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Related party transactions

The term Related Party resembles that it talks about someone related but when we talk about the legal understanding of the same under the corporate law it is clearly defined under sec 2(76) of the Companies Act, 2013. The definition provided under the Act is exhaustive in nature. Under the Companies Act 2013, there is a concept of Related Party transactions which has been incorporated under sec 188 of the Act.

The concept was introduced to increase the transparency and to keep a vigil upon all the transactions. All accountability and key management related areas need to be disclosed by way of general meeting and to shareholders about any such arrangement. Related Party Transactions basically happens when the management of the company enters into a contract with related parties, that is, officers and directors of the firm and their relatives, large shareholders, or other parties affiliated with these individuals.

Such contracts are commonly referred to as related party transactions. Analyzing the business and commercial transactions in the market it can be concluded that majority wherever the large organizations are involved the impact of their transactions always affect the people at large. If in such organizations there is any fraudulent act committed it would directly affect people, so further just to avoid such mishaps with the people's vested interests such regulations have been bought into the Act.

Statement of problem
Many high profile accounting frauds in recent years (Enron, Adelphia, Tyco, Refco etc.) have involved related party transactions in some way, creating concern among regulators and other market participants about the appropriate monitoring and auditing of these transactions.

We will compare related party transactions and arm length price and dealing with transfer pricing which. We find that frauds involving RPTs had a lower impact on financial statement, but we are likely to involve misappropriation and to involve a top executive. The application of the procedure regarding related party transactions is not done in a proper manner which is not actually justified for the shareholders.

The disclosure before the Registrar of Companies is although mandatory but the exception of arm's length is being misused. The most frequent type of transactions were loans to related parties and payment to company officers for goods or services that were either unapproved or non-existent.

Scope of the study
The scope is to:
  • Identify related parties and transactions with them.
  • Identifying outstanding balances and commitments between the reporting entity and related parties in the consolidated financial statement, separate financial statements and individual financial statements.
  • Recognizing the circumstances in which disclosures will be required in the above stated situations.
  • Determine the disclosures to be made 

Legal Provisions
The transactions entered by a company i.e., the principal should be disclosed to the shareholders i.e., agents and their rights should not be infringed by keeping them in disguise as they are the ones who have their financial interests vested with the company.

To protect the rights and interests of these shareholders, the Companies Act 2013 incorporates and establishes legal obligations on the Directors of the company to avoid the conflict of interests. Under the Companies Act 2013, sec 188 talks about the Related Party Transactions which is read with sec 2(76) of the Act stating the definition of the related party. It includes:
  1. a director or his relative
  2. key managerial personnel or his relative
  3. a firm, in which a director, manager or his relatives is a partner
  4. a private company in which a director or manager is a member or director
  5. a public company in which a director or manager is a director or holds along with his relatives, more than two percent of its paid-up capital
  6. anybody corporate whose Board of Directors, managing director or manager is accustomed to act in accordance with the advice, directions or instructions of a
  7. any person on whose advice, directions or instructions a director or manager is accustomed to act.
  8. any company which is a holding, subsidiary or an associate company of such company and a subsidiary of a holding company to which it is also a subsidiary;

Related party as per section 2(77)

Relative with reference to any person means anyone who is related to another if:
  1. they are members of a Hindu Undivided Family
  2. they are husband and wife; or 
  3. one person is related to the others in such manner as may be prescribed

Comparisons Between Companies Act 2013 and 1956

When we compare the Companies Act 2013 with the Companies Act 1956 incorporation of this concept was not there, but it was divided into several names in the latter Act, now in the former Act the concept has been incorporated specifically under sec 188 of the Act with the clarity of the terms used, by the means of the definitions under sec 2 of the said Act.

It is the duty of employee or the director to disclose the information and if such duty is violated on part of the employee or director, they are punishable with imprisonment up to one year or with a fine ranging between Rs 25,000 to Rs 5,00,000 or both if the default is made under listed companies, while for default in the other companies other than the listed companies only the abovementioned fine is charged.

