Loans to Directors and Inter-Corporate Finance: Sections 185 and 186

Apply the two sections separately

Section 185 asks who is receiving a loan, or whose borrowing is backed by the company. Section 186 regulates covered loans, guarantees, security and acquisitions of securities, including limits, approvals, disclosures and records. One transaction can trigger both sections. For an audit to which CARO 2020 applies, paragraph 3(iv) requires reporting on compliance with both provisions.

Section 185: recipient, exception and use of funds

Provision	Test to apply
Section 185(1)	Subject to a valid exception, the company may not directly or indirectly advance a loan (including one represented by a book debt), guarantee borrowing or provide security for a loan to a director of the lending company or its holding company, a partner or relative of such a director, or a firm in which such a director or relative is a partner. A general member approval does not lift this prohibition.
Section 185(2)	For a person in whom a director is interested as defined in the subsection, pass a special resolution in general meeting. The explanatory statement must give full particulars, intended use and other relevant facts. The borrower must use the funds for its principal business activities. The covered recipients include a private company in which the lending company's director is a director or member, a body corporate where one or more such directors can exercise or control at least 25% of total voting power at a general meeting, and a body corporate whose relevant management is accustomed to act on directions of the lending company's Board or director(s).
Section 185(3)(a) and (b)	A loan to a managing or whole-time director may qualify under service conditions extended to all employees or a member-approved scheme by special resolution. A company providing loans, guarantees or security in the ordinary course of its business can qualify under clause (b) subject to the statutory interest condition for the loans: use the prevailing yield of the specified Government security closest to the loan tenor. The RBI bank rate is not the test.
Section 185(3)(c) and (d)	A holding company's loan to its wholly owned subsidiary, or its guarantee or security for a loan made to that subsidiary, can qualify under (c). Under (d), a holding company may give a guarantee or security for a bank or financial institution loan to its subsidiary. In both cases the loan must be used for the subsidiary's principal business activities. Clause (d) does not exempt a direct loan to a non-wholly-owned subsidiary; determine independently whether the section restricts that loan.

For the private-company exemption under G.S.R. 464(E), verify that no other body corporate has invested in its share capital; relevant borrowings from banks, financial institutions and bodies corporate are strictly below the lower of twice paid-up share capital or ₹50 crore; and no repayment default on those borrowings subsists at the transaction date. Also check the condition added by G.S.R. 583(E) concerning defaults in filing financial statements or annual returns under sections 137 and 92. A private company does not qualify merely because of its legal form. The notification does not remove the need for a separate section 186 analysis.

Section 186: approvals and records

1. Calculate the higher of 60% of paid-up share capital, free reserves and securities premium combined, and 100% of free reserves and securities premium combined. Identify free reserves under section 2(43) from the latest audited balance sheet and document their availability for distribution. Compare the limit with the aggregate covered exposures, including the proposal.
2. Where section 186(5) applies, obtain a resolution at a Board meeting with the consent of all directors present; a circular resolution is insufficient. Resolve any interest, participation and quorum questions first. If a public financial institution term loan subsists, obtain prior approval from the institution unless both the aggregate is within the statutory limit and there is no default in repayment of instalments or interest.
3. Where the aggregate exceeds the statutory limit, obtain prior authority by special resolution under section 186(3), unless its proviso applies. That proviso covers specified loans, guarantees and security to a wholly owned subsidiary or joint venture, and acquisition of a wholly owned subsidiary's securities by its holding company. It is limited to the member-resolution requirement. Follow rule 11 and make the required financial statement disclosures.
4. For a loan governed by section 186(7), use the prevailing yield of the one-, three-, five- or ten-year Government security closest to the loan tenor as the minimum interest rate. Keep contemporaneous evidence of the chosen benchmark. A special resolution exemption does not remove the interest floor.
5. Check the two-layer restriction for investment companies in section 186(1) and its statutory exceptions, separate from other layering rules. Check the deposit-default restriction in section 186(8) and the transaction-specific carve-outs in section 186(11). The latter do not generally waive the layering rule.
6. For applicable transactions, keep Form MBP-2 at the registered office, preserve it permanently and record particulars chronologically within seven days. The company secretary or another person authorised by the Board authenticates the entries under rule 12. Keep approval, purpose, rate, disbursement and monitoring records and make the disclosures required under section 186(4).

