Related party transactions (RPTs) occur between two or more parties which have a pre-existing relationship, such as a parent company and its subsidiaries, or two companies having common directors or significant shareholders to each other either monetarily or non-monetarily. Transactions that occur with related parties may be with respect to purchase or sale of goods or availing or rendering of services or may be with respect to financial transactions such as granting of loans or providing security or subscribing to securities in capital of any related party, or may be with respect to appointment of related party to any office whether as director or otherwise or for underwriting the subscription of shares, etc.
It is a common practice of the companies to do business with their professional or personal connections. These connections can be its shareholders, a subsidiary company, or even a minority-owned company. Various provisions in the law are provided to regulate related party transactions that take place in the company, including but not limited to the Companies Act, 2013 (hereinafter called the “Act”), Securities Exchange Board of India (Listing Obligation and Disclosure Requirement) Regulations 2015 (“SEBI (LODR) Regulations, 2015”) and others.
The company, being a separate legal entity, cannot make its own decisions. All the decisions or transactions of the company are taken by its directors or members, and this creates space for suspicious transactions. Therefore, the law faces a greater challenge in keeping its identity separate and thus the natural persons must be regulated. Hence, it is necessary to understand the legal provisions as well as the procedural compliances of related party transactions.
Laws governing related party transactions:
- Companies Act, 2013 – Section 177 and 188
- SEBI (LODR) Regulations, 2015 – Regulation 23 read with Schedule V
The requirements concerning related party transactions under the Act and SEBI (LODR) Regulations, 2015 may be divided into four key parts:
Who is Related Party ?
What are Related Party Trancactions?
Approval process under the Act
The Act requires that all RPTs must be disclosed in the financial statements of the company, and a resolution must be passed by the board of directors approving the transaction after considering the nature of the transaction, its terms and conditions, and whether the transaction is in the interest of the company.
- Audit Committee :
Section 177 of the Act deals with the establishment of an audit committee, which is responsible for ensuring the proper disclosure of related party transactions in the financial statements of the company. The Audit Committee must be comprised of at least three directors, and at least one of them should be an independent director. The Audit Committee is responsible for approving all RPTs and ensuring that such transactions are at arm’s length and in the best interest of the company. The committee must also provide its approval for all material RPTs, which are those transactions that exceed certain thresholds as prescribed by the law. All RPTs shall require approval or subsequent ratification of audit committee. Subsequent modifications in related party transactions shall also require approval of audit committee.It’s important to note that related party transactions must have the audit committee’s approval; recommendations do not suffice.
Section 177 of Act and Regulations 23 of SEBI (LODR) Regulations, 2015 permits the audit committee to grant omnibus approval on annual basis subject to fulfillment of certain conditions.
- Approval of the board of directors :
Section 188(1) of the Act provides that company cannot enter into following contract or arrangment with its related parties without approval of its board of directors at a meeting:
a) Sale, purchase or supply of any goods or materials
b) Selling or otherwise disposing of, or buying, property of any kind
c) Leasing of property of any kind
d) Availing or rendering of any services
e) Appointment of any agent for purchase or sale of goods, materials, services, or property
f) Related party’s appointment to any office or place of profit in the company, its subsidiary company or associate company, and
g) Underwriting the subscription of any securities or derivatives thereof, of the company
i) In case of transactions with its related parties in ordinary course of business and at arm’s length basis, the approval of board of directors is not required.
ii) Approval of board of directors for related party transactions is required to be taken at a board meeting and cannot be taken through a resolution by circulation.
iii) Any contract or arrangement entered by director or any employee, without approval of board of directors, such approval may be taken within 3 months from date on which such contract or arrangement.
iv) In case any director is interested in any contract or arrangement with related party, such director shall not be present at the meeting during discussion on the subject matter of the resolutions relating to such contact or arrangement.
