Applicability Of CSR Provisions To S.8 Companies

Prefatory Note

The UN Industrial Development Organization defines Corporate Social Responsibility ('CSR') as a mechanism to strike a balance between economic, environmental and social imperatives. The concept of CSR imposes more outstanding obligations on the corporates of being responsible corporate citizens rather than just operating with a profit motive.

The advent of liberalization and assimilation of the Indian economy with the global economy brought a paradigm shift in how businesses operate. This led to the realization of the need to bring more transparency and accountability in how businesses operate and the imposition of obligations greater than just pertaining to the operations of the corporations. The Companies Act, 2013 ('CA13') introduced well-defined provisions around CSR and mandated the applicability of CSR norms to corporates subject to specific threshold requirements.

As a matter of general law, any company satisfying the threshold prescribed in s.135 of the CA13 must undertake CSR activities in accordance with Schedule VII ('S.VII') of the CA13 and make relevant compliances as per the CA13 and the allied rules.

S.8 companies, commonly referred to as 'not for profit' entities, are incorporated with specific objectives including, but not limited to, the promotion of commerce, art, science, sports, education, research, and charity. In light of their defined objectives and the constraints imposed upon them, such as the prohibition of distribution of dividends to their members, application of its profits towards its objectives, etc., these companies are accorded certain exemptions under the provisions of various statutes, such as the CA13 and the Income-tax Act, 1961.

Therefore, when relaxations and exemptions are conferred upon such companies, a significant inquiry arises regarding the applicability of CSR provisions to these entities, especially in the absence of any explicit provision exempting them from such obligations. The need for clarity in this matter is crucial. Additionally, should the CSR provisions be deemed applicable to these companies, further inquiries arise concerning the specific manner in which these companies are to comply with and discharge their CSR obligations.

CSR Norms Under Companies Law

Applicability of CSR Criteria

CSR has been defined under Rules 2(d) of the Companies (Corporate Social Responsibility) Rules, 2014 ('CSR Rules') and means activities undertaken by a company in pursuance of its statutory obligation under s.135 of the CA13. However, certain activities undertaken in the ordinary course of business, such as contributions to political parties, activities undertaken outside India, activities benefitting employees, etc., have been excluded from the ambit of CSR.

As per s.135 of the CA13, every company meeting the criteria of a net worth of INR 500 crore or more, a turnover of INR 1,000 crore or more, or a net profit of INR 5 crore or more during the immediately preceding financial year is mandated to undertake CSR activities. These companies are mandated to contribute at least 2% of the average net profits of the company made during three immediately preceding financial years in pursuance of the CSR Policy formulated as per S.VII of the CA13.

To undertake CSR activities, the companies must ensure certain procedural compliances, including forming a CSR committee comprising directors, formulating a CSR committee, preparing an annual report on CSR, obtaining CSR registration and undertaking necessary annual form filings.

The CSR Rules prescribe the modes/structures through which the companies may undertake such CSR activities.¹ The company may undertake such activity through itself, through a s.8 company, registered public trust or society exempted under the provisions of the Income-tax Act, 1961. The company may incorporate such structures for specifically undertaking such activity either singly or in collaboration with other companies or maybe outsourced to such an entity as mentioned above, having an established track record of at least three years in undertaking similar activities.

Further, it has been stipulated that surplus/unspent CSR funds would not form a part of the business profit of the company and would have to be ploughed back into the same project or transferred to an 'unspent CSR account' or transferred to a fund specified in S.VII of the CA13. However, only the funds remaining unspent in respect of an ongoing project may be transferred to an unspent CSR account, while other unpent CSR amounts must be transferred to the S.VII Fund.

It is highlighted that S.VII of the CA13 prescribes the list of activities the companies may undertake to fulfil their CSR obligations. This schedule closely resonates with the definition of 'charitable purposes' under s.2(15) of the Income-tax Act, 1961. Therefore, the charitable activities undertaken by a trust, society or a s.8 company may generally overlap with the activities' scope as enshrined in S.VII.

Overview of Charitable Companies

As stated above, s.8 companies are incorporated with specific objectives such as promoting art, commerce, education, charity, etc., and intend to apply their profits towards promoting these objectives. Such companies are incorporated as limited liability companies. They are subject to the same obligations as imposed upon these companies unless an exception is precisely carved out under the provisions of any applicable law.

