The New Indian Corporate Legislation With Respect To Related Party Transactions
By Ms. Pallavi Dinodia
Posted: 1st May 2014 08:45
India is a country in which more than 80 per cent of businesses are family owned, run or managed. These family enterprises are often characterised by concentrated ownership and widespread use of a maze of entities performing an array of activities.
The Indian Corporate Law (Companies Act, 2013) along with disclosures of related parties (as per AS-18) and the Chapter X provisions of the Income Tax Act have laid down a comprehensive framework for reporting of transactions with related parties (including specified persons, eligible businesses etc.) and their impact in the financial statements together with the need for the determination of their arm’s length price. This is important since transactions between related parties may have some degree of flexibility in setting prices by virtue of control or exercise of significant influence over the other party.
In India in view of the changing regulatory landscape it is imperative to tie the knot between the corporate and the taxation laws and to lay down standard procedures for determination of arm length price of transactions with the related parties to be followed by conglomerates.
The Companies Act, 2013 under Section 188 requires that except with the consent of Board of Directors and in some cases by way of a special resolution subject to certain conditions, no company shall enter into certain transactions with its related parties. There is an exception provided to the above, which states that for transactions in the ordinary course of business of the Company and they being transacted on arm’s length price the consent of the Board of Directors or a special resolution is not needed.
The Securities Exchange Board of India that governs listed entities has amended the Clause 49 of Listing agreement and added a new class of related parties to the definition to include close family members, fellow group entities, joint ventures of same third party and combinations thereof, which enhances the definition in accounting standard or the Companies Act. It has also made it mandatory for companies to seek requires shareholders’ approval for all material related party transaction with no exception for transactions in ordinary course of business or at arm’s-length.
Further, in the case of listed companies section 177 of the Companies Act, 2013 has extended the scope of the audit committee and made it mandatory to approve the transaction with related parties, if not covered by Clause 49 of the Listing agreement.
Section 188 also requires that where any director is interested in any contract or arrangement with a related party, then such director shall not be present at the meeting during discussions on the subject matter of the resolution relating to such contract or arrangement. Therefore, in cases where board resolutions or special resolutions are required they would need to be passed by the majority of the minority.
The other related sections are; Section 184 which governs disclosure of interest by directors in any company or companies or body corporate, firms, or other association of individuals. The directors need to disclose whether directly or indirectly they are concerned or interested in a contract arrangement or proposed contract or arrangement entered into or to be entered into, with a body corporate in which such director or such director in association with other director holds more than 2 per cent of the shareholding of the body corporate or as a promoter or manager or CEO of that body corporate or with a firm or other entity in which such director is a partner/owner or member as the case may be.
Section 185 aims to restrict loans to directors or to any person in whom a director interested or gives any guarantee to provide any security in connection with any loan taken by him or such other person.
The exception to this clause is only in the case of Managing Director or whole-time director wherein extending loans as part of conditions of service and is applicable to all employees or is approved by a scheme in special resolution.
Section 186 of the Act limits the scope of a company from giving loans or guarantees to body corporate of persons exceeding 60 per cent of its paid-up share capital or reserves and securities premiums or hundred percent of its pre-reserves and securities premiums and whichever is more. If the additional limits are exceeded, then a Special Resolution is required at a general meeting.
Section 189 of the Act requires that every company shall keep a register giving the details of all contracts or arrangements in which directors are interested and of related parties in prescribed Performa. Such register is required to be placed before the next board meeting and signed by directors present at the meeting. Section lays down maintenance and visibility details of such of the register.
Therefore in a nutshell, Section 184 read with Section 188 seeks to exercise such limits on transactions which may ordinarily have flexibility owning to the nature of relationship between the parties entering into such contracts or arrangements.
Section 185 and 186 aim to prohibit loans to directors and other body corporate which may be prejudicial to a company and creates safeguarding in case of such transactions are entered into.
The exception to Sec 188 requires, under the new corporate regime, the arm’s length price of the transactions be determined (which has been defined as a transaction between two related parties i.e. conducted as if they are unrelated) so that there is no conflict of interest. What would be in the ordinary course of business has not been defined and leaves much of it grey.
The Indian Income Tax Act has a robust regime which has detailed provisions and rules for the determination of the arm’s length price of related party transactions under Chapter X which was introduced in 2002. It may be effective for the regulatory authorities, to use these rules with regard to the methods etc. for determination of the arm’s length price, to help companies avoid duplication of compliances under different laws.
The guidelines under the law and under the reporting standards are being tied in India as it is being done across the world to ensure that related party transactions (controlled transactions) are conducted with fairness. It is to ensure that the relationship between parties does not have an effect on the financial position and operating results of the reporting enterprise, for its benefit or for the benefit of its related parties.
Globally, as the world trade increases and entities transact businesses in multiple jurisdictions, India is not alone in evolving its laws governing related party transactions every jurisdiction has over a period developed its own mechanism to minimise the misuse of Related Party Transactions (RPTs), though there is wide variability in their approaches. The right balance is difficult but as economies change the ongoing process of evolving the law will help institutions to adopt the best practices and make a corporate governance framework effective globally.
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Whilst every effort has been taken to ensure that the contents are factually correct at the time of printing, rules, regulations and tax laws do change. Readers are advised to seek professional advice before making any decision based on the information contained herein.