Companies set up with an express 'not-for-profit' charter have come under government scrutiny for going against that mandate. 

The finance ministry has sought a review of the regulatory regime for such so-called Section 25 companies under the Companies Act, including foreign direct investment (FDI) policy as it relates to them to plug possible loopholes and abuse of their special status, which confers special tax concessions. 

The finance ministry has written to the ministry of corporate affairs and the department of industrial policy & promotion (DIPP) to tighten regulations to prevent misuse. 

The crackdown comes after it was found that Section 25 companies had issued shares at a premium to investors, thereby earning profit on the original investment, and pointing to possible wider misuse. "There are a lot of grey areas in the current norms that give room for misuse... These need to be tightened," said a government official aware of the discussions on the issue.

Section 25 companies are usually set up to promote commerce, art, science, religion, philanthropy or any other useful public objective and have to deploy profit or other income to further these aims. Distribution of dividends to members is prohibited.

The official pointed out that there was no provision in the Companies Act prohibiting shareholders in such companies from issuing shares at a premium to new investors, a loophole that can allow investors to make windfall gains. 

One Section 25 not-for-profit company was found to have issued shares to non-resident investors at a premium, which it said was in line with valuation norms prescribed by the RBI. 

The finance ministry has a twofold objection to this. The company was able to issue shares at a premium because it had accumulated significant reserves, which goes against the not-for-profit charter. Meanwhile, the reserve accumulation itself was possible because the company priced its operation or product well above cost to generate a surplus. 

In such a scenario, promoters can cash out of a company at a substantial gain by selling shares at a premium. Incoming shareholders can also do the same thing, as the policy is silent on the issue, said the official. 

The ministry has already put in place a stringent monitoring mechanism under the income-tax department to keep a close watch on not-for-profit organisations to prevent misuse of tax breaks. 

It has now asked DIPP to clarify in the companies law if Section 25 companies can accumulate reserves and surpluses and what the pricing or valuation methodology for shares of such entities should be. 

The ministry also wants DIPP to clarify the FDI policy on Section 25 companies, since there is no direction on whether overseas investments get automatically approved or not. Experts agree. "While the FDI policy currently does not differentiate between a Section 3 or a Section 25 company, it is good to have clarity on the policy. The policy should also be aligned with the Foreign Contribution Regulation Act," said Akash Gupt, executive director, PwC. 

The Financial Action Task Force, the global watchdog monitoring illicit flows and terror financing, had raised concerns over the functioning of the notfor-profit sector in India in a report two years ago. (Economic Times)