Related Party Transactions & Legal Provisions

Investment is one of the major decisions in finance. Analysis of Financial information provided by the entity is one of the significant task to take right decisions. To protect the interest of the investors, transparency in the books of account is essential. Indian companies have been viewed by the outside world as family controlled and not professionally managed.



Family controlled businesses represent almost 80% of the listed companies. These companies carry on their business through subsidiaries, associates and acquire interest in other enterprises. The transactions between these entities play very important role in analyzing the investment feasibility of an entity. If these transactions are unchecked, companies will use this opportunity for tax evasion and cheat the investor. One more instance where we can find these types of transactions are directors entering into transactions with the company and gain personal benefit. To avoid these types of transactions and to bring transparency, stringent provisions are introduced in various laws.



In this article an attempt has been made to make a analysis of provisions under different laws relating to Related Party Transactions. An awareness of various provisions is very much required so as to take adequate care while entering into related party transaction and disclosing the same in the Financial Statements.



In a corporate world, the real owners are different from the management. So there is possibility that, management by using their powers may cheat the investors.



Companies Act



To have control on all these activities 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 Governament approval if the company has more than one crore paid up capital.



At the same time 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 & 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 intentions behind these sections are 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.



Accounting Standard



To make investor aware about these transactions the Institute of Chartered Accountants of India 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.

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. There are several gaps that need to be bridged.

Income Tax

A disclosure that a related party transaction was made during the year serves little purpose, unless one is apprised of the terms of the transaction and tax implication. 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.

After having discussion on the various provisions, we move our discussion on who will be consider as related party? For this different law gives different meaning.



Companies Act



Section 297 of the Companies Act 1956, describes the transaction with the following persons as related party transaction.



a director of the company
relative of the director
a firm in which such a director or relative is a partner
any other partner in such a firm
a private company of which the director is a member or director


Accounting Standard



As per Accounting Standard 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



Holding companies, subsidiaries and fellow subsidiaries
Associates and joint ventures
Individuals (incl. their relatives) - having voting power giving them control or significant influence
Key management personnel including their relatives
Enterprises where controlling individual or key managerial personnel has significant influence


However, disclosure is mandatory for the following categories of companies.



Companies which are listed or are in process of listing
Banks, financial institutions and insurance companies
Enterprises having turnover > Rs. 50 cr.
Enterprises having borrowings > Rs. 10 cr.
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.



Further, Auditing and Assurance Standard 23- Related Parties impose duty on auditor to identify and disclose the related party transaction in the financial statements.



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 it 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.



Income Tax



The scope of word related party under The Income Tax Act is included the following.

(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 the association or family, or any family 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; or

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. As per the AS-18, relative means spouse, son, daughter, brother, sister, father and mother. If we compare these two acts Companies Act is wider term. The Income tax Act defines the word relative as spouse, son, and daughter, brother, sister or any lineal ascendant or descendent.

Clearly, there are more reasons than one to go through the section in the company’s annual report which details related party disclosures. It will provide a better understanding of the company’s operations.