Transactions between “related parties” are all too common and a host of legislations define the term “related party”. From law and tax stand-point, the requirement is to ensure reasonable judgment while making commercial decisions and to curb any undue advantages and misappropriation of assets, opportunities or information for personal profits that may be available by reason of “being related”. Various statutes have tried to address and regulate related party transactions by way of disclosures and pre and post transaction compliance. In this post, we have attempted to provide a brief overview of treatment of related party transactions (“RPT”) under various statutes.
There are other compliances, disclosure of methods of arriving at valuation for listed entities under SEBI (LODR) and Accounting Standards, which are we not touching upon.
Companies Act, 2013: The Directors of a Company are under a fiduciary duty to discharge the affairs of the Company in good faith. While acting in the authority of regulation of affairs of the Company, the Company may enter into transactions with related parties.
|Who is a related party?
Section 2(76), Companies Act, 2013 r/w Rule 3 Companies (Specification of Definitions Details) Rules, 2014
Provides that in relation to a Company, a related party means: (i) a director or his relative; (ii) 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 2% of its paid-up share capital; (vi) anybody corporate whose Board, 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; and (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 venture of the company;
Rule 3, Companies (Specification of Definitions Details) Rules, 2014 provides that related parties would include any director (other than independent director) or key managerial personnel of holding company or his relative with reference to a Company.
|What transactions are prohibited as RPT?
Section 188: Prohibits the following transactions, unless approved by the Board:
a) Sale, purchase or supply of goods and services; b) Selling or otherwise disposing of or buying property of any kind; c) Leasing of property of any kind; d) Availing or rendering of services; e) Appointment of agent for purchase or sale of goods, materials, services or property; f) Appointment of such related party to any office or place of profit in the company, or its subsidiary or associate company; g) Underwriting of any securities or derivatives of the company.
|What are the prescribed conditions for entering into related party transaction?
Rule 15 of the Companies (Meetings of Boards and Its Power) Rules 2014:
Board Approval: All related party transactions need Board approval.
RPTs can be entered into after obtaining Board approval. Companies Act, 2013 prescribes the conditions that should be met for approval.
Voting: A director, who is interested in a contractual agreement with a related party shall abstain himself from such meeting wherein discussion on such matter are taking place. This restriction is not applicable in instance where the company in which ninety per cent. or more members, in number, are relatives of promoters or are related parties.
Shareholders’ Approval: In the below-mentioned cases, in addition to board approval, the Company also requires a shareholders’ approval via an ordinary resolution:
a) If the following type of transactions amount to at least 10% of turnover of the company or Rs. 100 crore, whichever is lower :-
i. Sale, purchase or supply of goods or materials ;
ii. Selling, buying or otherwise disposing of property;
iii. Leasing of property;
iv. Availing or rendering of any services, directly or through appointment of agent.
The limit specified above shall apply for transaction or transactions to be entered into either individually or taken together with the previous transactions during a financial year.
b) Appointment to office of profit to a company, it’s subsidiary, associate or holding at a remuneration exceeding INR 2.5 lakh per month.
c) Remuneration for underwriting subscription of securities or derivative of exceeding 1%.
|What are the exemptions under RPT?
i) any transactions entered into by a Company in its ordinary course of business entered at arm’s length basis (as explained below).
ii) Board approval shall not be required 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.
|What are the compliance for related party transactions?
RPT provisions provide for the following types of disclosures
i) Board Meeting: Agenda of the board meeting shall disclose details such as the name of the related party, the nature of the relationship as well as all material terms of the contract and all financial payments due.
ii) Interested Directors Disclosure: All directors shall provide a disclosure in MBP-1 of his concerns and interest in other companies.
iii) Board Report: The justification for any RPT must be given in the Board’s report to the shareholders.iv) Disclosures made in Register: All companies have to maintain one or more registers in MBP 4, and shall enter the particulars of the RPT.
|What are the powers of the Audit Committee in relation to RPT?
Under Section 177(4) of the Companies Act, 2013 it is required that the audit committee (if any constituted in accordance with Section 177) approves or modifies the RPT, post scrutiny as per the provisions of the Act.
For the above, the audit committee has the power to obtain professional advice from external sources and have full access to information contained in the records of the company.
