1. BACKGROUND
The issue of the transactions between the related parties or associated parties have always been a matter of great concern for the revenue authorities along with other authorities along with the other stakeholders of the business of the entities. This is due to the reason that such transactions are highly subject to or prone to the tax avoidance, tax evasion, shifting of profitability from one related entity to the other related entity which might result in loss to the Revenue and other stakeholders.
Therefore, in this relation there are various laws and regulations implemented by various authorities at various levels to curb the mischiefs or negative impact on the operations of the business entities in the interest of various stakeholders. These laws and regulations have evolved over the time and implemented to constantly keeping checks on the business entities or groups so that no undue advantage is taken by these entities being the related parties who can control the transactions amongst themselves. Prominent laws and regulations are:
a. Chapter X pertaining to Transfer Pricing provisions under the Income-tax Act, 1961 (“the Act”)
b. Section 40A(20(b) of the Act
c. Disclosure Requirements under the Indian GAAPs viz. Accounting Standard (AS) 18 – Related Party Disclosures and Indian Accounting Standard (Ind AS) 24 – Related Party Disclosures
d. Regulations stipulated by Securities and Exchange Board of India (SEBI)
e. Regulations and compliances under section 188 of the Companies Act, 2013 (Cos. Act)
f. Provisions under the Goods and Services Tax Act
2. OBJECTIVES
In this article we are going to discuss:
a. the requirement of Related Party Transaction(s) (RPT) to be at arm’s length under the CoA;
b. the way or methods to determine such arm’s length; and
c. Consequences of not complying with provisions of section 188 of Cos. Act.
3. PROVISIONS UNDER THE COS. ACT
Related Party Transactions (Notified Date of Section: 01/04/2014)
“188. (1) Except with the consent of the Board of Directors given by a resolution at a meeting of the Board and subject to such conditions as may be prescribed, no company shall enter into any contract or arrangement with a related party with respect to—
(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 agent 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:
Provided that no contract or arrangement, in the case of a company having a paid-up share capital of not less than such amount, or transactions not exceeding such sums, as may be prescribed, shall be entered into except with the prior approval of the company by a resolution:
Provided further that no member of the company shall vote on such resolution, to approve any contract or arrangement which may be entered into by the company, if such member is a related party:
Provided also that nothing contained in the second proviso shall apply to a company in which ninety per cent. or more members, in number, are relatives of promoters or are related parties:
Provided also that nothing in this sub-section shall apply 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.
Provided also that the requirement of passing the resolution under first proviso shall not be applicable for transactions entered into between a holding company and its wholly owned subsidiary whose accounts are consolidated with such holding company and placed before the shareholders at the general meeting for approval:
Explanation.— In this sub-section,—
(a) the expression “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;
(b) the expression “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.
(2) Every contract or arrangement entered into under sub-section (1) shall be referred to in the Board’s report to the shareholders along with the justification for entering into such contract or arrangement.
(3) Where 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 resolution in the general meeting under sub-section (1) and if it is not ratified by the Board or, as the case may be, 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 or, as the case may be, of the shareholders and 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.
(4) Without prejudice to anything contained in sub-section (3), it shall be open to the company to proceed against a director or any other employee who had entered into such contract or arrangement in contravention of the provisions of this section for recovery of any loss sustained by it as a result of such contract or arrangement.
(5) Any director or any 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 twenty-five thousand rupees but which may extend to five lakh rupees, or with both; and
(ii) In case of any other company, be punishable with fine which shall not be less than twenty-five thousand rupees but which may extend to five lakh rupees.
4. EVALUATION AND APPLICABILITY OF ALP
4.1. From reading of the fourth proviso to sub-section (1) of Section 188 of the Cos. Act as reproduced below, it can be observed that if company has undertaken RPT on arm’s length basis and that too during the ordinary course of business the company is not required to comply with the provisions u/s 188 of the Cos. Act and the rules made/ prescribed thereunder:
“188. Related party transactions
(1) Except with the consent of the Board of Directors given by a resolution at a ………
……………………………………………………………………………………………..”
Provided also that nothing in this sub-section shall apply 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.
……………………………………………………………………………………………..”
4.2. As per clause (b) of Explanation to sub-section (1) of Section 188 of the Cos. 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.”
4.3. Along with Section 188 of the Cos. Act, Para 23 of Ind AS 24 also states as:
“Disclosures that related party transactions were made on terms equivalent to those that prevail in arm’s length transactions are made only if such terms can be substantiated.”
4.4. Now, section 2(76) defines “related party” as follows:
“(76) “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 or his relative is a member or director;
(v) 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;
(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 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;
(viii) any body corporate which is—
(A) a holding, subsidiary or an associate company of such company;
(B) a subsidiary of a holding company to which it is also a subsidiary; or
(C) an investing company or the venturer of the company;”;
Explanation.—For the purpose of this clause, “the investing company or the venturer of a company” means a body corporate whose investment in the company would result in the company becoming an associate company of the body corporate.
