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Related Party Transactions: All you Need to Know

24 May 2022

It is common for companies to indulge in business with their pre-existing professional and personal network. These close associates can be major shareholders, subsidiary companies or minority-owned companies. The transaction may relate to sales, lease, loans, etc., known as related party transactions (RPT). 

While these transactions are legal, they become detrimental to the interests of the existing shareholders, if undisclosed. 

This topic has become more relevant in recent years, with more such violations being reported. Very recently, a whistleblower flagged related party transactions between the promoters of Asian Paints, which benefited the promoters at the company’s cost. For such reasons, RPTs are regulated by various acts.

Who is a Related Party?

Before understanding what is related party transaction, it is important to understand what the term related party means. 

As the name suggests, related parties refer to the organizations or persons that the company is associated with for a business transaction. As per the Indian Accounting Standards (AS-18), parties are said to be related: “if one party can control or significantly influence the other in making financial and/or operating decisions in a particular reporting period.

Related parties may include:

  • A director and their relatives
  • Critical managerial personnel or their relatives
  • Firm or a private company in which director, manager or relative/member or director is a partner
  • If a director and his/her relatives hold more than 2% of the paid-up share capital in a public company
  • Anybody corporate where the director or manager enjoys large influence
  • Holding, Subsidiary or associate company of such company
  • A company that is also the subsidiary of the holding company

What are Related Party Transactions?

RPTs are business transactions entered into with the related parties. It is common for businesses to leverage their existing resources and enter into deals with pre-existing networks. Most such transactions make commercial and operational sense, provided the interests of the directors/managers and the companies mostly align. Sometimes there is no option but to engage with the associated company.

RPTs are regulated by various acts. This is because such transactions carry the risk of bias. Where the promoter or key personnel could favour the related party in a deal. It may harm the shareholders’ interests. 

For example, a company may lease a building from a director’s relative. And pay higher than the market value. Or provide a fee for service to the associated company at a much higher rate than its value. These often go from shareholders’ money. 

Tight scrutiny on RPTs is crucial for good corporate governance and preventing any legal liabilities.

How are RPTs regulated?

The Companies Act, 2013, mainly regulates RPTs. The Act doesn’t prohibit RPTs but lays down a few safety measures. Section 188 states that any related party transactions should be disclosed in the board report to the shareholder. And should be ratified (as per the threshold limits prescribed in the Act).

Transactions requiring approval of Board of Directors

Transactions exceeding limits requiring approval by company resolution (shareholders)

Sale, purchase or supply of any material or goods directly or through an agent 10% or more of the company turnover
Selling or buying of property 10% or more of the net worth of the company
or leasing of property directly or through an agent 10% or more of the company turnover
Availing or rendering any service, directly or through an agent 10% or more of the company turnover
Related party’s appointment to any office or place of profit in the company or its subsidiary Monthly remuneration exceeds Rs. 250000
Underwriting of securities or derivatives of the company 1% or more of the net worth of the company

Note:

  • These limits are taken on transactions done on a financial year basis
  • Turnover should be calculated based on the preceding year’s audited financial statements

SEBI (Listing Obligations and Disclosure Requirements) regulations outline the policies and compliance requirements for RPT. SEBI Clause 49 states regulatory requirements for RPTs.

  •   The GST Act lays down certain requirements for RPT supply.
  •   The Income Tax Act covers RPTs between domestic companies for their taxation.

The consequence of irregularities in compliance

  • Non-compliance with the requirements stated in the Companies Act can render the transactions void.
  • If an RPT contract/agreement has not been ratified by the board of directors or the shareholders, such contract agreement is voidable at the option of the board/shareholders.
  • If any director authorized the contract, the director must indemnify the company for any losses.
  • The company can proceed against the director or the employee for recovery of loss, if any, due to RPTs.
  • Such director/employee is liable to:
  1. imprisonment of up to 1 year, 
  2. a fine ranging between 2500 to 5 lakhs
  3. or both

Takeaway

Corporate governance is gaining importance in the business world. And any irregularities could hit the stakeholders’ confidence as it is their money at stake. So, it is better if investors check the RPTs regularly. And the onus is on the corporates to live up to the standards of good corporate governance and ethics.

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