Interpreting the Companies Act 2013, Section 185, 186 and 2(22)(e) of the Income Tax Act

The Companies Act, 2013, governs the incorporation, operation, and regulation of firms in India. Sections 185, 186 and 2(22)(e) of the Income Tax Act are among the numerous requirements that now regulate the manner in which businesses deal with loans, investments, and transactions between corporate entities. These are sections meant to make companies transparent, ensure the use of funds is honest, and establish fair governance standards.

This blog describes the main contents, points and consequences of Sections 185 and 186 of the Companies Act, 2013, and Section 2(22) (e) of the Income Tax Act.

Section 185 – Loan to Directors

The Companies Act, 2013, section 185 forbids companies from lending, offering guarantees or providing security to their directors or to any other person in whom the director is interested. This is aimed at preventing the misappropriation of the company’s funds in favour of oneself and ensuring that they are spent on valid business activities.

Key Provisions

Section 185(1) also specifically forbids an act by any company, public or private:

1. Making loans to its directors either directly or indirectly.
2. Any extension of any guarantee or security to that of loans borrowed by directors or other persons.

Another limitation is however given by the Act in Section 185(2) in which loans and guarantees can be allowed with exceptions that are subject to approval.

Permissible Transactions

A company can loan or make a guarantee when:

1. The general meeting takes a special resolution within the company.
2. The loans are made to those entities in which the directors are interested, but under the condition that the loans are utilised for the main business operations of the entity.
3. The transaction is conducted within the stated conditions and limitations of the Companies (Meetings of Board and its Powers) Rules, 2014.

Penalties for Contravention

In case a company breaches the provisions of Section 185:

1. The business can pay a fine ranging between Rs. 5 lakh and Rs. 25 lakh.
2. The lender or borrower of the loan is also exposed to imprisonment of up to 6 months or a fine of between Rs. 5 lakh and Rs. 25 lakh or a combination of both.

 Section 186 – Company Loan and Investment

Section 185 concerns loans to directors, whereas Section 186 concerns how a company may make loans, investments, guarantees, or provide security to other corporate entities. It imposes quantitative restrictions to prevent excessive exposure of company funds and to protect shareholders’ interests.

Applicability

Section 186 applies to both public and private companies. It seeks to ensure that there are no financial transactions between related corporate entities that are not transparent, accountable, or within permissible limits.

Key Limits under Section 186

Under Section 186(2), it is not in the power of a company to do or omit directly or indirectly:

1. Make any loan, or
2. However, guarantee anything or offer any security with regard to a loan to any other person, or
3. Purchase securities of a different body corporate.

beyond the following limits:

1. 60 percent of its paid-up capital in shares, free reserves, and securities premium, or
2. All its free reserves, and all its securities premium account, whichever is higher.

Whenever a company wants to go beyond these limits, it has to seek permission through a special resolution passed by the shareholders during a general meeting.

Approval Requirements

1. All such transactions must be pre-emptively agreed by the Board of Directors.
2. In case the limits are surpassed, a special resolution should be adopted by the shareholders.
3. Firms are required to keep a register of any loan, guarantee, or investment undertaken under Section 186.

Prohibited Loans and Interest Rate

The interest that is imposed on loans should not be lower than the yield of one-year, three-year, five-year or ten-year government security nearest to the tenure of the loan.

In addition, no company is allowed to issue loans to any entity that is involved in the investment or lending business unless the company is registered as a Non-Banking Financial Company (NBFC).

Disclosure and Compliance

Any loans and investments the company has incurred should be reported in the financial statements with the intention and manner in which they have been made. Failure to comply risks imposing hefty fines and can also influence the reputation of the company in the eyes of the government bodies.

Penalties

In case a company violates one of the provisions of Section 186:

1. Up to Rs. 5 lakh may be a penalty to the company.
2. All the defaulting officers can be imprisoned for a maximum of 2 years or fined a maximum of Rs. 1 lakh.

Section 2(22) (e) – Limitation of Borrowings (Interpretative Context)

Section 2(22)(e) of the Income Tax Act, 1961, which has pronounced implications for the companies and shareholders.

Under Section 2(22) (e), a loan or advance of any nature given by a closely-held company to:

1. A shareholder that possesses 10 per cent or more of voting power or
2. Such a shareholder has a substantial interest in a matter of concern,

is considered a dividend deemed taxable.

This implies that such payments are registered as dividends to the recipient and taxed as dividends regardless of the fact that they are not reported by the company as real dividends.

Interplay With Companies Act

Although the Companies Act, 2013, regulates corporate governance and compliance, the Income Tax Act, Section 2(22)(e), provides tax discipline in the same area.

A combination of all these provisions ensures that the directors or significant shareholders cannot misuse company money in the name of inter-corporate loans or advances.

Conclusion

Sections 185, 186 and 2(22)(e) all combine to create a powerful framework to address the misuse of company resources, financial disclosure, and the safeguarding of shareholder interests.

Whereas Section 185 limited the loan to directors, Section 186 regulates inter-corporate investments and guarantees. Section 2(22)(e) of the Income Tax Act, on the other hand, discourages disguised distribution of profits as loans to important shareholders.

These sections not only promote good corporate governance but also compliance, which is a legal requirement for companies. Efficient disclosures, timely board approvals, and compliance with statutory limits prevent penalties and foster trust among investors and other regulators.