- Approval of the shareholders:
The following transactions with related party shall require prior approval of shareholders:
a) Sale, purchase or supply of any goods or material, directly or through appointment of agent, amounting to ten per cent or more of the turnover of the company;
b) Selling or otherwise disposing of or buying property of any kind, directly or through appointment of agent, amounting to ten per cent or more of net worth of the company;
c) Leasing of property any kind amounting to ten per cent or more of the turnover of the company;
d) Availing or rendering of any services, directly or through appointment of agent, amounting to ten per cent or more of the turnover of the company;
e) Appointment of related party to any office or place of profit in the company, its subsidiary company or associate company at a monthly remuneration exceeding Rs. 2,50,000/-;
f) Remuneration for underwriting the subscription of any securities or derivatives thereof, of the company exceeding one per cent of the net worth.
i) In case of wholly owned subsidiary, the resolution passed by the holding company shall be sufficient for the purpose of entering into the transaction between the wholly owned subsidiary and the holding company.
ii) Related Party Transactions between two government companies are exempted.
iii) Member, which are interested in any arrangements or contract, shall not be present at the meeting during the discussion on the subject matter of the resolutions relating to such contact or arrangement.
Approval process under SEBI (LODR) Regulations, 2015
The SEBI (LODR) Regulations, 2015 require listed entities to comply with additional disclosure and approval requirements for RPTs. Under the regulations, all RPTs must be approved by the audit committee of the company, and a report on RPTs must be included in the company’s annual report. The report must contain details of all RPTs entered into during the year, the policy on RPTs adopted by the company, the business rationale for entering into the transaction, and the comparative market price of the transaction.
Policy on materiality of related party transactions:
As per Regulation 23 of SEBI (LODR) Regulations, 2015 every listed entity shall formulate a policy on materiality of related party transactions and on dealing with related party transactions including clear threshold limits duly approved by the board of directors and such policy shall be reviewed by the board of directors at least once every three years and updated accordingly.
When will a transaction with a related party be material?
a) A transaction with a related party shall be considered material if the transaction(s) to be entered into individually or taken together with previous transactions during a financial year, exceeds ten per cent of the annual consolidated turnover of the listed entity as per the last audited financial statements of the listed entity.
b) A transaction involving payments made to a related party with respect to brand usage or royalty shall be considered material if the transaction(s) to be entered into individually or taken together with previous transactions during a financial year, exceed five per cent of the annual consolidated turnover of the listed entity as per the last audited financial statements of the listed entity.
- Approval of Audit Committee:
All related party transactions and subsequent material modification shall require prior approval of the audit committee. Provided that only those members of the audit committee, who are independent directors, shall approve related party transactions.
a) The audit committee of a listed entity shall define “material modifications” and disclose it as part of the policy on materiality of related party transactions and on dealing with related party transactions.
b) A related party transaction to which the subsidiary of a listed entity is a party, but the listed entity is not a party, shall require prior approval of the audit committee of the listed entity if the value of such transaction whether entered individually or taken together with previous transactions during a financial year exceeds ten per cent of the annual consolidated turnover, as per the last audited financial statements of the listed entity.
c) With effect from April 1, 2023, a related party transaction to which the subsidiary of a listed entity is a party but the listed entity is not a party, shall require prior approval of the audit committee of the listed entity if the value of such transaction whether entered into individually or taken together with previous transactions during a financial year, exceeds ten per cent of the annual standalone turnover, as per the last audited financial statements of the subsidiary;
Omnibus Approval by Audit Committee:
Audit committee may grant omnibus approval for related party transactions proposed to be entered into by the listed entity subject to the following conditions, namely –
a) repetitiveness of the transactions (in past or in future);
b) the audit committee shall satisfy itself regarding the need for such omnibus approval and that such approval is in the interest of the listed entity;
c) the omnibus approval shall specify:
i. the name of the related party, nature and duration of transaction, maximum number of transactions that can be entered into;
ii. the indicative base price / current contracted price and the formula for variation in the price if any; and
iii. such other conditions as the audit committee may deem fit.
