Lending Between Your Own Group Companies: Section 185 or Section 186? What the Companies Act Actually Requires

Lending Between Your Own Group Companies: Section 185 or Section 186? What the Companies Act Actually Requires

A founder runs two private limited companies — an operating company that generates cash and a newer subsidiary that is still burning through its runway. The obvious move is to sweep the surplus from the profitable entity into the struggling one with a quick inter-company transfer. The accountant books it as a loan, everyone moves on, and nobody passes a single board resolution. Eighteen months later, during due diligence for a funding round, the investor's lawyer flags the transaction as a potential violation of both Section 185 and Section 186 of the Companies Act, 2013 — and suddenly a routine cash sweep has become a disclosure headache that threatens the term sheet.

This is one of the most misunderstood areas of Indian corporate law. Founders assume that because they own both companies, moving money between them is their own business. The Companies Act does not see it that way. Two separate provisions govern inter-corporate lending, they overlap in confusing ways, and getting the wrong one — or ignoring both — carries penalties that run into lakhs of rupees and can taint the very transaction you were trying to simplify.

What the law actually requires

Section 185 governs loans to directors and entities connected to them. In its post-2017-amendment form, Section 185 completely prohibits a company from advancing any loan, giving any guarantee, or providing any security to a director, or to a partnership/firm in which a director is a partner. That part is absolute — no shareholder approval can cure it.

But there is a second limb that catches group companies. Under Section 185(2), a company can lend to any person or entity in which a director is interested — which explicitly includes a private company where a director of the lending company is a director or member, and a body corporate where directors of the lending company control at least 25% of the voting power — but only if two conditions are met: (a) a special resolution is passed in general meeting, with the explanatory statement disclosing full particulars of the loan; and (b) the borrowing company uses the loan for its principal business activity. This is precisely the situation of two companies with common directors — the classic founder-owned group.

Section 186 governs inter-corporate loans and investments generally. Section 186 caps the total loans, guarantees, securities and investments a company can extend to any body corporate at the higher of (i) 60% of paid-up share capital, free reserves and securities premium, or (ii) 100% of free reserves plus securities premium. To go beyond that ceiling, you need a special resolution. Even within the ceiling, every such loan requires the unanimous consent of all directors present at a Board meeting (Section 186(5)), and the loan cannot be made at an interest rate lower than the prevailing yield of the relevant-tenure Government Security (the "not below G-Sec yield" rule).

The critical point founders miss: Section 185 and Section 186 are not alternatives you get to choose between. If common directorship or the 25%-control test is triggered, Section 185 applies in addition to Section 186. You must satisfy both — the special resolution and business-purpose test of Section 185, and the ceiling, board-consent and interest-rate discipline of Section 186. Compliance with one does not excuse the other.

Practical implications — what actually happens when this is ignored

The penalties are not trivial, and they hit both the entity and the individuals.

Under Section 185(4), if a loan is made in contravention: the lending company is liable to a fine of not less than Rs 5 lakh which may extend to Rs 25 lakh; every officer in default is liable to imprisonment up to 6 months or a fine of Rs 5 lakh to Rs 25 lakh, or both; and the director or entity to whom the loan was given faces imprisonment up to 6 months, or a fine of Rs 5 lakh to Rs 25 lakh, or both. Note that this is one of the relatively few Companies Act provisions that retains an imprisonment exposure for officers.

Under Section 186(13), contravention makes the company liable to a fine of Rs 25,000 up to Rs 5 lakh, and every officer in default liable to imprisonment up to 2 years and a fine of Rs 25,000 up to Rs 1 lakh.

Beyond the statutory fines, the practical damage lands elsewhere. The loan and its terms must be disclosed in the financial statements (Section 186(4)) and captured in the Register of Loans and Investments in Form MBP-2. A special resolution passed for either section must be filed with the ROC in Form MGT-14 within 30 days. Miss that filing and MCA21 v3 flags an incomplete resolution trail — increasingly cross-checked against your AOC-4 financials, where the auditor is now required to report on compliance with Sections 185 and 186 in the CARO 2020 report (clause (iv)). An adverse CARO remark is a permanent, public red flag on your company's file that every future investor, lender and acquirer will see.

For founders raising capital, this is the real cost. A Rs 5 lakh fine is survivable; a due-diligence finding that the promoters have been moving money in breach of the Act — with an unremedied CARO qualification sitting in the MCA record — is exactly the kind of governance signal that kills valuations or triggers heavy indemnities.

