Beneficial Ownership: Substance over Form

The doctrine of a Company being a ‘separate legal entity’ from its members was recognised by the House of Lords in the landmark case of Saloman vs. Saloman & Co in 1897. This concept limits the liability of the shareholders from the business obligations of the legal entity, virtually creating a ‘veil’ between the shareholders and third parties; and this dimension is the very basis of a corporate form of organisation.

While this has fundamental acceptance globally, in certain cases such as oppression and mismanagement, or transactions which are found to be colourable or artificial in nature, the Courts have held that the corporate personality of the Company could be disregarded. Over a period, it has been observed that under the shelter of Company being a distinct personality, complex structures and chains of corporate vehicles were being used to conceal the real owner behind certain transactions. To counter this practise, the Financial Action Task Force (‘FATF’) developed a series of recommendations for obtaining transparent disclosures of such ‘natural persons’ who hold ‘beneficial ownership’ in an entity thereby disregarding the artificial veil existing between the Company and its shareholders.

In this context, the legislature in India has also introduced certain crucial amendments to its statutory provisions, and the judiciary, as well, has interpreted laws so as to give effect to the spirit of the law rather than merely the letter of the law with the ultimate purpose to identify the ‘natural persons’ and effectively, pierce through the smokescreen between the real owners of a corporate structure. Such amendments to the existing laws, inter alia, require obtaining transparent disclosures every time such person acquires ‘beneficial interest’ or is a ‘significant beneficial owner’ in Company, further obligating them, with additional regulatory compliances prescribed under the laws. Some of these amendments are especially in an Indian regulatory context where the corporate structure has been abused by a few and has led to amendments, administration and interpretation of law which, in essence, is an “outlier legislation” i.e. legislation for dealing with the exceptions.

Be that as it may, this article endeavours to cover recent regulatory developments on the concept of ‘beneficial ownership’ and instances wherein the regulatory authorities have tested this concept by disregarding the sanctity of the corporate veil.

I. Under Companies Act, 2013 (“Companies Act”):

The provisions for declaration of beneficial interest pre-existed under section 187C of the Companies Act, 1956 wherein a person who was a registered owner but did not hold beneficial interest in a Company was required to make the prescribed declarations. This was typically applicable when Trusts, HUFs or partnership firms (‘PFs’) were shareholders of a Company, but the registered owner were its Trustees, Karta or the partners respectively.

Under the new Companies Act, section 89[1] requires a person who acquires any ‘beneficial interest in shares’[2] (irrespective of their percentage of holding) of a Company to make declarations. Further, Section 90[3] also requires identification of individuals holding ‘significant beneficial ownership’ (‘SBO’) to make declarations prescribed under the Companies (Significant Beneficial Owners) Rules, 2018[4] (‘SBO Rules’). The key provisions are tabulated for easy reference attached as Annexure 1 to this article.

The intention of enforcement of the aforesaid provisions and rules is to lift the veil and identify the ‘natural persons’ who hold SBO in a Company. However, it has also led to ambiguity in minds of shareholders and the Companies compliance officers in terms of the practical and administrative challenges encountered while determining the SBO which are discussed as under:

a) Investor Rights – Usually, under a share purchase agreement, various rights are granted to the financial or strategic investor - such as right of first refusal, anti-dilution rights, management or information rights, liquidation preferences etc, in order to protect their interest in the Company. Any direct or indirect exercise of such rights attached to a share (acquired through a contractual arrangement or an entitlement to a right) leads to holding a ‘beneficial interest’ in the Company.

A question may arise in a situation where an investor, who may hold even less than 10% shares in the Company, but holds ‘investor rights’, will have to make the requisite declarations and which the Government needs to clarify.

b) Hybrid Instruments treated as Shares – While section 2(84) of the Companies Act specifically defines ‘shares’ to mean share in the share capital of the company and includes stock, the SBO Rules consider GDRs, CCPS and CCDs ‘shares’; accordingly, the said instruments are required to be considered as a part of the share capital. Holders of such hybrid instruments would also require to disclose their SBO under the SBO Rules. By incorporating a wider definition to the term ‘shares’, it seems the SBO Rules intend to broaden the base of the normal provisions of the Companies Act.

