[2013] 38 taxmann.com 101 (Article)
Related Party Transactions under Companies Act, 2013
V.S. DATEY
BACKGROUND
1. Related party transactions are inevitable in any business. Business can grow only with mutual co-operation and support.
Para 15 of the AS-18 beautifully explains inevitability of related party transactions as follows - Related party relationships are a normal feature of commerce and business. For example, enterprises frequently carry on separate parts of their activities through subsidiaries or associates and acquire interests in other enterprises - for investment purposes or for trading reasons - that are of sufficient proportions for the investing enterprise to be able to control or exercise significant influence on the financial and/or operating decisions of its investee.
CONFLICTS OF INTERESTS IN RELATED PARTY TRANSACTIONS
2. Duty of a Director is comparable to that of a trustee. Like trustee, he is in a fiduciary position vis-à-vis the company. He is expected to act in the best interests of the company. Whenever personal interests and company interests clash, his personal interests should be secondary to the interests of the company.
In reality, the position is quite different. Ways are devised to siphon funds of the company for personal gains. There are many ways of doing this, but one most popular way is to divert funds of company through transactions with related parties.
Transactions with related parties are also used as a tool of 'tax management'. Provisions exist in income tax (like transfer pricing), excise law (in valuation) and customs law (in valuation) to control 'tax planning' through related party transactions.
The Companies Act, 2013 has made elaborate provisions to control such related party transactions and ensure that related party transactions are not used as a tool to divert funds of the company for personal benefit of directors.
MEANING OF 'RELATED PARTY'
3. Section 2(76) of the 2013 Act defines 'related party' as follows:
"Related party" with reference to a company means —
| (i) | a director or his relative | |
| (ii) | a key managerial personnel or his relative | |
| (iii) | a firm, in which a director, manager or his relative is a partner | |
| (iv) | a private company in which a director or manager is a member or director | |
| (v) | a public company in which a director or manager is a director or holds along with his relatives, more than two per cent of its paid-up share capital | |
| (vi) | 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 | |
| (vii) | any person under 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 | ||
| (viii) | any company which is — (A) a holding, subsidiary or an associate company of such company; or (B) a subsidiary of a holding company to which it is also a subsidiary | |
| (ix) | such other person as may be prescribed |
Key Managerial Personnel (KMP) - "Key managerial personnel", in relation to a company, means — (i) the Chief Executive Officer or the Managing Director or the Manager (ii) the Company Secretary (iii) the Chief Financial Officer; and (iv) such other officer as may be prescribed [section 2(51) of the 2013 Act]
Relative - "Relative" means a person who is a relative of another, if — (i) they are members of a Hindu undivided family (ii) they are husband and wife or (iii) one person is related to the other in such manner as may be prescribed [section 2(77) of the 2013 Act - Corresponding sections 2(41), 6 and Schedule IA of the 1956 Act]
Definition of 'relative' in the 1956 Act contained some 22 relations. Similar list may be prescribed under rules made under the 2013 Act.
Interested director - "Interested director" means a director who is in any way, whether by himself or through any of his relatives or firm, body corporate or other association of individuals in which he or any of his relatives is a partner, director or a member, interested in a contract or arrangement, or proposed contract or arrangement, entered into or to be entered into by or on behalf of a company [section 2(49) of the 2013 Act]
Associate Company - "Associate company", in relation to another company, means a company in which that other company has a significant influence, but which is not a subsidiary company of the company having such influence and includes joint venture company.Explanation — For the purposes of this clause, "significant influence" means control of at least twenty per cent of total share capital, or of business decisions under an agreement [section 2(6) of the 2013 Act].
Control - "Control" shall include the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner [section 2(27) of the 2013 Act]
TWO PUBLIC COMPANIES 'RELATED PERSON' EVEN IF JUST ONE DIRECTOR COMMON
4. Clause (v) of section 2(76) uses the words 'or', with the result that two public companies become 'related party' even if one director is common. This does not seem to be intention as section 184 of the 2013 Act about disclosure applies only when director has 2% or more shareholding in a public company.
STRANGE RESULTS DUE TO RULE BASED DEFINITION
5. Definition of 'related party' is rule based and not principle based. Such definition can sometimes lead to absurd results.
