Loan to Directors and Inter-Corporate Loans Under the Companies Act, 2013

You run a group of companies. Prism Industries has surplus cash. Vertex Traders (where you also happen to be a director and shareholder) needs ₹75 lakh for working capital. The obvious solution: lend the money from Prism to Vertex.

It sounds simple, but the law disagrees.

The moment a director has any connection to the borrower (as a member, a fellow director, a relative, or even indirectly through a partnership firm) two powerful provisions in the Companies Act, 2013 kick in. One prohibits the transaction outright. The other caps how much your company can lend, and dictates exactly how the board must approve it.

These two provisions are Section 185 and Section 186. Between them, they control how Indian companies can deploy funds as loans, investments, guarantees, and security.

And the consequences of getting them wrong are severe: violating Section 185 can land you in prison for six months. Violating Section 186 is a non-compoundable offence — you can’t just pay a fine and make it go away. The prosecution must run its full course.

This guide is not written for law students. It is written for the director sitting in a board meeting next Tuesday, the CFO preparing a board note for an inter-corporate loan, and the business owner trying to figure out whether he can lend money to his own group company. We will not dilute the law. But we will make it understandable.

Before getting into the details, understand the fundamental difference between these two sections.

Section 185 asks: “Who is receiving the money?” It is concerned with the identity of the recipient. If the recipient is a director, a director’s relative, a director’s firm, or an entity where the director has a stake, Section 185 either prohibits the transaction entirely or permits it only through a special resolution with strict conditions.

Section 186 asks: “How much is the company giving, and did it follow the right process?” It is concerned with the quantum and the procedure. It applies to every loan, investment, guarantee, and security that a company gives to any person or body corporate, regardless of whether a director is connected to the recipient.

Section 185 is the identity check. Section 186 is the limit check and the process check. When both sections apply to the same transaction (and they often do) you must satisfy both independently.

The Absolute Prohibition: The “Prohibited Category”

Section 185(1) draws a bright line. No company shall, directly or indirectly, advance any loan (including any loan represented by a book debt), or give any guarantee, or provide any security in connection with any loan taken by, certain persons connected to its directors.

The law lists ten categories. That sounds like a lot to remember. But there is a simple way to think about it: three rings radiating outward from the director.

This list is exhaustive. It does not expand by implication. But within its scope, the prohibition is absolute. There is no special resolution route, no board approval mechanism, nothing. For anyone falling within these three rings, the answer is: your company cannot give them a loan, guarantee, or security. The only escape routes are the specific exemptions under Section 185(3), which we will cover shortly.

To see how far the rings reach, consider a few examples. Your director’s wife? Ring 2 (relative) — prohibited. A partnership firm where your director’s brother is a partner? Ring 3 (firm of a relative) — prohibited. The LLP where a director of your holding company’s daughter is a designated partner? Also Ring 3 — prohibited. The rings extend further than most people expect.

The Conditional Route: Loans to “Persons in Whom Directors Are Interested”

For a second category of recipients, Section 185(2) does not prohibit the transaction outright. Instead, it permits it, but only through a specific gate.

A company may give a loan, guarantee, or security to “any person in whom any of the directors of the company is interested,” provided two conditions are met:

First, the company must pass a special resolution in a general meeting. The explanatory statement attached to the notice must lay bare the full particulars — the amount, the terms, the purpose for which the recipient will use the money, and any other relevant facts.

Second, the borrowing company must use the loan for its principal business activities — not for further on-lending or investments, but for its actual, core business.

The law defines three categories of “person in whom a director is interested”:

(a) Any private company of which any such director is a director or member. Note the word “member” — it includes holding even a single share. There is no minimum threshold. If your director holds one equity share in a private company, that company falls into this category.

(b) Any body corporate at a general meeting of which 25% or more of the total voting power may be exercised or controlled by any such director, or by two or more such directors together.

(c) Any body corporate whose Board of directors, managing director, or manager is accustomed to act in accordance with the directions or instructions of the Board, or of any director or directors, of the lending company. (This is the “shadow director” concept.)

Computing Voting Power: Why the Maths Matters

The 25% voting power test under limb (b) requires careful computation, because voting power cascades through layers of ownership.

