A Related Party Transaction refers to any transaction between a company and its related parties, such as its directors, key management personnel, their relatives, or any other parties that have control or significant influence over the company. These transactions could involve the sale or purchase of goods, services, assets, loans, or other financial dealings.

Under the Companies Act, 2013, Related Party Transaction is defined in Section 188 and refers to a transaction involving:

1. The company and its related parties (such as directors, relatives of directors, and companies controlled by directors).
2. Any agreement or contract involving a related party, like providing services, giving loans, etc.

Who are Related Parties under the Companies Act, 2013?

A related party includes:

1. Directors of the company
2. Key Management Personnel (KMP) – such as the CEO, CFO, etc.
3. Relatives of the directors or KMPs
4. Entities in which the director or KMP has significant influence – for example, a company where they have a substantial shareholding or voting rights.
5. Companies controlled or significantly influenced by directors or KMPs.

Important Clarification on Relatives:

A related party does not only refer to the relative of a director or KMP. It includes a wider group of parties, not just relatives. For example:

• Companies owned or controlled by directors or their relatives
• Partnerships, trusts, and other entities where the director or KMP has control or significant influence

The definition of a relative is wider, too, as per the Companies Act. It includes a director’s spouse, children, siblings, parents, and other specific family members as outlined in Section 2(77) of the Act.

In simple terms:

• A related party includes relatives of directors and KMP, but also includes other entities like a company where a director or their relative has control or influence.
• Related Party Transactions need to be disclosed and are subject to approval requirements if the value is significant (as per Section 188).

Example of a Related Party Transaction:

1. If a company sells goods to the director’s spouse or a company owned by the director.
2. If the company gives a loan to a relative of a director, like a brother or parent.

In summary, Related Party Transactions are not just limited to relatives; they also include entities where related parties (like directors) have a significant influence.

Let’s break this down with a clear and simple explanation based on the Companies Act, 2013:

1. Does “Related Party” include only relatives?

No, related party does not only include relatives. While relatives are part of the definition, the term also includes other entities (like companies or organizations) in which the director, key management personnel (KMP), or their relatives have control or significant influence.

According to Section 2(76) of the Companies Act, 2013, a related party includes:

• Directors of the company.
• Key Management Personnel (KMP), like the CEO, CFO, etc.
• Relatives of directors and KMP (e.g., spouse, parents, children, siblings, etc.).
• Companies or entities in which directors or their relatives have significant influence or control. For example:
  • A company where a director holds a significant portion of the shares.
  • A business where a director’s relative is in a key decision-making position.

2. Are Related Party Transactions Reportable?

Yes, Related Party Transactions (RPTs) are reportable and require disclosure under the Companies Act, 2013. This is outlined in Section 188 of the Act, which governs related party transactions.

Here’s why RPTs are reportable:

• Transparency: To ensure that the company’s dealings with related parties are done on arms-length terms (i.e., fair and at market rates). The Act requires companies to disclose such transactions to prevent any potential conflicts of interest, misuse of power, or insider dealings.
• Approval Requirement: If the value of the transaction exceeds a certain threshold, it requires the approval of the board of directors or, in some cases, shareholders. For example, if the transaction exceeds specific financial limits (e.g., ₹1 crore), shareholder approval is needed.
• Disclosure in Financial Statements: Related party transactions are also required to be disclosed in the company’s financial statements. This ensures that shareholders and other stakeholders are aware of any dealings between the company and its related parties.

3. What kind of transactions are reportable?

• Sale and purchase of goods and services.
• Leasing of property.
• Providing loans or guarantees to related parties.
• Remuneration paid to directors or KMP.
• Any other transactions that involve the transfer of money, assets, or services between the company and a related party.

4. Why are Related Party Transactions Reportable?

Related Party Transactions are reportable to:

1. Ensure fairness: To make sure the company is not engaging in unfair or biased transactions that benefit related parties at the expense of the company or its shareholders.
2. Prevent conflicts of interest: Transactions between related parties have the potential to favor the interests of the related parties over the company’s interests.
3. Regulatory compliance: To comply with the regulatory framework laid out by the Companies Act, 2013, and ensure transparency in the company’s financial dealings.

In summary:

• Related party includes not just relatives but also entities controlled by or significantly influenced by directors or their relatives.
• Related Party Transactions are reportable because they ensure transparency, fairness, and help prevent conflicts of interest. These transactions need to be disclosed and may require board or shareholder approval if they exceed specified limits.

Under the Companies Act, 2013, Related Party Transactions (RPTs) are defined broadly and are generally subject to certain disclosures, approvals, and regulations. However, there are some transactions that are not covered under the term “Related Party Transactions” as per the Act.

