Introduction
Understanding related party transactions
Arm's length transactions and ordinary course of business
Exemptions
Comment
Section 2(76) of the Companies Act 2013, provides that a related party of a company is defined as either:
- a director or key managerial personnel and their relative;(1)
- a firm, in which a director, manager or their relative is a partner;
- a private company in which a director or manager or their relative is a member or director;
- a public company in which a director or manager hold, along with their relatives, more than 2% of its paid-up share capital;
- any corporate entity whose board of directors, managing director or manager acts in accordance with the advice, directions or instructions of a director or manager except the advice, directions or instructions given in a professional capacity;
- any person on whose advice, directions or instructions a director or manager is accustomed to act, except that which is given in a professional capacity;
- any corporate entity which is:
- a holding, subsidiary or an associate company of such company;
- a subsidiary of a holding company to which it is also a subsidiary; or
- an investing company or the venturer of the company; or
- a director other than the holding company's independent director or key managerial personnel, or their relative.
Understanding related party transactions
A company typically enters into various transactions with different parties, including related parties. Any contract or arrangement with the related party(ies) falls within the ambit of Section 188 of the act if it relates to, inter alia, the sale, purchase or supply of goods or materials; selling, buying or leasing property of any kind; and availing or rendering any services beyond the ordinary course of business or as an arm's length transaction.
When a company enters into a related party transaction, covered under Section 188 of the act, this requires the consent of the company's board of directors. Also, if such a transaction exceeds the monetary thresholds prescribed under Rule 15(3) of the Companies (Meeting of Board and its Powers) Rules, 2014, approval of the shareholders will also be required by way of an ordinary resolution. Such consent can be obtained prior to, or within three months after, entering into the transaction.
The act also provides that certain companies must obtain prior approval of the audit committee before entering into a related party transaction. The audit committee may make "omnibus approval for related party transactions proposed to be entered into by the company" subject to conditions prescribed under the act.
The related party contracts are to be disclosed in the board of directors' report and a register of such contracts is to be made.
Arm's length transactions and ordinary course of business
The act describes an "arm's length transaction" as a transaction between two related parties that is conducted as if they are unrelated, to avoid conflict of interest. The concept was introduced in the act to ensure that both parties in the transaction act in their own interests and are not subject to any pressure from the other party. In general terms, an arm's length transaction indicates a transaction between two independent parties in which both parties are acting in their own interests. Both buyer and seller are independent, possess equal bargaining power, are not under pressure from the opposing party, and are acting in their own interests to attain the most beneficial deal.
The act uses the term "ordinary course of business" in various places, yet does not offer a definition or explanation. According to the dictionary, the term defines transactions that are a part of regular business activities as per the customs or common practices of the relevant sector/industry.
The following category of transactions, among other things, are exempt:
- those between related parties that align with the ordinary course of business and on an arm's length basis;
- those between a holding company and its wholly owned subsidiary, whose accounts are consolidated with the holding company, and thus do not require shareholders' approval if the transaction(s) exceed the prescribed threshold(s). However, board and audit committee approval is still necessary; and
- related party transactions entered into by a private limited company with its holding company, subsidiary company, fellow subsidiary company or an associate company, for which requisite approval(s) is not applicable.
Identifying the related party and determining the ordinary course of business is still a difficult job for many companies, and the ambiguous process of determining the price of arm's length transactions has increasingly led to corporations using loopholes. The rationale for entering into related party transactions and how to price them has yet to be established.
Several amendments have been made to the act in the eight years since its implementation, but there is still a need for the Ministry of Corporate Affairs (MCA) to specifically amend the related party transaction provisions and produce guidelines or rules that include proper explanations and methods of determining and computing the arm's length transaction price. Any such amendments or guidance from the MCA will not only reduce confusion and compliance costs but will also make a major step towards aligning with the government's "ease of doing business" motto.
For further information on this topic please contact Neetika Ahuja or Jatin Oberoi at Clasis Law by telephone (+91 11 4213 0000) or email ([email protected] or [email protected]). The Clasis Law website can be accessed at www.clasislaw.com.
Endnotes
(1) Under the Companies Act 2013, a "relative" is defined as any of the following:
- a member of a Hindu Undivided Family;
- a husband or wife;
- a father or mother, including step-fathers and step-mothers;
- a son or daughter, including step-sons and step-daughters;
- a son's wife or daughter's husband; or
- a brother or sister, including step-brothers and step-sisters.