Disadvantages of Incorporation of a Company

In this article, the author discusses the disadvantages of incorporation of a company under the Companies Act, 2013. The article mainly focuses on the doctrine of “lifting the corporate veil” and explains in details the various scenarios in which the courts look beyond the corporation and the actual forces behind its functioning.

I. Introduction

A company is the most important form of a corporate entity in today’s world. With the passage of time, the importance of corporate governance in a highly competitive business world became apparent which led to the restructuring of India’s legal regime in the form of Companies Act, 2013. A company has several advantages over other forms of business enterprises such as partnership firm, LLP, a Hindu undivided family, etc since it has a separate independent existence, limited liability, and many other rights which are available to a legal person such as the power to hold property, right to sue and be sued etc. However, there are certain disadvantages to this model of a corporate entity as well.

II. Disadvantages of Incorporation of a Company

1. Lifting the Corporate Veil

All the benefits associated with the incorporation of a company are based on the basic principle that a company is a separate entity from its shareholders for all purposes of the law. However, there are certain scenarios when it becomes necessary to look at the persons behind the corporate veil and then some of those advantages or benefits disappear.

The separate entity of the company is disregarded and the schemes and intentions of the persons behind are exposed to full view. They are made personally liable for using the company as a vehicle for undesirable purposes as in the case of Jai Narain v. Pushpa Devi Saraf [1], wherein the promoters-directors who used the company for their own personal objectives were held accountable for their actions.

It must be realized that the separate personality of a company is a statutory privilege which must be used for legitimate business purposes only. Where a fraudulent and dishonest use is made of the legal entity, the individuals concerned will not be allowed to take shelter behind the corporate personality. The Court will break through the corporate shell and apply the principle/doctrine of what is called “lifting of or piercing the corporate veil”.

The Court will look behind the corporate entity and take action as though no entity separate from the members existed and make the members or the controlling persons liable for debts and obligations of the company[2]. Thus, the advantage available to members on the premise that they only have limited liability is not an absolute right.

The provisions relating to the lifting of the corporate veil are found in sections 7(7), 251(1) and 339 of the Companies Act, 2013. These provisions look beyond the corporation to reach the real forces of action. Section 7(7) deals with punishment for the incorporation of a company by furnishing false information; Section 251(1) deals with liability for making a fraudulent application for removal of the name of the company from the register of companies and Section 339 deals with liability for fraudulent conduct of business during the course of winding up. The instances in which the corporate veil is lifted are given below:

• When it is Necessary to Determine the Legal Character of a Corporation

In the case of Daimler Co Ltd v. Continental Tyre & Rubber Co Ltd[3], the House of Lords held that a company, though registered in England, would “assume an enemy character when persons in de facto control of its affairs, are residents in an enemy country or, whether residents are acting under the control of the enemies.” From this case, it is clear that the court is willing to look beyond the corporate personality in certain crucial situations.

• When a Company is Conceived and Brought Forth for Fraudulent Purposes

In cases where a company uses the corporate veil for the commission of fraud or improper conduct, courts have lifted the veil and looked at the realities of the situation. In the case of Gilford Motor Co Ltd v. Horne[4], a company was restrained from acting when its principal shareholder was bound by a restraint covenant and had incorporated the company only to escape the covenant.

Another major case law in this regard is the case of Jones v. Lipman[5], in which case A agreed to sell certain land to B. Pending completion of formalities of the said deal, A sold and transferred the land to a company which he had incorporated with a nominal capital of £100 and of which he and a clerk were the only shareholders and directors. This was done in order to escape a decree for specific performance in a suit brought by B.

The Court held that the company was the creature of A and a mask to avoid recognition and that in the eyes of equity A must complete the contract since he had the full control of the limited company in which the property was vested, and was in a position to cause the contract in question to be fulfilled.

• For the Benefit of Revenue

Another instance when the corporate veil can be lifted is when it is found that the sole purpose for which the company was formed is to evade taxes. In such circumstances, the court will ignore the concept of a separate entity and make the individuals concerned liable to pay the taxes which they would have paid but for the formation of the company.

In the case of Re. Sir Dinshaw Maneckjee Petit[6], it was held by the court that the company was formed by the assessee purely and simply as a means of avoiding supertax and the company was nothing more than the assessee himself. It did no business, but was created simply as a legal entity to ostensibly receive the dividends and interests and to hand them over to the assessee as pretended loans”. The Court decided to disregard the corporate entity as it was being used for tax evasion.

