Directors Borrowing From Their Own Company: What Section 185 of the Companies Act Actually Prohibits

Directors Borrowing From Their Own Company: What Section 185 of the Companies Act Actually Prohibits

Your startup just raised ₹50 lakh. Cash is sitting in the company account. The founder needs personal liquidity — a home loan EMI, a family emergency, a quick bridge before the next salary cycle. So the company "lends" the director ₹10 lakh with a handshake understanding: repay in 90 days, no paperwork needed.

Six months later, the ROC scrutiny notice arrives.

This scenario plays out dozens of times a month across Indian private limited companies. The director is not acting in bad faith — they genuinely believe the company's money is, in some sense, "theirs" to use. What they do not know is that Section 185 of the Companies Act, 2013 imposes a near-absolute prohibition on exactly this kind of transaction. And the penalties — up to ₹25 lakh per violation plus imprisonment — are not theoretical.

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What the Law Actually Requires

Section 185(1) — The Core Prohibition

No company shall, directly or indirectly, advance any loan — including any loan represented by a book debt — or give any guarantee or provide any security in connection with any loan taken by:

• Any director of the company or of its holding company
• Any partner or relative of such a director
• Any firm in which such a director or relative is a partner
• Any private company of which such a director is a director or member

The word "indirectly" is the most dangerous word in this section. Routing money through an intermediary subsidiary, a holding entity, or a relative's personal account does not escape Section 185. The MCA and courts have consistently held that substance governs over form.

Section 185(2) — The Only Permitted Exceptions

The Companies (Amendment) Act, 2017 added a narrow window of permitted transactions — but with strict preconditions:

• Loans to a wholly-owned subsidiary for its principal business activities
• Guarantees or securities for loans made to a subsidiary or associate company by a bank or financial institution

Even within these exceptions, the company must pass a special resolution (approval by shareholders holding at least 75% of the total voting power) before the loan or guarantee is given. A special resolution requires a general meeting or postal ballot — not a board resolution or an email approval chain. Form MGT-14 must be filed with the Registrar of Companies within 30 days of passing the resolution.

The Private Company Exemption — Conditional and Widely Misunderstood

Many founders have been told that private limited companies are exempt from Section 185. This is partially correct but dangerously incomplete.

The MCA notification dated June 5, 2015 exempts private companies from the prohibition in Section 185(1) — but only if all three of the following conditions are satisfied simultaneously:

• No other body corporate has invested in the private company (no company, LLP, or other incorporated entity holds shares)
• The company's borrowings from banks and financial institutions do not exceed twice the paid-up capital or ₹50 crore — whichever is lower
• The company has not defaulted on the repayment of any borrowing from a bank or financial institution

If your startup has received investment from any angel fund, SEBI-registered AIF, NBFC, or any body corporate — even a ₹1 lakh convertible note — the exemption is gone. You are back under the full prohibition of Section 185(1).

MCA21 V3 Cross-Verification: The New Automated Risk

As of the full rollout of MCA21 V3 in 2025, the Ministry of Corporate Affairs actively cross-validates filing data. When your company files AOC-4 (annual financial statements), the system compares loans and advances shown in your balance sheet against:

• Director identification data (DIN profiles, DIR-3 KYC records)
• Shareholding and board composition data from MGT-7 filings
• Historical filings in the same company's registry

If the system detects a balance sheet entry — "advance to directors," "loan to related party," "inter-personal advance" — matching a DIN on the company's board, it automatically flags the filing for manual scrutiny by the Registrar. This can trigger an adjudication proceeding under Section 454 without any complaint being filed.

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Practical Implications: What Actually Happens When This Is Ignored

Penalty Under Section 185(4)

A contravention of Section 185 attracts penalties for both the company and the officers:

These penalties are imposed through formal adjudication proceedings initiated by the Registrar of Companies under Section 454 of the Act. As of 2024–2025, ROC offices in Mumbai, Delhi, Bengaluru, and Chennai have dramatically increased the volume of Section 454 proceedings — partly as an enforcement priority shift, and partly because MCA21 V3 now surfaces potential violations that previously required a whistleblower or audit report.

