The Companies (Restriction on number of layers) Rules, 2017 (“Companies Layering Rules”), notified on September 20, 2017, along with the proviso to Section 2(87) of Companies Act, 2013 (“Companies Act”), imposed restrictions on Indian companies from setting up structures with more than two ‘layers’ of subsidiaries.

On the other hand, the Foreign Exchange Management (Overseas Investment) Rules, 2022 read with the Foreign Exchange Management (Overseas Investment) Regulations, 2022 (collectively, the “OI Framework”), notified on August 22, 2022 prescribes that a person resident in India is not permitted to invest in a foreign entity that has invested or invests into India, through a structure with more than two ‘layers’ of subsidiaries (“OI Layering Rules”).

While the Companies Layering Rules were notified with an objective to prevent misuse of complex corporate structures (by limiting the number of subsidiaries an Indian entity can set up), the OI Layering Rules were notified to allow persons resident in India to set up – hitherto prohibited – circular investment structures (also known as ODI – FDI structures) through up to two layers of subsidiaries.

As such, both the Companies Layering Rules and the OI Layering Rules indicate a regulatory appetite for structuring of investments and operations only through up to two layers of subsidiaries. Having said that, the fine print of these laws, even after being effective for a few years, leaves room for interpretational ambiguity. This article – presented in an FAQ format – highlights such ambiguities in their interpretation, by analysing them against the context in which these laws were sought to be implemented.

ANALYSIS OF COMPANIES LAYERING RULES

1. What do the Companies Layering Rules prescribe?

The Companies Layering Rules provide that Indian companies, other than as exempted^[1] (“Class Exemption”), cannot set up structures with more than two layers of subsidiaries^[2]. Exemptions to such restriction include: (i) not taking into account “one layer which consists of one or more wholly owned subsidiary or subsidiaries…”, towards the calculation of layers (“WOS Exemption”); and (ii) “acquiring a company incorporated outside India with subsidiaries beyond two layers as per the laws of such country” (“Acquisition Exemption”).

2. Are the layers referred to in the Companies Layering Rules, ‘vertical layers’ or ‘horizontal layers’?

The Companies Layering Rules do not specify if the ‘layers’ referred in it should be read as ‘vertical layers’ (i.e., step-down subsidiaries of a holding company) or ‘horizontal layers’ (i.e., sister subsidiaries below the same holding company). Given that the objective of the Companies Layering Rules is to curb opaque ownership structures^[3] and a restriction on horizontal expansion would present practical challenges (including potentially preventing companies from rationalising business verticals into separate balance sheets), it is arguable that the reference to ‘layers’ in the Companies Layering Rules should be read as ‘vertical layers’ only. However, pending a regulatory clarification in this regard, it is arguable (on a technical reading of the extant provisions) that even ‘horizontal layers’ fall within the purview of the Companies Layering Rules.

3. Are the Companies Layering Rules retrospectively applicable?

Indian companies were required to report to the Registrar of Companies (“ROC”), their multi-layered holding structures within 150 days of notification of the Companies Layering Rules. Accordingly, the structures existing at the time of notification of the Companies Layering Rules were ‘grandfathered’ (“Reported Structures”) and the Companies Layering Rules should not be interpreted to apply retrospectively.

4. If a Reported Structure has multiple independent layers – does the benefit of maximum number of grandfathered layers in a Reported Structure, extend to all verticals under the Reported Structure, i.e., can a reported vertical propagate vertically further if another vertical has reported a greater number of subsidiaries?

The legislative intent behind the requirement to notify Reported Structures to the ROC was to crystallize them in the ROC’s records (as such structures otherwise would have been in breach of the Companies Layering Rules).

While it is possible to argue that the benefit of maximum layers in a Reported Structure may be accorded to all verticals under the Reported Structure (including for verticals with fewer layers at the time of notification of the Reported Structure (compared to the maximum number of layers reported for other verticals in a Reported Structure)), Rule 2(4)(ii) of the Companies Layering Rules provides that a company:

“…shall not, after the date of commencement of these rules, have any additional layer of subsidiaries over and above the layers existing on such date.”

