Companies Act, 2013 Free Reserves and some related issues to find out circumstances in which revaluation gains can be considered as ‘free reserve’ and ‘net worth’.

[DEV KUMAR KOTHARI]

Companies Act, 2013

Free Reserves and some related issues to find out circumstances in which revaluation gains can be considered as ‘free reserve’  and ‘net worth’.

Summary:   in the context and situations of (a)  providing security for obtaining loans, and (b)  money lender providing secured loans,  the fair market value of security is very much relevant and  when we have to consider free reserves, then gains on revaluation of security are  in nature of ‘free reserves’, for the purpose of ascertaining value of security provided, and net worth of the  company.

General about definition clause:

Definition clause is generally  subject to context.

On reading of related provisions we find that the phrases‘ free reserves’ and ‘net worth’ are also  defined  in the definitions provisions contained in section 2 of the Companies Act 2013 and are subject to requirement of the context in which the expression is to be used.

Furthermore, this is also evident that  in other related provisions  the term has been used with some more explanations or exceptions in spite of definition provided in definition clauses in section 2.

Cash outflow: We also find that the provisions and circumstances in which restriction for use of profits and  free reserves are  found  relates to situation in which there is immediate or expected cash out flow. For example,  in case of payment of dividend and interim dividend immediate and permanent  cash outflow takes place. In case of bonus issue of shares, in future more cash out flow can take place by way of dividend and buyback of shares.   In case of intercorporate loans and investment also there is immediate cash out flow.

In provisions related to above situations, there is requirement that only free reserves should be considered besides there is, in respective provisions specific restrictions on use of revaluation surpluses on revaluation of assets or liabilities.

Secured loans vs. unsecured loans:

We find that in provisions relating to acceptance of deposits, which are generally unsecured, there is clear restriction that revaluation surpluses will not be considered for determination of limits up to which company can accept deposits.

Share premium:

Though , as per definition of ‘free reserves’ , share premium  is not ‘free reserve’ because  dividend cannot be declared out of share premium. However, ‘share premium’ is considered just like free reserves for many of purposes as per specific provisions.

Realized and unrealized gains:

In case of gains on sale of properties on capital account also the earned  gains are considered as part of free reserves.

 In case of gains due to actually reduced liabilities on account of remission, settlement at lower amount,  there is no such restriction such gains due to reduced liability  are considered a part of free reserve.  However if a revaluation gain on revaluation of liability is found without actual remission or reduction of liability,  then restriction apply and such gains will not qualify as part of ‘free reserve’.

Therefore, as per provisions found in the Companies act, 2013 itself,  it can be said that the phrase ‘free reserve’ in  situations and  contexts  entailing cash out flow, is used in a manner that any unearned gains are not considered as free reserves because  it is intended that a  company should not pay dividend or issue bonus shares  or  make intercorporate investment by way of loans and securities out of unearned profits or gains. This is also subject to some situations in which even borrowed funds can be used for such purposes.

Specific restrictions- some examples:

In section 63 relating to issue of bonus shares besides use of expression ‘free reserves’  there is also specific proviso for not permitting revaluation gains for issue of bonus shares.

In section 123  about dividend  and  interim dividend, and section 180 about  making of corporate loans and investments also we find that besides use of expression ‘free reserves’ there are specifically provided wording to deny use of revaluation gains on revaluation or restating of assets and liabilities. 

In section 186 about loan and investment by company also besides use of expression ‘free reserves’, specific restriction is imposed for not considering revaluation gains.

It is also worth to note that ‘securities / share premium’ is not available for declaration of dividend, however, it is permitted to be considered as  reserves for some other purposes.

It is also worth to mention that for some purposes, after recent amendments ‘share premium’ is now considered at par with other free reserves. This also suggest that on change of facts and circumstances, there is need for reconsideration of provisions in view of factual circumstances.

The above discussion clearly shows that the definitions of ‘free reserves’ and ‘net worth’ are subject to context and purposes for which reserves and surplus are to be considered and used.