Further, adding to the complexity, the challenge is whether the underlying interest in the equity held in the hybrid instruments is to be considered before the conversion option is exercised or should the dilution be considered only upon exercise of conversion rights. Severe challenges can be faced by the ultimate beneficial owner if the CCDs are issued with an option to first be converted into CCPS and thereafter into equity. Lack of conversion ratio upfront may cause faulty disclosures and make individual and corporates liable to the consequences.

c) Applicability to non-residents – The provisions are made applicable to non-residents who have invested in the Indian Companies under the FDI Scheme. In this way, the applicability of the Companies Act and the Rules have been extended to jurisdictions beyond India making it extremely difficult for a person resident outside India (‘PROI’) to abide with the same. The SBO Rules cast an onerous responsibility on the ultimate natural person who has SBO of 10% in the investee company which may lead to a negative sentiment within the investor markets.

d) No exemption to Listed Companies – While the Draft SBO Rules[5] granted an exemption to a listed company shareholder; however, such exemption has been withdrawn in the Final SBO Rules. This indicates that corporate shareholders are intended to be within the ambit of these provisions making it an administrative challenge for such individual shareholders to determine and disclose their ‘beneficial ownership’ held not only in the parent company but also indirect held in the subsidiary companies.

e) Imprisonment – Failure of prescribed disclosures by the individual casts a stringent implication in terms of monetary prescribed fines or imprisonment which may extend to one year or both. Further, in case the SBO furnishes false or incorrect information to supress any material disclosures, he would be liable under section 477 i.e. punishment for fraud. This indicates the seriousness of the Government to obtain the necessary declarations and its intent to ultimately curb any benami transactions or any money laundering activities which was the ultimate motive of FATF.

Considering the aforesaid operational challenges faced by the corporate sector at large, several representations were made and the MCA[6] has kept the filing of requisite disclosures in abeyance until the forms are revised and notified; which hopefully would address the challenges.

II. Under SEBI Regulations:

In a landmark decision of Sahara Asset Management Company Pvt Ltd vs. SEBI, the Securities Appellate Tribunal (‘SAT’) had recognised SEBI’s statutory power to lift the corporate veil under the SEBI Act in order to identify who controls a regulated entity to take actions in the interest of protecting the interests of the investors.

While this power is to be exercised to determine the real owner whenever interests of the investors are affected or likely to be affected, on 10 April 2018, SEBI, had tightened the KYC norms with regard to investment by residents and non-resident Indians through Category-II and Category-III Foreign Portfolio Investors (‘FPIs’) in order to curb money-laundering and round tripping concerns. SEBI employed standards drawn under the Prevention of Money-laundering (Maintenance of Records) Rules, 2005 (‘PMLA Rules’), to identify Beneficial owners and such standards to prohibit Resident Individuals, Non-Resident Indians and OCIs from being beneficial owners of the FPIs. The said circular put FPIs in a state of limbo especially given the fact that they were setup by obtaining SEBI’s prior approvals and making timely regulatory filings.  

However, after several representations, SEBI[7] relaxed the ‘eligibility criteria’ for new and existing FPIs having NRI participation and issued revised KYC norms to identify ‘beneficial owners’ being ‘natural persons’ as under:

• Holding controlling ownership interest (‘CoI’) (i.e. 25% in case of an FPI-Company and 15% for FPI-Trust or FPI-PF); and
• Exercising ‘control’ in the FPI.

Further, the KYC norms have stated to follow a ‘look-through principle’ to identify a BO – i.e. identification of natural person of an intermediate entity who has controlling ownership in the FPI. However, further clarity by SEBI on the disclosure of intermediate entities and on recognition of natural person in case a foreign listed company holding CoI in the FPI may assist in making the KYC norms more practical and easier to comply with.

III. Under Income – Tax Act, 1961 (‘IT Act’):

The lifting of corporate veil to identify the beneficial owner, even under the IT Act, is not new. In certain circumstances of alleged tax avoidance through complex corporate structures, the Revenue Authorities have looked through a transaction in order to determine substance of the transaction. One of the most controversial instances of lifting of the corporate veil in the context of tax assessments was Vodafone International Holdings B.V. v/s Union of India[8] wherein the Supreme Court disregarded Revenue Authorities claim of taxing an indirect transfer of shares of an Indian entity caused by a transaction between multiple offshore entities as capital gains tax in India.

However, the SC[9] has held that that the doctrine of lifting the corporate veil ought to be applied only as a matter of exception and not as a routine matter. In several cases, there has been a litigation on levying the tax on the actual taxpayer or the beneficial owner of such taxpayer. The key provisions under which the Revenue authorities test the concept of ‘beneficial interest’ which has also led to certain controversies are briefly discussed as under:

a) Registered Owner vs. Beneficial owner under Deemed Dividend provisions:

Deemed dividend provisions under section 2(22)(e) of the IT Act are attracted when a loan / advance (to the extent of accumulated profits) has been made by a closely held Indian Company to a shareholder, being a person who is the beneficial owner of shares, holding not less than 10% of the voting power in the Company.

