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The Companies Act, 2013 - Provisions relating to related Party disclosures

G S Rao 
on 09 November 2013

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Introduction:

The Companies Act, 2013(the Act or New Act) aims at enhancing Corporate Governance by clearly defining the duties of directors and fixing additional responsibilities and defining the attributes and role of independent directors to preserve their independence. It has increased the responsibility of auditors by imposing certain restrictions on providing services other than audit and huge penalties to ensure their independence. Disclosure of related party transactions and approvals for such transactions is one such area which is intended to prevent directors, Key managerial persons from taking undue advantage of their position for their personal benefit and ensure transparency in dealings of the company. This article is an attempt to highlight the issues that arise out of related party transactions.

 

Why law mandates disclosure of related parties?

The general presumption is that shareholders interests are compromised in related party transactions and goods or materials or services are sold at unreasonably low prices to related parties. Income tax looks at these transactions as tax evading transactions and values the related party transactions at Arm’s length. Analysts also fail to evaluate the financial results when related party transactions are understated or not given effect. Companies Act, in the name of good corporate governance mandates approvals of board and shareholders, disclosure of such transactions and imposes penalties for non compliance of relevant provisions.

 

Law with regard to related party transactions:

Under Old Act: In the old Act Section 297 and 299 and 301 and Schedule VI and read with Schedule-1A (relative of directors)  help in identifying the related parties, related party transactions and the restrictions imposed for such transactions. Section 297 of old Act requires board’s approval(Regional Director’s approval in case paid up capital is 1crore or more) for entering into any contracts/arrangement with parties declared therein. subject to certain exceptions(regularly traded materials /services). Section 299 requires a director to disclose his interest directly or indirectly in any transaction/arrangement and it is wider in its scope but the exception u/s 299(6) i.e  limit of less than 2% holding dilutes its effect. Section 301 requires the company to maintain a register in which disclosures of directors, contracts or arrangements entered into with the approval of board or shareholders.

New Companies Act:

In the New Act, the relevant sections which are connected for identifying related party transactions are given below. Frame work laid down by the new Act for treatment of related party transactions will be clear from clear from these sections.

 

Section 184- Newly appointed Directors have to disclose their interest in companies, firms or association of individuals at the very first meeting of the Board attended by them and thereafter every year in the prescribed manner (corresponds to old sec.299).Similarly if any director individually or together with other directors holds more than 2% in any body corporate, and any proposed contract or arrangement with such body corporate in which he is interested or concerned whether directly or indirectly, or in which he is a promoter or manager or CEO  of that body corporate then he has to make a disclosure of such interest. This limit  of 2% or more is not in line with AS-18 limits considered for control(more than 50% of voting power) and significant influence(more than20% of voting power).

 

Section 188- It deals with related party disclosures (covers sections 297,300,314 of Old Act) which are mentioned below in detail.

 

Section 189- Every director or KMP shall within 30 days of his appointment/relinquishment of office disclose his concern or interest in any company or body corporate, firms or individuals including his share holding and also contracts or arrangements in which he is directly or indirectly interested( Section 184). Every company is required to keep a register giving separately the particulars of all contracts or arrangements to which section 184(2) of section 188 applies and shall be placed before the board meeting and signed by all directors present at the meeting. Section 189(5) states that nothing in this section shall be applicable for contracts or arrangements for supply of goods/materials/service whose aggregate value is less than 5 lakhs

 

Who is a related party?

A related party is a person or entity that is related to the entity preparing its financial statements. Before we go deep into the requirements of Section 188, for better understanding it is necessary   to have a close look at Section 2(76) which defines related party with reference to a company:

 

i.  director or his relative,

ii. a key managerial personnel (MD/WTD/Manager/CEO/CFO/Co.Secretary) 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.  any body 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;

 

It would be evident from the above that the New Act  has included  KMP or his relatives , influential persons such as promoters or their relatives according to whose instructions  bodies corporate or directors or managers act (instructions given in  professionals are excluded) and it may add in future any other person.

 

Definition of Relative:

Now let us examine definition of relative {Section 2 (77)} which gives a foundation for understanding of related parties, connected relatives and transactions with the related parties. Section 2(77) defines relative as follows:-

Relative with reference to any person, means any one who is 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;

 

Recently MCA uploaded Rules in phases  for comments from public and the relevant Rule no.1.4  of Companies Rules,2103 declares the following as relatives for the purpose of Section 2(77) (iii)

 

A person shall be deemed to be the relative of another, if he or she is related to another in the following manner:

Spouse, Father including step-father, Father’s father and  mother, Mother including step-mother, Mother’s mother and father, Son including step-son, Son’s wife, son and daughter, Daughter including step-daughter, Daughter’s husband, Brother including step-brother, Sister including step-sister.

 

Restrictions with regard to related party transactions {Section 188}:

1. Boards Approval for certain transactions : Unless Board of directors approve, no company shall enter into any contract with a related party involving  the following {Section 188(1)}:

sale, purchase or supply of any goods or materials;

selling or otherwise disposing of, or buying, property of any kind;

leasing of property of any kind;

-  availing or rendering of any services

- appointment of any agent for purchase or sale of goods, materials, services or property

such related party's appointment to any office or place of profit in the company,

its subsidiary company or associate company; and

underwriting the subscription of any securities or derivatives thereof, of the company

 

2. Prior approval of Shareholders for related party transactions: Prior approval of the company by a special resolution is required in the case of a company having such paid up capital or transactions value not exceeding such amount as may be prescribed[First proviso to Sec.188(1)}.

