By notifying amendments to Section 135 of the Companies Act, 2013 (hereinafter "The Act") and to the Rules pertaining to Corporate Social Responsibility(CSR) right at the fag- end of the financial year 2020-21, i.e., from January 22, 2021, the Ministry of Corporate Affairs(MCA) has literally set the cat among the pigeons. The changes made have far reaching consequences and as the amendments, save and except for those specifically stated, have application effective from the date of the notification, the task of ensuring compliance on the part of companies for the financial year 2020-21 has been rendered onerous and irksome, given that the changes will have to be administered in the Reports for circulation to the shareholders for the financial year 2020-21.The irony is that companies following the calendar year as their financial year have got a reprieve fortuitously from the requirement of the revised provisions for the year 2020 as the onset of the changes is post December 2020. Ideally the amendments ought to have been made prospective from April 1, 2021 to facilitate seamless integration with the existing regimen of procedures.
Be that as it may, it would be appropriate to run through the amended provisions through a tooth comb. Such introspection will, as the reader will observe, throw up several areas of contradictions and paradoxes with which the Corporates will have to contend with effective from the date of the notification to stay tuned with the revised requirements relating to CSR, albeit in respect of a portion of the financial year 2020-21. As opposed to analyzing the ramifications of the changes made to the entire gamut of the law, given the constraints of space in a discussion paper, we shall cherry pick in this exposition only some of the aspects in the amendments made and make a clarion call to the MCA to revisit some of the changes already made.
Section 135(1)-Dichotomy with Rule 3(2)of the CSR Rules
Section 135(1) sets out the thresholds for determining the entry point, in a manner of speaking, for the application of the provisions relating to CSR. It contemplates that a company shall be obliged to set up a CSR Committee of its directors if it satisfies any of the following requirements which are mutually exclusive:
a) Net worth of rupees five hundred crore or more.
b) Turnover of rupees one thousand or more,
c) Net profit of rupees five crore or more.
It is pertinent to note that the above criteria has to be satisfied during the immediately preceding financial year as clarified by the amendment put through by the Companies (Amendment) Act, 2017 with effect from 19.9.2018 as opposed to the original requirement that the thresholds can be applied to “any financial year”. From the above, it follows that where a company does not meet the criteria in the preceding financial year, it does not have to constitute a CSR Committee.
Rule 3(2) of the Companies(Corporate Social Responsibility Policy)Rules, 2014 however, contradicts Section 135(1) by stipulating that every company which ceases to be covered under Section 135(1)for three consecutive financial years, shall not be required to constitute a CSR Committee and comply with the provisions contained in sub-sections(2) to (5) of Section 135 till such time it meets the criteria specified in sub-section (1) of section 135.It may be noted that the above sub-rule existed from the inception of the above rules from April,1, 2014 and ought to have been logically deleted in line with the amendment made to Section 135(1) by the Amendment Act 2017 referred to above so that it would have been in harmony with the above sub-section as amended. This was unfortunately not to be and the sub-rule continues to exist even today.
The fall out of the above are two-fold as under
a) Even if the constitution of the CSR Committee is rendered unnecessary under section 135(1) if the criteria is not satisfied in the previous financial year, the sub-rule compels the continuance with the Committee for three consecutive years even after sub-section (1) has become inapplicable which is completely unintended.
b) The sub-rule also states that sub-section (5) of section 135 which is in a sense the charging sub-section shall not have to be complied with where a company does not meet the criteria set out in sub-section (1) till such time it meets the criteria in section 135(1)once again .This leads to an inference that a company which does not have to comply with subsection (1) does not fall within the ambit of Section 13595) whereby it is obliged to have CSR spends.
The above sub-rule is also out of sync with the newly introduced sub-section(9) under Section 135.Section 135(9) as introduced by the Companies (Amendment)Act, 2020 and notified with effect from January 22, 2021 provides that where a company has a CSR spend which does not exceed rupees fifty lacs in a financial year, the CSR committee of the Board can be dismantled with the responsibility of steering the company’s CSR initiatives being thrust on the Board thereafter.
