1

Damodaram Sanjivayya National law University

Corporate Law Project on

Various Grounds on which corporate veil can be lifted.

By

Praveen.K.Nair VII SEMESTER 200928

List of Contents
Introduction to incorporation Concept of Corporate veil Grounds on which corporate veil can be lifted The role of fraud in lifting the corporate veil Sanctity of corporate form Conclusion References

3 List of cases Salomon v Salomon & Co Ltd Adams v Cape Industries Vodafone international vs UOI DHN Food Distributor vs Tower Hamlets London Borough Council Hashem v. Shayif Woolfson v. Strathclyde Regional Council State of UP v. Renusagar Novartis v. Adarsh Pharma Great Pacific Navigation v. M.V. Tongli Yantai Lee v. Lee Air Farming Secretary of State v. Neufeld

4 Why incorporation1? Incorporation of company is done because of the fundamental advantages mentioned below 1) The personal liability of person(s) running the company can be limited for business debts. Its a separate legal entity 2) When an enterprise requires larger amount of capital that the resources of few persons cannot provide 3) An incorporated company never dies. It is called concept of perpetual succession, where Members may come and go but the company can go on for ever.2 4) The Concept of Separate property. A company, being legal person, is capable of owning, enjoying and disposing of property in its own name3. 5) Capacity to sue and be sued .The concept of corporate veil A registered company is a legal person separate from the shareholders .The consequences of this were stated in Salomon v Salomon & Co Ltd4The company is at law a different person altogether from the subscribers to the memorandum: and the company is not in law the agent of the subscribers or trustee for them. The veil of incorporation separates the incorporators from the company; in a group context it operates to make each company in the group a separate legal entity with no liability for the debts or liabilities of other group companies. The concept of lifting the corporate veil is disadvantage to incorporation because the above-mentioned advantages no longer exist if once corporate veil of a company is pierced or lifted. The above concepts are regarded as fundamental of company law. In England It is as easy to state that the origin of the separate entity principle is often traced to Salomon v Salomon as it is difficult to outline when a court will lift the veil. The best judicial analysis is Slade LJs masterly treatment of the subject in Adams v Cape Industries5. In India In Vodafone case6, there are important differences in the approach of the Chief Justice and K.S. Radhakrishnan J., and the Chief Justices judgment suggests that the court may more readily lift the veil than is commonly supposed. The Chief Justice begins by affirming that a subsidiary and its parent are totally distinct taxpayers and that the fact that a parent exercises substantial control over the affairs of its subsidiary is not in itself a reason to depart from this principle. The Chief Justice then outlines important exceptions to this principle in particular, that it is permissible to ignore the separate legal status of
1

A legal process through which a company receives a charter and the state in which it is based allows it to operate as a corporation 2 Gower, Principles of modern company law,76(3 rd Edn, 1969) 3 Avatar singh, Company law,9,(15th edn) 4 [1897]AC 22 5 [1990] Ch 433
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2009(4)BomCR25

5 the subsidiary if its decision-making is fully subordinate to the holding company or if the parent company makes an indirect transfer through abuse of legal form and without reasonable business purpose, and clarifies that these are by no means exhaustive. At first sight, the fully subordinate language the Chief Justice uses may suggest that a court will readily lift the veil, but it is submitted that the better view is that the Chief Justice is simply referring to the well-known exception (accepted in Adams) in which the business of the subsidiary is in fact the business of the holding company. The Chief Justice then holds that India has a judicial anti-avoidance rule which allows the Revenue to invoke substance over form or pierce the corporate veil if it discharges its burden of establishing that the transaction in which the corporate entity is used is a sham or tax avoidant. While the word tax avoidant may give rise to the impression that every case in which the use of a corporate entity leads to a reduction in the tax liability of the assessee is covered, it is submitted that the better view, and one which is consistent with the rest of the Chief Justices analysis, is that no substantial departure is intended from the limited grounds on which the veil may presently be lifted. That view is reinforced by the fact that sham is used in conjunction with tax avoidant, and by the examples given by the Chief Justice in the sentence that immediately follows round tripping and payment of bribes. The example of lack of business purpose is also given, but the Chief Justice clarifies that this lack of business purpose must not be a result of dissecting the legal form of a transaction as the Revenue sought to do in Vodafones case. The most important part of the Chief Justices analysis is the list of six factors set out to assist the Court in determining on which side of this test a particular transaction falls: participation in investment, duration of existence of holding structure (prior to acquisition), period of business operations in India, generation of taxable revenues in India, timing of exit and continuity of business on exit. This analysis suggests that it may be a mistake to read this judgment as a complete victory for tax planning, because the dominant purpose of a transaction may easily be found, on the application of these factors, to lack commercial substance, even though it may not satisfy the traditional tests of lifting the corporate veil. It also suggests, so far as tax avoidance is concerned, that the test in India. It is also interesting to contrast this with the analysis in Adams v Cape Industries. In that case, Slade LJ clearly stated that the fact