Arm Length Price
An exception under which the related party transactions are approved i.e., Arm's Length Transaction. Arm's length transactions mean a transaction between two related parties which is conducted as if they were unrelated so that there is no conflict of interest. Arm length price means correct market price or fair price, but if due to ALP there is reduction in the income or increasing the losses then transfer pricing provisions shall not apply.

An arm's length price for a transaction is therefore what the price of that transactions would be given on the open market. Both the parties usually have equal access to information related to the deal. It also assures third parties that there is no collusion between the buyer and seller.

Example: If Arm Length Price is 90 lakh and dealing is made in 1 crore than we should recognized revenue as one crore. But if 1.5 crore then revenue should be recognized as 1.5 crore based on transfer pricing provisos.

Arm's length transactions are commonly used in real estate deals because the sale effects not only those directly involved in the deal but the other parties as well, including lenders. If two strangers are involved in the sale and purchase of a house, it is likely that the final agreed upon price is close to fair market value, assuming that both parties have equal bargaining power and equal information about the property.

Transfer pricing
Transfer Pricing is discussed in Income Tax Act. Income Tax Act, 1961. Transfer Pricing is recognized based on Arm Length Price. As per provisions of Income Tax Act 1961, Transfer Pricing Provisions is dealt under section 92. It means that not only the income from an international transactions is to be computed as per arm's length price but also any expense or cost to be incurred in an international transaction in connection with a benefit or service or facility to be provided will be computed as per arm's length price.

Exceptions: As per transfer pricing provisions there are different methods for computation of Arm Length Price. However, if more than one price is determined as per the most appropriate method the average of such price shall be ALP. If the difference between Actual Transaction Price & Arm Length Price is up to 3% (1%in case of wholesale trading) of actual transaction price then such difference shall be ignored & actual transaction price shall be treated as ALP.

Transfer pricing refers to value attached to transfer of goods or services between the related parties. Thus, transfer pricing can be defined as the price paid for goods transferred from one economic unit to another, assuming that the two units involved are situated in different countries but belong to the same international firm. As per Transfer pricing provision any income, expenditure, interest & allocation of cost in relation to international transactions or specified domestic transactions (aggregate value of such transactions in the previous year exceeds 20 crore) shall be computed having regard to arm length price.

Arm's Length Principle applied to Transfer Pricing and Attribution of Profits

The arm's length principal transfer pricing and attribution of profits. Such an application makes no distinction between a branch or subsidiary through which it carries on business in a country.

Transfer Price is Not Arm' Length Price

Transfer price is the price charged in a transaction. The term transfer price is used to describe the actual price charged between the associated enterprises in an international transaction. Transfer pricing issue arises when entities of multinational corporations' residents in different jurisdictions transfer property or provide services to one another.

These entities do not deal at arm's length and thus, transactions between these entities may not be subject to ordinary market forces. Where the transfer price is different from the price which would have been charged if the enterprises were not associated and the difference gives rise the tax advantage, the tax is calculated based on arm's length price.

Importance of Transfer Pricing:

Multi-National Companies operating in more than one country transfer physical goods and intangible property or provides services to their associated enterprise in another country. Two enterprises are Associated enterprise if one of the enterprises participates directly or indirectly in the management, control or capital of the other or if both the enterprises are under common control.

While doing so, the Multi-National Companies concerned has in mind the goal of minimizing tax burden and maximizing profits but the two tax jurisdiction have also the consideration of maximizing their revenue while making laws that govern such transactions. It is an internationally accepted practice that such Transfer Pricing should be governed by the Arm Length Price and the Transfer Price should be the price applicable in case of a transactions of arm's length. The transactions between Associates should be priced in the same way as a transaction between Independent enterprises to avoid loss of revenue to the concerned tax Jurisdictions.