A strict interpretation of the above rule suggests that the Companies Layering Rules would restrict expansion of all verticals in a given Reported Structure (that have been grandfathered). Accordingly, if a particular layer in a Reported Structure has reported a certain number of subsidiaries – such vertical would not be permitted to add additional layers of subsidiaries, even if another vertical in such Reported Structure has reported a higher number of subsidiaries. Absent an express regulatory clarification in this regard, it may be risky to propagate verticals in a Reported Structure with reference to other verticals (with higher number of layers) in the same structure.

5. How will the layer of wholly owned subsidiaries for the WOS Exemption be calculated? Is this layer required to be a layer directly below the reference holding entity or can this layer be anywhere in a vertical of layers? Can the WOS Exemption apply to multiple layers of wholly owned subsidiary(ies) occurring at different places (which are not contiguous) in an ownership chain?

The second proviso to Rule 1 of the Companies Layering Rules states that “Provided further that for computing the number of layers under this rule, one layer which consists of one or more wholly owned subsidiary or subsidiaries shall not be taken into account.”

A literal reading of the above provision does not suggest that the layer of wholly owned subsidiary(ies) to be exempted from the layering restriction, should be housed directly under the ultimate holding entity. A contrary interpretation in this regard would require ‘first’ layer to be read into the phrase ‘one’ layer in the relevant provision (contrary to the express wordings of the proviso and against established principles of statutory interpretation).

Having said that, the above view has not been formally supported or clarified by the Ministry of Corporate Affairs (“MCA”). Hence, it is possible to be argued (and we have seen instances of such interpretation being taken in the market) that the ‘one’ layer of wholly owned subsidiary(ies) proposed to be exempted should, in fact, be the ‘first’ layer under the ultimate holding entity. Such a view is premised on the principle that the (possible) legislative intent behind this exemption is only to exclude wholly owned subsidiaries, the ownership of which can be traced to the ultimate holding entity directly (which would then qualify to be the mirror image(s) of such holding company, thereby justifying their exclusion from the purview of the layering restriction)).

The latter interpretation in our view would significantly limit the scope of the WOS Exemption and hence merits a clarification from the MCA expeditiously.

Regardless of which interpretation is favored, given that the proviso states only ‘one’ layer will be excluded for such calculation – the benefit of this exemption should be extended only to one layer of wholly owned subsidiary(ies) in a given layers of subsidiaries (and should not be availed more than once, by multiple layers of wholly owned subsidiary(ies) in such vertical).

6. How does the Acquisition Exemption apply? Does it extend to incorporation of new entities offshore, by an Indian holding company?

The first proviso to Rule 1 of the Companies Layering Rules provides that “Provided that the provisions of this sub-rule shall not affect a company from acquiring a company incorporated outside India with subsidiaries beyond two layers as per the laws of such country”.

An expansive reading of the provision would suggest that this exemption should extend to any offshore structure – whether acquired or newly set up. However, such a view may not be supported by a literal interpretation of this provision, given that it explicitly refers to ‘acquisitions’ of offshore entities (and not to ‘incorporation’ or ‘setting up’ of new offshore entities). Further, the express reference to ‘companies incorporated outside India with subsidiaries beyond two layers’, could have been intended to to pre-suppose the existence of such structures at the time of the relevant ‘acquisition’. To that extent, the Companies Layering Rules arguably seeks to exempt only such layers that have been ‘acquired’ offshore, and does not permit Indian companies to set up offshore structures by ‘incorporating’ new entities.

Again, given the importance of allowing Indian companies to expand internationally, a clarification on the above issue would support structures involving setting up of (offshore) multilayered structures backed by bona fide commercial objectives.

ANALYSIS OF OI LAYERING RULES

7. What do the OI Layering Rules prescribe?

 The OI Layering Rules provide that Indian persons (and entities) cannot make overseas investments that results in a structure with more than two layers of subsidiaries.