The controversy stems in the case of loan advanced by the company to its shareholders being PFs, Trusts or HUFs (being beneficial owner) but whose registered owners are their partner, Trustees or Karta respectively.

Whilst the Mumbai Special Bench (‘SB’)[10] has held that shareholder under section 2(22)(e) of the IT act must be both – registered and beneficial owner of shares, the Delhi HC[11] has observed that the argument that a PF cannot be treated as a ‘shareholder’ only because the shares are held in the names of its partners was not acceptable.

One may argue that the provisions of section 2(22)(e) of the IT Act should be strictly construed since it creates a deeming fiction which brings in amounts paid otherwise than as dividends, into the net of dividends itself; however, given such controversies regarding the registered owner and beneficial owner, the matter is now pending for adjudication before the larger bench of the SC for the final verdict.

b) Change in beneficial ownership vs legal ownership for carry forward of losses:

As per Section 79 of the IT Act, in case of a change in shareholding of a company, other than a company in which the public is substantially interested, no loss incurred in any previous year, is allowed to be carried forward and set-off, unless shares carrying not less than 51% of the voting power are beneficially held by persons who also held such shares in the year in which the loss was incurred.

The underlying issue is whether there could be a denial of carry forward of losses on account of change in shareholding of a closely held company, even if shares representing 51% or more of the voting rights remained within the same group. A catena of contrasting judicial precedents has further created a degree of legal uncertainty surrounding this issue.

The Mumbai ITAT in case of Wadhwa & Associate Realtors Pvt Ltd[12] held that the phrase ‘beneficially held’ would contemplate wider meaning to cover situations wherein the same person is able to influence voting rights to the extent of 51% in the loss-making Company through a chain of holding in the same group. Accordingly, carry forward and set off of losses is permissible even when 51% of the voting power is ‘beneficially held’ by the same persons during the year of losses as well as in the year of set-off.

However, there are contrasting views taken by the HC’s in this regard. The Delhi HC in the case of Yum Restaurants[13] disallowed the carry forward of losses by holding that the transfer of shares of an Indian company by its holding company (i.e. Yum Asia) to another related holding company (i.e. Yum Singapore) results in change of ‘beneficial ownership’ of shares, even though the ultimate beneficial owner remains the same (i.e. Yum USA). In contrast, the Karnataka HC in case of AMCO Power Systems Ltd[14] held that that the purpose of the provision of section 79 is to prevent misuse of losses by transferring ownership and the application of the same should be restricted to only when there is a change in the ‘beneficial ownership’ loss making company.

As seen above, due to conflicting view of the HC’s divergent interpretations have been taken on applicability of ‘legal ownership’ vs. ‘beneficial ownership’ under these provisions, which could possibly be set at rest by clarifying the intent of the law or through a CBDT circular introducing appropriate amendments in the tax laws in this regard.

c) Double Tax-Avoidance Agreements (‘DTAAs’):

India follows the UN Model approach and as a source state, usually has the right to tax passive incomes such as royalties, fees for technical services (FTS) and dividends under the bilaterally negotiated DTAAs. Most of the DTAAs provide that such passive incomes are taxed (as per the relevant DTAAs) in the hands of the non-resident, being the beneficial owner of the income (which term is neither defined under the IT Act nor under DTAAs).

In the words of Professor Vogel, a ‘beneficial owner’ is a person who is free to decide whether or not the capital / assets should be used / made available for use by others and how the yields from them should be used. Under the Indian taxation regime, following circulars / judicial precedents can be relied upon:

• Tax Residency Certificate (‘TRC’) would serve as a valid document for establishing ‘beneficial ownership’ as well as status of residency for applying the DTAA - Circular 789[15], issued in the context of India-Mauritius DTAA, but widely used for other DTAAs.
• In case of ADIT v Universal International Music B.V[16], the Bombay HC placed reliance on the Circular 789 (as discussed above) and, in view of the certificate of beneficial ownership issued by the Revenue authorities in Netherlands, held that the assessee was a ‘beneficial owner’ of royalty income received from Universal India. The ITAT also held that royalty income would be taxed at beneficial tax rate of 10% as per India-Netherlands treaty since the assessee was a ‘beneficial owner’ of the income.

IV. Under other regulatory provisions:

a) Insolvency and Bankruptcy Code, 2016 (‘IB Code’):

Section 29A(c) of the IB Code disqualifies a person to be an eligible bidder if he manages or controls a corporate debtor which is classified as a non-performing asset (‘NPA’) for more than a year.

