By K P C Rao.,
LLB., FCS., FCMA
kpcrao.india@gmail.com
MEANING
OF THE RELATED PARTY TRANSACTION
‘Related
Party Transaction’ may be defined as a business deal or arrangement between two parties
who are joined by a special relationship prior to the deal.
American public companies are
required to disclose all transactions with related parties such as executives,
associates and their family members in their annual 10-K report.[1]
While the great majority of related-party transactions are perfectly normal,
the special relationship inherent between the involved parties creates
potential conflicts of interest which can result in actions which benefit the
people involved as opposed to the shareholders.
i) Under the Companies Act
Section
297 of the Companies Act 1956, describes the transaction with the following
persons as related party transaction.
a)
A director of the company
b)
Relative of the director
c)
A firm in which such a director or
relative is a partner
d)
Any other partner in such a firm
e)
A private company of which the
director is a member or director
ii) As per the Accounting Standard 18
(AS – 18)
As
per AS-18 - ‘Related Party Disclosures’
issued by the ICAI, ‘Related party’
means “Parties are considered to be related if at any time during the reporting
period one party has the ability to control the other party or exercise
significant influence over the other party in making financial and/or operating
decisions” and ‘Related Party transaction’
means “a transfer of resources or obligations between related parties,
regardless of whether or not a price is charged. The following are the related
parties as per AS-18
a)
Holding companies, subsidiaries and
fellow subsidiaries
b)
Associates and joint ventures
c)
Individuals (including their
relatives) – having voting power giving them control or significant influence
d)
Key management personnel including
their relatives
e)
Enterprises where controlling
individual or key managerial personnel has significant influence
PRESENT REGULATIONS AND COMPLIANCES
i) The Companies Act, 1956
The
Companies Act imposes certain conditions through various sections, when a
company entering into any transaction in which directors are interested.
Section
297 of the Companies Act 1956 requires board approval for entering into any
contract or arrangement with the related parties. However this section will
cover only transactions relating to sale, purchase or supply of any goods,
materials and services or for underwriting the subscription of any shares in,
or debentures of, the company.
Further,
there is a requirement to take central Government approval if the company has
more than one crore paid up capital.
Section
297 (2) provides exemption to get approvals if:
a)
Purchase/sale is for cash and at
prevailing market prices or
b)
Contract relates to goods,
materials and services regularly traded or done business provided the contract
is less than Rs 5000/-
c)
In the case of a banking or
insurance company any transaction in the ordinary course of business of such
company.
Section
299 imposes duty on directors to disclose their interest in other concerns to
the Board of Directors before entering into any contract with the related parties.
Sec 299 is much wider than Sec 297 since it covers any contract or arrangement
with entities in which director is concerned or interested. Only exception is
where directors of one company taken together have less than 2 % of paid up
capital of another company.
Sec
299 (1) requires that notice of such interest be disclosed by the directors.
Section 299 (3) allows for a general notice of interest, which shall be valid
for a year and can be renewed for a further period of one year in the last
month of the Financial year. Such general notice and renewal should also be
given in the Board Meeting.
Section
300 disallows the director to participate in voting when the board resolution
is passed relating to any business in which he is interested. The main
intention behind these sections is to avoid personal gain by the interested
director. But mere taking approval from the board to enter into transaction is
not serve the purpose as outside world can’t know about this transactions.
ii) Under the Accounting Standards
The
Institute of Chartered Accountants of India has introduced Accounting Standard
18 - ‘Related Party Disclosures’ and
made it mandatory for companies to disclose related party transactions in the
financial statements.
Indian
investors may find that details of relevant related party transactions are
available in a few places other than the section on related party disclosures.
The section on managerial remuneration, loans/advances due from directors and
subsidiaries and the auditor’s report (which may certify/qualify certain
transactions) may provide important supplementary information.
