In layman’s language, a Related Party Transaction is nothing but businesses carried out among the relatives of different companies. On the other hand, legally speaking, there are many financial and commercial legal instruments which define and provide for such transactions.
Section 188 of the Companies Act, 2013 does not disallow or prohibit Related Party Transactions (for brevity, RPTs) but in fact, lays down how the contracts or arrangements involving related parties should be made keeping in mind the interests of the company, investors and other tax compliances. It is to be noted that the definitions of related parties have been given in not just The Companies Act, 2013 but also in Indian Accounting Standards-18 which is a tax compliance rule. Additionally, under the S. 41 of the Income Tax Act, 1961, while considering the taxable status of transactions, the following have been regarded as related parties:
assessee is an individual – any relative of the assessee; (ii) assessee is a company, firm, association of persons or HUF – any director of the company, partner of the firm, or member of the association or family, or any relative of such director, partner or member; (iii) any individual who has a substantial interest in the business or profession of the assessee, or any relative of such individual; (iv) a company, firm, association of persons or Hindu undivided family having a substantial interest in the business or profession of the assessee or any director, partner or member of such company, firm, association or family, or any relative of such director, partner or member; (v) a company, firm, association of persons or Hindu undivided family of which a director, partner or member, as the case may be, has a substantial interest in the business or profession of the assessee; or any director, partner or member of such company, firm, association or family or any relative of such director, partner or member; (vi) any person who carries on a business or profession, (A) where the assessee being an individual, or any relative of such assessee, has a substantial interest in the business or profession of that person; or (B) where the assessee being a company, firm, association of persons or Hindu undivided family, or any director of such company, partner of such firm or member of the association or family, or any relative of such director, partner or member, has a substantial interest in the business or profession of that person.
Therefore, it is always better to go through the section in the company’s annual report which details related party disclosures to get a fair idea of the operative mechanism of the company.Globally speaking, in countries like South Korea, RPTs act as a tool to transfer wealth from one generationof controllers to the next in avoidance of inheritance taxes. In business adverse jurisdictions with stringent tax system, RPTs is a way of accruing private benefits.
Impact of RPTs
The RPTs have a tendency to adversely affect the financial health of the corporates by the undesired influence or control or joint control on the policies of the administration and operation of companies. The corporate wealth can be misappropriated by reducing the profits to the outside investors and shareholders. Tax evasion is also accompanied with such actions by managers of the company-. The best corporate governance practices are thus challenged owing to poor monitoring and disclosure policies of the companies in case of RPTs. Recent corporate scandals have heightened the concern to understand the phenomenon. Accounting frauds in Enron, Tyco, Parmalat, and Satyam are glaring examples of the same. There has always been an incessant effort made to highlight the significance of transactions done based on arm length principle (usually, the parties to the transactions act independently without showing any personal interest in the business).
Let’s look at the laws in place
RPTs under Indian Accounting Standards
Under AS 18, related party includes:
Enterprises, directly or indirectly, controlled by one or more other enterprises;
Associates or Joint Ventures of an enterprise;
Individuals who own interest in the voting power of an enterprise and are in a position tosignificantly influence the enterprise;
Key Management Personnel and their relatives;
Enterprises which share common directors.Now comes the analysis part, if we compare the two definitions, we will come to know that AS 18 is wider in purview than the Companies Act. The Companies Act requires approval only when a director and his/her relatives are involved in the transactions. However, even if substantial interest is involved if the key management personnel (i.e -a director), is not involved in any transaction, the approvals are not required-. In this way, AS-18 takes a lead because it requires the approval from all key management personnel transacting with related parties.
Presence of parent or controlling company is to be revealed in the financial statements irrespective of the transaction between the two. However, before the Ministry of Corporate Affairs gave a clarification through a circular issued in 2014, to exclude mergers and acquisitions transactions from the purview of related party transactions (RPT) provision in the new company law. Prior to this, there were much speculations u/s 188 since the provision was not clear.
Under both CLA, 2013 and SEBI Code, approval of the shareholders through special resolution needs to be obtained in addition to the requirement that the related parties must abstain from voting on such resolutions. But, the problem with this might be the rising of doubts in the minds of minority shareholders who have every right to disapprove a non-abusive RPT without wholly examining the proposed transactions. Not only this, it is highly imperative on the part of independent directors on the board to effectively monitor and identify the RPTs. Until these things materialize, Indian capital markets will continue to suffer.
Further, Auditing and Assurance Standard 23 Related Parties impose duty on auditor to identify and disclose the related party transaction in the financial statements of the company. This is in correspondence to the roles of auditors in a company.
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