6 that justice so requires is never a reason to treat a subsidiary as anything other than a separate legal entity; that certain observations of Lord Denning MR in DHN Food Distributor7s may have gone too far; that it is settled in English law that a subsidiary can be ignored only if it is the alter ego or agent or part of a single economic entity with, the parent; and that it is such only if the business of the holding company is the business of the subsidiary. This test may be considerably narrower than the factors outlined in the Chief Justices judgment (duration of existence of holding structure etc.). Indeed, the application of the Adams test to the facts of that case so suggest in that case, although the Court concluded that AMC (the Liechtenstein corporation) was a faade, it held that CPC (the American marketing company set up after NAAC was liquidated) was not the alter ego of Cape and Capasco even though Cape exercised substantial control over it, because CPC had control over its day to day activities, paid rent for its premises, paid income tax separately etc. K.S. Radhakrishnan J.s judgment appears to endorse Adams (but see below), and recognises that members of a company have no interest in its assets. More significantly, the judgment appears to implicitly hold that the separate entity will prevail except in very limited circumstances, for it repeatedly observes that the veil can be lifted only if the Revenue establishes that the corporation has been used for a fraudulent or dishonest purpose (as opposed, for example, to a benign purpose through an entity that is part of a single economic unit). It begins by holding that many factors may guide the choice of a vehicle for doing business through a corporation, of which one can legitimately be a desire to minimise tax liabilities. K.S. Radhakrishnan J. then holds that the burden is on the Revenue to show that the corporation was used for a fraudulent, dishonest purpose, so as to defeat the law.it is held that the fact that a parent and a subsidiary may have economic union of interest and a consolidated balance sheet does not mean that they are not distinct legal entities and that the veil can be lifted only if the Revenue shows that the company has been used to perpetrate fraud or wrongdoing. Even in approving Adams , K.S. Radhakrishnan J. specifically observes that the Court of Appeal emphasised

[1976] 1 WLR 852

7 in that case that a subsidiary can be ignored where special circumstances exist indicating that it is a mere faade concealing true facts. This theme is repeated subsequently, when K.S. Radhakrishnan states that the court will not permit a corporate entity to be used as a means to carry out fraud or evade tax All of this indicates that K.S. Radhakrishnan J. has virtually rejected the single economic entity or alter ego grounds for lifting the veil (or confined its application to rare instances), although there is one reference to sham and agent. It is submitted that K.S. Radhakrishnan J.s approach, even if it perhaps goes too far, is, with respect, preferable to the approach of the Chief Justice, for the latter analysis would permit the veil to be lifted on a number of grounds that may not be entirely consistent with the sanctity of the separate entity principle. Indeed, the Chief Justices analysis leaves one with the impression that Vodafone prevailed not on the ground that the veil cannot be lifted except on Adams grounds, but on the ground that the veil should not be lifted for it had demonstrated business purpose and commercial substance. The grounds for lifting the Corporate Veil In the above paragraphs we have seen how the concept of corporate veil has been established in England and India. Now in this paragraph we will see on what grounds the corporate veil can be lifted. In Hashem v. Shayif8 case it appears from the judgment that the only case in which the corporate veil could be lifted was where the company was a faade. In order to support this conclusion, Justice Munby relied on several cases, but most prominently on the decision of the Court of Appeals in Adams v. Cape Industries plc., and on an observation by Lord Keith in the House of Lords decision in Woolfson v. Strathclyde Regional Counci9l that it is appropriate to pierce the corporate veil only where special circumstances exist indicating that it is a mere faade concealing the true facts. A significant fallout of the decision in Hashem v. Shayif is its refusal to distinguish between various grounds on which the corporate veil can be lifted, specifically agency and single economic entity, and this aspect perhaps merits greater discussion. In Woolfson, as the judgment itself notes, the line of argument based on agency was not pressed before the Court by the parties. Thus, the Court was not required to consider agency-based arguments at all. That left the Court with the arguments relating to single economic entity and faade. It is in this context that the Court held that a faade was a necessary requirement for lifting the corporate veil. Woolfson rejected the single economic entity argument. However, that does not mean
8
9

