10/27/2014 Related Party Transaction: FAQs

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Related Party Transaction: FAQs
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Tweet Share 61 The Future Of Tax!
Published on Tue, May 13,2014 | 23:15, Updated at Tue, May 13 at 23:15Source : Moneycontrol.com
DLF & The Housewives!
Treaty Abuse: From Double-Taxation ...
By: Pankaj Chadha, Partner-Member Firm, EY Global
OECD's 'Intangible' Solution!

Transactions with related parties GAAR Deferred! Industry Delighted!

Transactions with related parties are of vital interest to Australia's Chevron Problem!
majority and minority shareholders alike and it is important CBDT Chairman & A Room Full Of
that the interests of shareholders as a whole are fully Cons ...
protected especially when control of the company or the The CBDT Chairman Interview
Board resides with a single party. Many related party
Vodafone Share Issuance: Capital Re ...
transactions are in the normal course of business. In such
circumstances, they may carry no higher risk than similar transactions with unrelated parties. Arbitration = Litigation?!
However, the nature of related party relationships and transactions may, in some
circumstances, give rise to higher risks of abuse than transactions with unrelated parties. For
example, related parties may operate through an extensive and complex range of relationships Twitter
and structures, with a corresponding increase in the complexity of related party transactions;
related party transactions may not be conducted under normal market terms and conditions
(for example, some related party transactions may be conducted with no exchange of
consideration).

While the great majority of related-party transactions are perfectly normal, the special
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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. Not all the firm 46m
RPTs are beneficial to investors. Though they are not illegal, the intricacies underlying them @thefirmupdate
are difficult to identify. RPTs include granting loans, writing off loans and dues, selling assets The Future of Tax!
to a related entity for a price significantly below the market price, and so on. Such RPTs are thefirm.moneycontrol.com/story_page.php…
#IFACONGRESS2014
usually indulged in by dominant shareholders, who have significant control rights compared to
their cash flow rights, creating a strong incentive to expropriate the minority shareholders.
Many high-profile accounting frauds in recent years (such as Enron in US and Satyam the firm 6h
Computers in India) have involved RPTs in one way or the other. Adverse RPT reduces @thefirmupdate
transparency in reporting, decreases the value of the firm, and stunts the growth of the capital ...Rajkot-based Bullion Trader Pankaj Chimanlal
Lodhiya (2/2)
markets ultimately.
Tweet to @thefirmupdate

All RPTs, are not abusive. A related-party transaction can also play a beneficial role by saving
transaction costs and improving the operating efficiency of a company. In fact, there maybe
several such transactions that are unavoidable because they make commercial sense for the
company; if companies are prohibited from entering into such transactions, it might work
against the principle of maximising the shareholder value. For example, many multinational Find us on Facebook

companies operating outside their parent countries have business models that involve RPTs.
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The parent companies bring in technology and know-how as well as financial assistance to
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the subsidiaries as and when needed.

6,060 people like The Firm CNBC TV18.

In this context, it may be useful to highlight the key RPT Regulations in the U.S. Under the
Sarbanes Oxley Act 2002, public companies are prohibited from making or arranging for
personal loans to any director or executive officer. The NASDAQ also requires that the audit
committee or another committee of independent directors reviews and approves all RPTs.
Further, the Securities Exchange Commission (SEC) requires a disclosure of transactions in
excess of USD 120,000 in which a related person, has a director indirect material interest.
There is no requirement in the U.S. for shareholder approval of RPTs as in India. However,
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the U.S. has strong legal provisions that enable investors to take legal actions against abusive
related-party transactions. For example, the Material Definitive Agreement has to be disclosed
to the Securities Exchange Commission in the U.S. within four days of entering the
agreement.

In India, Regulations related to RPTs are found in the Companies Act, 1956, the Indian
Accounting Standard 18, the Auditors Report Order, and Clause 49 of the Listing Agreement.
The Income Tax Act 1961 also contains provisions related to transfer pricing issues on such
transactions. Recent changes in Income Tax (domestic transfer pricing), Companies Act,
2013 and Clause 49 are significant steps by regulators towards addressing risks arising from,

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10/27/2014 Related Party Transaction: FAQs
that have until now been somewhat inadequately addressed, adverse related party
transactions.

Changes introduced through Clause 49 and Companies Act, 2013 are an attempt to improve
the corporate governance framework in India and respond well to the global practices in this
regard. These changes have expanded definition of related party; coverage of type of such
transactions; have brought in the concept of approval of audit committee or board of directors
or the shareholders for all related party transactions. Implementation effectiveness would be
result of application of these new regulations by various stakeholders. Anxiety of various
stakeholders in this regard can be viewed through questions below that would require good
understanding of the provisions to enable successful implementation.