Directly participants              Directly participants  
Eg: A---------------------------------B---------------------------------C
      Directly participants
A--------------------------------B
      Indirectly participants
A------------------------------------C

Both B and C would be Associated Enterprise of A.(92A)
Most commonly used guidance in this regard under income tax provisions is given in international and domestic tax laws in the context of transfer pricing regime. One may even refer to rules for registered valuers wherein valuation methodologies are prescribed for registered valuers. It should also be noted that these guidelines are not conclusive and persuasive value. One can consider various qualitative and quantitative assessments to determine arm's length.


Disclosure as per IAS 24

  1. Transactions between enterprises that are considerably related parties must be adequately disclosed in financial statements of the reporting entity. IAS 24 prescribes extensive disclosure in this regard.
  2. Parents and subsidiaries are bound by IAS 24 to disclose relationship irrespective whether there have been transactions between them, The IAS requires disclosure of Related Party Relationship where control exists. Thus, by inference it could be concluded that in this case by virtue of Significant Influence there is no need to disclose a related party relationship under this standard unless there has been an actual transactions based on the relationship.
  3. IAS does not make it mandatory that related party transactions be at arm's length.
  4. It is also important that Related Party Transactions are not stated in the financial statement to be on arm's length unless arm length can be substantiated.
  5. Certain related party transactions can be approved in the manner specified in Companies Act 2017 (Loan to Associates).

Example: under the Companies Act of a certain nation, in addition to the usual disclosures pertaining to related party transactions under the corporate law, companies are required to disclose not just year end balances that are due from the directors or certain other related parties, but are also required to disclose the highest balances for the period which were due to or due from them to the corporate entity.

Disclosure as per Transfer Pricing Provisions:

As per Chapter X of the Income Tax Act, any international transactions entered into with Associated Enterprise and any specified Domestic Transactions mentioned as per Section 92B shall be computed at arm length price.

Potential Risk
  1. Failure to identify and appropriately disclose significant related party transactions may lead to
    1. Material misstatement of the financial statements.
    2. Hindering of the financial statements from giving a true and fair view of the state of the affairs of the entity and of the results of affairs of the entity and of the result of its operations.
       
  2. Corporate insiders to prop up earnings and tunnel resources from the entity.
     
A corporate group has several foreign subsidiaries. Will provisions in relation to related parties apply to foreign companies as well?
The term 'Company as defined under the Companies Act 2013, is a company incorporated under this Act or any previous company law. The company incorporated under the relevant legislation of a foreign country is not a 'company' under Companies Act 2013.

However , transactions by an Indian company with a foreign company, which is a subsidiary, associate, fellow subsidiary, joint venture of the same venture or company under control of the same promoter, would be covered, based on an understanding of combined reading of revised clause 49 and Companies Act 2013.

Conclusion
After the detailed analysis of the Companies Act, 2013 with reference to Related Party Transactions, it is necessary for the Directors to disclose the information to the Board of Directors and auditors, when entering into the related party transactions in the ordinary course of business and for the approval a resolution is to be passes by the Board.

But, under the Act ordinary course of business (it covers the usual transactions, customs and practices of a business and of a company) has not been clearly defined and has been left subjective in nature. Further, considering the Arm's Length Transactions such related party transactions are allowed if the Board and Audit Committee approves it. It was also observed that this exception can be taken advantage of for entering into transactions with the related parties if the procedures are as per the mandate are not followed.

A special committee should be established assisting the registrar of companies to keep a check upon the companies. When compared with the earlier Act, there was no such provision which could provide for the loss suffered due to the related party transactions but in the present act there are fines and punishment of imprisonment which have been incorporated to protect the interests of the shareholders and to create a locus standi before the court when there is any default.

A new concept has been introduced to bring the clarity for the people and to avoid further discrepancies. In addition, the level of a check of the process in the hierarchy that has been incorporated has been able to reduce the level of the frauds and defaults on the part of the employee or director making the business more transparent and viable for the shareholders.

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