EWHC 2380 (Fam) 1978 SLT 159

8 that it negated agency-based arguments also. The distinction between these two kinds of arguments is in fact strengthened by Adams v. Cape Industries, which rejected the single economic entity rationale expressly, but rejected the agency arguments only on the grounds that an agency was not established in the facts of the case. Thus, the position arising from Adams is that a group of companies cannot be treated as one on the sole ground that the companies are part of the same economic group. However, if it can be established that a company habitually acts according to the wishes of one shareholder, then a factual agency can very well be established. This would allow the Courts to lift the corporate veil. A single economic entity argument is based on the fact that two or more companies are part of one economic group, while a factual agency argument is based on the degree of control over a company by another (legal or natural) person. Rejection of one argument does not mean rejection of the other. To this extent, then, Hashem v. Shayif does not appear to lay down the correct principle of law. State of UP v. Renusagar10 was decided in 1988. In Renusagar, the Court did not have the benefit of the decision in Adams. The Court proceeded, therefore, on the basis of prior English law which had accepted the single economic unit argument. Thus, Renusagar seems to support the conclusion that a single economic entity argument would succeed in India. The Renusagar decision went on to note, It is high time to reiterate that in the expanding of horizon of modern jurisprudence, lifting of corporate veil is permissible. Its frontiers are unlimited. It must, however, depend primarily on the realities of the situation. The aim of the legislation is to do justice to all the parties. The horizon of the doctrine of lifting of corporate veil is expanding. If this was the last word of the Indian judiciary on the point, then one could say that in India the corporate veil could be lifted on grounds of single economic entity as well as public interest; thus signifying a significant difference in the Indian and UK positions. However, Indian Courts have not been entirely unaffected by the changes in British law. In so far as taxation-related veil issues are concerned, this might mean that Courts will tend to be less open to lifting the veil on assessments of hypothetical motive. Among the Indian decisions which have taken into consideration the developments in British law is the judgment of the Madras High Court in Novartis v. Adarsh Pharma11. In this case, an argument was made that the corporate veil could be lifted only in cases where the corporate form was abused leading to unjust and inequitable results. The Court took this stance after noting Adams. Nonetheless, the Court held that a single economic unit argument could work in certain circumstances. These circumstances would depend on the factual control exercised. This view is strengthened by the Supreme Court decision (cited in Novartis) in New Horizons v. Union of India (It is not impermissible to treat) a subsidiary as the agent or the alter ego of its parent, provided
10 11

