Related Party Transactions
It is common to enter into arrangements with individuals and entities within their personal and professional network. Related party transactions are governed by multiple legal and accountancy frameworks – Companies Act, Income Tax Act (for tax purpose) and under Accounting Standards (for accounting purposes). These can potentially be used to distort the impact of income tax laws by shifting income from one taxable party to another, an evil sought to be regulated by the concept of ‘Transfer Pricing under tax laws.
Under the Companies Act, the primary intention behind regulating related party transactions is to prevent directors from deriving personal benefits at the cost of Shareholders.
The Companies Act have several provisions which regulate conflict of interest provisions regulate the conduct of directors at the board or committee meetings.
Who is Included Within the Purview of a Related Party?
Under the applicable law, following person is included within the definition of relatives:
- Members of Hindu Undivided Family;
- Husband and wife;
- Father and mother, including step-parents;
- Son and son’s wife, including Step son;
- Daughter and daughter’s husband;
- Brother and sister, including step.
What are the Types of Related Party Transactions which are Regulated by the Companies Act?
The list of restricted contracts has been expanded by the 2013 Act- earlier, it stipulated contracts for sale, purchase, a supply of any goods, material, and services, for underwriting the subscription of any shares or debentures of the company.
As per the 2013 Act, selling, leasing or otherwise transferring property, appointment of agents for sale, purchase, or supply of goods and services and appointment of the person to an ‘office of profit’ (which is any position where remuneration is received in any capacity other than as a director- receipt of salary, fee, commission, and perquisites qualifies as remuneration for holding an office) in the company or its group companies are covered within the ambit of related party transactions.
The Companies Act specifies which types of transactions between related parties are regulated – the list is wide enough to cover almost any kind of commercial arrangement-
- Sale, purchase, availing or rendering or supply of any goods, material, property or services;
- Appointment of an agent for the purpose of sale of goods, material, services or property;
- Appointment of the related party to any office for profit (if the person is a director, any remuneration received above his remuneration and perks as a director) in the company or its subsidiary or associate company;
- Arrangements for underwriting the subscription of any shares in, or debentures of the company.
Exception: Certain transactions will not be treated as related party transactions:
- Transactions which are undertaken in the ordinary course of business at an “arm’s length” basis, i.e. transactions which were with the related parties but act independently like unrelated parties;
- Transactions which arise out of restricting, merger or acquisitions;
- A transaction entered into between a holding company and its wholly-owned subsidiary whose accounts are consolidated with such holding company and which have been approved by the shareholder in general meeting;
- In case of private companies, transactions between holding company, subsidiary, associates and fellow subsidiary or a company will not be considered as related party transactions.
How to Undertake Related Party Transaction?
Related party transactions are not prohibited- they are merely regulated under the law to ensure that interest of the shareholders is not compromised due to a possibility of the underlying personal interest of a director. Under the 1956 Act, companies with more than INR 1 crore paid-up capital required Central Government approval to enter into related party transactions, but the 2013 Act does not have any such requirement.
Depending on the transaction, the following checks are to be followed:
- Related party transactions require approval through a board resolution- individual directors cannot enter into the transaction. This board resolution also cannot be passed through circulation.
The board of directors has the power to designate an individual director or third party to perform certain functions and bind the company (through a board of resolution or power of attorney).
The director who is interested in a contract with a related party cannot vote or be present at the board meeting called for approving such a transaction. However, this provision is not applicable to private companies.
- Transactions exceeding certain thresholds require prior approval of the shareholders by a resolution- A threshold is applicable not only to a single transaction but all transactions of a similar nature taken together during the financial year. No such member who is a related party to that particular agreement or arrangement of the company shall be allowed to vote on a resolution for approving any arrangement entered by the company.
- However, passing of such resolution is not required in case of transactions entered between a holding company and a wholly-owned subsidiary, whose accounts are consolidated with such holding company and placed before the shareholders at the general meeting of approval.
- In companies which are required to have an Audit Committee, related party transactions or any modifications to them must be approved by audit committee as well.
- As per the 2017 amendment, the Audit Committee can give recommendations to the Board for transactions other than related party transactions mentioned In Section 188 of the Companies Act, when such transactions are not approved by them, the board will need to consider such transactions.
- Another provisions inserted is to Section 177(4)(iv) which states that the transactions involving an amount not exceeding 1 crore can be entered into by a director or officer of the company with the related party without obtaining the prior approval of the Audit Committee. However such transactions should be ratified by the Audit Committee within three months from the date of a transaction. In absence of such ratification, the transactions shall be voidable at the option of the Audit Committee. Also, if such transaction is with a related party of any director or person authorized by a director, the concerned director will immediately indemnify the company against the loss incurred. Criminal consequences are also prescribed for the breach of related party transaction procedures. Under the new Act, all directors or company employee who entered into or authorized a related party transaction can be fined an amount between Rs. 25000 to Rs. 5 lakhs and for listed companies, the [punishment can include up to 1 years’ imprisonment.
- Thus, the Companies Amendment Act 2017 relaxed the pre-approval requirement of the Audit committee for related party transactions under Rs 1 crore.
- Another provision inserted through the recent amendment states that any transaction between a holding company and its wholly-owned subsidiary will not any requires prior approval of the Audit Committee. However, it should be noted that if these require the approval of the board under Section 188 of the Companies Act 2013, then these shall also require an approval of the Audit Committee.
When Should the Audit Committee for Related Party Transactions be Constituted?
Audit Committee is required to be constituted by all listed companies and those unlisted companies which satisfy any of the following conditions:
- Paid-up capital of Rs. 10 crores or more, which does not include premium paid on the shares.
- Turnover of Rs. 100 crore or more;
- Outstanding loans and, borrowings, debentures or deposits of Rs. 50 crore or more.
What is the Compliance Aspect of the Related Party Transactions?
- Every related party transaction must be referred to in the Board’s report to the shareholders along with the justification of entering into such an arrangement.
- All companies must keep a separate register containing details of all related party transactions entered into by it by the value exceeding Rs. 2 lakhs and must be placed before the next meeting of the board and be signed by all the directors. Such register must be kept at the registered office if the company and during the annual general meeting of the company for the inspection by its members. (Form MBP-4)
- Disclosure of interest: Directors must individually disclose their interest, shareholding or ownership, in other entities to the board of Directors in corporate bodies of which the director is a promoter, manager, CEO, shareholder or other entities of which the director is owner, member or partner.
The exception is where the directors of one company taken together have less than 2% of the paid-up capital of another company.
As per the Companies Act 2013, this disclosure must be mandatorily made on annual basis, beginning from the first general meeting of the board from when the director assumes the office. Any periodical changes must be made at the next board meeting. This discloser must be made as per Form MBP-1.
What are the key Changes with Respect to the Related Party Transaction in Companies Act, 2013?
- Central government approval of related party has been done away with;
- “Arm’s length” transaction has been substituted with cash at prevailing market price;
- Related party transaction must be described in the board’s report along with the justification for entering into such arrangement;
- A special provision has been enacted which outlines the consequences of contravention of the requirements of the Companies Act.