Seven worked examples

1. Private-company limit: A company with ₹2 crore paid-up capital proposes a ₹1.50 crore loan to a firm in which its managing director's spouse is a partner. Relevant drawn borrowings of ₹6.50 crore exceed the lower statutory ceiling of ₹4 crore by ₹2.50 crore. The notified exemption fails regardless of other conditions. Unless another applicable exception exists, the proposed loan to that firm is prohibited under section 185(1).
2. Two subsidiaries: A holding company proposes ₹10 crore each to its wholly owned subsidiary and its 72%-owned subsidiary (₹20 crore in total). The first may qualify under section 185(3)(c) if the use test is met. The second direct loan is outside section 185(3)(d); apply section 185(2) if the borrower meets its interest definition. Mere ownership is insufficient to determine that definition. Review section 186 for both, including the scope of its special-resolution proviso.
3. Calculating headroom: Paid-up capital is ₹10 crore and securities premium ₹45 crore. Assume the company has established that only ₹7 crore of a ₹15 crore general reserve is distributable after accounting for an ₹8 crore debit balance; that is an assumption about these accounts, not a blanket netting rule. The two limits are 60% × ₹62 crore = ₹37.20 crore and 100% × ₹52 crore = ₹52 crore. With no prior covered exposures the quantitative limit is ₹52 crore; other approvals and conditions still apply.
4. Three-year loan: Assume ₹5 crore is outstanding for a full year on a three-year joint venture loan. If the verified relevant benchmark is 7.12% and the agreed rate is 4.5%, the shortfall is 2.62 percentage points, or ₹13.10 lakh for that year on a simple-interest basis. The joint venture approval relief does not cure the interest issue. Where applicable report under CARO; later amendments or recovery do not automatically erase a prior breach.
5. Use of proceeds: A private borrower with a covered director interest and 30% voting power controlled by relevant directors draws ₹8 crore for a warehouse but diverts ₹5 crore, or 62.5%, into an investment outside its principal business activities. Only ₹3 crore remains for the stated project. A special resolution does not cure the use-of-funds failure. Investigate the breach and document remedial steps and applicable reporting.
6. Board vote: On a ₹12 crore proposal, five out of six directors present vote in favour and one abstains. Assuming all six may validly participate and section 186(5) applies, five affirmative votes do not meet the consent-of-all test. Obtain a valid resolution before disbursement.
7. Missing register: An illustrative group has ₹150 crore of loans, guarantees and deposits across 14 subsidiaries. Classify each item before concluding how much falls under section 186. Where reportable items were omitted from MBP-2, reconstruct the register from primary records, assess disclosure and audit implications, and document the lapse. The facts alone do not establish any particular prosecution or adjudication outcome.

Common questions

Can a company lend to its managing director?

Check the specific service-condition or member-approved scheme exception in section 185(3)(a), or a valid notified exemption. Also assess other applicable provisions. The MCA employee-loan circular addresses ordinary employee loans and advances under service terms and remuneration policy where applicable; it is not a blanket director-loan permission.

Is ordinary trade credit a loan?

Genuine commercial credit is not automatically a loan merely because it is a receivable. Section 185 includes a loan represented by a book debt; assess the substance, terms and evidence, especially for unusual related-party balances.

What are the potential sanctions?

Under section 185(4), the company's fine is ₹5–25 lakh. An officer in default faces up to six months' imprisonment or a fine of ₹5–25 lakh; a covered recipient can face either or both. Section 186(13) provides a ₹25,000–₹5 lakh company fine; for an officer in default it specifies imprisonment up to two years and a ₹25,000–₹1 lakh fine. The statutory text, facts and applicable enforcement process determine the outcome.

What should the approval file contain?

Keep the recipient and director-interest analysis, the exemption evidence, exposure calculation, applicable lender consent, meeting minutes, resolution and filing evidence, yield source, stated purpose, utilisation evidence and MBP-2 record.

Sources

• Companies Act, 2013: section 185
• Companies Act, 2013: section 186
• Gazette: G.S.R. 464(E), private-company exemptions
• Gazette: G.S.R. 583(E), amendment to exemptions
• Gazette: Companies (Meetings of Board and its Powers) Rules, 2014
• MCA: Companies (Meetings of Board and its Powers) Amendment Rules, 2018
• MCA General Circular 04/2015: employee loans and advances
• CARO 2020: paragraph 3(iv)