1988 AIR 1737, 1988 SCR Supl. (1) 627

2004 (29) PTC 108 Mad

9 the facts of the case justified such a conclusion. However, it would seem that the facts would have to reveal a very high degree of control by the parent over the subsidiary before a Court would conclude that an agency relationship had been established This, thus, accepts the Adams position of leaving open the factual agency grounds; while recognizing that the factual burden is not an easy one to discharge. To conclude, the following broad principles can be drawn from the existing case-law: Single economic entity: In England, the mere fact of a two companies constituting a single economic entity is not sufficient to lift the corporate veil. In India, Courts are more likely than English Courts to accept this argument, considering that there are Supreme Court judgments which have done so. However, later decisions seem to have noted the change in the English position and have impliedly gone by the Adams trend. In India, the single economic entity argument has not been clearly distinguished from agency arguments. Perhaps, this is the reason why single economic entity arguments have not been rejected outright. It is to be hoped that Indian Courts draw the distinction between these arguments before entirely rejecting the single economic entity argument. Factual Agency: In England as well as in India, factual agency is a ground to lift the veil. Although on facts this is a difficult ground to establish, there is no authority to reject the argument on law. The test is whether it is reasonable to assume that transactions entered into by the company were entered on behalf of one individual / another company. It must be shown that the company so habitually acts according to the wishes of that other individual / company, that it is justifiable to treat the two as one legal entity. Faade: In order to establish a faade, there must be a showing of impropriety. The impropriety must be linked to the use of the company structure to avoid or conceal liability. Public Interest: In England, public interest standing alone is not a ground to lift the veil. It might still be open to argue on the basis of public-interest in India. The Courts will rely on this ground when lifting the veil is the most just result, but there are no specific grounds for lifting the veil. Thus, public interest may in some cases be used by Indian Courts to lift the veil even when the strict test for establishing a faade is not satisfied.

Lifting the Veil: Is 'Fraud' Necessary? The sanctity of the corporate veil is among the most important pillars of certainty in commercial law today. English Courts have given great respect to independent personality, refusing to lift the veil on grounds of economic reality such as single economic entity, or subjective notions such as public interest. This tendency has been in existence since Adams v. Cape; an important example is seen in Hashem v. Shayif. The approach in Hashem v. Shayif has been approved by the Court of Appeal, and has also

10 been applied in subsequent judgments in England. In India, as we had noted previously, the grounds for lifting the corporate veil are broader. An example of this broader approach is seen in the decision of a Division Bench of the Bombay High Court in Great Pacific Navigation v. M.V. Tongli Yantai.

Great Pacific appealed against an order of a Single Judge directing release of an arrested ship, Tongli Yantai. The Appellant, entered into an agreement with Tongli Samoa is respect of a ship called the Nasco Diamond. There were disputes under this agreement. The agreement contained an arbitration clause. In order to secure the award which may be passed in arbitration proceedings, the Appellant sued the Respondent for arrest of the ship. The arrested ship was of the registered ownership of Halycon. The Nasco Diamond was of the registered ownership of Tongli Samoa. The case of the Appellant was that the respondent ship as well as the ship Nasco Diamond were beneficially owned by the same entity, i.e Tongli China.

Tongli China (the alleged beneficial owner) entered into an agreement with one Shipyard for the purchase of Tongli Yantai. Tongli China paid 10% of the price. 60% of the price was paid by FEHL. Halycon, the registered owner of the ship, was a subsidiary of the subsidiary of FEHL. Halycon entered into a charter party agreement with Eastshine. Eastshine paid the balance 30% price. On these facts, the Appellant claimed that the ship was of the beneficial ownership of Tongli China.

The Single Judge refused to lift the veil of Halcyon; and refused to consider Halycon as being the alter ego of Tongli China. In doing so, the Appellant argued, the Single Judge fell into error. It argued, It may be rather myopic not to consider the true position of the parties behind legal and juristic faade

The issue, thus, was whether the Court could go behind the registered owner Halycon, to determine the true owner of the ship either as a matter of admiralty law or as a matter of lifting the corporate veil. The following facts, inter alia, weighed with the Division bench:

11 1. The original purchaser of the arrested ship was Tongli China. 2. 10% of the purchase price was paid by Tongli China. FEHL financed Halcyon to the extent of 60% of the value of the ship payable to the shipyard. Halcyon entered into an agreement with Eastshine, also a Tongli group company. Eastshine had to pay Halcyon 30% of the value of the ship as advance charter. Tongli China guaranteed the payment by Eastshine to the shipyard. 3. The addresses, telephone numbers and emails of all the companies in the group was shown in certain filings to be the same. 4. The charterparty arrangement was a unique one, in that the only relationship between the two contracting parties is of Halcyon having been nominated by Tongli China under its corporate guarantee Once that is through, Eastshine, the other sister concern of Tongli China as reflected in the aforesaid evidence, would be entitled to the rights of ownership as also the difference of amount keeping intact its position free from encumbrances such as transfer by mortgage or otherwise by Halcyon to any other party.

