Related Party Transactions under Companies Act 2013 (Section 188)

Overview

A company enters into various transactions with different parties for is business. Sometimes these transactions are amongst parties who are related to each other since it is more convenient, though these transactions are legal but the parties have to ensure that the transactions are at an arms length to protect the rights of the shareholders.

When these transactions are not made at an arms length basis there are consequences of these transactions that are borne by the shareholders of the Company and in order to avoid these implications, there are certain rules and regulations prescribed by the Regulatory Authority.

Who is a Related Party

According to Section 2(76) of the Companies Act, 2013, Related Party, with reference to a company, means

1. a director or his relative
2. key managerial personnel or his relative
3. a firm, in which a director, manager or his relative is a partner
4. a private company in which a director or manager or his relative is a member or director
5.  a public company in which a director or manager is a director and holds along with his relatives, more than two per cent. of its paid-up share capital
6. any body corporate whose Board of Directors, managing director or manager is accustomed to act in accordance with the advice, directions or instructions of a director or manager
7. any person on whose advice, directions or instructions a director or manager is accustomed to act: Provided that nothing in sub-clauses (vi) and (vii) shall apply to the advice, directions or instructions given in a professional capacity
8. any company which is:
   • a holding, subsidiary or an associate company of such company or
   • a subsidiary of a holding company to which it is also a subsidiary or
   • an investing companies. For the purpose of this definition, the investing company means the body corporate whose investment in the company would result in the company becoming an associate company of the body corporate
   • such other person as may be prescribed.

Related Party Transaction

As per regulation 2(1)(zc) Related party transaction, means a transfer of resources, services or obligations between a listed entity and a related party, regardless of whether a price is charged and a transaction with a related party shall be construed to include a single transaction or a group of transactions in a contract.

Provided that this definition shall not be applicable for the units issued by mutual funds which are listed on a recognized stock exchange(s)

Relative Under Companies Act

According to Section 2(77) of the Companies Act, 2013, the term, relative, with reference to any person, means anyone who is related to another, if

1. they are members of a Hindu Undivided Family
2. they are husband and wife

Or any person is related to the other in such manner as may be prescribed. Rule 4 of Companies (Specification of Definitions Details) Rules, 2014 provides that a person shall be deemed to be the relative of another, if he or she is related to another in the following manner, namely:-

• Father - Father includes step-father.
• Mother - Mother includes the step-mother.
• Son: - Son includes the step-son.
• Sons wife.
• Daughter.
• Daughters husband.
• Brother - Brother includes the step-brother
• Sister -Sister includes the step-sister. 

Arms length transaction:

Arms length transaction means a transaction between two related parties interest. (Explanation to sub-section (1) of Section 188 of the Act)

Wholly Owned Subsidiary Company:

A Wholly Owned Subsidiary Company is an entity of which 100% shares are held by another company. For example, if ABC Pvt. Ltd. owns 100% shares of the XYZ Pvt. Ltd. Then XYZ Pvt. Ltd. becomes a wholly-owned subsidiary of the company of the ABC Pvt. Ltd.

Turnover and Net worth

The turnover or net worth referred in the above sub-rules shall be computed on the basis of the audited financial statement of the preceding financial year

Office/place of profit

• Where such office/place held by a Director and he receives anything over and above the remuneration to which he is entitled as director.
• Where such office/place held by individual other than Director/firm/Pvt. Co/Body Corporate and person holding it receives anything by way of remuneration.

Transactions Covered under Related Party Transactions -Section 188(1)

Following transactions if entered into with Related Party would attract RPT Compliances:-

1. Sale, purchase or supply of goods or materials.
2. Sell, buy or otherwise dispose of property of any kind.
3. Lease Property of any kind.
4. Avail or render any Service.
5. Sell, purchase of goods, materials, services or property through Agent.
6. Appointment of Related Party to office or Place of profit in Company, its Subsidiary or Associate.
7. Underwriting the subscription of any securities or derivatives of Company.

Requirements

• The Act requires disclosure of related party transactions in the Directors Report.
• The Accounting Standards mandate disclosure of the amount of the transactions with related parties.
• According to the provisions of the Act, the following items require shareholders approval:

Approvals Required for Related Party Transactions

a) Audit Committee.

• Either by Meeting,
• Circular Resolution
• Omnibus Approval (Section 177(4)(iv))

b) Board.

• At Board meeting and not circular resolution -Section 188(1)

c) Shareholders.

• At shareholders meeting or postal ballot by ordinary resolution (Section 188(1)1st proviso and Rule 15)
• In case RPT is between Company & its Wholly Owned Subsidiary whose accounts are consolidated and placed at a general meeting for approval then, Shareholders approval shall not be required for entering into such RPT.

Ordinary Resolution is mandatory to be passed:

Restriction at Meetings

Board Meeting

• If a Director is interested in any Contract/Arrangement with a related party he shall not be present at the meeting during discussions on such resolution. (Rule 15(2))
• Moreover if RPT is such that Director is interested as per section 184(2) then he shall neither discuss nor vote and also not be counted for quorum in respect of such transaction. (Section 184(2) read with 174(3))

General Meeting

Related party cannot exercise the voting right on shares held by him/her if RPT is being entered into with such related party. (2nd proviso to Section 188(1))

Related Party Transaction Provisions does not apply to:

1. To a Private Company and IFSC Public Company
2. To a Section 8 (Not for Profit Company) if value of transaction is up to Rs. 1,00,000/- (Rupees One Lakh).
3. To transactions between two Government companies or if the Government companies obtain approval of ministry in charge.
4. Where at least 90% of the number of members are relatives of promoters or are related parties
5. To any transactions entered into by the company in its ordinary course of business other than transactions which are not on arms-length basis.