Step-by-step: what to do before lending to a group company

• Run the relationship test first. Identify whether any director of the lending company is also a director or member of the borrowing company, or whether the lending company's directors control 25% or more of the borrower's voting power. If yes, Section 185(2) is triggered and you need the special-resolution route — not just the ordinary Section 186 process.
• Confirm the "principal business activity" condition. Section 185(2) permits the loan only if the borrower will use it for its own principal business. Document this purpose in writing; a vague "general corporate purposes" note is not enough.
• Check your Section 186 headroom. Calculate 60% of (paid-up capital + free reserves + securities premium) and 100% of (free reserves + securities premium). If the proposed loan plus existing exposures crosses the higher figure, you need a special resolution under Section 186 as well.
• Pass a Board resolution with unanimous consent. Convene a Board meeting and record the approval of all directors present — Section 186(5) requires unanimity, not a simple majority. Fix the interest rate at or above the prevailing yield of a Government Security of comparable tenure.
• Pass the special resolution(s) in general meeting. Hold an EGM (or include it in the AGM) and pass the special resolution required by Section 185(2), and by Section 186 if you are exceeding the ceiling. The explanatory statement must disclose full particulars — amount, purpose, terms.
• File Form MGT-14 within 30 days of each special resolution with the ROC. Late filing attracts additional fees of Rs 100 per day per form with no upper cap.
• Enter the loan in Form MBP-2 (Register of Loans, Guarantees, Security and Investments) and ensure the disclosure flows into the financial statements and the Board's Report.
• Execute a proper loan agreement. Papers matter: a dated agreement stating principal, interest rate (>= G-Sec yield), tenure and repayment schedule turns an informal "sweep" into a defensible transaction.

Why even careful founders get this wrong

The confusion is structural, not careless. Section 186 reads like the natural home for "inter-corporate loans," so advisors default to it, tick the 60%/100% ceiling, take unanimous board consent, and consider the job done. They never re-run the Section 185 relationship test — because on its face Section 185 looks like it is only about "loans to directors," and no one thinks of a loan to their own other company as a loan to a director. But the 2017 amendment deliberately extended Section 185(2) to bodies corporate where the lending company's directors hold 25% control or share directorships, and that is the ordinary shape of a founder group. The result is a silent double-requirement: the transaction is perfectly within the Section 186 ceiling, board-approved and correctly priced, yet still unlawful because the Section 185 special resolution was never passed.

There is a further trap in timing. Both special resolutions must be passed before the loan is disbursed — a resolution ratifying a loan already made does not cure the original contravention under Section 185. Combined with the 30-day MGT-14 deadline and the auditor's CARO obligation to report on Sections 185 and 186 compliance, this means a single unplanned cash sweep can generate three separate compliance failures at once: an unlawful loan, a missed ROC filing, and an adverse audit remark. Treating the sequence as a checklist — test, approve, resolve, disburse, file — is the only reliable defence, and it costs a fraction of what remediation during a funding round does.

FAQ

Q: My company is a wholly-owned subsidiary. Do these sections still apply?
Section 186 grants specific exemptions for loans, guarantees and securities given by a holding company to its wholly-owned subsidiary (and for guarantees/securities in connection with loans by banks to a subsidiary), provided the loan is used for the subsidiary's principal business. However, the Section 185 analysis on common directors is separate — check it independently rather than assuming the WOS exemption covers everything.

Q: Can I just book it as a current-account advance instead of a loan to avoid this?
No. Regulators and auditors look at substance, not the ledger label. A recurring, unsecured advance that funds the other company's operations is a loan for the purposes of Sections 185 and 186 regardless of what you call it in the books.

Q: What interest rate is safe?
Section 186(7) requires the rate to be not lower than the prevailing yield of the Government Security closest in tenure to the loan. Lending interest-free or below that yield to a group company is itself a contravention, even if every approval is in place.

Q: We already made the loan without any resolution. Can we fix it now?
You cannot retroactively make an unlawful loan lawful, but you can and should remedy the position: pass the required board and special resolutions now, file the belated MGT-14, update MBP-2, and disclose the transaction in the current financials. If the Section 185 test was triggered, consult a professional about the contravention exposure — voluntary rectification and disclosure is materially better than waiting for the ROC to find it, especially with the CCFS-2026 relief window closing 15 July 2026.

Closing

Inter-company lending inside a founder-owned group is not a private matter — it sits at the intersection of two of the Companies Act's most heavily enforced provisions, both of which now feed directly into your CARO report and MCA21 v3 record. The safe path is boringly procedural: run the relationship test, pass the right resolutions, price the loan at or above G-Sec yield, and file MGT-14 on time. For a compliance audit of your company, visit pvtltd.co.