The Shadow Director: A Concept Most Directors Have Never Heard Of

Section 185(2), Explanation (c) catches something subtle and dangerous: any body corporate whose board is “accustomed to act” on the lending company’s instructions. This is the Indian law equivalent of what English law calls a “shadow director.”

The leading authority is the English case of Re Hydrodam (Corby) Ltd, decided by Millett J in 1994. The case arose from a multi-layered corporate structure where a parent company’s directors were alleged to be shadow directors of a deeply nested subsidiary. The court laid down a four-part test that has been widely adopted, including in Indian corporate governance practice:

To establish that a person (or entity) is a shadow director, you must prove:

1. Who are the directors of the company, whether de facto or de jure;
2. That the alleged shadow director directed those directors how to act;
3. That those directors actually acted in accordance with such directions; and
4. That they were accustomed so to act — meaning a pattern of behaviour, not a one-off event.

The practical implication for Indian companies is this: if a parent company routinely tells a subsidiary’s board what to do (and the subsidiary’s board routinely follows without exercising independent judgement) the subsidiary may be a “person in whom the director is interested” under limb (c). Any loan to that subsidiary would then require the Section 185(2) special resolution route.

The default presumption, however, is that every properly constituted board acts independently. The burden of proof lies on whoever alleges otherwise. This was reinforced in Secretary of State for Trade and Industry v. Becker [2003] 1 BCLC 555, where the court held that a “consistent pattern of compliance” with the shadow director’s instructions must be proved.

The Exemptions: When Section 185 Steps Aside

Section 185(3) carves out four specific situations where neither the prohibition of S.185(1) nor the conditions of S.185(2) apply:

The Private Company Exemption: A Lifeline with Conditions

The MCA notification dated 5 June 2015 exempts private companies from Section 185 entirely, but only if all three of these conditions are met simultaneously:

All three must be true at the time of the transaction. If any one fails, the full rigour of Section 185 applies.

Book Debts: When Credit Sales Become Disguised Loans

This is one of the most practically dangerous areas under Section 185, and it catches companies that think they are doing nothing more than selling goods on credit.

Section 185(1) explicitly includes “any loan represented by a book debt.” This phrase was inserted to close a loophole that existed under the old Companies Act, 1956.

In that case, the company sold a flat to a director, partly for cash and partly on credit. The Registrar of Companies argued this was an indirect loan to a director. The Bombay High Court disagreed, holding that the debt arose from a sale, not an advance — and that the word “indirectly” in the section cannot be read as converting what is not a loan into a loan. The 2013 Act plugged this gap by explicitly including book debts.

The harder question is where a normal credit sale to a director-connected entity crosses the line into a “loan represented by a book debt.” The answer lies in four parameters:

There is also a fifth indicator: if the credit period has expired and the company makes no effort to recover the amount — while actively pursuing other debtors — the book debt may have silently morphed into a loan from the date the recovery effort should have started but didn’t.

The Income Tax Sting: Deemed Dividend Under Section 2(40)(e)

Even if you clear Section 185 without trouble, there is a second trap waiting — this time in the Income Tax Act.

Under the Income Tax Act, 2025 (which replaces the 1961 Act and applies from 1 April 2026), Section 2(40)(e) carries forward the deemed-dividend rule formerly in Section 2(22)(e). When a closely held company (essentially any private company) gives a loan or advance to a shareholder holding 10% or more of the voting power, the loan is treated as a “deemed dividend” — taxable in the shareholder’s hands, to the extent of the company’s accumulated profits.

So even if your private company is exempt from Section 185 under the 2015 notification, the director who receives the loan may still face income tax on the entire amount as deemed dividend. Worse, even if the director repays the loan in the same financial year, the deemed dividend character does not vanish. The tax liability crystallises the moment the loan is advanced.

Penalties Under Section 185(4)

In the HPE India case (NCLAT, 2023), even an inadvertent violation of Section 185 (a ₹360 crore loan between fellow subsidiaries sharing a common director) resulted in a ₹10 lakh compounding fee being upheld on appeal.

The 60%/100% Formula

Section 186(2) caps how much a company can deploy (across all loans, investments, guarantees, and security combined) without shareholder approval. The ceiling is the higher of:

Limit A: 60% of (Paid-up Share Capital + Free Reserves + Securities Premium Account)

Limit B: 100% of (Free Reserves + Securities Premium Account)

Whichever is MORE is your threshold.