For example, Mr. Mukesh Ambani and Mr. Anil Ambani may not be on speaking terms, but the biological fact that they are brothers cannot be denied. Hence, they become 'related party' as per rule based definition, though ground realities may be quite different.
It is also possible to manipulate the provisions so that though they are related parties, they do not fit in the definition of 'related party'. One crude way of doing this is to appoint clerks, drivers and peons as directors (and even shareholders).
Though such directors can come within the clause 'any person under whose advice, directions or instructions a director or manager is accustomed to act', this becomes difficult to prove. Of course if a director admits that he is acting on advice and directions of another person, he is surely violating all his duties as a director.
Consent of Board in case of related party transaction
A company can enter into specified related party transaction only with approval of Board and subject to prescribed conditions - Section 188(1) of the 2013 Act [Corresponding to section 297 of the 1956 Act].
The consent must be obtained in the Board meeting and not by circular resolution.
The provision applies to following contracts or arrangements
| (a) | sale, purchase or supply of any goods or materials. | |
| (b) | selling or otherwise disposing of, or buying, property of any kind. | |
| (c) | leasing of property of any kind. | |
| (d) | availing or rendering of any services. | |
| (e) | appointment of any agents for purchase or sale of goods, materials, services or property. | |
| (f) | such related party's appointment to any office or place of profit in the company, its subsidiary company or associate company; and | |
| (g) | underwriting the subscription of any securities or derivatives thereof, of the company. |
Meaning of 'office or place of profit' - 'Office or place of profit" means any office or place—
| (i) | where such office or place is held by a director, if the director holding it receives from the company anything by way of remuneration over and above the remuneration to which he is entitled as director, by way of salary, fee, commission, perquisites, any rent-free accommodation, or otherwise | |
| (ii) | where such office or place is held by an individual other than a director or by any firm, private company or other body corporate, if the individual, firm, private company or body corporate holding it receives from the company anything by way of remuneration, salary, fee, commission, perquisites, any rent-free accommodation, or otherwise [Explanation to section 188(1) of the 2013 Act]. |
Prior approval in general meeting by special resolution in case of large companies or large contracts
In the case of a company having paid-up share capital of not less than prescribed amount, or transactions not exceeding prescribed sums, the contract or arrangement can be entered into by company only after prior approval by special resolution in general meeting - Firstproviso to section 188(1) of the 2013 Act.
The member who is a related party shall not vote at the general meeting - Second proviso to section 188(1) of the 2013 Act.
Drafting mistake - The term 'not exceeding prescribed sums' is not correct. It should be 'exceeding prescribed sums'.
This drafting mistake has really made the section ineffective. Central Government will have to amend the section. In the meanwhile, it may issue notification under section 470 of the Act to remove the difficulty.
WHEN THE PROVISIONS DO NOT APPLY
6. The provisions relating to related party transactions do not apply in certain situations.
Provisions not applicable to transactions in ordinary course of business - The provision of section 188(1) of the 2013 Act are not applicable to any transactions entered into by the company in its ordinary course of business, other than transactions which are not on an arm's length basis - Third proviso to section 188(1) of the 2013 Act.
"Arm's length transaction" means a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest - Explanation (b) to section 188(1) of the 2013 Act.
This provision seems very litigation prone, as it is not clear who is going to decide whether the transaction is in 'ordinary course of business' and whether the transaction is at 'arm's length.
It seems the burden of proof will be on concerned director to establish that the transaction is in ordinary course of business and is at arm's length.
Provision not applicable to small value transactions upto Rs. five lakhs - Provisions relating to disclosure by director or KMP (Key Managerial Personnel) of transactions in which he is interested does not apply for contract or arrangement for the sale, purchase or supply of any goods, materials or services if the value of such goods and materials or the cost of such services does not exceed five lakh rupees in the aggregate in any year - Section 189(6)(a) of the 2013 Act.
As an obvious corollary, provisions of section 188 are also not applicable. This provision should have been included in section 188 itself to avoid unnecessary controversy.
