Enquiry:

The Companies Ordinance, 1984 (the “Ordinance”) in its Section 3 lays down the definition of ‘subsidiary’ and ‘holding company’ as follows:

“Meaning of “subsidiary” and “holding company”.-(1) For purposes of this Ordinance, a company or body corporate shall be deemed to be a subsidiary of another if –

(a) that other company or body corporate directly or indirectly controls, beneficially owns or holds more than fifty per cent of its voting securities or otherwise has power to elect and appoint more than fifty per cent of its directors; or

(b) the first mentioned company or body corporate is a subsidiary of any company or body corporate which is that other’s subsidiary;

Provided that where a central depository holds more than fifty percent of the voting securities of a company, such company shall not be deemed to be a subsidiary of the central depository save where such voting securities are held beneficially by the central depository in its own behalf.

(2) For the purpose of this Ordinance, a company shall be deemed to be another’s holding company if, but only if, that other is its subsidiary.”

2. In view of this, if a Company ‘A’ holds, owns or directly controls more than 50 percent of the shares of another company ‘B’, any such company ‘B’ would become the subsidiary of company ‘A’ without any doubt.

3. However, since the financial and operating policies of an organization are governed by the board of directors of a company. Decisions are made through majority rule in a board of directors meeting. Accordingly, there can be certain instances where a company ‘A’ holds, owns or directly controls quite less than 50 percent of the shares of another company ‘B’ (assuming that company ‘B’ does not hold any shares of company ‘A’), but both the companies have common board/ directorship or they have majority of the board members in common. In this scenario, the Commission would like to seek the views of the Institute of Chartered Accountants of Pakistan (ICAP) as to whether the company ‘B’ would be the subsidiary company of company ‘A’. What impact would this scenario have if the chief executive of company ‘B’ is one of the common directors, as chief executive is a position that brings with it, the control of the company in which the person is the chief executive officer?

4. Moreover, there can be such other instances where a company ‘A’ holds, owns or directly controls quite less than 50 percent of the shares of another company ‘B’ (assuming that company ‘B’ does not hold any shares of company ‘A’), but both the companies have common board / directorship or they have majority of the board members in common, and the total number of shares of company ‘B’ are held by all the common directors and the company ‘A’, which, in aggregate, constitute a collective holding of more than 50 percent shares of company ‘B’. So, the Commission would also like to seek the views of the ICAP in this scenario as to whether the company ‘B’ would be the subsidiary company of company ‘A’, as company ‘A’ directly and indirectly holds or controls more than 50 percent shares of company ‘B’. What impact would this scenario have if the chief executive of company ‘B’ is one of the common directors? Will it further strengthen the indirect control of company ‘A’ over company ‘B’?

5. It would be pertinent to state that the definition of subsidiary in Ordinance clearly refers to both direct as well as indirect control and at the same time the Ordinance does not further define the term “control” (be it direct or indirect).

6. For ease of reference, the 9th Edition of the Black’s Law Dictionary was also referred, which defines the term ‘control’ as:

“control, n (16c) The direct or indirect power to govern the management and policies of a person or entity, whether through ownership of voting securities by contract, or otherwise; the power or authority to manage, direct, or oversee <the principal exercised control over the agent>control, vb. (15c)

1. To exercise power or influence over <the judge controlled the proceedings>.

2. To regulate or govern <by law, the budget office controls expenditures>.

3. To have a controlling interest in <the five shareholders controlled the company>.

7. From the above-quoted definition of the term ‘control’, it is quite evident that control is fairly attributable to the direct or indirect power or influence to govern the management and policies of a company, regardless of the fact that such control or power has been acquired or is exercised by means of ownership or otherwise.

8. Your timely valuable opinion in the matter discussed hereinabove would enlighten us and would help the Commission in implementing and enforcing the relevant provisions of the law, accordingly.

Opinion:

The Committee considers that the issues highlighted by you are very relevant for corporate structure in Pakistan and would take more significance as IFRS 10 is applied. The Committee also considers that in addition to analysis for the purposes of Companies Ordinance, 1984 (the Ordinance), this analysis should also be carried out for accounting purposes i.e. whether or not these may be regarded as subsidiaries under IAS 27 or IFRS 10. Before this analysis, for ease of reference we have briefly quoted some of the paragraphs of IAS 27 and IFRS 10. However, we emphasize that for each situation all facts and circumstances need to be examined and there may be other paragraphs of the standard which may be relevant.

IAS 27 ‘Consolidated and Separate Financial Statements’ (2008)

Definitions

Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.

13. Control is presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity unless, in exceptional circumstances, it can be clearly demonstrated that such ownership does not constitute control. Control also exists when the parent owns half or less of the voting power of an entity when there is:

(a) power over more than half of the voting rights by virtue of an agreement with other investors
(b) power to govern the financial and operating policies of the entity under a statute or an agreement;
(c) power to appoint or remove the majority of the members of the board of directors or equivalent governing body and control of the entity is by that board or body; or
(d) power to cast the majority of votes at meetings of the board of directors or equivalent governing body and control of the entity is by that board or body.

IFRS 10 ‘Consolidated Financial Statements’

6. An investor controls an investee when it is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee.

7. Thus, an investor controls an investee if and only if the investor has all the following:
(a) power over the investee (see paragraphs 10–14);
(b) exposure, or rights, to variable returns from its involvement with the investee (see paragraphs 15 and 16); and
(c) the ability to use its power over the investee to affect the amount of the investor’s returns (see paragraphs 17 and 18).

17. An investor controls an investee if the investor not only has power over the investee and exposure or rights to variable returns from its involvement with the investee, but also has the ability to use its power to affect the investor’s returns from its involvement with the investee.

