Related Party Transaction Provisions | Section 188 | Companies Act, 2013

Generally, any person or any entity which is related to the reporting entity is said to be a related party. Further, a related party can be the situation when a person or a close member of that person’s family is associated with an entity. For example, a person has control, joint control, or significant influence over the entity or is a member of its key management personnel. In that case, the person or entity is called a related party.

Section 188 of Companies Act 2013 talks about Related Party Transactions that are applicable to both Private and Public Limited Company.

Let us dive into details of Section 188:-

Table of contents:

• Who is a related party?
• What is meant by related party transactions?
• Identifying Related party transactions
• Approvals Required
• Meaning of Ordinary course of business
• Meaning of Arm’s Length Price
• Points to be considered
• Penalties stated under Sec 188
• Conclusion.

Who is a Related Party?

With the help of few examples let us identify the related parties concerning Company ABC Ltd (just for explanation purposes). Let’s assume Mr. A, B, and C are directors of ABC Ltd.

So the related parties for the company are as under:-

S.No	Related Parties	Examples
1	A director or his relative (member of the same HUF, husband, wife, father, stepfather, mother, stepmother, son, stepson, son’s wife, daughter, daughter’s husband, brother, stepbrother, sister, step-sister)	Mr. A, Mr. B and Mr. C are directors and their relatives are considered as related parties.
2	Key managerial personnel (KMP) or their relative	Say, Mr. D is a Company secretary (KMP) so his relatives will be considered related parties
3	A firm where the director, manager, or relative is a partner.	Mr. A is a partner at PAR & Associates i.e. another firm. This firm will also be treated as a related party.
4	A private company where a director, manager, or relative is a member or director.	Mr. B is also a director in B Pvt. Ltd – In this case B Pvt. ltd becomes a related party. Even when Mr. B’s relative is a member or director in B Pvt. ltd, this company will be treated as a related party.
5	A public company in which a director or manager is a director and hold along with his relatives of more than 2% of its paid-up capital.	Mr. C with his relatives holds more than 2% of the paid-up capital of C ltd. In this case, C Ltd will be considered as a related party.
6	A body corporate whose board of directors, MD or manager is required to act on the advice, directions or instructions of a director or manager (Not Applicable in cases where these directions are followed in the professional capacity)	If K Ltd acts on the directions of Mr. A, K Ltd will be a related party.
7	A person on whose advice, directions or instructions a director or manager need to act (NA when this is done  in a professional capacity)	Mr. K holding 51% in ABC Ltd on whose advice Mr. A has to act will be treated as a related party.
8	Holding, Subsidiary or Associate company of such company.	These all will be treated as related parties: a) LMN Ltd holding 51% in ABC Ltd. (Holding Company) b) ABC Ltd holding 51% in XYZ Ltd. (Subsidiary Company) c) DEF Ltd holding 30% in ABC Ltd. (Associate Company)
9	Any company which is a subsidiary of a holding company to which it is also a subsidiary	Both PQR & ABC are subsidiaries of LMN ltd. So, PQR also became a related party

 What is meant by Related Party transactions?

Since now we know the term Related party let us understand the Related party Transactions

Any transaction between a Company and its related party associated to:

• A transaction of sale, purchase, or any supply of any goods.
• Selling, disposing, or buying property of any kind;
• Leasing a property of any kind;
• Availing or the rendering services of any kind;
• Appointment of any agent for purchase/sale of goods, materials, services, or property;
• Such related party’s placement to any office or place of profit in which the company, its subsidiary company or associate entity.
• Underwriting the subscription of any securities or derivatives thereof of the company;

Let us now read how we will identify whether the proposed transaction is a Related Party Transaction u/s 188 of Companies Act, 2013:-

Identifying Related party transactions

First Stage

1. Is it a transaction (Contract or arrangement) that comes under Section 188(1)(a) to (g) mentioned above of the Companies Act, 2013; &

2. Is it a related Party in Section 2(76) the Act read with Rule 3 of Companies (Specification of Definitions Details) Rules, 2014? For sub-clause (ix) of clause (76) of section 2 of the Act, a director or key managerial personnel of the holding company or his relative concerning a company shall be considered a related party.

If the replies to both the above questions are affirmative only then, we need to comply with the provisions of RPT as per the Act. If the answer to any of the above questions is negative then, we don’t need to abide by the rules of RPT for such transactions.

Second Stage

There are following two levels of Compliances u/s 188 of the Act with respect to Related party transaction:-

1. “PRIOR”permission of the Board in a Meeting (One cannot pass a resolution through Circular; A meeting of the Board needs to take up the matter).