Any transaction of amount not exceeding INR 1,00,00,000/- entered into by a director or officer of the company without obtaining the approval of the Audit Committee and not ratified by the Audit Committee within three months from the date of the transaction, shall be voidable at the option of the Audit Committee and if the transaction is with the related party to any director or is authorised by any other director, the director concerned shall indemnify the company against any loss incurred by it.
|What is the penalty for non-compliance?
Any contract or arrangement into by a director or an employee without obtaining the consent or ratification of the Board or by a resolution in the general meeting is voidable at the option of the Board and the director shall have to indemnify the company for any loss occurred.
Any director or any other employee of a company, who had entered into or authorized the contract or arrangement in violation of the provisions 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.
|Related Person under Goods and Services Tax (GST) regime*
Under the GST regime, transactions between related persons are treated as Supply even if made without consideration. All transactions including those listed in Schedule 1 of the Central Goods and Service Tax, 2017 even if made without consideration are now taxed under the GST regime. The parties pay tax on the same and later claim it as an input tax credit.
|What is the definition of Related Persons?
|Explanation to Section 15(5) of the Central Goods and Service Tax Act provides for the definition of Related persons
a) persons shall be deemed to be “related persons” if––
(i) such persons are officers or directors of one another’s businesses; (ii) such persons are legally recognized partners in business; (iii) such persons are employer and employee; (iv) any person directly or indirectly owns, controls or holds twenty-five per cent. or more of the outstanding voting stock or shares of both of them; (v) one of them directly or indirectly controls the other; (vi) both of them are directly or indirectly controlled by a third person; (vi) together they directly or indirectly control a third person; or (vii) they are members of the same family.
b) the term “person” also includes legal persons including entities incorporated outside India;
c) persons who are associated in the business of one another in that one is the sole agent or sole distributor or sole concessionaire, howsoever described, of the other, shall be deemed to be related.
This definition has been adopted from the Customs Valuation Rules, 2007, Rule 2(2). The only modification appears to be that under the Customs Valuation Rules, Explanation II, the persons who are associated in the business of one another where one is the sole agent or sole distributor or sole concessionaire, have to meet one of the abovementioned seven specified criteria to qualify as being ‘related’; however, under the Act, the persons associated in the business of one another shall qualify as ‘related persons’ merely by virtue of being the sole agent or sole distributor or sole concessionaire.
|What transactions will be treated as Supply and be taxed even when made without consideration?
|Schedule 1 of the Act, 2017:
1. Permanent transfer or disposal of business assets where input tax credit has been availed on such assets.
2. Supply of goods or services or both between related persons or between distinct persons as specified in section 25, when made in the course or furtherance of business:
Provided that gifts not exceeding fifty thousand rupees in value in a financial year by an employer to an employee shall not be treated as supply of goods or services or both.
3. Supply of goods—
a) by a principal to his agent where the agent undertakes to supply such goods on behalf of the principal; or
b) by an agent to his principal where the agent undertakes to receive such goods on behalf of the principal.
c) Import of services by a taxable person from a related person or from any of his other establishments outside India, in the course or furtherance of business
|How do you determine the value of taxable supply?
Section 15 of the CGST Act r/w Rule 2, 4 and 5 of the GST Valuation Rules
Section 15 provides for the determination of the value of taxable supply.
a) the price actually paid or payable for the said supply of goods or services or both where the supplier and the recipient of the supply are not related and the price is the sole consideration for the supply.
Inclusions: all taxes, cess, amount to be paid in relation to supply, incidental expenses, interest or late fee, subsidies etc.
Exclusions: discounts etc.
Rule 2 provides for the determination of value of supply of goods or services or both between distinct or related persons, other than through an agent will be:
a. be the open market value of such supply;
b. if open market value is not available, be the value of supply of goods or services of like kind and quality;
c. if value is not determinable under clause (a) or (b), be the value as determined by application of rule 4 or rule 5, in that order.
If the supply is of good intended for further supply the value shall, at the option of the supplier, be an amount equivalent to ninety percent of the price charged for the supply of goods of like kind and quality by the recipient to his customer not being a related person.