 No specific restriction about revaluation gains for obtaining loans:

In relation to taking loans we find restrictions in S.180 as follows (so far in relation to any non-banking company):

Restrictions on powers of Board

    “ 180. (1) The Board of Directors of a company shall exercise the following powers only with the consent of the company by a special resolution, namely:-

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       (c)  to borrow money, where the money to be borrowed, together with the money already borrowed by the company will exceed aggregate of its [paid-up share capital, free reserves and securities premium], apart from temporary loans obtained from the company's bankers in the ordinary course of business:

          Provided that  xxx  not relevant hence not reproduced.

          Explanation.-For the purposes of this clause, the expression "temporary loans" means loans repayable on demand or within six months from the date of the loan such as short-term, cash credit arrangements, the discounting of bills and the issue of other short-term loans of a seasonal character, but does not include loans raised for the purpose of financial expenditure of a capital nature; “

Unquote:

 Here it is worth to note a distinction  that in this provision of S.180 (c)  there is only use of expression ‘free reserves’ and there is no specific prohibition about revaluation gains as is found in other situations involving cash out flow, as discussed earlier.

 Nonuse of specific restrictive wordings and absence of specific bar on consideration of  revaluation gains is  obviously for the reason of contextual differences and purpose seeking requirements.

In case of secured loan transactions , while a company providing security to money lender,  can  reasonably ask that the fair market value of security need to be considered.

If fair market value is  higher , the  excess  of fair market value over book value can be considered as ‘free reserve’  for the purpose of limitation on amount of loans which company can take or a money lender can grant keeping reasonable margins.

The money lender is concerned about coverage of security and for that purpose, fair market value of security provided is relevant and not the cost  or book value.

 Let us consider reverse situation of fall in value of security, if value of security is lesser than book value or valuation earlier considered at the time of granting loan or credit facility and then the fair market value falls the financier will reduce amount of security held and will ask for further security or reduce credit facility by reducing drawing powers and in case of need will call for repayment so that loans are within agreed norms of margins.

 This is common practice, even in case of secured loans against current assets like stock-in-trade, securities, sundry debtors etc. any significant  fall in value immediately draw attention of money lender and he ask the borrower to pay part of loan or furnish additional security.

Therefore, in the context and situation of providing security for obtaining loans, the fair market value of security is very much relevant and  when we have to consider , even accounting concepts like ‘free reserves’ or ‘net worth’ , then gains on revaluation of security are in nature of free reserve, for the purpose of ascertaining value of security provided, and ‘net worth’ of company based on which a money lender can decide limit up to which loan can be given.

For valuation of shares of companies, also fair market value of assets is to be considered in one of method of valuation of equity shares.  This is as per provisions of Income-tax Act and Income-tax Rules about valuation of shares of unlisted companies  current valuation of certain  properties owned are to be considered.

In case of change in controlling stake even in case of listed company’s fair market value of properties, including intangible assets, future benefits , are considered during negotiations and due diligence enquiry. That is why there is either a premium or a discount in comparison to market value and book value  of shares of listed companies.  

Therefore, in context of obtaining of loan or credit facility by a borrower, and  granting of loans or credit facility by a money lender or financier current value of security is very much relevant. Any appreciation in value of security should therefore be considered as ‘ free reserve’ or ‘net worth’ of borrower. This concept can equally be applied even in case of a company, as per provisions, context and purpose seeking approach.

Particularly in case of situations in which it is found that appreciation of security is not only long-term but is of reasonable permanence in case of normal situations and can be ascertained. For example, in case of properties like land where there is normally no wear and tear, and plantations in which there is long lasting productive capacity and  value appreciate because of increasing costs in replacement for example tea and rubber plantations, and valuable trees which grows and regenerate etc. Even in case of buildings, which are properly maintained there is appreciation due to cost of replacement increasing.

In such cases, there is no sense in considering cost or book value for the purpose of evaluating security provided by such assets.

It is up to the money lender to decide about margins vis a vis the fair market value of security and loans or credit facilities to be extended.

Readers are requested to provide their views and feedback.   