(ix) such other person as may be prescribed;”
Further, “relative” has been defined u/s 2(77) of CoA:
“(77) “relative”, with reference to any person, means any one who is related to 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;”
They term “related party” or “relative” or “associated enterprise (AE)” has also been defined under various regulations as well but its not necessary that they are exactly same as per the CoA stated above. Few of them are:
| S. No. | Name of Statue, Rules or Regulations |
| 1 | Regulation 2(1)(zb) of SEBI (Listing Obligation and Disclosure Requirement) Regulation 2015 defines related party u/s 2(76) of CoA |
| 2 | Para 9 of Ind AS 24 defines related party |
| 3 | Para 10.1 of AS 18 defines related party |
| 4 | Section 2(41) of the Act defines relative |
| 5 | Section 56(2) of the Act defines relative by way of explanations under various clauses |
| 6 | Section 40A(2)(b) of the Act specifies various parties as related parties |
| 7 | Section 92A of the Act defines AEs similar to related parties |
4.5. Attention is invited to the Guidance Note on “Related Party Transactions” issued by the Institute of Company Secretaries of India (ICSI) issued in March 2019 (‘the GN”) which clarifies arm’s length transaction (ALT) under Para 1.3 as follows:
“Arm’s length basis does not mean arm’s length price as price is just one of the components of the terms of dealing with the other party and there are several other matters which need to be considered. For example, in case of trading of goods, the price charged to both related and unrelated party is Rs. 100 per unit. Based on the price charged, it may seem to be an arm’s length transaction. However, if the credit period granted to an unrelated party is 15 days whereas to a related party it is 6 months, it will not be considered as an arm’s length transaction. The transaction as a whole and the entire bundle of the terms and conditions needs to be considered for determining whether the transaction is on an arm’s length basis.”
4.6. The GN vide para 1.2 also explains the term “ordinary course of business” as “part of doing regular business; the regular or customary condition or course of things; as things usually happen.” This para further explains that “ordinary course of business” as per the Black’s Law Dictionary means “normal routine in managing trade or business”. As per the said para any activity which is routine and in accordance with the usual customs and practices of a particular business can be described to be “in the ordinary course of business”. For a company, the interpretation needs to be contextual, taking into account the nature of the activity and its relevance in the overall context of the company’s businesses as held in the following case laws:
a. Bharti Televentures Ltd. v. Addl./Jt. Commissioners of Income-tax [ITA 1395/2006, ITA 1656/2010]
b. Seksaria Biswan Sugar Factory v. Commissioner of Income-tax AIR 1950 Bom 200
c. Commissioner of Income-tax and Excess Profits Tax, Madras v. The South India Pictures Ltd. (1922) 12 Tax Cas. 427
4.7. The said provisions of Section 188 of the CoA came into effect from 1st April 2014 but till date the Cos. Act, any of the rules or regulations made thereunder, the Listing Regulations, Ind AS or any other rules, regulations or laws applicable to the companies in this respect does not prescribe any methods or the ways to determine the ALT or arm’s length price (ALP) between the related parties except as per the Income-tax Act, 1961. Further, the GN which has been issued in March 2019 itself refers to the provisions under Chapter X of the Act pertaining to the Transfer Pricing to determine the ALP between the related parties, which are termed as associated enterprises (AEs) under the Act. Section 92F(ii) of the Act defines ALP as:
“(ii) “arm’s length price” means a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions;”
From above we can observe that methods of determining ALP as defined under the Act can be applied to the RPTs for the purposes of Cos. Act in the absence of anything prescribed therein. Further,
4.8. Further, The MCA has, vide General Circular No. 30/2014 dated 17th July 2014 clarified the following:
(a) Transactions arising out of compromises, arrangements and amalgamations dealt with under specific provisions of the Companies Act, 1956 / Companies Act, 2013, will not attract the requirements of Section 188 of the Companies Act, 2013.
(b) Contracts entered into by companies, after making necessary compliances under Section 297 of the Companies Act, 1956, which came into effect before the commencement of Section 188 of the Cos. Act (i.e. before 1st April 2014) will not require fresh approval under Section 188 till the expiry of the original term of the contracts. Thus, if any modification is made to such contracts on or after 1st April 2014, the requirements of Section 188 will have to be complied with.
Therefore, the company is not required to comply with section 188 of the Cos. Act in the above situations.
4.9. From the above paragraphs, we can conclude that:
a. Any transaction amongst the related parties as per the Cos. Act have to be undertaken at ALP if the company does not want to comply with Section 188 of the Cos. Act; and
b. Computation of ALP have to done as per the methods prescribed u/s 92C of the Act r.w.r. 10B and 10AB of the Income-tax Rules, 1962 (“the Rules”) as recommended by the GN.