Director Disqualification Under Section 164

A conviction or adjudication order under Section 185 can constitute grounds for director disqualification under Section 164(2). Once disqualified, the director cannot serve on the board of any Indian company for five years. The disqualification is recorded in MCA21 and is visible to every investor, bank, government department, and counterparty conducting a basic company search.

The Fundraising Impact

Every institutional investor — from angel networks to Series A VCs — conducts a standard MCA compliance check before term sheets are signed. An open adjudication proceeding under Section 185, or even a historical violation visible in the company's filings, is a material red flag. In competitive fundraising rounds, it can result in lower valuation, escrow holdbacks, or outright rejection.

The GST Dimension You Were Not Expecting

If the director loan is interest-free — as the vast majority of startup director loans are — the GST department can treat the foregone interest as a supply of service and raise a demand for GST on the notional interest. Under the GST Act, loans between related parties at below-market rates are subject to open-market valuation. GST authorities have issued demand notices on exactly this basis in multiple states. The Section 185 Companies Act violation and the GST demand can arrive simultaneously from two different departments.

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Step-by-Step: What to Do

If You Have Not Yet Advanced the Loan

Step 1: Verify your exemption eligibility. Review your complete cap table. If any body corporate has invested, you are not exempt. Check your borrowing levels against the threshold (twice paid-up capital or ₹50 crore). Confirm there are no bank or NBFC defaults.

Step 2: Consider director remuneration instead. Under Section 197 and Schedule V of the Companies Act, you can pay a director a salary, performance bonus, or commission. This is taxable in the director's hands but entirely clean from a Companies Act perspective. For private companies without public shareholders, Schedule V caps are more flexible.

Step 3: If a subsidiary loan is genuinely needed, convene a general meeting, pass a special resolution with at least 75% shareholder approval, document the purpose and interest rate, and file Form MGT-14 on MCA21 V3 within 30 days. The filing fee for MGT-14 starts at ₹300 and scales with authorised capital.

Step 4: Maintain a formal loan agreement. Even if the transaction is legally permitted, a written loan agreement — stating amount, purpose, interest rate, and repayment schedule — is essential for any future audit or investor due diligence.

If You Have Already Advanced the Loan

Step 5: Recall the loan immediately. Direct the director to repay the full outstanding amount, backed by a board resolution noting the recall and supported by bank transfer records.

Step 6: Audit your AOC-4 filings. If the loan appeared in the balance sheet for any financial year already filed, check how it is labelled. "Loans to directors" is an explicit MCA21 V3 scrutiny trigger. Even "sundry debtors" or "other advances" can attract scrutiny if the amount corresponds to a director's DIN.

Step 7: Use CCFS-2026 if you have pending ROC filings. The Ministry of Corporate Affairs' Companies Compliance Facilitation Scheme, 2026 (General Circular No. 01/2026) runs from April 15 to July 15, 2026. Under this scheme, companies can regularize pending AOC-4, MGT-7, and other e-form filings at just 10% of the applicable additional late fees — a 90% waiver. This window closes permanently on July 15, 2026 — approximately 34 days from today.

Step 8: Respond promptly to any Section 454 notice. Under Section 454(4), a person against whom an adjudication order is proposed must be given an opportunity to be heard. In many cases, if the violation is rectified before the adjudication order is passed, or within 30 days of the initial notice, penalty immunity can apply under the specific provisos to Section 454(3). Engage a practicing Company Secretary or corporate law advocate immediately upon receiving any notice.

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FAQ

Q: Our company has no institutional investors. Can we give a loan to the director under the private company exemption?

Potentially yes — if you satisfy all three conditions of the June 5, 2015 MCA notification (no body corporate investor, borrowings within the prescribed threshold, no default on existing borrowings). This is not a blanket exemption; it must be verified at the time of the loan, not just at incorporation. Even if you qualify, document the loan properly.