8. Are circuitous investment structures now permissible in terms of the OI Framework?

 Circuitous investment structures – previously viewed unfavorably by the Reserve Bank of India (“RBI”) as devices for ‘round tripping’ of funds for tax evasion and money laundering – have now been permitted. In this respect, it may be worthwhile to note that while there was no express prohibition of circuitous investment structures in the erstwhile overseas investments regulatory regime, the RBI regulated such structures under Regulation 6(2)(ii) of the now repealed Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004 (“Erstwhile ODI Regulations”). The Erstwhile ODI Regulations allowed direct investment in overseas ‘wholly-owned subsidiaries’ or ‘joint-ventures’ only if they were engaged in a ‘bona fide’ business activity. While the term ‘bona fide’ was not defined, the RBI viewed any structures wherein an ownership chain could be established between an Indian entity to another Indian entity, through overseas holdings, as being violative of this provision. Such an approach was expressly confirmed by the RBI in 2019 (as part of its FAQs released in relation to the Erstwhile ODI Regulations).

While the restrictions on such structures were aimed at preventing illegitimate activities, it also adversely impacted structuring of legitimate transactions – for instance, acquisitions by Indian entities of overseas conglomerates with part operations in India (whether pre-existing or post-facto).

The OI Layering Rules seek to address such challenges, by permitting circuitous investment structures, through two layers of subsidiaries.

9. How are the ‘two’ layers referred under the OI Layering Rules calculated? Do the two layers include subsidiaries of the Indian entity subject of the ‘FDI’ in the ‘ODI-FDI’ loop, i.e., subsidiaries of the Indian entity at which the circuit ends?

On a plain reading of the OI Layering Rules (reproduced below), it appears that the layers of subsidiaries referred thereunder are not linked to a particular entity.

“No person resident in India shall make financial commitment in a foreign entity that has invested or invests into India, at the time of making such financial commitment or at any time thereafter, either directly or indirectly, resulting in a structure with more than two layers of subsidiaries”

It is unclear from the above as to whether the ‘two layer’ restriction would apply only to offshore entities, or even to layers below the Indian entity, which receives the circuitous foreign investment through the overseas structure.

The prevalent market view in this regard appears to be that the restriction does not extend to (and thereby, does not take into account) subsidiaries of the Indian entity in which, the offshore circuitous investment loop ends. However, an express clarification from the RBI to this effect would provide much needed clarity to the interpretation of this provision.

CONCLUSION

This article has attempted to highlight some open questions under both the Companies Layering Rules and the OI Layering Rules on which clarity from a regulatory perspective would be welcome. While both these legislations are aimed at preventing misuse of opaque corporate structures, lack of regulatory clarity on critical issues (such as those highlighted in this article) continues to be roadblocks to structuring of corporate structures with legitimate commercial objectives. In an era where India is seeking to attract more foreign investment (and is marketing itself as a jurisdiction which fosters ‘ease of doing business’), it is critical that its laws unambiguously support legitimate commercial structures and transactions (without any scope for regulatory gaps to be used against such sentiment).

Footnotes:

[1] Banking companies, systemically important non-banking financial companies, insurance companies and government companies

[2] As per Section 2(87) of Companies Act, 2013, a “subsidiary company” or “subsidiary”, in relation to any other company (that is to say the holding company), means a company in which the holding company:

(i) controls the composition of the Board of Directors; or

(ii) exercises or controls more than one-half of the total voting power either at its own or together with one or more of its subsidiary companies:

Provided that such class or classes of holding companies as may be prescribed shall not have layers of subsidiaries beyond such numbers as may be prescribed.

Explanation.—For the purposes of this clause,—

(a) a company shall be deemed to be a subsidiary company of the holding company even if the control referred to in sub-clause (i) or sub-clause (ii) is of another subsidiary company of the holding company;

(b) the composition of a company’s Board of Directors shall be deemed to be controlled by another company if that other company by exercise of some power exercisable by it at its discretion can appoint or remove all or a majority of the Directors;

(c) the expression “company” includes any body corporate;

(d) “layer” in relation to a holding company means its subsidiary or subsidiaries;

[3] while not explicitly indicated, the Companies Layering Rules appear to follow the recommendations of the Joint Parliamentary Committee Report on Stock Market Scam and Matters Relating Thereto of 2002, that suggests casting restrictions on multi-layered structures.