Some relevant provisions:

Relevant portion of above sections are reproduced below with recent amendments and  highlights:

 Companies Act, 2013

Definitions

2. In this Act, unless the context otherwise requires,-

  (43) "free reserves" means such reserves which, as per the latest audited balance sheet of a company, are available for distribution as dividend:

          Provided that-

               (i)  any amount representing unrealised gains, notional gains or revaluation of assets, whether shown as a reserve or otherwise, or

               (ii)  any change in carrying amount of an asset or of a liability recognized in equity, including surplus in profit and loss account on measurement of the asset or the liability at fair value, shall not be treated as free reserves;

(57) "net worth" means the aggregate value of the paid-up share capital and all reserves created out of the profits ¹²[, securities premium account and debit or credit balance of profit and loss account,] after deducting the aggregate value of the accumulated losses, deferred expenditure and miscellaneous expenditure not written off, as per the audited balance sheet, but does not include reserves created out of revaluation of assets, write-back of depreciation and amalgamation;

Issue of bonus shares

     63. (1) A company may issue fully paid-up bonus shares to its members, in any manner whatsoever, out of-

           (i)  its free reserves;

          (ii)  the securities premium account; or

          (iii) the capital redemption reserve account:

     Provided that no issue of bonus shares shall be made by capitalising reserves created by the revaluation of assets.

     (2) No company shall capitalise its profits or reserves for the purpose of issuing fully paid-up bonus shares under sub-section (1), unless-

          (a)  it is authorised by its articles;

          (b)  it has, on the recommendation of the Board, been authorised in the general meeting of the company;

          (c)  it has not defaulted in payment of interest or principal in respect of fixed deposits or debt securities issued by it;

          (d)  it has not defaulted in respect of the payment of statutory dues of the employees, such as, contribution to provident fund, gratuity and bonus;

          (e)  the partly paid-up shares, if any outstanding on the date of allotment, are made fully paid-up;

          (f)  it complies with such conditions as may be prescribed.

     (3) The bonus shares shall not be issued in lieu of dividend.

 

CHAPTER VIII

DECLARATION AND PAYMENT OF DIVIDEND

Declaration of dividend

     123. (1) No dividend shall be declared or paid by a company for any financial year except-

          (a)  out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of sub-section (2), or out of the profits of the company for any previous financial year or years arrived at after providing for depreciation in accordance with the provisions of that sub-section and remaining undistributed, or out of ²[both:]

³[Provided that in computing profits any amount representing unrealised gains, notional gains or revaluation of assets and any change in carrying amount of an asset or of a liability on measurement of the asset or the liability at fair value shall be excluded; or]

          (b)  out of money provided by the Central Government or a State Government for the payment of dividend by the company in pursuance of a guarantee given by that Government:

     Provided that a company may, before the declaration of any dividend in any financial year, transfer such percentage of its profits for that financial year as it may consider appropriate to the reserves of the company:

     Provided further that where, owing to inadequacy or absence of profits in any financial year, any company proposes to declare dividend out of the accumulated profits earned by it in previous years and ⁴[transferred by the company to the free reserves], such declaration of dividend shall not be made except in accordance with such rules as may be prescribed in this behalf:

     Provided also that no dividend shall be declared or paid by a company from its reserves other than free reserves.

    ¹[Provided also that no company shall declare dividend unless carried over previous losses and depreciation not provided in previous year or years are set off against profit of the company for the current year. ]

     (2) For the purposes of clause (a) of sub-section (1), depreciation shall be provided in accordance with the provisions of Schedule II.

    ⁵[(3) The Board of Directors of a company may declare interim dividend during any financial year or at any time during the period from closure of financial year till holding of the annual general meeting out of the surplus in the profit and loss account or out of profits of the financial year for which such interim dividend is sought to be declared or out of profits generated in the financial year till the quarter preceding the date of declaration of the interim dividend:

Provided that in case the company has incurred loss during the current financial year up to the end of the quarter immediately preceding the date of declaration of interim dividend, such interim dividend shall not be declared at a rate higher than the average dividends declared by the company during immediately preceding three financial years.]