Meridian’s free reserves are large relative to its paid-up capital, so Limit B wins. In companies with high paid-up capital but low reserves, Limit A will often be higher, which is why you should always compute both.

Points to Watch on Aggregation

This is a cumulative limit across all transactions — loans given + investments made + guarantees given + security provided. It is not per-transaction.

When Special Resolution Is Required

A special resolution under Section 186(3) is needed when the aggregate (existing + proposed) crosses the Section 186(2) limit. But there are two important carve-outs:

Even these carve-out transactions must be counted in the aggregate for limit purposes and disclosed in the financial statements.

The Board Resolution: Why “Unanimous” Does Not Mean What You Think

Section 186(5) contains one of the most distinctive requirements in the Companies Act. No investment, loan, guarantee, or security shall be made unless the resolution sanctioning it is passed at a meeting of the Board with the consent of all directors present at the meeting.

Minimum Interest Rate: The G-Sec Benchmark

Section 186(7) says: no loan shall be given under this section at a rate of interest lower than the prevailing yield of 1-year, 3-year, 5-year, or 10-year Government Securities, whichever is closest to the tenor of the loan.

Employee loans are exempt: Since the Explanation to Section 186(2) excludes employees from the word “person,” the minimum interest rate does not apply to loans given to employees.

Cross-border loans create transfer pricing friction: When an Indian holding company lends to a foreign subsidiary, the Indian G-Sec yield applies. But in jurisdictions like the UK or the US, prevailing interest rates may be much lower. The subsidiary’s local tax authorities may challenge the high interest rate under transfer pricing rules.

The MCA’s clarificatory circular dated 9 April 2015 offers a partial solution: if the effective yield on the loan (factoring in exchange rate movements, such as the benefit the lender gets from rupee depreciation against the foreign currency) exceeds the G-Sec benchmark, there is no violation. The effective yield must be tested at the time of sanctioning the loan.

Performance Guarantee vs. Financial Guarantee

Section 186 covers guarantees “in connection with a loan” — these are financial guarantees. It does not cover performance guarantees.

If your company guarantees that a subsidiary will supply goods on time, or complete a construction project, that is a performance guarantee. It does not count toward the Section 186(2) limit and does not require the unanimous Board resolution under Section 186(5).

But if your company guarantees repayment of a bank loan taken by a subsidiary, that is a financial guarantee — squarely within Section 186. This distinction matters enormously for infrastructure and manufacturing companies that routinely issue performance bonds for their subsidiaries.

Can a Guarantee Be Given Without a Fee?

Yes. Section 186(7) prescribes a minimum interest rate for loans. There is no equivalent provision for guarantees. A company can provide a financial guarantee on a gratuitous basis. However, if the guarantee is given to a related party, the arm’s length pricing requirement under Section 188 must still be considered.

The Two-Layer Subsidiary Restriction

Section 186(1) prohibits a company from making investments through more than two layers of investment companies. The Companies (Restriction on Number of Layers) Rules, 2017 go further, restricting any company from having more than two layers of subsidiaries.

What Happens If the Borrower Claims Your Loan Was Ultra Vires?

This is a developing area of law with real commercial consequences.

Penalties Under Section 186(13)

Section 185(2): Giving a Loan to a Person in Whom a Director Is Interested

Section 186: Giving a Loan / Investment / Guarantee / Security

What Every Director Should Remember

Sections 185 and 186 exist because of a simple governance principle: when a company parts with its money, the interests of shareholders must be protected.

Section 185 guards against directors treating the company as their personal bank. Section 186 ensures that even legitimate inter-corporate transactions are subject to limits, disclosure, and proper board governance.

The practical discipline is simple: before approving any loan, guarantee, investment, or security, run the transaction through both sections. Use the decision tree to identify which provisions apply. Follow the process flow to ensure every approval is in place. Complete the checklist before signing anything.

The penalties are real. The NCLT and NCLAT are actively adjudicating violations. And the non-compoundable nature of Section 186 offences means that procedural shortcuts today can become criminal proceedings tomorrow.