Q1. Are requirements of 2013 Act, Accounting Standard and SEBI requirement with
respect to related party aligned?

No. Following are some examples:

1. 2013 Act requires disclosure at the time of entering into contract or arrangement whereas
accounting standard requires disclosure at the time of entering into a transaction

2. Clause 49 adds new class of related parties to the definition thereof given under the 2013
Act and includes close family members, fellow group entities, joint ventures of same third
party and combinations thereof, which are not in accounting standard or the 2013 Act.

3. Revised clause 49 requires shareholders’ approval for all material related party transaction
with no exception for transactions in ordinary course of business or at arms-length. Definition
of material transactions differs.

In case of deviation, as a thumb rule, provision of the stricter of the applicable regulations shall
be followed.

Q2:A corporate group has several foreign subsidiaries. Will provisions in relation to
related parties apply to foreign companies as well?

A: The term ‘company’ as defined under the 2013 Act is a company incorporated under the
Companies Act 2013 or any previous company law. Company incorporated under the relevant
legislation of a foreign country is not a ‘company’ under the 2013Act. However, transactions
by Indian company with a foreign company which is a subsidiary, associate, fellow subsidiary,
joint venture of the same venturer or company under control of same promoter, would be
covered based on understanding of combined reading of revised clause 49 and 2013 Act.

Q3: Provisions of 2013 Act are made effective from April 1, 2014 and those under
clause 49 are effective from October 1, 2014 though early application is permitted.
Operations of companies are ongoing and related party transactions are consummated.
What assessment is required of the existing related party transactions, if any?

A. All companies are required to comply with requirements in relation RPTs, prospectively
from the date of applicability of underlying regulation. Any default will be regarded as non-
compliance and may attract penal provisions under the 2013 Act. Following actions are
recommended to avoid any risk of default:

1. Companies should carefully review its related parties under the regulations and identify all
existing and new related parties together with all existing and new contracts, arrangements
and transactions etc. It shall develop its policy on materiality of related party transactions
together with manner of dealing with them. Amongst other matters, the manner of dealings
shall cover aspects relating to determination of key terms including arms-length price.

2. An immediate dialogue needs to be initiated with the Audit Committee to assess and confirm
their expectations from the policy and review/approval protocols. A careful evaluation of
existing and proposed RPTs is not unwarranted.

3. Company shall develop process and methodology and make necessary changes in
systems and procedures adapting to the new set of regulations.

Q4. As regards the 2013 Act, many companies have expressed a view that if related
party transactions are entered into ordinary course of business and are on arms-length
basis then no board or shareholder’s approval is required. Which transactions will be
regarded as ordinary course?

The phrase “ordinary course of business” is not defined under the Companies Act 2013 or
rules made there under. It seems that the ordinary course of business will cover the usual
transactions, customs and practices of a business and of a company. In its guidance to

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10/27/2014 Related Party Transaction: FAQs
auditors, the Institute of Chartered Accountants of India has included following few examples
of transactions that are considered outside the entity’s normal (or ordinary) course of
business:

· Complex equity transactions, such as corporate restructurings or acquisitions.

· Transactions with offshore entities in jurisdictions with weak corporate laws.

· The leasing of premises or the rendering of management services by the entity to another
party if no consideration is exchanged.

· Sales transactions with unusually large discounts or returns.

· Transactions with circular arrangements, for example, sales with a commitment to

repurchase.

· Transactions under contracts whose terms are changed before expiry.

The assessment of whether transaction is in ordinary course of business is very subjective,

judgemental and can vary on case-to-case basis giving consideration to nature of business
and objects of the entity. The purpose of making such assessment is to determine whether the
transaction is usual or customary to the company and/ or its line of business. Companies
should consider variety of factors like size and volume of transactions, arms-length,
frequency, purpose etc. to make this assessment.

Q5. Definition of related parties is very wide. What are key actions which management
should take to ensure a robust process for identifying related parties?

Some of the key action areas which management can consider include:
Make all covered parties accountable towards making disclosure of their interest - for e.g.
relevant information should be captured from vendor/customer at the time of including their
names in the master vendor/client database. This might require workshops with the covered
parties so that they understand and appreciate requirements fully.
Formalize the disclosure process through defined frequency, information and ownership
Conduct one time exercise to identify current spectrum of related parties
Set up a mechanism for ongoing updation of the related parties
Specify responsibility for disclosure in the event of change of interest and define responsibility
for administering the process
Create comprehensive repository of all related parties with restricted access and monitoring /
updation procedure
Define frequency for updation of related parties’ repository on a periodic basis (apart from
updating based on event based disclosures) along with approval matrix for making the
changes and facility to maintain change logs.
Integrate identification with the primary ERP to enable identification of transactions with related
parties - Customer master, Vendor Master, Employee Master, etc.
Q6. In case of 2013 Act, is the board required to approve all related party
transactions?