        (4) The amount of the dividend, including interim dividend, shall be deposited in a scheduled bank in a separate account within five days from the date of declaration of such dividend.

     (5) No dividend shall be paid by a company in respect of any share therein except to the registered shareholder of such share or to his order or to his banker and shall not be payable except in cash:

     Provided that nothing in this sub-section shall be deemed to prohibit the capitalisation of profits or reserves of a company for the purpose of issuing fully paid-up bonus shares or paying up any amount for the time being unpaid on any shares held by the members of the company:

     Provided further that any dividend payable in cash may be paid by cheque or warrant or in any electronic mode to the shareholder entitled to the payment of the dividend.

     (6) A company which fails to comply with the provisions of sections 73 and 74 shall not, so long as such failure continues, declare any dividend on its equity shares.

 

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Notes:-

1. Inserted vide  THE COMPANIES (AMENDMENT) Act, 2015 - dated 25th May 2015

2. Substituted vide The Companies (Amendment) Act, 2017 Dated 03-01-2018 w.e.f. 09 February, 2018, before it was read as, "both; or"

3. Inserted vide The Companies (Amendment) Act, 2017 Dated 03-01-2018 w.e.f. 09 February, 2018

4. Substituted vide The Companies (Amendment) Act, 2017 Dated 03-01-2018 w.e.f. 09 February, 2018, before it was read as, "transferred by the company to the reserves"

5. Substituted vide The Companies (Amendment) Act, 2017 Dated 03-01-2018 w.e.f. 09 February, 2018, before it was read as, "(3) The Board of Directors of a company may declare interim dividend during any financial year out of the surplus in the profit and loss account and out of profits of the financial year in which such interim dividend is sought to be declared:

      Provided that in case the company has incurred loss during the current financial year up to the end of the quarter immediately preceding the date of declaration of interim dividend, such interim dividend shall not be declared at a rate higher than the average dividends declared by the company during the immediately preceding three financial years."

 Restrictions on powers of Board

     180. (1) The Board of Directors of a company shall exercise the following powers only with the consent of the company by a special resolution, namely:-

          (a) to sell, lease or otherwise dispose of the whole or substantially the whole of the undertaking of the company or where the company owns more than one undertaking, of the whole or substantially the whole of any of such undertakings.

     Explanation.-For the purposes of this clause,-

               (i)  "undertaking" shall mean an undertaking in which the investment of the company exceeds twenty per cent of its net worth as per the audited balance sheet of the preceding financial year or an undertaking which generates twenty per cent of the total income of the company during the previous financial year;

               (ii)  the expression "substantially the whole of the undertaking" in any financial year shall mean twenty per cent or more of the value of the undertaking as per the audited balance sheet of the preceding financial year;

          (b)  to invest otherwise in trust securities the amount of compensation received by it as a result of any merger or amalgamation;

          (c)  to borrow money, where the money to be borrowed, together with the money already borrowed by the company will exceed aggregate of its ¹[paid-up share capital, free reserves and securities premium], apart from temporary loans obtained from the company's bankers in the ordinary course of business:

          Provided that the acceptance by a banking company, in the ordinary course of its business, of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise, shall not be deemed to be a borrowing of monies by the banking company within the meaning of this clause.

          Explanation.-For the purposes of this clause, the expression "temporary loans" means loans repayable on demand or within six months from the date of the loan such as short-term, cash credit arrangements, the discounting of bills and the issue of other short-term loans of a seasonal character, but does not include loans raised for the purpose of financial expenditure of a capital nature;

          (d)  to remit, or give time for the repayment of, any debt due from a director.

     (2) Every special resolution passed by the company in general meeting in relation to the exercise of the powers referred to in clause (c) of sub-section (1) shall specify the total amount up to which monies may be borrowed by the Board of Directors.

     (3) Nothing contained in clause (a) of sub-section (1) shall affect-

          (a)  the title of a buyer or other person who buys or takes on lease any property, investment or undertaking as is referred to in that clause, in good faith; or

          (b)  the sale or lease of any property of the company where the ordinary business of the company consists of, or comprises, such selling or leasing.

