By Raj Barot and Mehul Modi
The Companies Act, 2013 ushered in a host of sweeping changes that will set the tone for modern legislation that facilitates growth and greater regulation of the corporate sector in India. The government designed the 2013 Act to enhance self-regulation, encourage corporate democracy, and reduce the number of required government approvals for transactions. As a result, the 2013 Act is expected to improve corporate governance norms, and better protect the interests of various stakeholders such as lenders and investors (particularly small investors).
The new law, which received presidential assent on August 29, 2013 and appeared in the Official Gazette on August 30, 2013,represents a transition from an approval regime to a disclosure regime and provides relief from obtaining cumbersome approvals from regulatory authorities. As of April 26, 2014, 283 sections have been notified (brought into effect), and the corresponding sections of the Companies Act, 1956 have ceased to have effect.
This article highlights important changes for related party transactions (RPTs) under the 2013 Act and examines several provisions that require further clarification before parties can confidently engage in these transactions.
Broad Definition of “Related Party”
The RPT provisions of the 2013 Act are materially different in scope and applicability than their predecessors in the 1956 Act.For example, the 2013 Act comprehensively defines the term “related party” for the first time and broadly interprets the term to include the following relationships:
- directors and key managerial personnel (KMP)and their relatives;
- firms or companies in which a director, manager, or their relative is a partner, member,or director;
- public companies in which a director or manager is a director and holds, along with their relatives, more than 2 percent of its paid-up share capital;
- corporations 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; and
- any person on whose advice, directions, or instructions a director or manager is accustomed to act.
The law further defines related parties to a company to include its holding, subsidiary, associate, and fellow subsidiary companies.The Act authorizes the government to amend this list of related parties.
Expanded List of Covered Transactions
Under the new law, a transaction with any related party requires approval from the board of directors if the transaction does not occur in the ordinary course of business or at an arm’s length basis. The 2013 Act expands the types of transactions subject to examination. The 1956 Act included only sales, purchases, or supply-related contracts involving any goods, materials, or services and underwriting the subscription of shares in or debentures of a company. The 2013 Act extends coverage to several additional types of transactions:
- buying, selling, or disposing of any kind of property;
- leasing of property;
- appointing an agent to buy or sell goods, materials, services, or property; and
- appointing a related party to the company, its subsidiaries, or its associate companies.
Here are a few examples illustrating RPTs covered by the 2013 Act:
- Under the 1956 Act, a company must prepare its financial statements according to certain accounting standards. Under Accounting Standard 18, which governs RPT disclosures, an Indian company must disclose in notes to audited financial statements any transaction with its foreign parent company or its fellow subsidiaries. Under the 1956 Act, these RPTs did not require any approval from board members, shareholders, or the government. However, the 2013 Act defines the term “related party”as including a holding company—that is, a foreign parent company. Therefore, these transactions require approval if either of two conditions is true: (1) the transaction does not take place in the ordinary course of business or (2) the transaction takes place in the ordinary course of business but the negotiation does not take place at an arm’s length price.
- A sale of immovable property by a director to the company or vice versa would not require government approval under the 1956 Act. However, under the 2013 Act, buying, selling, or disposing of property of any kind requires necessary compliance and approvals in case the transaction exceeds prescribed limits and disclosures.
- A sale of a vehicle to a director of a company may require government approval. Assume an Indian subsidiary of a U.S. company having paid-up capital of more than the prescribed limit (e.g., ₹100 million) and engaged in the business of providing information technology services is to sell a company vehicle to any of its directors (who may be based in the United States or in India) at the prevailing market price. Even though the transaction will be at an arm’s length price, it will require approval under the 2013 Act as it may not be regarded as “in the ordinary course of business of the Indian subsidiary” because the subsidiary’s business is information technology, not automobile sales.
Additional Duties Imposed on Organizations
Under the 2013 Act, RPTs that fall outside the ordinary course of business or that occur on a basis other than at arm’s length trigger a number of compliance duties, including the following critical responsibilities:
- Audit committee approval: The company’s audit committee must approve RPTs and subsequent modifications, if applicable.
