Getting related-party transactions right

Updated: May 20 2014, 03:10am hrs
The question of transparency in deals with related parties has often been a topic of debate and discussion. The enactment of the Companies Act, 2013 (Cos Act) has sweeping implications on compliance requirements for related party transactions (RPTs). Recently, Sebi also amended certain clauses of the Listing Agreement (LC49) to align the same with the Cos Act. To ensure stricter compliance with the provisions, the Cos Act and LC29 contain provisions for personal liability on directors/officials for loss suffered by the company, imposition of penalty or prosecution and disqualification from acting as director in the case of non-compliance.

The Cos Act requires a Board resolution where a related parties transaction (RPT) has not been entered in the ordinary course of business and/or the transaction is not on an arms length basis. Additionally, an approval of the company through a special resolution by disinterested shareholders is also required where the share capital of the company exceeds R10 crore or the transaction value exceeds the prescribed threshold. To sum up, exemption from Board resolution and special resolution is provided if the RPT is entered in the ordinary course of business and is on an arms length basis

Unlike the Cos Act, LC49 does not exempt RPTs from special resolution based on the aforesaid criteria. The only exemption from special resolution under LC49 is that the transaction does not breach materiality threshold. A listed company needs to consider the two requirements carefully and apply stricter of the two. Considering the impact of the Cos Act and LC49, the approval requirements will operate as discussed here.

To comply with LC49, a listed company needs to get all RPTs approved by the Audit Committee. It also needs to get all material RPTs approved by the special resolution. The exemptions given under the Cos Act will not apply.

For immaterial transactions of listed companies and all RPTs of unlisted entities, approval requirements of the Cos Act apply. It may be noted that due to differences in criteria, even an immaterial RPT (as per LC49) may still need board/ shareholder approval under the Cos Act. For example, this may arise because transaction is not in the ordinary course of business and/or not on arms length basis, and the share capital or transaction value thresholds are breached.

Ordinary course of business

The phrase ordinary course of business is not defined under the Cos Act. It seems that the ordinary course of business will generally cover the usual transactions, customs and practices of a business and of a company. For example, a TV manufacturing company sells TV to its sister concern and to unrelated customers. In this case, it seems clear that the company has entered into the transaction in its ordinary course of business.

Similarly, in certain cases, it may be clear that the transaction is highly unusual and/or extraordinary from the company as well as its business perspective. Such cases may not be in the ordinary course of business.

The above examples are just illustrative and not conclusive. In cases where RPT is not falling under either of the two extremes, the assessment of whether a transaction is in the ordinary course of business is likely to be highly subjective, judgemental and will vary on case-to-case basis.

The Cos Act does not prescribe methodologies and approaches to determine whether a transaction has been entered into on an arms length basis. In the absence of any specific guidance, one may consider methodologies/ approaches under the transfer pricing (TP) guidelines of the Income-Tax Act. However, it may be noted that the objective of the TP guidelines is different from that of the Cos Act. The purpose of the TP guidelines is to ensure that there is no tax leakage. The Cos Act requirements aim to protect shareholders interest. Hence, one may need to factor these differences when referring to the TP guidelines.

The Cos Act provides that no company shall enter into any RPT without undertaking the necessary compliances. Given that the provisions are not effective retrospectively, one can take a view that the same are applicable only to new contracts/ arrangement entered into by a company. Hence, it may be argued that grandfathering may be permitted. However, any modification in the nature and type of existing contract should trigger necessary approval requirements.

For listed companies, the LC49 expressly requires that all existing material related party contracts or arrangements, which are likely to continue beyond March 31, 2015, should be placed for shareholders approval.

While there are several areas which require further clarifications, considering the penal/prosecution consequences, it is absolutely imperative for companies to institutionalise a sustainable framework for identification, assessment, approval and reporting of RPTs.

Avan Badshaw

Jaiman Patel, associate director, Tax & Regulatory Services, EY contributed to the article

The author is Tax Partner, EY. Views are personal