Provision not applicable to banking company for collection of Bills - Provisions relating to disclosure by director or KMP of transactions in which he is interested does not apply to contract or arrangement by banking company for collection of bills in ordinary course of business - Section 189(6)(b) of the 2013 Act.
As an obvious corollary, provisions of section 188 of the 2013 Act are also not applicable. This provision should have been included in section 188 itself to avoid unnecessary controversy.
RESPONSIBILITY OF DIRECTOR OR KMP TO DISCLOSE THEIR INTEREST
7. Every director or key managerial personnel shall, within a period of thirty days of his appointment, or relinquishment of, his office, as the case may be, disclose to the company the particulars specified in section 184(1), relating to his concern or interest in the other associations which are required to be included in the register of contracts or arrangements in which directors or KMP are interested - section 189(2) of the 2013 Act.
As per section 189(7) of the 2013 Act, the penalty for contravention of the provision by director is Rs. 25,000.
Disclosure by director at Board meeting - Every director shall give notice in writing to the company at a meeting of the Board, of such matters relating to himself as may be necessary for the purpose of enabling the company to comply with the provisions of section 189 relating to registrar of contracts in which directors and KMP are interested - Section 189(3) of the 2013 Act.
Thus, indirectly, it means that the director is required to disclose the details of contracts or arrangements in which he is interested.
Disclosure in Board's report of related party transactions - Every contract or arrangement entered into under section 188(1) shall be referred to in the Board's report to the shareholders along with the justification for entering into such contract or arrangement - As per Section 188(2) of the 2013 Act.
CONSEQUENCES IF CONTRACT OR ARRANGEMENT IS NOT RATIFIED BY BOARD/GENERAL MEETING
8. If any contract or arrangement is entered into by a director or any other employee, without obtaining the consent of the Board or approval by a special resolution in the general meeting under section 188(1) of the 2013 Act, and if it is not ratified by the Board or by the shareholders at a meeting within three months from the date on which such contract or arrangement was entered into, such contract or arrangement shall be voidable at the option of the Board.
If the contract or arrangement is with a related party to any director, or is authorised by any other director, the directors concerned shall indemnify the company against any loss incurred by it - Section 188(3) of the 2013 Act.
Company can recover losses from director or other employee - Company can proceed against a director or any other employee who had entered into such contract or arrangement in contravention of the provisions of section 188, for recovery of any loss sustained by the company as a result of such contract or arrangement - Section 188(4) of the 2013 Act.
Punishment to director or employee for contravention - Any director or other employee of a company, who had entered into or authorised the contract or arrangement in violation of the provisions of this section shall,— (i) in case of listed company, be punishable with imprisonment for a term which may extend to one year or with fine which shall not be less than Rs. twenty-five thousand but which may extend to Rs. five lakh, or with both; and (ii) in case of any other company, be punishable with fine which shall not be less than Rs. twenty-five thousand but which may extend to Rs. five lakh - Section 188(5) of the 2013 Act.
DIRECTOR NOT TO VOTE AT BOARD MEETING WHEN HE IS INTERESTED
9. As per Secretarial Standard (SS-1) of ICSI (which is presently recommendatory in nature), if Chairman of meeting is himself interested in a particular resolution, he should entrust conduct of the meeting in respect of such item to other dis-interested director and resume the Chair after that business is transacted.
As per Secretarial Standard SS-5 on Minutes issued by ICSI (which is presently recommen-datory in nature), this should be recorded in the Minutes of the meeting.
Director cannot vote at general meeting
If a related party is member of the company, it cannot vote at the general meeting at the time of approval in general meeting. Thus, there should be quorum in the general meeting excluding such 'related parties'.
Earlier, there was no such provision.
REGISTER OF CONTRACTS OR ARRANGEMENTS WHICH DIRECTORS ARE INTERESTED OR RELATED PARTY TRANSACTIONS
10. As per section 189(1) of the 2013 Act, every company must maintain a register where all specified particulars of following contracts or arrangements should be entered - (a) where directors are interested [section 184(2) of the 2013 Act] and (b) contracts or arrangements covered under 'related party' transactions [section 188 of the 2013 Act], - [Corresponding to section 301(1) of the 1956 Act].