     (4) Any special resolution passed by the company consenting to the transaction as is referred to in clause (a) of sub-section (1) may stipulate such conditions as may be specified in such resolution, including conditions regarding the use, disposal or investment of the sale proceeds which may result from the transactions:

    Provided that this sub-section shall not be deemed to authorise the company to effect any reduction in its capital except in accordance with the provisions contained in this Act.

    (5) No debt incurred by the company in excess of the limit imposed by clause (c) of sub-section (1) shall be valid or effectual, unless the lender proves that he advanced the loan in good faith and without knowledge that the limit imposed by that clause had been exceeded.

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Notes:-

1. Substituted vide The Companies (Amendment) Act, 2017 Dated 03-01-2018 w.e.f. 09 February, 2018, before it was read as, "paid-up share capital and free reserves"

 Loan and investment by company

     186. (1) Without prejudice to the provisions contained in this Act, a company shall unless otherwise prescribed, make investment through not more than two layers of investment companies:

     Provided that the provisions of this sub-section shall not affect,-

          (i)  a company from acquiring any other company incorporated in a country outside India if such other company has investment subsidiaries beyond two layers as per the laws of such country;

          (ii)  a subsidiary company from having any investment subsidiary for the purposes of meeting the requirements under any law or under any rule or regulation framed under any law for the time being in force.

     (2) No company shall directly or indirectly -

          (a)  give any loan to any person or other body corporate;

          (b)  give any guarantee or provide security in connection with a loan to any other body corporate or person; and

          (c)  acquire by way of subscription, purchase or otherwise, the securities of any other body corporate,

exceeding sixty per cent of its paid-up share capital, free reserves and securities premium account or one hundred per cent of its free reserves and securities premium account, whichever is more.

²[Explanation.-For the purposes of this sub-section, the word "person" does not include any individual who is in the employment of the company.]

     ³[(3) Where the aggregate of the loans and investment so far made, the amount for which guarantee or security so far provided to or in all other bodies corporate along with the investment, loan, guarantee or security proposed to be made or given by the Board, exceed the limits specified under sub-section (2), no investment or loan shall be made or guarantee shall be given or security shall be provided unless previously authorised by a special resolution passed in a general meeting:

     Provided that where a loan or guarantee is given or where a security has been provided by a company to its wholly owned subsidiary company or a joint venture company, or acquisition is made by a holding company, by way of subscription, purchase or otherwise of, the securities of its wholly owned subsidiary company, the requirement of this sub-section shall not apply:

     Provided further that the company shall disclose the details of such loans or guarantee or security or acquisition in the financial statement as provided under sub-section (4).]

     (4) The company shall disclose to the members in the financial statement the full particulars of the loans given, investment made or guarantee given or security provided and the purpose for which the loan or guarantee or security is proposed to be utilised by the recipient of the loan or guarantee or security.

     (5) No investment shall be made or loan or guarantee or security given by the company unless the resolution sanctioning it is passed at a meeting of the Board with the consent of all the directors present at the meeting and the prior approval of the public financial institution concerned where any term loan is subsisting, is obtained:

     Provided that prior approval of a public financial institution shall not be required where the aggregate of the loans and investments so far made, the amount for which guarantee or security so far provided to or in all other bodies corporate, along with the investments, loans, guarantee or security proposed to be made or given does not exceed the limit as specified in sub-section (2), and there is no default in repayment of loan instalments or payment of interest thereon as per the terms and conditions of such loan to the public financial institution.

     (6) No company, which is registered under section 12 of the Securities and Exchange Board of India Act, 1992 (15 of 1992) and covered under such class or classes of companies as may be prescribed, shall take inter-corporate loan or deposits exceeding the prescribed limit and such company shall furnish in its financial statement the details of the loan or deposits.

     (7) No loan shall be given under this section at a rate of interest lower than the prevailing yield of one year, three year, five year or ten year Government Security closest to the tenor of the loan.