In
their present form, the related party disclosures (as detailed by Accounting
Standard 18) may leave investors in public companies more enlightened about how
the company is managed. However, there still appears to be considerable room
for improving the present disclosures.
iii)
Under
Auditing and Assurance Standards
‘Auditing and Assurance Standard 23- Related
Parties’ impose duty on auditor to identify and disclose the related party
transaction in the financial statements.
iv) Under the Income Tax Act,1961
Section 40 A (2) of the Income tax Act disallows the
expenditure incurred in respect of specified
persons (Related Parties) if it is the opinion of the Assessing officer
that the expenditure is excessive and unreasonable. These expenditures are:
a)
The fair market value of goods,
services or facilities for which the payment is made or persons (Related
Parties) or
b)
Legitimate needs of business or
profession of the assessee or
c)
The benefit derived by or accruing
to the assessee from the payment.
However,
disclosure is mandatory for the following categories of companies.
a)
Companies which are listed or are
in process of listing.
b)
Banks, financial institutions and
insurance companies.
c)
Enterprises having turnover more
than Rs50 cr.
d)
Enterprises having borrowings more
than
Rs 10 cr.
e)
Holding / subsidiary company of any
of the above
If any company does not fall in any of these categories, after having been applicable earlier, then it shall continue to apply unless it is not covered in any category for 2 consecutive years.
ANALYSIS OF DIFFERENT PROVISIONS
If we make comparison between these
two definitions, we will come to know that AS-18 is wider than Companies Act.
The Companies Act requires approval only when a director and his/her relatives
involve in the transaction. However, if the key management personnel, who is
not a director involved in any transaction, the approvals are not required,
even though interest is involved. However, AS 18 makes it mandatory to disclose
the transaction with the key management personnel also.
The
scope of word ‘related party’ under the
Income Tax Act is as follows:
(i)
Where the assessee is an any
relative of the assessee; individual
(ii)
Where the assessee is a any
director of the company, company, firm, association partner of the firm, or
member of persons or Hindu undivided 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 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;
The word relative in relation to
individuals includes different persons under various laws. Schedule 1A of the
companies Act 1956 gives list of 22 persons as relatives. According to Clause 2(77) of the Companies Bill, 2011
“relative”, with reference to any person, means anyone who is a 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;
As per the AS-18, relative means
spouse, son, daughter, brother, sister, father and mother. If we compare these
two, the scope given under the Companies Act is wider. The Income tax Act
defines the word relative as spouse, son, and daughter, brother, sister or any
lineal ascendant or descendent.
RELATED PARTY
TRANSACTION - COMPANIES BILL, 2011
The
Companies Bill, 2011 which is pending before the parliament proposed the
following provisions regarding related party transaction.
(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 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)
Anybody 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
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;
Related
party transactions (Clause188)
(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 special resolution:
Provided
further that no member of the company shall vote on such special 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 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.[2]
(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 special 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 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 authorized 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.
CONCLUSION
While directors have the authority
to regulate the affairs of the company collectively as Board, their duties of good
faith and fair dealings are owed by each director individually. Directors have
the duty not to place themselves in a position when their fiduciary duties
towards the company conflict with their personal interests. And in case it
happens, directors have the duty to prefer interests of the company. Directors
should not use company’s assets, opportunities or information for their own
profit.
The issue as to whether
transactions/contracts in which directors or their relatives are interested
should be regulated through a Government Approval-based regime or through a
Shareholder Approval and Disclosure-based regime has been discussed at various
Fora. However, keeping the international practices into consideration, it was felt
that the latter approach i.e., through a ‘Shareholder
Approval and Disclosure-based Approach’ would be more appropriate in the Indian
context and the modifications have been contemplated by the regulators namely
MCA / SEBI accordingly.
In
general, the related party disclosures presented by companies to meet with the
requirements of the US GAAP have been far more detailed than those presented to
meet the requirements of AS-18. A number of technological, economic changes,
social events, globalization, liberalization, privatization etc. have
influenced auditing to a great extent in the course of development of auditing
and caused considerable changes and improvements in the techniques, principles,
standards, reporting, professional ethics and responsibilities of auditor.
[Published in 'CIRCUIT' a Monthly Journal of the Hyderabad Chapter of the ICAI during March,2012 & May 2012]
[1] A Form 10-K is an annual report required by the
U.S. Securities and Exchange Commission (SEC) that gives a comprehensive
summary of a public company's performance.
[2]
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. [Explanation (b) to Clause 188 (1)]
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