18. Thus, an investor with decision-making rights shall determine whether it is a principal or an agent. An investor that is an agent in accordance with paragraphs B58–B72 does not control an investee when it exercises decision-making rights delegated to it.

B38 An investor can have power even if it holds less than a majority of the voting rights of an investee. An investor can have power with less than a majority of the voting rights of an investee, for example, through:
(a) a contractual arrangement between the investor and other vote holders (see paragraph B39);
(b) rights arising from other contractual arrangements (see paragraph B40);
(c) the investor’s voting rights (see paragraphs B41–B45);
(d) potential voting rights (see paragraphs B47–B50); or
(e) a combination of (a)–(d).

B42 When assessing whether an investor’s voting rights are sufficient to give it power, an investor considers all facts and circumstances including:

(a) the size of the investor’s holding of voting rights relative to the size and dispersion of holdings of the other vote holders noting that:
(i) the more voting rights an investor holds, the more likely the investor is to have existing rights that give it the current ability to direct relevant activities;
(ii) the more voting rights an investor holds relative to other vote holders, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;
(iii) the more parties that would need to act together to outvote the investor, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;
(b) potential voting rights held by the investor, other vote holders or other parties (see paragraph B47-B50)
(c) rights arising from contractual arrangements (see paragraph B40)
(d) any additional facts and circumstances that indicate the investor has, or does not have, the current ability to direct the relevant activities at the time that decisions need to be made, including voting patterns at previous shareholders’ meetings.

B58 When an investor with decision-making rights (a decision maker) assesses whether it controls an investee, it shall determine whether it is a principal or an agent. An investor shall also determine whether another entity with decision-making rights is acting as an agent for the investor. An agent is a party primarily engaged to act on behalf and for the benefit of another party or parties (the principal(s)) and therefore does not control the investee when it exercises its decision-making authority (see paragraphs 17 and 18). Thus, sometimes a principal’s power may be held and exercisable by an agent, but on behalf of the principal. A decision maker is not an agent simply because other parties can benefit from the decisions that it makes.

B73 When assessing control, an investor shall consider the nature of its relationship with other parties and whether those other parties are acting on the investor’s behalf (i.e. they are ‘de facto agents’). The determination of whether other parties are acting as de facto agents requires judgment, considering not only the nature of relationship but also how those parties interact with each other and the investor.

B75 The following are examples of such other parties that, by the nature of their relationship, might act as de facto agents for the investor:
(a) the investor’s related parties
(b) —- (d)
(e) An investee for which the majority of the members of its governing body or for which its key management personnel are the same as those of the investor

An analysis of the three situations for the purposes of the Ordinance and for accounting purposes under IAS 27 and IFRS 10 could be as follows:

1. Company ‘A’ holds, owns or directly controls more than 50 percent of the shares of another company ‘B’

Companies Ordinance, 1984  

In the absence of any other agreement, the Company B would appear to be subsidiary of Company A.

IAS 27

In the absence of any other agreement, the Company B would appear to be subsidiary of Company A. In the absence of any other agreement, the Company B would appear to be subsidiary of Company A.

IFRS 10
An analysis of the factors other than voting rights e.g. identification of the relevant activities, understanding the purpose and design of an investee, other contractual arrangements, pattern of voting rights held by others, and specific voting rights for specific relevant activities etc. is also necessary to determine control over an investee.
2. Company ‘A’ holds, owns or directly controls quite less than 50 percent of the shares of another company ‘B’ but both the companies have majority of the board members in common

Companies Ordinance, 1984 

In the absence of any other agreement giving power to Company A to elect and appoint more than fifty per cent of directors of Company B, Company B would not appear to be subsidiary of Company A. The Company A does not seem to have power to elect and appoint more than fifty percent of directors of Company B.

The term ‘indirectly controls’ has not been defined in the Companies Ordinance. In the absence of any other instructions, the committee considers that the term used in paragraph 13 of IAS 27 ‘indirectly through subsidiaries’ should be applied.

IAS 27 

Under IAS 27, an investor may have control over an investee while holding less than 50% of the voting rights. Conditions given in para 13 of IAS 27 (reproduced above) need to be carefully reviewed for analyzing control.

In Committee’s view, by having common members on the respective board of directors, or by having Chief Executive Officer of Company B on the board of Company A, may not itself provide corroborative evidence that Company A has a control over Company B. All facts and circumstances would need to be analysed.

IFRS 10

Under IFRS 10 as well, an investor can control an investee with less than the majority of voting rights. Refer paragraph B38 above.

For this to be the case all facts and circumstances reproduced in B42 above would need to be considered.

B75(e) gives example that an investee for which the majority of the members of its governing body or for which its key management personnel are the same as those of the investor, may act as de facto agents for the investor.

The Committee considers that common directorship is not a conclusive factor for determining control. Other factors like contractual arrangements and circumstances discussed above may also require judgment and need to be considered.

IFRS 10 includes a number of application examples to illustrate the analysis that is required and the Committee would recommend referring them for guidance purposes.

3. Company ‘A’ holds, owns or directly controls quite less than 50 percent of the shares of another company ‘B’ but both the companies have majority of the board members in common, and the total number of shares of company ‘B’ are held by all the common directors and company ‘A’, in aggregate, constitute a collective holding of more than 50 percent shares of company ‘B’.

Refer case no. 2 above.

Note of Caution:

The Committee would like to highlight here that the above views are based purely on theoretical scenarios presented. Therefore, application of views presented above based on these theoretical scenarios to actual conditions without considering all relevant underlying factors in accordance with provisions of relevant applicable standards may not be appropriate.

(December 24, 2014)