) into line with the previous legal position under article 372A (3) of the 1956 law. By general circular n ° 06/2013 of March 14, 2013, the MCA clarified that in cases where the effective yield (effective rate of return) of the non-taxable bonds is higher than the yield of the bank rate in force, there must be no violation of article 372A (3) of the law of 1956. The same legal position now also exists under section 186 (7) of the 2013 Act.
Exemption of loans granted to WOS – the distinction between the 2013 law and the 1956 law
Under section 372A (8) of the 1956 Act, a loan made by the holding company to its WOS was exempt from complying with all the requirements of section 372A. The interest rate requirements under Section 372A (3) did not apply when a loan was made by a holding company to its WOS.
But the legal situation under the 2013 law is different and there is no general exemption. The first provision of section 186 (3) states that a loan made by a holding company to its WOS will be exempt from complying only with section 186 (3) and must comply with all other provisions of the Section 186. Therefore, a loan from the holding company to its WOS must comply with Section 186 (7).
This leads to multiple practical difficulties, especially in a situation where a holding company wishes to grant a loan to a WOS incorporated outside India (i.e. a foreign WOS). The practical problems that arise in this situation are explained below with an illustrative example.
Take the example of a company – ABC SA – which is a listed company incorporated in India. XYZ Ltd. is a WOS of ABC Ltd which is incorporated in Japan. DEF Ltd. is another WOS from ABC Ltd, which is incorporated in Vietnam. In many situations, a WOS such as XYZ or DEF may not be able to borrow directly from the market and will therefore depend on the holding company (ABC) for its funding.
Now, if ABC grants a loan to XYZ or DEF, section 186 (7) will apply. Pursuant to Section 186 (7), the interest rate on the loan may not be less than the current yield of a government guarantee of one year, three years, five years or the nearest ten years. the term of the loan.
Since the loan is granted by ABC Ltd to its foreign WOS (which is incorporated in Japan / Vietnam), there may be a conflict of applicable laws. Under Indian law, namely Section 186 (7), the rate of interest cannot be below a particular threshold. The laws applicable in the foreign jurisdiction may provide that the interest rate cannot be above a prescribed threshold.
The overseas WOS will also have a mandate to comply with local Japan / Vietnam company law. The application of Indian benchmark interest rates may therefore create a conflict of applicable laws, particularly in situations where the foreign jurisdiction contains different benchmark interest rates. In addition, interest rates in India are likely to be significantly higher than rates in jurisdictions such as Japan or Vietnam.
This creates practical difficulties when holding companies are unable to finance their foreign WOS. Companies are therefore finding innovative ways to circumvent the requirement of Article 186 (7) – through methods such as issuing redeemable preferred shares or optionally convertible bonds. Another method is also used – where the foreign WOS borrows in the local currency and the parent company incorporated in India provides collateral in accordance with FEMA regulations.
Even for legitimate business transactions, holding companies have difficulty providing funding to their foreign WOS, due to the interest rate requirement in Section 186 (7). The law as stated in article 186 (7) is therefore not in line with the reality of the market.
As the law does not conform to market realities, it is necessary to make an appropriate amendment to Article 186 (7) – by which loans granted by the holding company to its foreign WOS are exempted from complying with Indian interest rate thresholds.
It is relevant to note here that loans granted by a holding company to its foreign WOS will also have to comply with the FEMA framework. Even if section 186 (7) is amended and interest rate thresholds are removed, loans to a foreign WOS will still have to comply with FEMA regulations. Therefore, sufficient guarantees will continue to exist.
In its report, the Company Law Committee, 2016 also considered whether holding companies should be allowed to provide interest-free loans to their WOS. The Committee considered that it would not be desirable to allow a WOS to accept interest-free loans from its parent company. Although the granting of interest-free loans is not permitted, Article 186 (7) should be amended to ensure that benchmark Indian interest rates are not applied to loans made to a foreign WOS.