On these facts, the Respondents argued that where there was no fraud made out, lifting the veil would not be possible. In other words, absent fraud, economic and commercial unity is no ground to lift the veil. It is worth noting that the Single Judge had not recorded any finding that there was a fraud involved. The Division Bench however held, Mr. Dwarkadas' contention that only in cases of fraud the corporate veil may be lifted to see which company other than Tongli Samoa would incur liability upon the charter party signed by Tongli Samoa would be rather inaccurate given the precedents that govern this issue and this is even from the British Courts

On the detailed facts, if a finding of fraud were reached, there would not be much quarrel with lifting the veil. However, the observations of the Division Bench are extremely broad. The statement that such a broad reading is also supported by British Courts, is entirely untenable. For instance, the Division Bench extensively relied on DHN Food Distributors.In England, DHN has been substantially watered down in a number of

12 judgments; prominent amongst them being Adams v. Cape Industries . This was not taken into account by the Division Bench at all; the Court makes a bland reference [see Adams v. Cape Industries] without considering the import of Adams at all. In further comments, the Court stated, As the financial and economic situations become more and more complex in the commercial and business world, the ambit of the employment and application of the doctrine would grow commensurately. It would be required to be more frequently invoked upon present day considerations when such situations arise oftener enjoining courts to use their discretion to do complete justice upon equitable consideration

Again, these remarks were not required on the facts; the decision could have rested simply on the documentary evidence between the parties and by coming to a conclusion that there was a fraud involved. (Whether the fact were sufficient to reach a finding of fraud or not is a separate issue: the Courts observations go much beyond that; indicating that lifting the veil even in the absence of such a finding may be justified.) These assertions of the Court are, with great respect, unwarranted.

The suggestion that more complex commercial arrangements require greater latitude in lifting the veil even in the absence of fraud does not appear justified. These decisions again serve to illustrate that the approach to the issue in India and England has grown to be completely disparate. Sanctity of the Corporate Form Few issues have proved to be more controversial than the strength of the principle that the company is a separate legal entity. The exceptions to the principle commonly referred to as lifting or piercing the corporate veil are both statutory and judgemade. The statutory exceptions are, in the main, not controversial. However, while there is agreement that courts are entitled to lift the corporate veil under certain circumstances, it has proved difficult to define what these circumstances are. The

13 modern economy makes this task even more onerous, with the rise of group entities, the ubiquitous investment company and so on. In DHN Food Distributors v. Tower Hamlet, Lord Denning MR preferred to ignore the separate legal entities of various companies within a group, and to look instead at the economic entity of the whole group. These observations were doubted in Woolfson v. Strathclyde. In the famous judgment in Adams v. Cape Industries, the Court of Appeal effectively rejected the approach in DHN, and reiterated the importance of the corporate form. In particular, the Court regarded only agency and fraud as proper exceptions to the corporate veil, and held that there is no presumption that the existence of a single economic unit is a reason to ignore the corporate form. This was reiterated by the Court of Appeal in 2008, these controversies on several occasions. Over the years, this issue arose in a variety of contexts, of which one of the most prominent was whether a controlling shareholder of a company can also be an employee of that company. To some extent, the question had been answered by the Privy Council in the leading case of Lee v. Lee Air Farming12, where the issue was whether Mr. Lee, the controlling shareholder, was also employed as a pilot by the company that he controlled. Since it is settled law that the power to control is an essential ingredient of an employer-employee relationship, it was thus argued that a controlling shareholder, whose contract cannot be terminated without his consent, or duties altered without his consent, is not an employee of the company. The Privy Council nevertheless held that he was an employee, since the principle that a company is a separate legal personality cannot be disregarded. In this connection, a recent judgment of the Court of Appeal in Secretary of State v. Neufeld13, is of enormous significance. The immediate context was employment legislation in the United Kingdom, which provides, under certain circumstances, that an employee of an insolvent company is entitled to recover his unpaid dues from the Government. Quite obviously, the purpose of this legislation was to extend support for

