Is arm’s length price way out for big firms caught in the governance net?

October 9, 2019 4:29 PM

Recently, large corporates like Indigo, IL&FS, Crompton Greaves, Raymonds and Bhushan Power & Steel garnered undesired media attention for allegedly engaging in unsubstantiated related party transactions (RPTs).

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By Gaurav Jain, Priya Bhutani, Sana Siddiqui

Recently, large corporates like Indigo, IL&FS, Crompton Greaves, Raymonds and Bhushan Power & Steel garnered undesired media attention for allegedly engaging in unsubstantiated related party transactions (RPTs). Instances where a feud between promoters prompted attention of the Securities Exchange Board of India (SEBI) or a resentful managing director blowing the whistle against the board have been doing the rounds in the morning newspapers.

Much hype has been created around the RPTs and though a few companies have been successful in salvaging the situation, one cannot ignore the impairment of the brand associated with these companies even if such damage was short lived. As a combat step, corporates have come up with strategies like increasing the number of board members to accommodate independent directors, imposing a threshold over RPT which requires mandatory external consultancy, following a bidding process, etc.

The RPTs have become an integral part of the way conglomerates operate in today’s integrated global economies wherein such transactions rationally fulfill economic demands of a company, for example, by providing access to in-depth skills, finance, centralized services and common cost sharing. On the downside, these transactions may also be used as conduits for tainted businesses as RPTs by their very nature carry the potential of conflict of interest which, if unregulated, could prove to be toxic.

Current RPT disclosure requirements

Disclosure requirements with respect to RPTs have been part of the Indian regulatory framework for quite some time. Indian accounting standards (Ind AS), which are converged standards for International Financial Reporting Standards (IFRS) mandate reporting of RPTs including details of related parties such as subsidiaries, associates and joint ventures.

SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 specifies a range of disclosure requirements for listed companies when they enter into RPTs, with the most recent addition being furnishing of disclosures of RPT on a consolidated basis within 30 days of publication of consolidated and standalone half-yearly financial results. The above regulations act as a check-point when business conglomerates enter into RPTs. However, mere disclosure of RPTs does not guarantee that the same are legitimate. Instead, they only act as a starting point for further investigation.

Arm’s Length Testing Requirements

While Ind AS and SEBI require only disclosure requirements, the Companies Act, 2013 mandates not only disclosure but also pricing of the RPTs to conform with the arm’s length standard. Section 188 of The Companies Act, 2013 lays down that RPTs require the consent of the board of directors via an ordinary resolution. The arm’s length analysis as per Companies Act, 2013 means the transaction between related parties should be conducted as if they are unrelated without any conflict of interest.

The Income Tax Act, 1961 (the Act) introduced transfer pricing provisions way back in the year 2001 to govern the RPTs and regulating them to meet arm’s length test. However, the provisions as introduced originally covered only RPTs entered into with non-resident associated enterprises.

In 2012, the Act expanded the scope to cover domestic transactions as well. However, the Modi government with an intent to reduce compliance burden on taxpayers limited the domestic transfer pricing provisions to a few situations only. It is no secret that RPTs, their related tax avoidance and transfer pricing regulations are always at the center stage of, both local and international transactions. Due to increased awareness, countries across the globe have introduced harmonized and digitized mechanisms to combat tax avoidance. With classified information being freely available to governments via automatic exchange agreements and increased surveillance, MNCs are under increased pressure to maintain consistency and transparency in their dealings with related parties vis-à-vis unrelated parties.

Though, cross border transactions are under continuous monitoring, there are countries which have domestic transfer pricing provisions in place either for specific transactions or businesses. Such countries include Singapore, Malaysia, Russia, Denmark, Spain and Turkey, which have given weight to address tax avoidance exposures domestically as well.

RPTs in the Indian business landscape

Large corporates are fueled by various stakeholder interests including investors, lenders, creditors and employees. The stakeholders are sideline observers who do not participate in the day-to-day functioning of the company. Hence, in a country like India where most of the business houses are primarily promoter-led and consist of family business structures, domestic RPTs assume more significance. RPTs undertaken by Indian companies which are subject to more or less the same tax rates (ie. domestic transactions) may not be relevant today from a tax point of view.

However, undeniably they are still important from the view point of stakeholders. Furthermore, such RPTs are being viewed by the Indian tax department as means of round-tripping black money and has also caught the interest of other regulatory bodies like Reserve Bank of India, SEBI, etc. It is expected that in future RPTs entered into by Indian businesses will be monitored very closely for any possible slip-ups.

Only time will tell, whether the predicament surrounding the recent cases will result in legal or penal actions. However, the impact of these allegations could almost be seen immediately on the market price of the shares which went spiraling downwards after the news of suspicious RPTs was captured by the media. Distrust around a company only results in tarnishing of the company’s image and unless the problem is rooted out at an early stage, it may result in far-reaching dire consequences.

What is required to curb this emerging issue is cogent steps from both regulatory bodies as well as stakeholders. The regulators can evaluate a framework to scrutinize only certain transactions selected on the basis of qualitative parameters which could be criticality of a given RPT and/or put in place quantitative thresholds for regulating RPTs. The stakeholders can device ex-ante policies for proposed RPTs which mandates testing arm’s length basis of every RPT they decide to enter into, irrespective of approval being sought by the Board of Directors/Audit Committee.

However, the importance of audit committees’ oversight cannot be undermined as they act as an effective check towards truth and fairness of the financial statements. To illustrate, in a relatively recent case of Crompton Greaves Power and Industrial Solutions Ltd, the cascading effect of the audit committee’s vigilance was observed wherein the committee was unconvinced with the backup documents or evidences maintained for RPTs, resulting in resignation of the auditor mid way. This led to fall in the company’s net worth, further probe into the assets and liabilities, summoning of key stakeholders by the Ministry of Corporate Affairs for further questioning and finally resulting in discharge of company’s chairman.

In today’s world where public opinion comes thick and fast, organisations can no longer stop at just getting their related party disclosures right, they should proactively take up arm’s length analysis for RPTs to avoid potential scrutiny and even defamation. Having appropriate internal controls in place, especially with respect to RPTs will go a long way in protecting stakeholder interest and upholding the company’s respectability.

(CA Gaurav Jain is Transfer Pricing Expert. Priya Bhutani and Sana Siddiqui have provided inputs. The views expressed are the authors’ own.)

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