 

3. Vote can not be cast: Further the 2nd proviso to 188(1) stipulates that if any member is a related party, he is barred from casting his vote on such special resolution. As per Rules currently displayed, the prescribed capital is one crore or more and transaction value individually or in aggregate  is 5% of the turnover or net worth in the financial year as specified in recently.

 

Exemptions:

Approvals are not necessary for any transactions entered into by the company in its ordinary course of business other than those which are not on an arm length’s basis. As per the explanation the expression “arms length transaction” means a transaction between two related parties conducted as if they were unrelated and there is no conflict of interest {Third proviso to Sec 188(1)}

 

Disclosure requirements:

Every contract or arrangement with related parties shall be referred in the Board’s report to the shareholders along with justification for such contract or arrangement. As per AS 18 discussed below, disclosures in relation to related party transactions are to be made  by the reporting enterprise in the financial statements. {Sec.188(2)}. Revised Schedule-III requires disclosure of loans and advances from related parties. Similarly loans and advances due by directors or other officers of the company or any of them either severally or jointly with any other persons or amount due by firms or private companies respectively in which any director is a partner or director or  a member should be separately stated.

 

Consequences of not obtaining approvals:

 

In case any contract or arrangement which 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 shareholders as the case may be within three months from the date of the contract or arrangement, such contract or arrangement shall be voidable at the option of the Board. 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 by such transactions.{Sec.188(3)}.

 

In addition to the above remedy, 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.{Sec.188(4)}.

 

Requirements as mentioned in Companies Rules,2013: The notice of board meeting at which the related party contract or arrangement is moved for its  approval, shall disclose full details  such as name of the party, relationship, particulars of contract(materials terms, duration, value etc),money paid or received. Rules prohibit the presence of interested director at the meeting during the discussion on the related party transaction. The prescribed share capital for the purpose of Section 188(1) is one crore or more. If the value of transaction or aggregate value is 5% of annual turnover or net worth which ever is higher, then approval from shareholders is required.

 

AS- 18 in relation to related party transactions:

It would be useful now to discuss the AS-18 frame work created by ICAI in relation to related party transactions. Section 129 of the Act stipulates that financial statements shall give a true and fair view of the state of affairs of the company and comply with the Accounting standards. As per Section 133, Central government is empowered to prescribe accounting standards as per recommendation of Institute of Chartered Accountant and confirmation of those by the National financial reporting Authority. It is clarified in Rule no.9.9 that till new standards are prescribed, the existing Accounting standards shall continue. This the present Accounting standard  AS-18  which deals with disclosure of related party transactions continues to be applicable to all companies whether listed or not, firms and sole proprietor ships etc.,

 

According to AS-18, if one party has the ability to control the other party or has significant influence then parties are considered to be related parties.

 

For the purpose of ascertaining whether any transaction entered into by a company with any party comes under related party transaction or not one has to first examine  whether the party is related or not and then whether that party can exercise  control or significant influence. Related parties defined by AS-18 is  similar to the definition in Section 2(76)

 

Control for this purpose means:

If a party:

 

owns directly or indirectly  more than half of the voting power  of the other enterprise

- Controls the composition of the board of directors  in the case of a company or governing body in any other case

 

The other factor significant influence means control of 20% or more of interest directly or indirectly in the voting power of the other enterprise.

 

Now New Act which defined KMP, Associate company, to align with the requirements in AS 18.It is relevant to note that although associate company has been defined, the word significant influence has not been defined. Section 129(3) stipulates that where a company has subsidiaries, in addition to its financial statements, consolidated financial statement of the company and all of its subsidiaries shall be prepared in the same manner as of its own. AS 18 exempts disclosure requirements if a consolidate financial statements are prepared in respect of intra group transactions. This appears to be confusing.

 

Income tax Angle:

Transactions with related parties come under the scrutiny of Income tax and run the risk of disallowance u/s 40A (2), if they do not meet the test of arms length price.

 

Areas of concern:

The interested director has different meaning for the purpose of 40A(2) of IT act, companies Act compliance, and AS-18. The relative defined by AS18 and new Act (Rule no. 1.4), 40 A (2) (b)  of IT act(lineal ascendants and descendants) are also different and a uniformity would bring harmony and avoid confusion. It is hoped that the revision in AS-18 would address these issues.

 

What is the penalty for violation?

If any director or any other employee enters into a contact or arrangement with related parties in violation of the provisions of section shall:

- 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 Rs.25,000/- but may extend to 5lakhs or with both.

- in case of any other company, be punishable with fine which shall not be less than Rs.25,000/- but may extend to five lakh rupees.

   

Conclusion: It is always better for a director to disclose list of his/her relatives, list of companies in which he/she is a director, firms in which he /she is a partner, including shareholding in reporting enterprise and other enterprises. This will save director and will be in a position to defend, if any transaction takes place without his/her knowledge. Moreover this disclosure will allow the company to see the aggregate holding of all directors is exceeding 2% or not for seeking exemption under Companies act. However it is safe to seek approval of the board or shareholders as the case may be  to come out of the rigors of the penalties.

 

G S Rao,

DGM(Legal),OCL India Limited

Tags: The Companies Act, 2013, Related party transactions, AS-18 issued by ICAI

 

Disclaimer:

This article contains interpretation of the Act and personal views of the author are based on such interpretation. Readers are advised either to cross check the views of the author with the Act or seek the expert’s views if they want to rely on contents of this article.


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