12 13

[1961] AC 12

Howe [2009] EWCA Civ 280 CA

14 employees whose means of livelihood is terminated by the unforeseen insolvency of a company, and not to compensate the shareholders of the company. In this context, the question of whether a controlling shareholder who also had a contract of employment with the company was covered became important. Relying on this reasoning, an Employment Tribunal held that Lees case (above) is not relevant to an employment protection context, and some courts accepted this view, while others differed. In Neufeld, the Court of Appeal has rejected this reasoning and held that a controlling shareholder is entitled to take advantage of the employment legislation and claim compensation from the Government in his capacity as an employee. In a comprehensive and well-reasoned opinion, the Court has reviewed all the authorities on the corporate veil, and extracted the principles applicable to such questions. In brief, the Court held that the economic interest that the controlling shareholder has in the company is irrelevant. The following observations are apposite: There is no reason in principle why someone who is a shareholder and director of a company cannot also be an employee of the company under a contract of employment. There is also no reason in principle why someone whose shareholding in the company gives him control of iteven total control (as in Lee's case)cannot be an employee. In short, a person whose economic interest in a company and its business means that he is in practice properly to be regarded as their owner can also be an employee of the company. It will, in particular, be no answer to his claim to be such an employee to argue that: (i) the extent of his control of the company means that the control condition of a contract of employment cannot be satisfied; or (ii) that the practical control he has over his own destinyincluding that he cannot be dismissed from his employment except with his consenthas the effect in law that he cannot be an employee at all. The Court recognised that an exception to this principle is an instance where the so-called employment contract is a sham contract or not a genuine employment relationship. However, sham is a legal, not economic concept and only requires the Court to

15 determine whether the legal substance of the relationship between the parties is what it purports to be. For example, if A and B enter into an agreement that is called a Licence Agreement, a Court is bound to examine whether the terms of the agreement are characteristic of a license. However, the Court cannot look to whether in economic reality the party acquires something other than the rights of a licensee. In this instance, if the court finds that the contract is neither a sham and is a valid or true contract of employment, the employment legislation will apply. This confirms that recent developments in English law are receding from any dilution of the sanctity of the corporate form, which is significant not just in employment law, but in taxation as well, as the Vodafone dispute illustrates Conclusion The various opinions of judges have not helped to lay concrete grounds on which corporate law can be lifted, because each single case has to be dealt considering its individual merit but not any rigid rules, more than statutory provisions regarding the lifting of the corporate veil the judicial decisions have helped to achieve the goal of incorporation. The courts are not ready to lift the corporate per se. the case laws evolved over the time has brought some efficient tests to test the sanctity of corporate form. And I find only slight differences in lifting of corporate veil in UK and India. Though the grounds for lifting the corporate veil appears diluted in India still the sanctity of incorporation is maintained. I would like to suggest that not only legal sense is taken into consideration but also economic condition of that particular case to be taken into consideration and committees consisting of legal and economic experts shall be appointed when a case of lifting of corporate veil occurs.

16 References Book reference Company law-Avatar Singh Internet Reference http://www.familylawweek.co.uk/site.aspx?i=ed27725 http://www.3vb.com/userfiles/article_JIBFL_on_the_veil.pdf http://legaldevelopments.blogspot.in/2008/10/normal-0-false-false-false.html http://indiacorplaw.blogspot.in http://www.bailii.org/ew/cases/EWHC/Fam/2008/2380.html http://en.wikipedia.org/wiki/Woolfson_v_Strathclyde_Regional_Council http://www.lawteacher.net/company-law/cases/ http://en.wikipedia.org/wiki/DHN_Food_Distributors_Ltd._v._Tower_Hamlets_London_ Borough_Council http://en.wikipedia.org/wiki/Adams_v_Cape_Industries_plc http://en.wikipedia.org/wiki/Piercing_the_corporate_veil http://www.indiankanoon.org/doc/1901448/ http://www.indiankanoon.org/doc/1454766/ http://www.bombayhighcourt.nic.in/data/judgements/2011/OSAPP50511.pdf http://www.bailii.org/cgibin/markup.cgi?doc=/ew/cases/EWCA/Civ/2009/280.html&quer y=neufeld&method=boolean http://legaldevelopments.blogspot.in/2008/10/normal-0-false-false-false.html

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