4.10. Therefore, Most Appropriate Method (MAM) as per Section 92C of the Act r.w.r. 10C of the Rules have to be evaluated from amongst following prescribed method under the Act:
a. Comparable Uncontrolled Price (CUP) Method
b. Resale Price Method (RPM)
c. Cost Plus Method (CPM)
d. Profit Split Method (PSM)
e. Transactional Net Margin Method (TNMM)
f. Other Methods as prescribed under Rule 10AB of the Rules
4.11. The above discussion is in light of the GN as issued by the ICSI which is recommendatory in nature. However, if a company thinks not to apply methods as prescribed in relation to the TP provisions under the Act, and want to apply methods or ways prescribed under other statutes like GST law, valuation guidelines or any scientific method or way to determine the ALP, then also it can be considered that Other Method prescribed under Rule 10AB of the Rules has been applied.
5. COMPLIANCES NEEDS TO BE DONE IF RPT IS NOT AT ALP?
5.1. Prior approval of BOD by way of passing the resolution subject to following compliances:
Compliances u/s 188 (1) Cos. Act r.w.r. 15(1) of the Companies (Meetings of Board and its Powers) Rules, 2014 (“Cos. Rules”) for BM Resolution
Note: Where any Director is interested in any CorA such director shall not be present in such BM where resolution is going to be passed for such RPT.
5.2. In certain circumstances as mentioned below prior approval of shareholders by way of passing the ordinary resolution (OR) is required along with approval of BOD (Board of Directors) in BM (Board Meeting) as per compliances u/s 188 (1) Cos. Act r.w.r. 15(3)(a) of the Cos. Rules for OR:
| S. No. | Nature of RPT | Monetary Limit when OR to be passed |
| 1 | Sale, purchase or supply of goods or materials; or appointment of agent for this purpose | >=10% of Turnover (TO) |
| 2 | Leasing of property of any kind | >=10% of TO |
| 3 | Availing or rendering of any services; or appointment of agent for this purpose | >=10% of TO |
| 4 | Selling or disposing off or buying property of any kind; appointment of agent for this purpose | >=10% of Networth (NW) |
| 5 | Appointment of RP at office or Place of Profit in the Co., its subsidiary or its Associate | > INR 2.5 lakhs p.m. |
| 6 | Remuneration for underwriting subscription of any securities or derivatives | >1% of NW |
| Note: 1. TO or NW to be taken as per the audited Financial Statements of preceding FY.
2. No member shall vote on such resolution, to approve any CorA which may be entered into by the Company, if such member is a party related or interested to the CorA. However, this condition will not apply if >=90% are relatives of promoters or are related parties. |
||
Compliances u/s 188 (1) Cos. Act read with explanation (3) to Rule 15(3) of the Cos. Rules relating to the OR to be passed by shareholders
5.3. Every CorA shall be referred to in the Board’s report to the shareholders along with the justification for entering into such CorA.
5.4. Points to be considered in relation to wholly owned subsidiary (WOS) and Holding Companies:
> The requirement of passing the OR shall not be applicable for transactions entered into
between a holding company and its WOS whose accounts are consolidated with such holding company and placed before the shareholders at the general meeting for approval. [Fifth proviso to section 188(1)]
> In case of WOS, the OR is passed by the holding company shall be sufficient for the purpose of entering into the transactions between the WOS and the holding company. [Explanation (2) to Rule 15(3) of the Cos. Rules]
5.5. Above all, approval of the Audit Committee is necessary irrespective of the RPT at ALT/ ALP in ordinary course of business under section 177 of the Cos. Act.
5.6. With such rigorous compliances it is clear that the intention of the law is to keep the procedures of RPTs entered by the companies to be transparent so that the said RPTs are entered in the interest of the company and its stakeholders. Thereby mostly the companies try to keep the RPTs at ALP/ ALT.
6. CONSEQUENCES OF NON-COMPLIANCE OF SECTION 188(1):
6.1. When any CorA entered into by any director or employee without obtaining prior approval of the BOD or shareholders, as the case may be, if in <= 3 months from date of entering into such CorA it is not ratified:
i. It becomes voidable at the option of BOD or shareholders, as the case may be.
ii. If CorA is with RP to any director or authorised by any director, they shall indemnify the company for any loss.
iii. The company can proceed against any director or any other employee who has entered into such CorA which is contravening section 188(1) for recovery of any losses sustained due to entering into such CorA.
6.2. Any director or any employee who has entered into or authorised the CorA in violation of section 188 shall:
i. Listed Company case: Punishable with imprisonment for <= 1 year or fine >= INR 25,000 to <= INR 5 lakhs or with both;
ii. In other cases: Punishable fine >= INR 25,000 to <= INR 5 lakhs.
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