Layering Restrictions on Formation of Multiple Subsidiaries

If you ask experts whether there is a possibility of the formation of multiple subsidiaries of a single company? The answer will be a ‘Yes’, however, maximum two layers of subsidiaries can be formed by a holding company with few exemptions to certain companies.

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In order to understand the way multiple subsidiaries’ can be formed keeping in mind the layering restriction, let us read the below write-up.

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1.  Meaning of subsidiary company

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In layman language, a subsidiary company means a company owned by some other company known as a holding company. The Companies Act, 2013 (‘the Act’) provides the legal definition of ‘subsidiary’ under section 2(87) of the Act as a company in which the holding company either controls the composition of the Board of Directors or 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.

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Further, it is clarified via explanation to that section that a company is also a subsidiary of the holding company even if the control of the composition of the board of directors or voting power is of another subsidiary company of the holding company. This can be understood with an example. Suppose A Ltd. holds 70% shareholding in B Ltd. and B Ltd. is holding 60% of capital in C Ltd. then, by virtue of this explanation, C Ltd. will also be a subsidiary of A Ltd even though A Ltd. is directly not holding any share in C Ltd. but holding shares in B Ltd.

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2.  Layering restriction on Holding and subsidiary company

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To curb the practices of siphoning of funds and money laundering activities using multiple layers of subsidiaries, the Government has provided restrictions on layers of companies by which a controlling company can have a limited number of subsidiaries.

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The rule of layering restriction comes from the provisions of sections 2(87) and 186 of the Act along with Companies (Restriction on Number of Layers) Rules, 2017 ('Layering Rules').

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• As per proviso to section 2 (87) of the Act, such class or classes of holding companies shall not have layers of subsidiaries beyond such numbers as may be prescribed. For this purpose, rule 2 of the Layering Rules provides that no company is permitted to have more than 2 layers of subsidiaries.

• Section 186 (1) pertaining to loan and investment by company also provides similar provision stating that unless otherwise prescribed, a company shall make investment through not more than two layers of investment companies.

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Notably, the term ‘layer’ is defined as a subsidiary or subsidiaries in relation to a holding company. Given the intent of the section, ‘layer’ refers to the vertical limit.

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For the purpose of computing the number of layers under the layering rules, one layer which consists of one or more wholly-owned subsidiaries or subsidiaries should not be taken into account. Therefore, the exemption is only in a layer which represents a wholly-owned subsidiary. However, it is pertinent to note that the layer of wholly-owned subsidiaries has to reflect in the first layer and not thereafter in order to avail of the exemption.

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3.  Illustrations of layering restrictions on Holding and subsidiary company

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4.  Exempted companies from restriction of layering

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Following class of companies are exempted from restriction of layering for having more than two subsidiaries by a holding company:

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• A banking company as defined in section 5(c) of the Banking Regulation Act, 1949.
• A non-banking financial company as defined in clause (f) of Section 45 of the Reserve Bank of India Act, 1934  which is registered with the Reserve Bank of India and considered as a systemically important non-banking financial company by the Reserve Bank of India.
• An insurance company being a company which carries on the business of insurance in accordance with provisions of the Insurance Act, 1938.
• lnsurance Regulatory Development Authority Act, 1999.
• A Government company referred to in section 2(45) of the Act.
• A company incorporated outside India. For a company incorporated outside India, the restriction of having only 2 layers of subsidiaries is not applicable in a way that a company is not prohibited to acquire a company incorporated outside India and have more than 2 layers of subsidiaries.

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5.  Consequences of contravention of layering restriction rules

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If any holding company contravenes any provision of layering restriction rules, the holding company and every officer in default will be punishable with fine which may extend to INR 10,000. In case of continuing default, a further fine which may extend to INR 1,000 for every day during which such contravention continues.

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6.  Conclusion

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With a view to protect interest of minority shareholders and check diversion of funds via misusing multiple subsidiaries, the Government came up with a provision of restriction on layering of subsidiaries. 

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Accordingly, a holding company is allowed to have only up to two layers of subsidiaries excluding one layer of wholly-owned subsidiaries. Parallelly, the restriction on investment through not more than two layers of investment companies also applies. However, banking companies, systemically important non-banking financial companies, insurance firms, and government companies are exempt from the layering restrictions.