Transactions not covered under Related Party Transactions:

1. Routine Business Transactions conducted in the ordinary course of business and on arm’s-length basis (i.e., fair market value or normal business terms). These are transactions that are standard and customary in the business operations of the company.
   • For example:
     • Sale or purchase of products or services that are part of the company’s normal business operations.
     • Transactions at standard commercial rates and terms, like paying for regular supplies or services from a related party, if they are at market prices.
2. Transactions with Public Companies: If the related party is a public company, and it follows standard market terms, such transactions may not require separate disclosure, approval, or reporting.
3. **Transactions in the normal course of business between two or more companies where one or both are government companies, provided the transactions are in compliance with applicable government policies and pricing guidelines.
   • For instance, the purchase of goods by a government company from a related government company under the same set of government norms may not require separate approval.
4. Share Issuances and Bonus Shares: Issuances of shares or bonus shares to related parties under stock option plans or employee stock option schemes (ESOS), if applicable, are typically not treated as RPTs under the Act. This is because they are issued based on predetermined schemes and don’t involve transactions in the usual sense (i.e., exchange of goods or services).
   • For example, if an employee or director receives bonus shares or stock options as part of their remuneration, it may not require approval under RPTs.
5. **Transactions involving the purchase of securities or investments from related parties at market prices, when it is part of a company’s normal business and does not provide any special advantage to the related party. For example, buying or selling shares of listed companies at market prices in the open market may not be covered under RPTs.
6. Transactions covered under regular banking operations: Some transactions conducted by a company with a bank or financial institution (if the bank or financial institution is a related party) may not fall under the purview of RPTs, provided they are standard banking transactions at market rates and on an arm’s-length basis.
   • For example: A loan taken by the company from a related bank at standard interest rates and under normal banking conditions.
7. Private Placements of Securities: In cases of private placements or preferential allotments, transactions with related parties may be excluded if they are conducted at fair market value, provided they do not violate the arm’s-length principle.
8. **Transactions involving financial arrangements, like financing or borrowing from related parties at market interest rates, which are in line with normal financial practices.

Important Notes:

• Even if a transaction is not typically covered under Related Party Transactions, the company’s board and auditors must still ensure that the transaction is fair, transparent, and follows the arm’s-length principle.
• In certain cases, approval from the board or shareholders may still be required, depending on the nature and value of the transaction, even if it is not categorized strictly as an RPT.

Why are these transactions excluded?

The exclusion of these types of transactions from the RPTs regulation is generally because:

• They are routine business activities that do not give rise to potential conflicts of interest.
• They are done at market prices, ensuring fairness to all parties involved.
• They don’t involve special treatment of related parties over other stakeholders, maintaining a level playing field.

In summary:

Transactions that are routine, occur in the ordinary course of business, are conducted at market rates, or are part of regulatory compliance (like government transactions, public company transactions, and routine banking) are generally not covered under Related Party Transactions as per the Companies Act, 2013. However, it’s always important to check the specifics of each case and ensure that transactions comply with the arm’s-length principle and transparency requirements.

Related Party Transactions (RPTs) and Transfer Pricing:

Related Party Transactions (RPTs) and Transfer Pricing are closely related concepts, especially in the context of multinational corporations or groups with subsidiaries in different countries. Here’s a breakdown of both concepts and how they connect:

1. What is a Related Party Transaction (RPT)?

A Related Party Transaction (RPT) refers to any transaction between a company and its related parties. Related parties can include the company’s directors, key management personnel (KMP), their relatives, or companies/entities where the directors or KMP have control or significant influence.

Under the Companies Act, 2013, Section 188 defines related party transactions and lays down the requirement for the disclosure, approval, and reporting of such transactions. These can include:

• Sale or purchase of goods and services.
• Leasing of property.
• Providing loans, guarantees, or security.
• Remuneration paid to directors or KMP.

2. What is Transfer Pricing?

Transfer Pricing refers to the pricing of goods, services, or intellectual property (IP) that is exchanged between related parties, typically within a multinational group. For example, if a parent company in the U.S. sells goods to its subsidiary in India, the price at which the goods are sold between the two entities is called the transfer price.

• Transfer Pricing Rules are put in place to ensure that transactions between related parties are conducted at market-based prices, known as arm’s-length prices.
• Arm’s-length pricing means that the transaction should be priced as if the related parties were independent of each other, i.e., the price should reflect what would have been agreed upon between two unrelated parties in a competitive market.