The above sub-rule is also discordant with the provisions of Section 139(9)since it speaks about the Committee being dismantled only if three financial years have elapsed from the year in which Section 135(1) had become inapplicable to the company.
Rules are subservient to the Act
It is a settled legal principle that Rules are sub-ordinate legislation and if only they are in conformity with the Act, they are to be treated as part of the Act.(Chief Forest conservator(Wildlife)v Nisar Khan (AIR 2003SC 1897).
However, if there is any conflict between the statute and the subordinate legislation, the Statute shall prevail over the subordinate legislation in the face of competition between the two and if the subordinate legislation is not in conformity with the Statute, the same has to be ignored.(B.K.Garad v Nasik Merchants Co-op. Bank Ltd (1984)2 SCC 50).
It is clear from the above discussion that sub-rule3(2) travels beyond the contours of sub-sections (1),(5) and (9) of Section 135 and should be expunged from the Rule Book forthwith.
Charging sub-section(5) of Section 135 is not in harmony with subsection(1) and is regressive
Sub-section(5) of Section 135 as amended by the Companies (Amendment)Act, 2019 is reproduced as under:
"The Board of every company referred to in sub-section (1)shall ensure that the company spends in every financial year at least two percent of the average net profits of the company made during the three immediately preceding financial years or where the company has not completed the period of three financial years since its incorporation, during such immediately preceding financial years )in pursuance of its Corporate Social Responsibility Policy".
Note: The portion of Section 135(5) reproduced above in italics represents the insert thereto made thereto by the Companies (Amendment)Act 2019 made effective from January 22, 2021.
The two provisos under Section 135(5) which are not relevant for the purpose of our discussion have not been reproduced above.
A plain reading of the above subsection reveals the following:
i)For subsection (5) to come into play, the company should be one which falls within the ambit of Section 135(1). Conversely put, if a company does not satisfy the thresholds laid down in sub-section (1) in the preceding financial year, subsection(5) does not come into effect. The existence of the minimum threshold profitability of rupees five crore in the preceding financial year is a pre-requisite for a company to have CSR spends. Thus arguably if the company does not have the minimum profitability threshold, it has no obligation to make spends as sub-section (5) ordains the Board of only a company referred to in sub-section (1) to have the minimum spends for CSR.
It is pertinent to note that to facilitate harmonious reading of subsection (5) with subsection (1), subsection (5) ought to have been amended simultaneously with subsection (1)when the words “ the immediately preceding financial year” were introduced in substitution of the words” any financial year” by the Companies (Amendment)Act 2017 as elaborated above.
As the above amendment was not put through to subsection (5)it has become compulsory for a company to spend in every financial year at least two percent of the average net profits of the company during the immediately preceding three financial years even if the threshold profitability cannot be ensured for a financial year.
It is submitted that logically the charging subsection135(5) should have taken effect only if the threshold profit criteria in subsection (1) had been generated by the company.
It is pertinent to note that in terms of construction, section 135(5) is not interdependent or interlinked with section 135(1) and both operate on independent domains; sub-section (1) sets out the ground rules for setting up the CSR Committee and subsection(5) imposes the burden of spends based on three-year average profitability even where the threshold profitability is not satisfied for a financial year.
The relevance of "or" in the amended provisions of section 135(5)
It is pertinent to note that the amendment made to sub-section (5) by the Companies (Amendment)Act, 2019 referred to above starts with the conjunction ”or”.In ordinary usage, the expression “and” as used in a statute is conjunctive in that it connects words and phrases in a sentence whereas the expression “or” when used in the statute is really disjunctive and serves to disjoin, separates and denotes an alternative in a series of exclusive arrangements.(Maharaja Sir Pateshwari Prasad Singh v State of Uttar Pradesh(1963)(50 ITR 731(SC).
In view of the above, the amendment made to section 135(5) by the Amendment Act, 2019 stretches the contours of the subsection to bring within its ambit even a company which has not completed the period of three financial years since its incorporation.
