Corporate Veil Theory

The separate legal entity of a company is one of its most unique features. In this article, we will look at the famous Corporate Veil Theory and try to understand the scenarios under which lifting or piercing the corporate veil is possible.

What is the Corporate Veil Theory?

The Corporate Veil Theory is a legal concept which separates the identity of the company from its members. Hence, the members are shielded from the liabilities arising out of the company’s actions.

Therefore, if the company incurs debts or contravenes any laws, then the members are not liable for those errors and enjoy corporate insulation. In simpler words, the shareholders are protected from the acts of the company.

This brings us to some important questions:

1. If lifting or piercing the corporate veil possible?
2. If yes, then what are the scenarios and the rules that govern piercing the corporate veil?

Piercing the Corporate Veil means looking beyond the company as a legal person. Or, disregarding the corporate identity and paying regard to humans instead.

In certain cases, the Courts ignore the company and concern themselves directly with the members or managers of the company. This is called piercing the corporate veil. Usually, Courts choose this option when the case involves a question of control rather than ownership.

Piercing the Corporate Veil

Scenarios under which the Courts consider piercing or lifting the corporate veil are as below,

1] To Determine the Character of the Company

There are cases where the Courts need to understand if the company is an enemy or friend. In such cases, the Courts adopt the test of control. The Courts usually avoid piercing the corporate veil, unless the public interest is in jeopardy. However, to ascertain if a company is an enemy company, the Court might choose to do so.

So, how can a company be an enemy? It does not have a mind or consciousness and cannot be a friend or foe, right? However, if the affairs of a company are under the control of people from an enemy country, then the company might be an enemy too. In such cases, the Court may examine the character of the humans who are at the helm of affairs of the company.

2] To Protect Revenue or Tax

In matters concerning evasion or circumvention of taxes, duties, etc., the Court might disregard the corporate entity.

Imagine a company that is used to evade tax. In such cases, piercing the corporate veil allows the Court to understand the real owner of the income of the company and make the said person liable for legitimate taxes.

3] If trying to avoid a Legal Obligation

Sometimes the members of a company can create another company/subsidiary company to avoid certain legal obligations. In such cases, piercing the corporate veil allows the Courts to understand the real transactions.

Imagine a company liable to share 20 percent of its profits with its employees as a bonus. This is a legal obligation. To avoid this, the company opens a wholly owned subsidiary company and transfers its investment holdings to it.

The new company formed has no assets of its own and no business income either. It is completely dependent on the principal company.

By doing so, the principal company reduced the amount of bonus liable to be paid to its employees. The Courts, by piercing the corporate veil, can understand the real intention of the principal company and ensure that it fulfils its legal obligations.

4] Forming Subsidiaries to act as Agents

Sometimes, the basis of the formation of a company is to act as an agent or trustee of its members or of another company. In such cases, the company loses its individuality in favour of its principal. Also, the principal is liable for the acts of such a company.

5] A company formed for fraud or improper conduct or to defeat the law

In cases where a company is formed for some illegal or improper purposes like defeating the law, the Courts might decide to lift or pierce the corporate veil.

Solved Example on Piercing the Corporate Veil

Q: ABC Limited purchases shares of XYX Limited by investing Rs. 20 lakh. The dividend received on these shares reflects in the profit and loss account of the company. Further, the workers of the company receive an annual bonus and the dividend amount is taken into account in calculating the overall bonus figure.

A few years later, ABC Limited transfers the shares of XYZ Limited to LMN Limited, which is a wholly owned subsidiary of ABC Limited. Post transferring of the shares, the dividends do not reflect in the accounts of ABC Limited. This leads to a reduction in the overall bonus amount figure. Is ABC Limited legally allowed to do so?

Answer: In this case, the Court will observe that LMN Limited has no assets of its own, except those transferred to it by ABC Limited. Also, LMN Limited has no business or income of its own except receiving dividends from the said shares.

Hence, ABC Limited has created a subsidiary and transferred the shares to it with the intention of reducing the amount paid to its workers as a bonus. The Court will opt for piercing of corporate veil and conclude that ABC Limited has created LMN Limited with the intention of avoiding its legal obligation. Hence, the Court voids the separate existence of the subsidiary company (LMN Limited).