3. Connection Between Related Party Transactions and Transfer Pricing

When related party transactions take place across borders or between different subsidiaries of a multinational group, transfer pricing rules come into play. These rules ensure that the prices charged for such transactions are in line with market conditions and not manipulated to shift profits to low-tax jurisdictions (tax avoidance) or inflate expenses within one part of the business.

Example:

• A company in India may purchase raw materials from its parent company in the UK. The price at which the raw materials are sold from the parent to the subsidiary is the transfer price.
• Transfer pricing ensures that the price is set at a level that would be charged if the two companies were unrelated, preventing the company from artificially inflating or deflating the price to reduce its tax liability.

4. Key Objectives of Transfer Pricing in Related Party Transactions

• Avoid Tax Evasion or Avoidance: One of the main purposes of transfer pricing is to ensure that companies do not manipulate prices between related parties to shift profits from high-tax countries to low-tax jurisdictions (tax havens).
• Ensure Fairness and Transparency: Transfer pricing rules prevent companies from overcharging or undercharging related parties to distort financial results, which might mislead stakeholders or inflate profits within one jurisdiction.
• Compliance with International Standards: Transfer pricing rules are aligned with the OECD (Organisation for Economic Co-operation and Development) guidelines, which provide a global standard for determining arm’s-length prices. Most countries, including India, follow these international standards.

5. Transfer Pricing and Indian Tax Law

In India, transfer pricing is governed by the Income Tax Act, 1961 (Section 92 to 92F) and the Indian Transfer Pricing Rules. These rules require that transactions between related parties must be conducted at arm’s length and the taxpayer must document the transfer pricing method used to determine the arm’s-length price.

Key provisions under Indian law:

• Section 92 of the Income Tax Act: It mandates that any income arising from transactions between related parties must be computed based on arm’s length pricing.
• Section 92C: Specifies the methods for determining the arm’s length price, such as the Comparable Uncontrolled Price (CUP) method, Resale Price Method (RPM), Cost Plus Method (CPM), and others.
• Documentation Requirements: Companies are required to maintain detailed documentation supporting their transfer pricing policies, and they must submit it to tax authorities if requested.

6. Examples of Related Party Transactions and Transfer Pricing

• Example 1: Cross-Border Sale of Goods
  A company in India sells machinery to its subsidiary in the U.S. The price at which the machinery is sold to the U.S. subsidiary must be determined based on arm’s-length principles (i.e., the price would be what an independent buyer would pay for the same machinery).
• Example 2: Provision of Services
  A parent company in Germany charges its Indian subsidiary for management services. The transfer pricing rules require that the fee charged for such services should be comparable to what an unrelated third party would charge for the same or similar services in the open market.
• Example 3: Loan Transactions
  If a parent company in the U.K. lends money to its subsidiary in India, the interest rate charged on the loan must be consistent with what an independent lender would charge for a loan with similar terms and risk.

7. Key Transfer Pricing Methods

To determine an arm’s-length price, the following methods are commonly used:

1. Comparable Uncontrolled Price (CUP) Method: Compares the price charged in a related party transaction with the price charged in a similar transaction between independent entities.
2. Resale Price Method (RPM): This method is used when a product is sold by the tested party (e.g., subsidiary) to an independent buyer. The resale price is reduced by an appropriate gross margin to determine the arm’s-length price.
3. Cost Plus Method (CPM): The cost of production of the goods or services is added to an appropriate profit mark-up to determine the price.
4. Transactional Net Margin Method (TNMM): This method examines the net profit margin relative to a cost or sales base of the tested party, comparing it to independent parties.
5. Profit Split Method (PSM): This method allocates the combined profits from a transaction between the related parties based on their contributions to the transaction.

8. Penalties for Non-Compliance

Both Companies Act, 2013 (in the case of RPTs) and Income Tax Act, 1961 (in the case of transfer pricing) impose penalties for non-compliance:

• Non-disclosure of RPTs or incorrect reporting in financial statements can lead to penalties or fines under the Companies Act.
• Transfer pricing non-compliance can lead to adjustments by the tax authorities, and the company may be charged penalties if the transfer pricing is found to be non-arm’s length.

In Summary:

• Related Party Transactions are business dealings between a company and its related parties (directors, KMPs, relatives, entities with significant control).
• Transfer Pricing refers to setting the prices for transactions between related parties to ensure they are at arm’s length, i.e., as if the parties were unrelated, to prevent tax evasion and maintain fairness.
• Transfer pricing is particularly important for cross-border RPTs, ensuring that the company does not manipulate prices to shift profits inappropriately between jurisdictions.

Guidance Note: https://www.icsi.edu/media/webmodules/publications/A20ChapterPages.pdf