SECTION 188: RELATED PARTY TRANSACTIONS
Updated: Oct 7, 2022
INTRODUCTION:
The Companies Act of 2013 was enacted to encourage businesses, with compliance and transparency as the primary goals. Among the numerous issues addressed in this Companies Act,2013 Related Party Transactions began, and this is a term that has made all organizations nervous about the complexities surrounding it for many years.
WHAT IS RELATED PARTY TRANSACTIONS ?
A related-party transaction is a deal or arrangement made between two parties who have a prior business relation or a common interest. Companies frequently seek business deals with people or organizations they are familiar or share a common interest. Although related-party transactions are legal in and of themselves, they can lead to conflicts of interest or other illegal situations. These transactions must be disclosed by publicly traded companies.
TYPES OF TRANSACTIONS:
Transactions with a subsidiary, an associate, or a joint venture;
Transactions involving Directors, Key Persons, Directors' Relatives, and Key Persons;
Transactions among Relatives of the Entity's Owner;
RELATED PARTY TRANSACTIONS EXAMPLES:
Example:1
PQ Ltd. has investment and holds 29% of shareholding of AB Ltd. and AB Ltd. holds 52% of shareholding of XY Ltd.
Solution:
Company AB Ltd. is an Associate company of Company PQ as it has more than 20% of shareholding of Company AB Ltd. Transactions between these companies, i.e., PQ Ltd. and Associate Company, i.e., AB Ltd. to be disclosed in the Financial Statement of the Company. PQ Ltd. and at the time of preparation of consolidated Financial Statements.
All the related parties transactions among PQ Ltd., AB Ltd. and XY Ltd. to be recorded in Financial Statements because of XY Ltd. is a subsidiary company of AB Ltd. and AB Ltd. is an associate company of PQ Ltd.
Example:2
Company K has 65% of shareholding of Company L. Company K sold the goods of $3 Million to Company L during the financial year.
Solution:
Company K is a holding Company of Company L as it has more than 51% Shareholding of Company L and Transactions between Holding Company, i.e., J and Subsidiary Company, i.e., L to be disclosed in Financial Statement of Company J and at the time of preparation of consolidated Financial Statement.
In the preceding example, Company A must declare the related party transaction in its financial statements, as well as its type.
ADVANTAGES:
If family members own a major portion of the entity, the entity may gain from such transactions. For example, a corporation that sells finished items at cost to a linked party may not sell at that cost to another consumer.
For a more accurate depiction, it should be declared individually in the Financial Statements.
Unrelated parties are not permitted to get into transactions with related parties.
DISADVANTAGES:
If family members do not own a large portion of the entity, the entity may suffer losses as a result of such transactions.
Management has the ability to restrict such transactions and may profit from doing so.
For better representation, it should be declared separately in financial statements; otherwise, financial accounts will convey an incorrect and misleading impression.
These transactions may have a negative impact on an entity's profit and loss statement and financial situation.
LIMITATION:
Private advantages of control are values that are enjoyed solely by the party in control and are not shared equally among all shareholders in proportion to the number of shares possessed.
Management may be unable to regulate some related party transactions in which parties have substantial control (more than 50%) of the board.
These are only motivated by mutual rewards.
These are only motivated by private benefits.
SEBI REGULATES THE RELATED PARTIES AND RELATED PARTY TRANSACTIONS:
Certain regulatory criteria for related party transactions are also stated in SEBI Clause 49. A related party transaction is defined as one that involves the transfer of resources/services/obligations.
Its scope is broader than that of the Companies Act of 2013. Immediate family members of directors or key management staff are included, as is a private corporation in which directors or competent authority and their families have control or considerable influence.
Every substantial related party transaction must be approved by the shareholders via a special resolution, and all connected parties are not permitted to vote on such motions.
IMPORTANT POINTS TO NOTE:
For the purposes of calculating turnover or net worth under the Companies Rules 2014, the audited financial statements must be used.
The transaction does not need to be approved by the board or the company if it is done in the normal course of business and on an arm's length basis.
If a member is a linked party, he or she may not vote on the special resolution.
Every contract is entered into shall be referenced in the Board's report, along with reasons for the same.
Within three months, the Board or the stakeholders may approve the deal. If this is not done, the contract will be voidable at the Board's discretion.
If the contract is with someone related to the director or is allowed by another director, the directors involved must compensate the firm for any damages.
The penalties stated in Section 188 include,
Listed Organization: Imprisonment for up to one year and a fine amounting to Rs. 25000 to Rs. 500000, or both.
Any other Company: A fine amounting to Rs. 25000 to Rs. 500000 is imposed. The meaning of the phrase related-party-transaction will continue to perplex us, and we hope to find a one-stop answer to put our confused minds at ease.