Register to be kept available for inspection at registered office and general meeting
The register for contracts or arrangements in which director and KMP are interested should be kept available for inspection during business hours. Extracts from the register and copies have to be supplied by charging cost - Section 189(4) of the 2013 Act [Corresponding to section 301(5) of the 1956 Act]
The register should be produced at commencement of every Annual General Meeting and shall be open for inspection during meeting to any person who has right to attend the meeting - Section 189(4) of the 2013 Act
DISCLOSURES IN ANNUAL REPORT
11. Particulars of contracts or arrangements with related parties referred to in section 188(1) shall be disclosed in a prescribed form. Loans and advances from and to related parties shall be disclosed - General Instructions for Preparation of Balance Sheet - Schedule III of the 2013 Act. Disclosures as per 'Related Party Disclosures' Accounting Standard shall be made in Annual Report.
Board's report of related party transactions
Every contract or arrangement entered into under section 188(1) of the 2013 Act shall be referred to in the Board's report to the shareholders along with the justification for entering into such contract or arrangement - Section 188(2) of the 2013 Act.
DUTIES OF INDEPENDENT DIRECTORS
12. The independent directors shall pay sufficient attention and ensure that adequate deliberations are held before approving related party transactions and assure themselves that the same are in the interest of the company - Schedule IV of the 2013 Act.
This is duty of all directors and not only of independent directors.
Disqualification for appointment as a director - A director is disqualified for appointment, if he has been convicted of the offence dealing with related party transactions under section 188 at any time during the last preceding five years - As per section 164(1)(g) of the 2013 Act.
ROLE OF AUDIT COMMITTEE
13. The role of audit committee of the Board shall include approval or any subsequent modification of transactions of the company with related parties - Section 177(4)(iv) of the 2013 Act.
Auditor to report in his report as per CARO
As per Companies (Auditor's Report) Order 2003 (CARO), Auditor, in his audit report, is required to indicate the specified details in respect of contracts and arrangements in which directors are interested. He has to indicate whether the contracts are entered in the register under section 301- whether prices reasonable (The information required in case of transactions exceeding Rs. 5 lakhs per party per year).
After the Companies Act, 2013 is notified. The CARO is likely to be amended suitably.
SEBI REQUIREMENTS IN RESPECT OF LISTED COMPANIES
14. Disclosures as per 'Related Party Disclosures' Accounting Standard shall be made in Annual Report. [Clause 32 of Listing Agreement]
Accounting Standard
AS-18 (Accounting Standard 18) deals with disclosures in case of related party transactions. This Standard deals with related party relationships described in (a) to (e) below:
| (a) | enterprises that directly, or indirectly through one or more intermediaries, control, or are controlled by, or are under common control with, the reporting enterprise (this includes holding companies, subsidiaries and fellow subsidiaries); | |
| (b) | associates and joint ventures of the reporting enterprise and the investing party or venturer in respect of which the reporting enterprise is an associate or a joint venture; | |
| (c) | individuals owning, directly or indirectly, an interest in the voting power of the reporting enterprise that gives them control or significant influence over the enterprise, and relatives of any such individual; | |
| (d) | key management personnel and relatives of such personnel; and | |
| (e) | enterprises over which any person described in (c) or (d) is able to exercise significant influence. This includes enterprises owned by directors or major shareholders of the reporting enterprise and enterprises that have a member of key management in common with the reporting enterprise. |
Broadly, whatever is covered under provisions of Companies Act would get covered in this definition also, though definition in Companies Act is rule based, while definition in Accounting Standard is principle based.
CONCLUSION
15. The provisions relating to related party transactions have been tightened. Specific responsibilities have been cast on Audit Committee, Independent Directors and Auditors, in addition to general responsibilities have been cast of all the directors of the company.
Though there is no Government approval required in related party transactions, disclosures and provisions for heavy penalties will ensure proper checks.
This is in addition to provisions in Income-tax, Central Excise and Customs Law keeping eye and check on such transactions.
In short, directors have to be very careful in complying with the requirements relating to related party transactions.
Of course rule based definitions give scope to follow the law in letter while killing spirit behind the law.
Regards
Prarthana Jalan
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