Related-Party Loan and Board Approval Under Section 185
Ravi and Meera hold 55% of Vantage Components Pvt Ltd and are its only two directors. Vantage needs working capital of INR 2 crore. Ravi's wholly owned proprietorship, Sunrise Traders, agrees to lend INR 2 crore at 11% per annum for 18 months, secured by a charge on Vantage's receivables. The CFO circulates a board note for a meeting to be held on 3 April with 48 hours' notice; the agenda lists only 'working capital financing'. The board passes a resolution approving the loan, with Ravi participating and voting in favour. Meera asks whether the resolution is valid, whether the interest is deductible, and what the auditor should report. The company has no audit committee and has never defaulted on borrowings.
1. Is the board resolution approving the borrowing from Sunrise Traders valid? Identify the specific defect and the corrective route.
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The borrowing itself is not prohibited: a company may borrow from a director or a person in whom a director is interested, provided the conditions in the governing provision are satisfied. The defect here is procedural, not substantive.
- Interest disclosure and special resolution. Where the lender is a director or a person in whom a director is interested, the company must obtain prior approval by special resolution, and the notice must disclose the lender's interest, the purpose, and the material terms. A plain board resolution on a 48-hour notice with an agenda item reading only 'working capital financing' fails this test.
- Conflicted participation. Ravi is interested. He may attend and explain, but his vote should not be counted; the resolution should record that the interested director did not vote.
- Corrective route. Convene a general meeting with proper notice, disclose the terms (amount, 11% rate, 18-month tenor, security), pass a special resolution, then ratify the borrowing. Interest already accrued remains payable, but the underlying approval should be regularised before the next financial statements are signed.
- Practical lesson. A borrowing approved only by an interested board is not void for all purposes, but it is vulnerable to being treated as unauthorised, and the auditor will qualify the internal financial controls reporting.
2. How should the auditor treat the 11% interest for tax purposes, and what documentation is needed?
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Interest paid to a resident lender attracts withholding tax at the applicable rate under the domestic TDS provisions; failure to deduct makes the expense disallowable to the extent of 30% of the expenditure plus the tax not deducted. The auditor should test:
- Deduction and deposit. Whether TDS was deducted at the time of credit to the interest account or payment, whichever is earlier, and deposited within the statutory period.
- Rate reasonableness. The arm's-length question arises only if the transaction crosses the related-party threshold under transfer pricing; a wholly owned proprietorship of a director is a related party, so the interest rate should be benchmarked to a comparable market rate. 11% for an 18-month secured loan is within a defensible band, but the file should carry a benchmarking note.
- Documentation. Loan agreement, board and special resolutions, PAN of the lender, Form 26Q entries, bank statements, and a confirmation of the closing balance.
- Disclosure. Related-party disclosures in the financial statements and the register of contracts maintained under the companies law.
If the special resolution is not obtained, the auditor reports the non-compliance rather than adjusting the interest itself; the deduction stands if TDS and arm's-length conditions are met.