     (8) No company which is in default in the repayment of any deposits accepted before or after the commencement of this Act or in payment of interest thereon, shall give any loan or give any guarantee or provide any security or make an acquisition till such default is subsisting.

     (9) Every company giving loan or giving a guarantee or providing security or making an acquisition under this section shall keep a register which shall contain such particulars and shall be maintained in such manner as may be prescribed.

     (10) The register referred to in sub-section (9) shall be kept at the registered office of the company and -

          (a)  shall be open to inspection at such office; and

          (b)  extracts may be taken therefrom by any member, and copies thereof may be furnished to any member of the company on payment of such fees as may be prescribed.

     ⁴[(11) Nothing contained in this section, except sub-section (1), shall apply-

(a) to any loan made, any guarantee given or any security provided or any investment made by a banking company, or an insurance company, or a housing finance company in the ordinary course of its business, or a company established with the object of and engaged in the business of financing industrial enterprises, or of providing infrastructural facilities;

(b) to any investment-

(i) made by an investment company;

(ii) made in shares allotted in pursuance of clause (a) of sub-section (1) of section 62 or in shares allotted in pursuance of rights issues made by a body corporate;

(iii) made, in respect of investment or lending activities, by a non-banking financial company registered under Chapter III-B of the Reserve Bank of India Act, 1934 (2 of 1934) and whose principal business is acquisition of securities.]

     (12) The Central Government may make rules for the purposes of this section.

     (13) If a company contravenes the provisions of this section, the company shall be punishable with fine which shall not be less than twenty-five thousand rupees but which may extend to five lakh rupees and every officer of the company who is in default shall be punishable with imprisonment for a term which may extend to two years and with fine which shall not be less than twenty-five thousand rupees but which may extend to one lakh rupees.

     Explanation.-For the purposes of this section,-

          (a)  the expression "investment company" means a company whose principal business is the acquisition of shares, debentures or ⁵[and a company will be deemed to be principally engaged in the business of acquisition of shares, debentures or other securities, if its assets in the form of investment in shares, debentures or other securities constitute not less than fifty per cent. of its total assets, or if its income derived from investment business constitutes not less than fifty per cent. as a proportion of its gross income.]

          (b)  the expression "infrastructure facilities" means the facilities specified in Schedule VI.

 

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Notes:-

1. Inserted vide F. No. 1/13/2013-CL.V-Part - Dated 13-2-2015,

2. Inserted vide The Companies (Amendment) Act, 2017 Dated 03-01-2018 w.e.f. 07^th May, 2018

3. Substituted vide The Companies (Amendment) Act, 2017 Dated 03-01-2018 w.e.f. 07^th May, 2018, before it was read as, "(3) Where the giving of any loan or guarantee or providing any security or the acquisition under sub-section (2) exceeds the limits specified in that sub-section, prior approval by means of a special resolution passed at a general meeting shall be necessary."

4. Substituted vide The Companies (Amendment) Act, 2017 Dated 03-01-2018 w.e.f. 07^th May, 2018, before it was read as,

"(11) Nothing contained in this section, except sub-section (1), shall apply-

          (a)  to a loan made, guarantee given or security provided by a banking company or an insurance company or a housing finance company in the ordinary course of its business or a company engaged in the business of financing of companies or of providing infrastructural facilities;

          (b)  to any acquisition -

                (i)  made by a non-banking financial company registered under Chapter IIIB of the Reserve Bank of India Act, 1934 (2 of 1934) and whose principal business is acquisition of securities:

               Provided that exemption to non-banking financial company shall be in respect of its investment and lending activities;

                (ii)  made by a company whose principal business is the acquisition of securities;

               (iii)  of shares allotted in pursuance of clause (a) of sub-section (1) of section 62.

             ¹[(iv) made by a banking company or an insurance company or a housing finance company, making acquisition of securities in the ordinary course of its business.]"

5. Substituted vide The Companies (Amendment) Act, 2017 Dated 03-01-2018 w.e.f. 07^th May, 2018, before it was read as, "other securities"