The SC, in the course of the insolvency resolution process of Essar Steel India Limited (‘Essar’), applied the principle of lifting of corporate veil in order to apply ineligibility prescribed under section 29A(c) of the IB Code to the ultimate shareholder of the two bidders i.e. ArcelorMittal India Private Limited (‘ArcelorMittal’) and Numetal Limited (‘Numetal’), thereby espousing the theme of substance over form, but provided them two weeks to clear the defaults (before submitting revised bids) as discussed below. 

In the case of Numetal, it was observed that one of the shareholders was Rewant Ruia whose father, Ravi Ruia was a promoter of Essar Steel (which was declared as an NPA; undergoing insolvency proceedings). Further, Ravi Ruia had also issued a guarantee in favour of the creditors of Essar Steel. Therefore, Numetal was held ineligible in view of Section 29A of IBC.

On the other hand, ArcelorMittal was held to be ineligible under Section 29A(c) of IBC, as ArcelorMittal Netherlands (\"AM Netherlands\") was found to have been the promoter or exercised control over two companies namely, Uttam Galva Steels Limited and KSS Petron Limited, which were classified as an NPA for more than 1 year prior to the commencement of the insolvency resolution process of Essar Steel.

b) Foreign Exchange Management Act, 1999 (‘FEMA’):

Regulation 2(xviii) of FEMA 20(R)[17] defines ‘Foreign investment’ to mean any investment made by a PROI on a repatriable basis in capital instruments of an Indian company or to the capital of an LLP. The explanation to the said regulation clarifies that if a declaration is made by persons as per the provisions of the Companies Act about a ‘beneficial interest’ being held by a PROI, then even though the investment may be made by a resident Indian citizen, the same shall be counted as foreign investment.

Accordingly, the PROI and the Indian Companies may have to analyse the impact (if any) of declarations being made under section 89 and 90 of the Companies Act on FEMA regulations.

Concluding Remarks:

The concept of a company being a separate legal entity has evolved from the 18^th century which was laid primarily to encourage business transactions, promote investment and maximise the profits and earnings. This concept also recognised the limited liability of the shareholders held in such legal entities. The global move to identify ‘natural persons’ could potentially affect these objectives of setting up a separate legal entity at the outset. Therefore, the legislature, in its wisdom, should strive to preserve and balance the ideals of corporate jurisprudence that have evolved through a number of years, while at the same time put in place measures that would enable the enforcement authorities and the judiciary to lift the corporate veil; however, lifting the corporate veil by way of prescribing disclosures may tilt the balance towards outlier legislation rather than sparing use of the principle of lifting of corporate veil.

Whilst the SBO disclosures have been kept in abeyance by the MCA at present, given the statutory amendments to the Companies Act in recognising the SBO, it is important to prescribe under what circumstances the statutes would ultimately hold the SBO’s liable for the deeds of the Company and to what extent. One may have to wait how such issues are addressed by the Government, keeping the sanctity of the corporate legal entity.

This article has been co-authored by Neha Lala

Annexure 1

[1] Section 89 notified by MCA on 7 May 2018

[2] Definition of beneficial interest in shares inserted under sub-section (10) to section 89 by Companies (Amendment) Act, 2017 and notified by MCA on 13 June 2018

[3] Substituted by the Companies (Amendment) Act, 2017

[4] Notified by MCA on 13 June 2018

[5] Draft SBO rules issued on 15 February 2018

[6] Vide Notification dated 10 September 2018

[7] CIR/IMD/FPIC/CIR/P/2018/132 dated 21st September 2018

[8] Vodafone International Holdings BV v. Union of India (UOI), Ministry of Finance and Asst. Director of Income Tax (International Taxation), [2009] 311 ITR 46 Bom.

[9] Juggilal Kamlapt v. CIT [ (1969) 73 ITR 702 (SC)]

[10] ACIT vs. Bhaumik Colour (P.) Ltd [2009] 118 ITD 1 (Mum) (SB)

[11] [2018] 89 taxmann.com 332 (SC)

[12] [2018] ITA No.967/M/2016, Assessment Year: 2012-13 (Mumbai ITAT)

[13] Yum Restaurants (India) (P.) Ltd. v. Income-tax Officer [2016] 66 taxmann.com 47 (Delhi)

[14] Commissioner of Income-tax, Bangalore v. AMCO Power Systems Ltd. [2015] 62 taxmann.com 350 (Karnataka)

[15] Circular 789 dated 3 April 2000

[16] [2013] 31 taxmann.com 223 (Bombay)

[17] Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017

[18] Inserted by the Companies (Amendment) Ordinance, 2018 dated 2 November 2018

[19] Section 90(1) of the Companies Act prescribes a minimum threshold of 25% which is reduced to 10% by the SBO Rules