Generally, s.8 companies are not-for-profit entities permitted to function within the scope of the aforesaid objectives. However, under certain circumstances, they may undertake activities with the intent of generating profits subject to the stipulation that such profit is not distributed amongst members/shareholders of the company and is ploughed back towards the promotion of the aforementioned objects. Therefore, s.8 companies may be divided as follows:

Based on the above, a pertinent question arises: Where are the activities to be undertaken pursuant to S.VII of the CA13 similar to those undertaken by s.8 companies, and shall the CSR mandate apply to such s.8 companies?

To analyse the aforementioned proposition, it is pertinent to answer the following questions:

Applicability Of CSR Mandate to S.8 Companies

As a matter of general law, s.135 of the CA13 applies to every company irrespective of the provisions under which it has been incorporated. There has been much debate regarding this, and several High-Level Committees constituted by the Ministry of Corporate Affairs ('MCA') have had a contradictory view. However, the prevailing view is that the CSR provisions would remain applicable since not all the s.8 companies carry out charitable activities.

Report of the High-Level Committee, 2015

The committee in this report noted that s.8 companies are 'not for profit' companies incorporated with the primary object of working in the social and development sector. Their involvement in charitable and philanthropic activities is already 100%. It was further noted that these companies prepare income and expenditure statements that reflect the surplus/deficit of an organization and not the profit of the company. The accrued surplus is not distributed amongst the members. Still, it is ploughed back into the company's expenditure, which is spent on social welfare activities already included in S.VII. Therefore, in light of the same, the committee noted that CSR provisions should not be applicable to s.8 companies.

Report of the High-Level Committee, 2018

Based on the recommendation of the 2015 committee to constitute another committee to revisit the CSR framework, the committee of 2018 was constituted. It was observed that all s.8 companies are not necessarily formed with charitable objects. Their being not-for-profit does not necessarily mean they do not generate profits. Instead, surplus income over expenditure is ploughed back to promote the objects and not distributed to its shareholders. Further, it was observed that s.8 company was like any other company. Therefore, in view of the same, the committee noted that there seemed no justification to exclude these companies from the CSR mandate.

Further, more pertinently, via the FAQs on CSR, the MCA has further clarified that as s.135(1) of the CA13 uses the term 'every company', it would also apply to s.8 companies.

Whether S.8 companies are required to further expense 2% towards CSR qualifying activity?

After considering the above discussion, it is pertinent to mention and understand that the question about the applicability of CSR provisions to s.8 companies further arises in light of the exception pertaining to the exclusion of 'activities undertaken in the normal course of business' from the ambit of CSR.

As discussed above, r.2(d) of the CSR Rules, which defines 'corporate social responsibility', excludes activities undertaken in the 'normal course of business' from the purview of CSR activity. In view of the same, an argument arises where s.8 companies, in the ordinary course of their business, are undertaking any of the activities specified in S.VII. Will they have to undertake any other activity as per S.VII? From a purposive interpretation, this Rule must be interpreted as applicable and directed towards companies undertaking non-charitable business activities. This provision, thus, prevents such companies from indirectly taking advantage of the CSR provisions to further their business activities in the garb of CSR expenditure.

The above interpretation finds logical support from the following example, which highlights a situation that would unintentionally arise in case charitable companies are required to further expense 2% towards CSR qualifying activities, more so in the case of charitable companies that are themselves formed to comply with CSR provisions by their profit-making sister/group companies:

• S.8 company, CSRCo, is formed to spend 2% of the profits of its group company ProfCo. Thus, the memorandum of association of CSRCo lists all the qualifying activities in S.VII of the CA13 as its main object.
• During a certain year, ProfCo's net profit is Rs. 1000 crores. As such, it is required to spend Rs. 20 crores on CSR activities.
• ProfCo transfers Rs. 20 crores to CSRCo for CSR compliance. With such a transfer, ProfCo's CSR compliance requirement is satisfied.
• CSRCo, however, can only spend Rs. 14 crores during the year towards its activities, such as education, poverty relief, etc. As a result, the surplus remaining with CSRCo is Rs. 6 crores, which is more than the net profit requirement contained in s. 135 of the CA13. Thus, CSRCo would also have to meet the CSR compliance requirements.
• Now, since its 'normal course of business' would include all activities contained in S.VII of the CA13, any amount it spends on any charitable activity would not qualify as a CSR expenditure, given the legal interpretation we are analysing.
• The only way remaining for CSRCo, thus, would be to transfer Rs. 12 lakhs (being 2% of Rs. 6 crores) to another charitable company or trust to satisfy this compliance requirement. Clearly, this cannot be the legal interpretation.