- Board approval:The prior consent of the board of directors is required before entering into RPTs. Further, independent directors are required to pay sufficient attention and ensure that they hold adequate deliberations before approving RPTs and assure themselves that the transactions are in the company’s best interests.
- Shareholder approval: Prior approval of the shareholders by way of special resolution at a general meeting is required in case the paid-up capital of the company or the transaction amount exceeds the prescribed limit. Rules have prescribed that a company would need shareholders’ approval if any of the following conditions is true:
a. its paid-up share capital is ₹ 100 million or more;
b. the specified transaction individually or taken together during a “financial year”(April to March) exceeds 25 percent of the company’s annual turnover or 10 percent of the company’s net worth according to its most recent audited financial statements;
c. the transaction relates to the appointment to any office or place of profit in the company, its subsidiary company, or an associate company that exceeds payment of monthly remuneration of ₹ 250,000; or
d. the transaction is for remuneration for underwriting the subscription of any securities or derivatives thereof of the company that exceed 1 percent of the company’s net worth according to its most recent audited financial statements.
- Disclosures:The board must disclose all RPTs regardless of whether they take place at arm’s length or in the ordinary course of business, along with a justification for each in the Board’s report.
- Interested directors: Any director who has an interest in any contract or arrangement with a related party cannot be present at the meeting where the board is considering that contract or arrangement.
- Notice: The notice calling the board meeting and general meeting shall contain disclosures as may be prescribed.
Noteworthy among the changes introduced under the new Act is the law’s mandate that a related party who is a member of the company cannot vote on a required special resolution in relation to matters requiring shareholder approval (as listed above). In other words, for RPTs that require approval, only shareholders who are not related parties can vote.
Penalties for Noncompliance
The 2013 Act has introduced stringent penalties for noncompliance. Any directors or employees of a company who entered into or authorized the nonconforming contract or arrangement may be subject to a fine and imprisonment. For listed companies, the penalties range from a minimum of ₹ 25,000 to a maximum of ₹ 500,000 along with imprisonment for a term that may extend to 1 year. Non-listed companies are subject only to the fine.
Gaps in the RPT Provisions of the 2013 Act
Although most of the suggested changes are welcome from the point of view of protecting the interests of shareholders, lenders, and other stakeholders, the new law comes with new challenges, most of which relate to the definitions of certain important terms. One challenge is presented by the term “ordinary course of business.” Because the 2013 Act does not define this term, its meaning will have to be subjectively determined based on the facts of each case.
So, too, is the case with “arm’s length transaction.” The 2013 Act defines this term as a transaction between two related parties who conduct the transaction as if they were unrelated, so that there is no conflict of interest. The basis for determining whether a particular transaction is at arm’s length has not been set forth in the Act. Instead, it appears that the burden of proof with respect to the arm’s length condition rests with the company itself as well as its directors,audit committee, KMP, and other officers in charge of the affairs of the company. Under the tax laws, there are methods for determining arm’s length pricing; the question is whether companies can use these methods for purposes of the 2013 Act and what would happen if the revenue authority were to hold subsequently that the method the company adopted is not correct.
Impact of the RPT Provisions
As the 2013 Act evolves, its RPT provisions should bring about a more transparent system by increasing reporting requirements, enhancing accountability,and focusing on self-regulation.This law requires taking a fresh look at existing structures and arrangements and changing them appropriately to ensure compliance from a tax and regulatory perspective. During this transitory period, many companies will experience a strain on their resources as they struggle to comply with the new requirements.
In the meantime, the best option for many companies will be to avoid RPTs until the government clarifies the terms “in the ordinary course of business” and “arm’s-length transaction” under the 2013 Act.
Raj Barot is Principal and Legal Counsel at Next Frontier LLC, a strategic advisory and implementation firm that assists clients with market entry and business growth in emerging and frontier markets in India and Southeast Asia.
Mehul Modi is a Partner at Deloitte Touche Tohmatsu India and assists clients with tax, regulatory and board secretarial matters including compliance with the Companies Act and the Securities Exchange Board of India (SEBI).
Disclaimer: The views expressed in this article are those of the authors only and not Deloitte Touche Tohmatsu India.