Q: What if the loan is just a salary advance to be deducted next month?

Salary advances to director-employees are generally not covered by Section 185, which targets loans, guarantees, and securities specifically. However, you must clearly document it as a salary advance — with a written request from the employee, HR records, and a payroll deduction plan. If it is recorded as "loan to director" in the accounts, it will be scrutinised as a Section 185 transaction.

Q: The loan was given two years ago and has been fully repaid. Are we still at risk?

The loan being repaid removes it from the balance sheet, which materially reduces exposure. However, if the contravention appeared in an AOC-4 filing for any year, it is on record with the ROC. MCA21 V3 retains historical filing data in a searchable format. If no adjudication notice has arrived since repayment, your risk is lower — but a formal CS review is advisable before your next fundraise.

Q: Our company gave a personal guarantee for the director's home loan. Does Section 185 apply?

Yes. Section 185(1) explicitly covers guarantees and securities provided "in connection with any loan taken by" a director. A company-issued guarantee enabling a director to obtain a personal home loan is a direct violation of Section 185(1). This applies even if the company qualifies for the general private company exemption, because a personal guarantee for a director's personal borrowing does not fall within any permitted exception under Section 185(2).

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Do Not Let a Routine Transaction Become a Criminal Proceeding

Section 185 violations are among the most common corporate governance errors in Indian startups — and also among the most expensive to resolve after the fact. The fine, the adjudication proceeding, the director disqualification risk, the investor due diligence flag, and the potential GST demand can collectively cost far more than the liquidity the loan was meant to provide.

If your company has advanced any amount to a director, guaranteed a director's personal borrowing, or provided security for a director's loan — even informally — get a compliance audit done before your next ROC filing.

For a compliance audit of your company, visit pvtltd.co

Frequently Asked Questions

Is the director loan trap under Section 185 the same as deemed dividend under the IT Act?

No, they are distinct. Section 185 of the Companies Act, 2013 regulates whether a company can legally make a loan to its director — violation is a criminal offence with imprisonment and fines. Deemed dividend under Section 2(22)(e) of the Income Tax Act is a tax consequence — if a closely held company lends to a shareholder with 10%+ voting power, the loan is taxable as dividend to the extent of accumulated profits. A single director loan can trigger both provisions simultaneously.

What are the exceptions to the Section 185 prohibition for private companies?

The Companies (Amendment) Act, 2017 introduced Section 185(2), which allows private companies to give loans to directors if: (a) a special resolution is passed, (b) the loan is utilised by the borrowing director for their principal business, and (c) the interest rate is not below the prevailing Government Security yield matching the loan tenor. The company must also not be in default on any existing loan repayment.

Can a company give a loan to a director's relative?

Section 185 prohibits loans to "any person in whom the director is interested." Under Explanation (a), this includes relatives as defined in Section 2(77) — spouse, father, mother, son, daughter, son's wife, and daughter's husband. A loan to any of these persons requires the same special resolution and conditions as a loan directly to the director.

What happens if a director loan is outstanding when the company faces insolvency?

Under the Insolvency and Bankruptcy Code, 2016, the resolution professional or liquidator can challenge director loans as preferential transactions (Section 43) or undervalued transactions (Section 45) if made within the lookback period (2 years for related parties). The director may be required to repay the loan to the company's estate, and personal liability under Section 66 (fraudulent or wrongful trading) may also apply.

Is interest-free loan to a director taxable?

Yes. Under Section 2(22)(e), the loan amount itself (not interest) is treated as deemed dividend. Additionally, if a loan is given interest-free or at a concessional rate, the interest saved can be treated as a perquisite under Section 17(2) if the director is also an employee. For Section 185 compliance, the loan must carry interest at least equal to the prevailing Government Security yield — an interest-free loan violates this condition.

I'm CA Harun Raaj, Visakhapatnam. If any of this affects you or your business, reach out — I'd be glad to help.