Will related-party transaction norms work

Updated: Apr 4 2014, 08:32am hrs
The Companies Act, 2013, in line with the theme of raising the bar on governance, places a lot of emphasis on investor protection and on related-party transactions. This is in line with Sebis focus on curbing abusive related-party transactions. Accordingly, both the Companies Act and the recent decision of Sebi to amend the listing agreement bring in certain onerous requirements and some newer conditions for companies to comply with as they undertake related-party transactions together with disclosures to enable more transparency. The previous requirement for central government approvals have been done away with and instead a self-regulatory mechanism has been introduced.

Under the Companies Act, all related-party transactions, whether covered under Clause 188 of the Act or not, are mandatorily required to be pre-approved by the audit committee; this is a baseline approval requirement. Further, Clause 188 of the Companies Act, 2013, along with the relevant rules, which has come into effect from April 1, 2014, requires the Board and the minority shareholders pre-approval for all related-party transactions that are not in the ordinary course of business or not at arms length, where companies either have paid share capital in excess of R10 crore or where the transactions meet certain monetary thresholds.

The Sebi requirements go a little further and require all material related-party transactions, even if they are at arms length, to be subject to a minority shareholder approval.

These provisions put the onus on the Board to justify the related-party transactions and hence management needs to provide basis of pricing and other commercial terms, as well as factors considered in determining the price and other aspects considered irrelevant by them. This will compel management to maintain details and rationale in relation to determining the pricing and other terms of every transaction in order to demonstrate whether prices are at arms length. In addition, the Board will now have to report every contract or arrangement with related party along with the justification of entering into the contract.

The corporate affairs ministry took into account the comments on the draft rules and made changes to the final rules on the definition of relatives and on related-party transactions. Key changes to the final rules include:

l Related-party definition rationalised. Directors and key managerial personnel of subsidiary and associate companies are not included any more. Further, senior management personnel (such as functional heads) are no longer part of the related parties definition under the final rules.

l Relatives have been redefined and now include only eight relationships instead of the 15 which was earlier envisaged in the draft rules. Third generation of relativesgrandparents and grandchildrenhave been excluded from list of relatives.

l Limits for obtaining shareholder approval have also been enhanced from those in the draft rules.

The 2013 Act prohibits members who are related parties to vote on contracts or arrangement in which they are interested. The difficulty in the case of transactions between wholly-owned subsidiary and holding company is that all members would be related party and hence if the wholly-owned subsidiary intends to enter into a contract or arrangement with the holding company, there will be no members left to vote on the special resolution.

In order to give relief to the aforementioned transactions, the rules specify that the special resolution passed by the holding company shall be sufficient for the purpose of entering into the transactions between wholly-owned and holding company.

While it is a relief to the corporates, the question that remains unanswered is who is to vote for transactions with fellow subsidiaries or with joint venture companies where all the shareholders will be precluded from voting.

While rationalising the various requirements, the 2013 Act also added stringent penal provisions. Penal provisions include if the director enters into a contract or arrangement that is not pre-approved or ratified by the Board and shareholders within the specified time is voidable at the option of the Board including recovery of any loss sustained as a result of such contract or arrangement. Punishment envisaged is imprisonment up to one year and penalty of up to R5 lakh.

The change brought about by the 2013 Act is welcome and should enhance the transparency in reporting of related-party transactions. While certain onerous requirements of tracking of all relationships has been put in, companies should start in the right earnest by establishing processes to ensure compliance.

Sai Venkateshwaran

The author is partner & head, Accounting Advisory Services, KPMG in India. Views are personal

Transfer pricing is one of the most controversial areas in international tax. Opinions differ and the computation of arms length price varies from person to person, thus making transfer pricing a contentious issue.

The Income-tax Act has very elaborate regulations for adherence to arms length price for protecting the tax base of the country through monitoring international as well domestic transactions. The Customs Law stipulates some level of arms length standard to meet. Therefore, there are regulatory checks and balances in place to ensure an arms length standard in related-party transactions.

The Companies Act, 2013, has also ventured into this area of arms length price in respect of related-party transactions. Clause 188 has mandated that related-party transactions need to meet an arms length basis. If these transactions do not meet the arms length standard, the Board of Directors need to pass a special resolution providing consent to such specified transactions with related parties, which further requires a pre-approval from the shareholders.

In case a transaction is determined to be not-at-arms-length, certain penal consequences arise if the pre-approvals of the shareholders and the Board are not obtained (depending on the size of the organisation and the size of the transaction). In respect of a non-listed company, financial penalties arise; however, in case of a listed company, the directors may be subject to prosecution as well. Also, since there is a risk of prosecution, listed companies need to pay special attention to determine arms length price of related-party transactions.

But who decides if the transaction is at arms length basis

Section 92 of the Income-tax Act provides the rules on how the arms length principle is to be applied and the level of documentation that needs to be maintained. In the absence of such guidance in Clause 188, companies need to rely on an analogous application of the arms length principle and adopt the methodology prescribed under the tax law. This would definitely lead to onerous reporting requirement for a company. Imagine a situation where the company has been dealing with its related parties for the last 10 years and reporting such transactions under the provisions of the tax law (Section 92). If the same transaction continues, the company may have to undertake compliance under Clause 188 of the Companies Act, apart from the compliance under the Income-tax Act. If a transfer pricing officer, under the income tax rules, determines a transaction to be non-compliant with arms length standard, would that automatically trigger a conclusion under Clause 188 that the transaction of the Company is not at arms length, thereby resulting in applicable penal consequences Would the company law provisions of penalties and prosecution be invoked only upon conclusion of the appeals under income tax or would a transfer pricing officers order trigger such a consequence

Given the uncertainty and the risk of prosecution, it may be imperative for a public company to take pre-approvals from the shareholders and the Board of Directors, for all specified transactions with related parties, even if the company believes that it meets the arms length threshold.

And this process may insulate the directors from penal consequences. However, that would result in a burdensome and onerous reporting and approval requirement.

However, would a tax base erosion criterion apply

The company law does not specify any base erosion criterion and, therefore, transactions that are not at arms length but are favourable from an Indian tax perspective (resulting in higher incidence of tax in India) while acceptable under the income tax transfer pricing rules may not be under the Companies Act. For example, transaction of an Indian-listed company obtaining free-of-cost services from a foreign affiliate is likely to be acceptable from an income tax perspective but is non-arms length according to the Companies Act. Would compliance need to be done in respect of such transactions and would penalties and prosecutions apply in case of non-compliance under the Companies Act (in respect of such transactions)

Given the onerous responsibility of arms length standard, the potential risk of prosecution and the duplication of efforts under various laws, the compliance burden of the Indian companies would increase substantially. Such compliance is duplicative in nature and the government should do away with such onerous compliance requirements for Indian companies.

Vijay Iyer

The author is partner & national leader, Transfer Pricing, EY.

Views are personal