Navigating The Layering Rules: Scope, Exceptions, Interpretation And Applicability To LLPS

INTRODUCTION

The corporate world has long leveraged complex organizational structures to optimize operations, manage risk, and achieve efficiency. However, governments have introduced legislative curbs on such complex multi-layered corporate structures. In India, one such regulatory intervention is the Companies (Restriction on Number of Layers) Rules, 2017 ("Layering Rules"), introduced by the Ministry of Corporate Affairs ("MCA") pursuant to Section 2(87) read with Section 469 of the Companies Act, 2013 ("Companies Act").

The Layering Rules aim to simplify corporate structures and enhance transparency by limiting the number of subsidiary layers a company can establish, enabling the traceability of ultimate beneficial ownership.

While the policy rationale is well-intentioned and clear, the Layering Rules raise several interpretational and practical challenges, especially for multinational corporate groups and hybrid organizational structures involving Limited Liability Partnerships (LLPs).

This article delves into the core principles of the Layering Rules, analyses their scope and exceptions, and evaluates their applicability to LLPs.

VERTICAL VS. HORIZONTAL LAYERING

Rule 2(1) of the Layering Rules provides that:

"no company, other than a company referred to in sub-rule (2), shall have more than two layers of subsidiaries."

A central ambiguity relates to whether the restriction imposed by the Layering Rules applies to vertical layering (i.e., successive tiers of subsidiaries) or horizontal layering (i.e., multiple subsidiaries at the same level under a holding company).

The general understanding is that the restriction applies to vertical layering, i.e., a company cannot have more than two successive/vertical layers of subsidiaries. However, a company may have multiple horizontal subsidiaries wherein such company has direct holding.

This general understanding aligns with the legislative intent to prevent complex multi-tiered structures, while still allowing legitimate operational subsidiaries to function directly under its holding entity.

EXEMPTION TO ACQUISITION OF FOREIGN ENTITIES

Proviso 1 to Rule 2(1) of the Layering Rules provides that:

"Provided that the provisions of this rule shall not apply to a company from acquiring a company incorporated outside India with subsidiaries beyond two layers as per the laws of such country."

This proviso provides an exception to acquisition of a foreign company with subsidiaries beyond two layers as per the laws of such country. This clause permits an Indian company to acquire a foreign entity that already has more than two layers of subsidiaries, so long as such structure is permissible under the laws of the jurisdiction in which the foreign entity is incorporated.

A literal interpretation of this proviso suggests that the exemption applies only to acquisitions and does not extend to incorporation of foreign subsidiaries to create a multi-layered structure beyond the permissible two layers. Accordingly, if an Indian company acquires a foreign entity with an existing multi-layered subsidiary structure, such acquisition will not violate the Layering Rules, provided that the structure was pre-existing and compliant with the laws of the foreign jurisdiction. Thus, the documentation should reflect that such foreign layering was pre-existing and legally compliant with the applicable foreign jurisdiction. However, there is uncertainty on whether exemption set out under first proviso to Rule 2(1) will extend to foreign subsidiaries incorporated subsequent to acquisition of a foreign company, or will such incorporation be construed as a layer while computing permitted two layers of subsidiary under the holding company. In the absence of express regulatory clarification, a conservative interpretation would treat such post-acquisition incorporations as contributing to the computation of layers, potentially leading to a breach of the Layering Rules, if such incorporation exceeds the permitted two layer of subsidiaries.

Accordingly, if a company is incorporated under a jurisdiction that permits more than two layers of subsidiaries, Indian regulators may recognize that structure as lawful, provided there is no subsequent contravention under Indian law due to post-acquisition restructuring. However, the extent of applicability of the aforementioned proviso remains subject to judicial interpretation and regulatory clarification and remains legally untested.

EXEMPTION TO "ONE OR MORE WHOLLY OWNED SUBSIDIARY / SUBSIDIARIES"

Proviso 2 to Rule 2(1) of the Layering Rules provides that:

"Provided further that the provisions of this rule shall not be applicable to one or more wholly owned subsidiary or subsidiaries."

The wording of this exemption is ambiguous and has given rise to differing interpretations. On one hand, a conservative view holds that only the first layer of wholly owned subsidiary / subsidiaries immediately under the parent company is exempt from counting towards the two-layer cap. On the other hand, a more liberal interpretation suggests that any number of vertical layer of wholly owned subsidiaries can be excluded, provided each such subsidiary in the chain is wholly owned by its immediate parent.

However, the prevailing interpretation of the aforementioned proviso and regulatory practice consensus in favour of the conservative interpretation, i.e. only the first vertical layer of wholly owned subsidiary / subsidiaries falling directly under the holding company is eligible for this exemption. This position is aligned with the general principal of layering rules being applicable to vertical layers and not horizontal layers, and is further reinforced by Rule 2(3), which prohibits structuring with the intent to circumvent the Layering Rules.

APPLICABILITY TO LIMITED LIABILITY PARTNERSHIPS

The applicability of the Layering Rules to Limited Liability Partnerships (LLPs) remains a contentious issue. As per Section 67 of the Limited Liability Act, 2008 ("LLP Act"), the central government has the authority to extend applicability of certain provisions of the Companies Act, to a limited liability partnership registered under the LLP Act ("LLP").

Pursuant to the notification dated February 11, 2022 issued by MCA, certain provisions set out under Section 90, Section 164, Section 165, Section 167, Section 206, Section 207, Section 252, and Section 439 of the Companies Act were made applicable to LLPs, with certain modification. However, the said notification did not include applicability of the Layering Rules to LLP.

Although, the definitions of "holding company" and "subsidiary company" under the Companies Act refer to "body corporates", which include LLPs, as per Sections 2(1)(d) and Section 3 of the LLP Act.

Accordingly, in a hybrid structures where both companies and LLPs coexist, inclusion of an LLP within a company-led chain may still trigger compliance obligations and such LLP would be construed as a layer while computing permitted two layers of subsidiary under the holding company. However, an LLP-only structure without any company involvement would fall outside the ambit of the Layering Rules.

Companies involved in group structures that include LLPs should evaluate whether such LLPs are part of the layers, especially where there is indirect company control or ownership.

CONCLUSION

In light of the above, while the objective of introduction of Layering Rules is clear, the actual implementation of the Layering Rules has given rise to interpretational challenges, especially in the context of structures with various permutation and combination of group entities (whether incorporated within India or outside India), foreign acquisitions, wholly owned subsidiaries, and hybrid corporate structures involving LLPs.

As corporate structuring evolves in complexity and cross-border linkages become more common, clarity in regulation will be essential. Until then, companies must tread cautiously, balancing legal compliance with business imperatives.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.