Disclosures Required For Related Party Transactions

1. Audit Committee

No specific disclosures are mandated under law, but as per section 177(6) the committee shall have full access to information contained in the records of the company and power to obtain professional advice from external sources, therefore adequate disclosure should also be given to the committee so as to ensure fair decision making by it, whether for specific approval or omnibus approval.

2. Board

The following information should be given in the agenda (Rule 15):-

• Name of the related party and nature of the relationship
• Nature, duration of contract/arrangement & its particulars
• Material terms of the contract/arrangement including value, if any
• Any advance paid or received for contract/arrangement
• Manner of determining pricing and other commercial terms

3, Shareholders

The following information should be given in Explanatory statement:-

A. General (Section 102)

• Concern or interest, financial/otherwise of any Director/KMP or their relatives.
• Any other information/fact that may enable members to understand meaning, scope and implication of resolution.
• In case resolution relates to another company then shareholding in that company of every promoter, Director and KMP if it exceeds 2% of paid-up share capital.

B. Specific (Rule 15)

• Name of related party
• Name of Director/KMP who is related, if any
• Nature of relationship
• Nature, material terms, monetary value and particulars of contract/arrangement
• Any information relevant/important to take decision by members

Consequences of Non-Compliance

Ratification:

• If Board/Shareholders approval not taken before entering into RPT, then same can be ratified by Board/ Shareholders within 3 months. If ratification not done then Contract/arrangement voidable at the option of Board.

Indemnification:

• If transaction was with a related party of Director/ authorized by any director then he shall indemnify the company against loss incurred.

Recovery of loss:

• Company may proceed against a Director/ employee who has entered into such contract/arrangement in contravention of section 188 for recovery of loss.

Penalty for Non Compliance

FAQs on Related Party Transaction:

1. Who determines that the transaction with a related party is in the ordinary course of business? Is it the Board or the Audit Committee?

The Act does not clearly lay down tests for determining whether a transaction is in the ordinary course of business. The Memorandum of Association of the company should be referred to for ascertaining whether the activity is covered in the objects clause therein. This is not a conclusive test but will assist in determining whether a transaction is in the ordinary course of business or not. The Audit Committee may decide whether a particular transaction is in the ordinary course of business and such decision will be based on the policy on transactions with related parties, if any. The company’s policy on transactions with related parties should specify the parameters to guide the Audit Committee on whether a transaction is in the ordinary course of business or not. Apart from such a policy, a company may formulate guidelines approved by the Audit Committee and the Board of Directors on transactions with related parties. In such cases, the company can enter into transactions based on the approved guidelines and every transaction need not be placed before the Audit Committee for determining whether the same is in the ordinary course of business or not. In case the company does not have an Audit Committee, the decision as to whether a transaction is in the ordinary course of business or not will be taken by the Board.

2. What are the parameters to be considered by the Audit Committee while considering whether a transaction is on arm’s length basis? How should the Audit Committee decide such an issue?

The Act does not prescribe methodologies and approaches which may be used to determine whether a transaction has been entered into on an arm’s length basis. Audit Committee may consider the parameters given in the company’s policy on transactions with related parties. Transfer Pricing guidelines given under the Income-tax Act, 1961 may also be used. Depending on the nature of the individual transaction, any appropriate method may be used by the Audit Committee to arrive at a considered decision to determine arm’s length price.

3. Is the amount referred to above considered as over and above the remuneration entitled as a Director as referred to in the Explanation to Section 188?

Yes, this is in addition to his remuneration as a director. Thus, it will be necessary to examine it with reference to arm’s length and ordinary course of business.

4. Leasing of property of any kind is covered u/s 188(1)(c ). Whether a Leave and Licence agreement will be counted as Leasing of property?

A Leave and Licence agreement is not treated as equivalent to the leasing of property. A licence creates limited rights with respect to use of immovable property. However, it will be a transaction with a related party covered under Section 177.

5. Whether the issue of shares and debentures to a related party, covered under the ambit of Section 188?

No. Shares are treated as goods once allotted. Hence, issue of shares and debentures will not fall under the purview of Section 188. However, the transfer of shares to a related party would be considered as a related party transaction. In case of an issue of shares and debentures to a related party by way of private placement, the transaction will be treated as one with a related party but would not be regarded as a related party transaction under Section 188 of the Act provided the valuation requirements are met. Further, issue of shares on rights basis, ESOPs, sweat equity, etc. will also not be treated as related party transactions under Section 188 of the Act, if they comply with the provisions of the Act/Listing Regulations.

6. Will remuneration by way of salary proposed to be paid to a director amount to a related party transaction?

Appointment of a director in a company requires the approval of the Board’s approval. There is no requirement of referring the appointment to the Audit Committee if the person proposed to be appointed as director is not a related party. 

When the appointment is approved by the Board, it has to be approved by the shareholders of the company at the ensuing Annual General Meeting (except in a few cases where the Act clearly mandates prior approval). At the time of appointment, the person proposed to be appointed is not a related party (not being from the promoter group or a relative of a director, etc) and therefore, there is no related party transaction.

If in a case the person proposed to be appointed as a director is a related party at the time of appointment, (for example if the person is a relative of a promoter who is also a director of the company), it will be a case of a related party transaction and therefore would require approval in the following order:

• Audit Committee as per Section 177
• Board as per Section 196.
• Shareholders in general meeting as per Section 196.

7. Will a transaction of payment of salary to an employee who is a relative of a Director, (where such payment is in the ordinary course of business and on arm’s length) require disclosure as a related party transaction in the Board’s Report?

The same need not be disclosed as a related party transaction in Form AOC-2 in the Board’s Report unless the same is material in the context of the company’s business.