Provided that where the need for related party transaction cannot be foreseen and aforesaid details are not available, audit committee may grant omnibus approval for such transactions subject to their value not exceeding rupees one crore per transaction.
a) the audit committee shall review, at least on a quarterly basis, the details of related party transactions entered into by the listed entity pursuant to each of the omnibus approvals given.
b) Such omnibus approvals shall be valid for a period not exceeding one year and shall require fresh approvals after the expiry of one year.
- Approval of the shareholder:
All material related party transaction and subsequent modifications shall require prior approval of shareholder through resolutions and parties to the transaction shall not vote on such resolutions.
Exemptions from above provisions:
a. transactions entered into between two government companies;
b. transactions entered into between a holding company and its wholly owned subsidiary whose accounts are consolidated with such holding company and placed before the shareholders at the general meeting for approval.
- Who determines that the transaction with related party is ordinary course of business?
The Act does not clearly lay down tests for determining whether a transaction is in the ordinary course of business.
The following factors may be considered when determining whether an activity conducted by the business is part of its “ordinary course of business”:
a) Activity should be covered in the objects clause of the Memorandum of Association.
b) Activity should be covered furtherance of the business.
c) Activity should be either in normal or routine nature of the particular business (i.e. activities like advertising, staff training, etc.)
d) Whether the activity is repetitive/frequent.
e) Whether the transactions are common in the particular industry.
f) Whether there is any historical practice to conduct such activities.
- What criteria should be considered by the audit committee when determining whether a transaction is conducted on an arm’s length basis? How should the audit committee decide such an issue?
The Act does not specify the procedures and methods that may be used to determine whether a transaction was made on an arm’s-length basis.
Explanation to sub-section (1) of Section 188 of the Act defines the term ‘arm’s length transaction’ as a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest.
Arm’s length basis does not mean arm’s length price as price is just one of the components of the terms of dealing with the other party and there are several other matters which need to be considered the transaction as a whole and the entire bundle of the terms and conditions needs to be considered for determining whether the transaction is on an arm’s length basis. One may check if there are comparable products in the market. If yes, check the terms of sale/purchase, etc. of similar transactions and try obtaining quotes from other sources. Price in isolation cannot be the only criteria. Terms of sale such as credit terms should also be considered.
Audit committee may consider the parameters given in the company’s policy on transactions with related parties. Transfer Pricing guidelines given under the Income-tax Act, 1961 may also be used. Depending on the nature of individual transaction, any appropriate method may be used by the audit committee to arrive at a considered decision to determine arm’s length price.
- Will providing corporate guarantee to the bank by the holding company for a loan availed by its subsidiary company attract the provisions of Section 188 of the Act?
The transaction of providing corporate guarantee is covered under Sections 185 and 186 of the Act, which also covers transaction described above. Ordinarily in such cases, Section 188 is not attracted, however requirements of Section 185 and 186 of the Act need to be complied.
- What are the consequences of failure to make disclosure of interest by a director in case of a private company?
MCA Notification dated June 5, 2015 which grants exemptions to private companies’ states that Section 184 (which deals with disclosure of Interest by Directors) will be applicable to a private company except that a director of a private company who is interested in a transaction with a related party will have to make a disclosure regarding the same and thereafter, he shall be entitled to participate as well as vote on the said transaction.
RPTs are an important aspect of corporate governance, and both the Act and the SEBI (LODR) Regulations, 2015 contain provisions to ensure that such transactions are conducted in the interest of the company and its stakeholders. In the business world, good corporate governance, which includes timely compliance, has gained tremendous significance. Stakeholders in any organisation must be protected, and in order to provide them with equal rights and transparency within the organization, various laws govern related-party transactions, which carry the risk of bias. Not only the Act, but SEBI laws, Income tax laws, Goods and services tax laws, accounting standards, Indian accounting standards, and others govern related-party transactions as defined in their respective manners. Companies must comply with the regulations to avoid penalties and maintain transparency with their shareholders. As a result, the materiality of these transactions must always be considered, as it involves the interests of several people.
Author: Arihant Jain, Associate.
Disclaimer: The content of this article is intended to provide a general guide to the subject matter and that the same shall not be treated as legal advice. For any queries, the author can be reached at email@example.com