Provided where the recipient is eligible for full input tax credit, the value declared in the invoice shall be deemed to be the open market value of goods or services.
Rule 3 provides that if the supply is via an agent the value of supply shall be the open market value of the goods being supplied, or at the option of the supplier, be ninety percent of the price charged for the supply of goods of like kind and quality by the recipient to his customer not being a related person, where the goods are intended for further supply by the said recipient;Rule 4 and Rule 5 provides for the determination of value based on cost and for the residual method for determination of the value of supply.
|Treatment of Related Persons under Income Tax Act, 1961 (Please obtain the opinion of a tax expert)
|What is the definition of Relative?
|Rule 2(41) of the Act, 1961 provides that a relative, in relation to an individual, means the husband, wife, brother or sister or any lineal ascendant or descendant of that individual.
|For the purpose of calculation of business income: How is Specified Persons defined?
Although Section 40 A(2) does not make specific reference to related party but disallows expenses or payments made to specified persons
These specified persons are as below:
a) In case of an individual: relatives or associates or any person in whose business or profession the assessee himself or his relative has a substantial interest.
b) In case of a company, firm, association of persons, HUFs; any director, partner, member of association, member of the family or their relatives, members of family or their relatives, any person in whose business or profession, as mentioned or relative has substantial interest, any individual, company or firm or association of persons or HUFs who have substantial interest in the business or profession of the assessee, any other company carrying on business or profession in which the abovementioned company have substantial interest.
- Substantial interest means: In case of a company, beneficial ownership of not less than 20% voting power and at least 20% of the profits in any other case.
Interestingly, the Court In CIT v V.S. Dempo And Co. Pvt.Ltd336 ITR 209, has held that a subsidiary is not a related party for the purpose of section 40 (2)(b).
|What are associated enterprises and how are arms-length transactions determined?
Chapter X, Section 92 of the Income Tax Act, 1961 provide that any income arising from an international transaction shall be computed at arm‘s length price.
Section 92 A provides that associated enterprise in relation to other enterprise, shall mean an enterprise which participates, directly or indirectly, or through one or more intermediaries, in the management, control, or capital of the other enterprise. The same is determined on various thresholds such as:
a) Voting power: directly or indirectly, holds shares carrying atleast 26% of voting power.The question arises hereon since contractually many entities provide voting rights to even preference shareholders. Since statutorily voting rights are now given to preference holders, thus may not be considered for the purpose of the limit of 26%.
b) Loan advancement: if the loan advanced by an enterprise to another constitutes atleast 51% of the book value of total assets of the latter (the borrowing enterprise).
c) Guarantee for borrowing: guarantees at least 10% of the total borrowings of another enterprise.
d) Appointment of Management/ Managerial Personnel’s: if more than 50% of the Board of Directors or members of the Governing Board, or one or more Executive Directors or Members of the Governing Board of an enterprise is appointed by another.
e) Dependability: If manufacturing or processing of goods or articles of an enterprise is wholly reliant on use of certain intangible assets of another or if atleast 90% of raw materials and consumables required for the manufacture or processing of goods or articles carried out by one enterprise are supplied by the other enterprise and the prices and other vital terms are fixed by the other enterprise;
f) Sale of Manufactured Goods: if the goods or articles manufactured or processed by an enterprise are sold to another enterprise, and the prices and other vital terms are fixed by the other;
Control of another enterprise: if two enterprises are controlled by the same individual or by his/her relatives. On the other hand, if an enterprise is controlled by a Hindu Undivided Family (HUF) and the other enterprise is controlled by a member of such HUF or their relatives.
Further, Section 92F provides for the definition of arms length as the price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions”
|How Is the Computation of arms’ length price done?
Section 92 C of the Income Tax Act, 1961 provides for the methods of computation of arms-length for transactions with related parties, which are: (i) comparable uncontrolled price method;(ii) resale price method;(iii) cost plus method;(iv) profit split method;(v) transaction net margin method and (vi)such other method as maybe prescribed by the Board.
Disclaimer: Related Party transactions, law, treatment in books of account, tax impact is very nuanced. This note is only from knowledge sharing perspective and any action to be taken should with an expert’s guidance.
Authors: Ms. Ayushi Singh and Ms. Sohini Mandal