Thus, in the case of charitable companies, the prohibition of not spending CSR amounts on activities carried out in the 'normal course of business' would have to be read purposively to mean activities undertaken with a 'for profit' motive. Therefore, in light of the above discussion and the situation as discussed, an s.8 company will not have to spend a further 2% of the net profits where its activities are aligned with S.VII of the CA13. However, as a matter of caution, in the absence of any regulatory framework, such s.8 companies may earmark 2% of the amounts spent as part of their charitable objectives, which is aligned with S.VII towards CSR compliance.

General Compliances

As discussed above, s.135 of the CA13, read with the CSR Rules, imposes certain compliance obligations on the companies mandated to undertake CSR activities. These compliances pertain to forming a CSR committee comprising a board of directors, formulating CSR policy, obtaining CSR registration, annual CSR reporting and form filings, etc. Given the general opinion and interpretation of the existing regulatory framework, as CSR provisions are applicable to s.8 companies, such companies will have to discharge these compliances.

Conclusion

Given that most of s.8 companies are incorporated with charitable objectives, philosophically, CSR provisions should not apply to s.8 companies. However, based on the general interpretation of CA13, recommendations of the High-Level Committee, and FAQs clarification of the MCA, the CSR provisions are also made applicable to s.8 companies. However, this should not be blanketly construed to mean that s.8 companies would have to further expense 2% of the net profits towards CSR expenditure where activities of such companies are analogous with s.8 companies.

However, the absence of regulatory guidance pertaining to the applicability of the CSR mandate to s.8 companies raises pertinent questions on account of certain differences pertaining to accounting principles, sources of funds, etc., between a s.8 company and a general limited company. In a profit and loss account of s. 8 company, there is no clear distinction between revenue and capital receipt, while such distinction exists in a limited company. Similarly, on the income side, the distinction in treatment lies between corpus and non-corpus donations.² Hence, because of this departure in accounting principles, questions such as whether capital receipts of s.8 companies, being corpus donations, should be factored in while determining the turnover. This would become relevant in the case of s.8 companies which have substantially high corpus donations. Further, this factor would also be relevant in the computation of 'net profit' since the determination of turnover would have a direct bearing on net profit (surplus, in the case of s.8 companies).

Moving ahead, a s.8 company may also receive donations that are returnable if certain conditions subject to which donations have been made are not met, for example, government grants. Further, this situation may also arise where a s.8 company is formed to fulfil the CSR mandate, in a situation where CSR policy is structured in a manner that unspent CSR amount must be returned to the parent company. As a matter of general accounting principle, such receipts are directly taken to the balance sheet, affecting assets and liabilities, without impacting profit loss account computation.³ Hence, under such circumstances, a query arises – such donations are treated as income of a charitable company and consequently considered for determination of the turnover or net profit.

As discussed above, s.8 company may also undertake for-profit activities subject to the stipulation that there should be no dividend payout. In a scenario where such activity generates a net profit of more than 5 crores, a question arises: Would such profit be consolidated with an overall surplus of s.8 company, or would it be considered alone?⁴ However, due to the lack of clear regulatory guidance, the stronger opinion is that such profits are consolidated with the overall surplus (profit) of the s.8 company.

Therefore, given the above predicament and philosophical contradiction, where the CSR mandate is held applicable to s.8 companies, there must be clear regulatory guidance for s.8 companies in adhering to the mandate.

Footnotes

1 Rule 4, Companies (Corporate Social Responsibility Policy) Rules, 2014.

2 Nalin Bajaj & Amar Gahlot, Applicability of CSR mandate on Charitable Companies, July 24, 2020, Taxsutra, https://www.lawstreetindia.com/experts/column?sid=442

3 Id.

4 Id.

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