Thus the charging subsection has applicability to both companies which are more than three years old as also to the fledgling companies which are in the nascent stage of their existence.
It is a settled principle that the hall mark of a company is to be able to show its resilience over the period of a trade cycle. A newly set up company may have the required threshold profitability through deployment of funds raised for its operations into temporary avenues. Such earnings are not sustainable. Yet the company will have to face the unconscionable burden of CSR spends under the amended law.
Viewed against this backdrop, the charging subsection as amended is regressive as the accounting convention does not distinguish for the purpose of determining earnings, their quality from the standpoint of sustainability.
Losses sustained have to be considered in determining average net profits during the preceding three years
There is some confusion in the fraternity as to the treatment of losses if any incurred by a company while computing the average net profits for the past three years for determining the quantum of CSR spend under Section 135(5).Net loss represents negative income or minus income. For the purposes of Section 135 ,net profit as provided by Rule 2(f) of the Companies (CSR Policy)rules, 2014 refers to net profit as per the financial statement prepared in accordance with the applicable provisions of the Act. Losses if any sustained will have to be set off against the net profit for determining the average profits based on a three years’ data. The losses if any for the cannot be ignoredaltogether.
It is pertinent to note that under the taxation laws although the principle that income includes loss may not have universal applicable depending upon the nature of the losses and also considering the different rules for carry forward and set off , there is no denying that for computing net profits, losses of earlier years will have to be considered. That the provisions relating to declaration of dividend under Section 123 also provide that before declaring dividend, losses including unabsorbed depreciation for past years need to be set off fortifies the above view.
Rule 2(h) relating to computation of net profit needs a review
Rule 2(h)in the Companies (CSR Policy)Amendment Rules, 2021 provides the definition of net profit. It postulates, inter alia, that net profit shall not include any profits from any overseas branch of the company regardless of whether it is operated as a separate company or otherwise. While it is in order not to consider the profit of a foreign branch if it is operated under the umbrella of the same company it is not clear as to how the profit of the overseas branch if operated as a separate company shall come into contention since CSR obligations are company specific.
Further, any dividend received from Indian companies shall not be included in the net profits only if the dividend paying company comes within the obligation of Section 135 and is complying with the requirements appropriately. The recipient company willtherefore have to seek confirmations from the dividend paying companies as regards their compliance with the provisions of Section 135 before ignoring the dividend income.
Transfer of assets created or acquired to Section 8 company-Rule 7(4)
Rule 7(4) of the amended CSR Rules provides , inter alia, that the the capital assets acquired or created for CSR purposes by a company will have to be held by a Section 8 company or a registered public Trust or Society or by self-help groups which are beneficiaries of the CSR Projects.
The assets could be both immovable and movable assets. There is no clarity in the Rules as to the value at which the assets have to be transferred except to say that where it comes to assets which are pre-acquired, the transfer has to be made within 180 days from January 22, 2021 subject to extension by a further period of ninety days based on approval by the Board with proper justification.
This requirement is bound to stir the hornet’s nest as it will raise several questions from the standpoint of taxation. Where immovable property is involved, it will raise questions relating to stamp duty. Where transfer of other capital assets takes place, both the transferor and transferee will have to factor in issues relating to capital gains. There exists therefore an urgent need for the MCA to address several issues which will emanate from the above.
What we have raised by way of issues can only be considered as the tip of the iceberg. Several other pertinent questions are being raised as to what should be the treatment of funds provided by the company to an Implementing Agency for specific projects of which only a portion has been used up by the agency-whether the company should recall the unspent money or whether the agency should transfer the funds to unspent Account on behalf of the company-at what point in time is a CSR project supposed to have been commenced etc. There are no easy answers to such questions and the need of the hour is for the MCA to rise up to the challenge and clear the cobwebs of doubt that exist. Until such time this happens we can argue until the cows come home on the above issues without coming to any authoritative conclusion
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