Beyond Separate Entities: Understanding the Corporate Veil Doctrine - MMJC

• Introduction to concept of corporate veil

The foundational principle of company law revolves around the concept of a “separate legal entity”. According to this principle, a company is distinct from its members and is recognized as a separate legal entity. This fundamental idea is rooted in the landmark case of Salomon v. Salomon Limited and is enshrined in the Companies Act ,2013 [“the Act”]. Section 9 of the Act explicitly states that, upon incorporation, the subscribers or members outlined in the memorandum of association form a distinct body corporate. This entity, identified by the name in the memorandum, possesses the capacity to perform all functions of an incorporated company as per the Act and enjoys perpetual succession with the authority to own, manage, and dispose of property. Section 9 underscores the independent existence of a company apart from its individual members.

While the principle of a separate legal entity is fundamental in company law, an exception exists—the doctrine of lifting the corporate veil, originating from the same Salomon v. Salomon Limited case. Corporate veil, as per blacks’ law dictionary means, a legal assumption that the acts of the corporation are not the actions of its shareholders so that the shareholders are exempt from the liability for the corporation’s actions. In other words, corporate veil represents the concept of a separate legal entity and lifting the corporate veil involves treating the company and its shareholders as one entity. This doctrine is typically applied to eliminate the distinction between the company and its controllers, aiming to hold the true wrongdoers accountable. This article explores instances where courts have lifted the corporate veil to address the actions of those hiding behind the concept.

Background/origin of concept of corporate veil

In order to better understand the doctrine of lifting of corporate veil, we must look at the point of its origin. As mentioned above, this concept finds its origin in the case of Salomon VS. Salomon ltd. In this case, Mr. Salomon had sold his business to a company called Salomon ltd which was incorporated by Salomon and his family members. The consideration for sale of business was paid by the company in the form of equity shares and debentures having floating charge on the assets of the company. As a result, the unsecured creditors could not recover its dues from the company at the time of its liquidation. It was argued by the liquidator and creditors before the court that, the company was sham, was essentially an agent of Salomon, and therefore, Salomon being the principal, was personally liable for its debt. In other words, the liquidator sought to overlook the separate personality of Salomon Ltd., distinct from its member Salomon.

The Court of Appeal, declaring the company to be a myth, reasoned that Salomon had incorporated the company contrary to the true intent of the then Companies Act, 1862, and that the latter had conducted the business as an agent of Salomon, who should, therefore, be responsible for the debt incurred in the course of such agency.

Even though, this decision of court of appeal was overturned by the House of Lords of UK, it introduced to the world, the concept of lifting of corporate veil in case of misuse of protection given to shareholders by the principle of separate legal entity of the company.

Situations under which corporate veil can be lifted

As discussed herein above, the corporate veil was lifted for the first time in a situation where the shareholder of the company had used the separate legal entity of the company to gain undue advantage over the unsecured creditors and taking the money out of the company. Further there were no clear provisions in the then company law to provide for situations wherein the corporate veil could be lifted and where it could not be lifted. The judgments of the courts were the only guiding principles to determine the situations where the lifting of corporate veil was permissible. Hence considering the case of Salomon vs Salomon limited as precedent, courts for a long time held that corporate veil could be lifted only in case of misuse of corporate structure for fraud. However, over the period of years the Indian courts have observed that fraud is not the only circumstance wherein the corporate veil can be lifted. Courts through various judgments have enumerated a number of situations wherein corporate veil can be lifted. We shall see some of such situations herein below.

Fraud

As discussed above, the perpetration of fraud is the basic and most common reason for which courts lift the corporate veil. Nevertheless, it is worth noting that each case of fraud does not warrant lifting of corporate veil. It is done only when the courts observe that the corporate structure is misused to commit a fraud. Hon’ble Delhi high court in its judgment dated 12^th April 2021 in the matter of SANUJ BATHLA & ANR versus MANU MAHESHWARI & ANR. Has held that, “However, it has to be borne in mind that the doctrine is not available in every case of alleged liability against a Company. It is only available in restricted cases and limited circumstances, where it is permissible to so do under a Statute or where the corporate structure has been instituted to perpetuate a fraud or is a camouflage, facade, or sham to avoid liability”. In this case, there was an allegation against the non-promoter directors of the company that they have syphoned off the funds given to the company as loan. Since the petitioners could not prove that the company was used as medium to perpetuate a fraud, the court did not lift the corporate veil. This shows that, in order to lift the corporate veil in case of fraud, it is necessary to prove that corporate structure is used to avoid liability or syphon off funds.

 Public interest or assurance of justice

One more reason for which corporate veil may be lifted is, public interest. That means, if any action of the company is injurious to public interest, then in such case court may lift corporate veil and punish the actual natural persons who are responsible for harming the public interest. This aspect of lifting the corporate veil was discussed by the Hon’ble Delhi high court in its order dated 24^th March 1987 in the matter of Jyoti Limited vs Kanwaljit Kaur Bhasin and Anr. In this case, the company had committed contempt of court by disobeying its orders. The court took a view that contempt of court is injurious to the public interest and punished the promoter directors of the company by lifting the corporate veil. The Hon’ble Delhi high court in its final order held that, “Thus, it is clear that the law of contempt is conceived in the public interest. In the present case, I have no doubt, the corporate veil is being blatantly used as a cloak to wilfully disobey the orders of the court-an improper purpose. Lifting the corporate veil, in these circumstances, is imperative to punish improper conduct. Public interest requires the corporate veil must be lifted to find out the person who disobeyed the order of the court.”.