The 2013 Act prescribes that company needs approval of the Audit Committee on all related
party transactions and subsequent modifications thereto. This is irrespective of whether they
are in the ordinary course of business and consummated at arm’s length price or they are
below prescribed thresholds. Further, for listed companies, Clause 49 prescribes audit
committee approval for all related party transactions and shareholders approval of all material
RPTs.

In case of a bank or a telecom company for example, directors/KMPs of a Bank may place
fixed deposit with the Bank or directors/KMPs of telecom service provider may avail telecom
services. Due to volume of similar transactions and impracticality to obtain prior approval from
the board or shareholders for such large volume of transactions, many companies are of a
considered view that lawmakers did not intend same to be required for transactions which are
in ordinary course of business and are at arms-length. For normal transactions, if company
has a well laid down policy framework which explicitly lays down terms of contract/transaction
and which are approved by audit committee then a separate approval will be unwarranted for
each such transaction. However, any modification/ transaction, which was not contemplated
in the framework and approved by the Audit Committee in its initial approval, would require
fresh approval of the Audit Committee.

Legal evaluation or a clarification from lawmakers would be necessary considering the

difficulties such an approval might impose.

Q7. Companies normally engage in Master Service Agreements (MSA) to decide overall
framework to avail services / goods. Will approvals be required at the time of entering

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10/27/2014 Related Party Transaction: FAQs
MSA and also at the time of entering purchase orders?

Intention of regulators is that Audit Committee/Board approvals terms and conditions of the
contract and transactions. MSA will satisfy definition of contract or arrangement and hence will
require approvals specified. Specific approval of purchase orders or sub-contracts may not be
required if MSA are not very general and lays down critical terms (nature of service, payment
terms, pricing formula, timing and manner of revisions in terms etc.) of arrangement based on
which sub-contracts or purchase orders are placed.

Q8. Many companies have existing contracts or MOUs or other arrangements entered
into prior to introduction of these new regulations but the underlying transactions are
likely to be operationalized in period after the introduction of the new regulations.
Would such contracts require a review and approval of the audit committee/board or
the shareholders, as the case may be, considering effective execution in the period
after introduction of the new regulations?

MOUs are merely an understanding and not a definitive contract or arrangement. Clearly,
these would require rigor of review under the new framework, prior to execution of definitive
agreement. In relation to other contracts or arrangements covered above, although differing
views might exist when evaluating the manner how regulations have been made, it would be
improper to assume that such contracts or arrangements are not required to go through rigor
of review now required considering these are operationalized only under the new regime of
regulations.

Q9. What is meaning of arms-length? Is meaning of arms-length same as transfer

pricing rules?

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. Most commonly used guidance in
this regard under Income Tax provisions is given in International and domestic tax laws in
context of transfer pricing regime. One may even refer to rules for registered valuers wherein
valuation methodologies are prescribed for registered valuers. It should be noted that these
guidance are not conclusive and have only persuasive value. One may consider various
qualitative and quantitative assessments to determine arms-length.

For e.g. Let’s assume a bank who normal course of business provide 9% rate to their
customers for placing fixed deposit for 2 year tenure. It offers 9.25% higher rate to all their
group employees. One may argue that same is not at arms-length. Alternatively, one may
argue that banks devise different strategy for various categories of customers. Employee
population of entire group provide a significant customer base for the bank and hence
providing higher rate is in accordance with business strategy and meets the criteria of arms-
length. The arms-length assessment is subjective exercise and requires judgement after
considering various parameters.

Q.10. Under the regulations, no member of the company is permitted to vote on a

special resolution to approve any contract or arrangement which may be entered into
by the company, if such a member is a related party. Does the bar from voting apply to
“all” shareholders who are related parties or only those related parties who are
conflicted?

In cases where shareholders are ‘related’ in some way or the other with the company (but are
neither the intended transacting party nor interested in the transaction directly or indirectly that
has been put up for approval) it will be inappropriate to interpret the law to say that all such
shareholders are prohibited from voting. The principles of “majority of minority” voting must not
result in any unfair advantage to the minority. However, plain reading of the regulations would
suggest all related parties shall abstain from voting, whether related or unrelated.
Consultations with legal experts might be required to ascertain intent of these provisions.

Concluding remarks
Implementation is key and would require not only significant effort of the corporates but also of
the regulators to continuously monitor the provisions and proactively provide necessary
guidance to various stakeholders for smooth transition.
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