The transactions surpassing the limits as given under Rule 15 of Companies (Meetings of Board and its Powers) Rules, 2014 (“the rules”) shall require “PRIOR” approval of members of the company by a resolution.

Approvals Required

S no.	Transactions as per Companies Act 2013 requiring Board’s approval	Transactions as per The Companies (Meetings of Board and its Powers) Rules 2014 requiring Company’s approval by the resolution
1	Goods and Material : Sale, purchase or supply	Sale/ Purchase / Supply of goods/ material directly or through an agents covering:
2	Property: Selling, Buying or Leasing	Sale/ Purchase of property directly or through an agent that is : In case of leasing of property directly:
3	Agent for (1) or (2)	Availing or rendering of services directly or through an agent which is
4.	Others: i. Availing of or rendering of the services ii. Underwriting of securities or derivatives iii. Related party’s appointment to a place of profit or office in the company/subsidiary/associate iv. If a Director or individual other than the director/firm/private company/body corporate receives an amount above the remuneration from the company (In the case of directors) and anything by way of remuneration for others, it will need approval from the Board by a resolution.	i. Related party’s selection to the place of profit or office in the company/subsidiary/associate where the remuneration surpasses two and a half lakh (2.5 Lakhs) ii. Underwriting of securities or derivatives when payment exceeds 1% of the net worth.

(All the above limits are to be taken on the transactions undertaken on a financial year basis.)

Exceptions

In the case of a Wholly Owned Subsidiary, the resolution passed by the holding company shall be enough for entering into the transaction between the wholly-owned subsidiary and the holding company.

Meaning of Ordinary course of business

The phrase “ordinary course of business” is not explicitly defined under the Companies Act 2013 or rules made there. It appears that the ordinary course of business will incorporate the everyday transactions, customs, and practices of a business and a company. In its guidance to auditors, the ICAI has included the following few examples of transactions that are considered outside the entity’s standard (or ordinary) course of business:

• Complex equity transactions – such as corporate restructurings or acquisitions.
• Transactions with foreign entities in areas with weak corporate laws.
• If no consideration is exchanged, the leasing of premises or rendering of management services by an entity to another party.
• Sales transactions at abnormally large discounts or huge sales returns.
• Transactions with circular arrangements. For example, sales with a promise to re-purchase.
• Contract transactions whose terms can be changed before expiry.

The assessment of whether a transaction is in the ordinary course of business is very personal, judgmental. It can vary on a case-to-case basis considering the nature of business and the objects of the entity. The purpose of making such an assessment is to determine whether the transaction is usual to the company or its business line. To make this assessment, companies should consider various specifics like size and volume of transactions, arms-length, frequency of transactions, purpose, etc.

Meaning of Arm’s Length Price

“Arm’s length transaction” means a transaction between two related parties undertaken as if they were unrelated so that there is no conflict of interest.

Most regularly used guidance under income tax provisions is given in international and domestic tax laws in the transfer pricing regime. We should note that these guidelines are not complete and have only efficient value. One may undertake various qualitative and quantitative assessments to ascertain arm’s length.

Points to be considered

1. If the transaction is in the ordinary course of business and undertaken on arm’s length basis, it shall not needthe approval of the Board or the company.

2. For the purpose of calculation under Companies Rules 2014 , the turnover or net worth shall be based on the audited financial statements

3. No member shall vote on the special resolution if such member is a related party.

4. Details of every contract entered into shall find its reference in the Board’s report along with justification about the same

5. Ratification of the transaction may be done by the Board or the shareholders within three months. The contract will be voidable at the option of the Board If the ratification is not done.

6. If the contract is with anyone related to the director or is authorized by any other director, the directors concerned shall make good to the company for losses if any caused to the company.

Like any other section of Companies Act this section also levies some penalties if contravention occurs

Penalties stated under Sec 188

Any director or any other employee of a company entered into or authorized the contract or arrangement in violation of the provisions of this section shall be liable to following penalties

Conclusion

It’s not surprising that every company in its day-to-day business enters into various transactions with individuals/ entities with whom they are related or have shared interests. Although such transactions are themselves legal, they may create disputes of interest or push other illegal situations and impact its financial position. Hence, to preserve the interest of stakeholders and keep transparency in business, such transactions with Related Parties are being regularized by section 188 of Companies Act 2013. The meaning linked with this expression-related-party transaction keeps on clouding our minds. We hope this article finds some way to have a solution to put your troubled minds to rest.