 Avoidance of legal obligations by misusing the corporate structure

Other than fraud and public interest there is one more reason for which courts have lifted the corporate veil. That reason is avoidance of legal obligations by misusing the corporate structure of holding and subsidiary companies. courts have observed that companies use the structure of holding and subsidiary relationship of companies to circumvent the legal obligations. In such cases courts lift the corporate veil and hold the subsidiaries to be alter ego of holding company.

Similar situation was observed in the case of State of U.P. And Ors vs Renusagar Power Co. And Others. In this case wholly owned subsidiary of Hindalco Ltd was used by the holding company to avoid liability under UP Electricity Duty Act, 1952. In this case, the Hon’ble Supreme Court of India held the holding company liable for paying the duty under said Act by lifting the corporate veil. The court in its judgment said,

“Horizon of the doctrine of lifting of corporate veil is expanding. Here, indubitably, we are of the opinion that it is correct that Renusagar was brought into existence by Hindalco in order to fulfil the condition of industrial licence of Hindalco through production of aluminium. It is also manifest from the facts that the model of the setting up of power station through the agency of Renusagar was adopted by Hindalco to avoid complications in case of take-over of the power station by the State or the Electricity Board. As the facts make it abundantly clear that all the steps for establishing and expanding the power station were taken by Hindalco, Renusagar is wholly owned subsidiary of Hindalco and is completely controlled by Hindalco. Even the day-to-day affairs of Renusagar are controlled by Hindalco. Renusagar has at no point of time indicated any independent volition. Whenever felt necessary, the State or the Board have themselves lifted the corporate veil and have treated Renusagar and Hindalco as one concern and the generation in Renusagar as the own source of generation of Hindalco. In the impugned order of the profits of Renusagar have been treated as the profits of Hindalco.

In the aforesaid view of the matter, we are of the opinion that the corporate veil should be lifted and Hindalco and Renusagar be treated as one concern and Renusagar’s power plant must be treated as the own source of generation of Hindalco and should be liable to duty on that basis.

Hon’ble Supreme court’s judgment sets a precedent by confirming that wherever it is observed that the corporate structure is being misused for avoiding liability or making improper gains, the courts can lift the corporate veil and punish the holding company even if there is no element of fraud.

• Care to be taken by group entities.

Hon’ble Supreme court judgment has posed a question before large conglomerates who have number of holding and subsidiary companies amongst the group, that in what circumstances will the holding company being the shareholder of the subsidiary, be made liable for the liabilities of the subsidiary by lifting the corporate veil. The answer to this question can be found in the above stated case itself. In the said case, court has held that corporate structure was misused for the reason that, the wholly owned subsidiary of holding company was totally controlled by holding company. even the day-to-day affairs were looked in to by the holding company and therefore the separate legal existence of the subsidiary was questioned. In order to avoid such a situation, the group companies may take following care,

• Financial independence

The subsidiary should be financially independent, that is it should have its own sources of funds. It should not be dependent on holding company for funding. Its profits and losses should be accounted and shown separately and should not be considered as that of holding company.

• Independent management and decision making

the management of the subsidiary should be separate and independent from the management of the holding company and it should take its decisions on its own, in the best interest of the subsidiary and without getting influenced by the board of the holding company. in other words, the directors of the subsidiary should not be accustomed to act as per the instructions of the directors of the holding company.

• Role of concept of POEM

As per section 6(3) of Income Tax Act 1961, the companies whose place of effective management (POEM) is in India, they are considered to be resident in India and hence their income is taxable in India. POEM refers to that place from where all the decisions relating to conduct of business are taken. The determination of POEM is very important for determining control specifically in case of foreign subsidiaries. If in case of a foreign subsidiary, all the policy decisions are being taken by the Indian holding company, then the POEM of the foreign subsidiary will be in India. Then in such a case, the separate legal entity of the foreign subsidiary can be questioned.

Conclusion

In essence, the principle of a separate legal entity forms the bedrock of company law, offering protection and autonomy to corporations and their shareholders. However, the doctrine of lifting the corporate veil, born out of the Salomon v. Salomon Limited case, serves as a necessary counterbalance. It becomes applicable not only in cases of fraud but also when public interest is at stake or when there’s an attempt to evade legal responsibilities through corporate structures. Recent legal precedents highlight the evolving nature of this doctrine, making it clear that the misuse of corporate structures can lead to the piercing of the corporate veil. Group entities are thus reminded to maintain financial independence and distinct management to safeguard against the lifting of the corporate veil. In navigating the intricate landscape of corporate law, a nuanced understanding of these principles is indispensable for fostering transparency, accountability, and legal compliance within the corporate realm.

This article is published in Taxmann. The link to the same is as follows:

https://www.taxmann.com/research/company-and-sebi/top-story/105010000000023585/beyond-separate-entities-understanding-the-corporate-veil-doctrine-experts-opinion

This article is written by Ms Rutuja Umadikar – Research Associate – RND Team – rutujaumadikar@mmjc.in