A more recent example is the case of Vodafone International Holdings B.V. v. Union of India & Another [7], in which the SC thoroughly discussed the factors which must be taken into consideration to determine whether the transaction is a bogus and whether the corporate veil is to be lifted. The factors to be taken into consideration are:

1. the concept of participation in investment,
2. the duration of time during which the Holding Structure exists;
3. the period of business operations in India;
4. the generation of taxable revenues in India;
5. the timing of the exit; and
6. the continuity of business on such exit.

• The Company is Only an Agent

The separate existence of a company may be ignored where it is being used as an agent or trustee. An example is the case of Re. R.G. Films Ltd [8], in which an American company produced a film in India technically in the name of a British Company, 90% of whose capital was held by the President of the American company which financed the production of the film. Board of Trade refused to register the film as a British film which stated that the English company acted merely as the nominee of the American corporation. The courts insist upon very strong evidence for this purpose. [9]

• When the Company’s Conduct is Against Public Policy

There have been many instances where the courts have lifted the corporate veil for protecting the public policy when a company’s conduct is in conflict with it. For example, in the case of Connors Bros. v. Connors [10], this principle was applied against the managing director who made use of his position contrary to public policy.

In this case, the House of Lords determined the character of the company as “enemy” company, since the persons who were de facto in control of its affairs, were residents of Germany, which was at war with England at that time. The alien company was not allowed to proceed with the action, as that would have meant giving money to the enemy, which was considered as monstrous and against “public policy.

• When the Company is Formed to Avoid Welfare Legislation

Much like tax evasion, avoidance of welfare legislation is very common and the approach in considering problems arising out of such avoidance has necessarily to be the same and, therefore, where it was found that the sole purpose for the formation of the new company was to use it as a device to reduce the amount to be paid by way of bonus to workmen; the Supreme Court has upheld the piercing of the veil to look at the real transaction.

A landmark case in this area is the case of The Workmen Employed in Associated Rubber Industries Limited, Bhavnagar v. The Associated Rubber Industries Ltd., Bhavnagar and another [11].

• When the Company is Formed for Inequitable Purposes

Where it is found that a company has abused its corporate personality for an unjust and inequitable purpose, the court would not hesitate to lift the corporate veil. Further, the corporate veil could be lifted when acts of a corporation are allegedly opposed to justice, convenience and interests of revenue or workmen or are against the public interest. Also, when used to hide criminal activities, the court can lift the corporate veil. Thus, in appropriate cases, the courts disregard the separate corporate personality and look behind the legal person or lift the corporate veil.

2. A Company is Not a Citizen

Another disadvantage that a Company has is that even though it is a legal person, it is not capable of citizenship under the Citizenship Act, 1955 or the Constitution of India. In the case of State Trading Corporation of India Ltd. v. C.T. O[12], the Supreme Court held that the State Trading Corporation though a legal person was not a citizen and can act only through natural persons. Nevertheless, it is to be noted that certain fundamental rights enshrined in the Constitution for the protection of a “person” are also available to a company. However, a company has nationality and domicile but unlike a natural person, a company cannot change its nationality.[13]

3. Formality and Expense

Another major disadvantage of incorporation of a company is that it is a very expensive affair. There are a number of formalities which have to be complied with both as to the formation of the company and the administration of its affairs.[14]

III. Conclusion

It is evident that there are both advantages as well as disadvantages incorporating a company under the Companies Act, 2013. It seems that a company is more suited for businesses where there are more capital investments as well as risks involved but a look at the pros and cons of incorporation reveals that the pros far outweigh the cons. As long as a company is utilized for conducting the lawful purposes for which it is incorporated, there will be no risk of the lifting of the corporate veil. Moreover, the initial expenses in forming a company will have benefits in the long run.

---

References

[1] (2006) 7 SCC 756

[2] Available Here

[3] (1916) 2 AC 307

[4] 1933 Ch 935 (CA).

[5] (1962) I. W.L.R. 832

[6] A.I.R. 1927 Bombay 371

[7] (2012) 6 SCC 613

[8] (1953) 1 All E.R. 615

[9] Avatar Singh, Business Law (10^th ed., 2014).

[10] (1940) 4 All E.R. 179

[11] A.I.R. 1986 SC 1.

[12] A.I.R. 1963 S.C. 1811

[13] Dhodha House v. SK Mangi, (2006) 9SCC 41

[14] Supra note 9

---

1. Company Law; Notes, Case Laws and Study Material
2. Law Library: Notes and Study Material for LLB, LLM, Judiciary and Entrance Exams