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Cos Act Ep#16 - RPTs: RELIEF?

Published on Sat, Aug 23,2014 | 12:52, Updated at Thu, Aug 28 at 22:40Source : CNBC-TV18 |   Watch Video :

I have said it before and I will say it again. If there is one section in the companies act 2013 that India Inc wishes did not exist it is section 188; Related Party Transactions. Well, some of that corporate complaining has hit home. Last week the ministry for corporate affairs (MCA) amended the rules governing related party transactions. The key changes pertain to those transactions that are not at arm’s length and not in the ordinary course of business and hence need shareholder approval via a special resolution.

Now the MCA has deleted a capital threshold which will result in fewer related party transactions needing shareholder approval but the transaction thresholds have been lowered and that means more transactions that India Inc would have liked will now have to go to shareholders for approval. What would be the net effect of these changes & changes that have been announced previously and how does the Companies Act regime of related party transactions sit with tax law.  

RPTs: RELIEF?
14th August, 2014
MCA amended Rules accompanying Section 188
Amended thresholds that determine which RPTs need shareholder approval
-          Deleted capital threshold
-          Lowered transa+ction thresholds

To discuss that I have with me on Companies Act this week Sudhir Soni and Darpan Mehta. Sudhir, Darpan thank you very much for joining us on the show.

Doshi: Before I get to the most material change that has taken place over the last weekend on related party transactions and the changes in thresholds, there have been several other changes that have taken place ever since the act was notified and the section was brought into force. Do you want to run us through very quickly on what those changes were and therefore what the impact on companies has been?

Soni: There have been several changes but these are more in the nature of corrections or clarifications to the law. The first was the issue of common directorship. So if you had a director who was on two public companies then the interpretation was that both the companies would become related because of the use of the words 'and' and 'or' in the act. So that was corrected and now the test is for both common directorship as well as having a two percent shareholding in paid up capital.

RPTs: RELIEF?
Removal of Difficulty: 5th Order  

Related Party Definition: Earlier
a public company in which a director or manager is a director or holds along with his relatives, more than two per cent. of its paid-up share capital

Related Party Definition: Revised
a public company in which a director or manager is a director and holds along with his relatives, more than two per cent. of its paid-up share capital

IMPACT: 2 companies having common Independent Director would not be considered Related Parties

The second order extends the scope of related parties by now including relatives of directors or managers if they have an interest in a private company then even those companies would be covered in the scope of related party. So that actually is not a concession that has added to the scope of related parties.

RPTs: RELIEF?
Removal of Difficulty: 6th Order

Related Party Definition: Earlier
a private company in which a director or manager is a member or director

Related Party Definition: Revised
a private company in which a director or manager or his relative is a member or director

IMPACT: Widens scope of definition

The third clarification was on who can vote in a shareholder’s meeting and there was a lack of clarity in the law as it was drafted that all related parties cannot vote. So it has now been clarified that only the related parties to the transaction who can vote in that.

RPTs: RELIEF?
Section 188 Proviso
No related party can vote on RPT related special resolution

July Circular
Only related party connected to RPT cannot vote on special resolution

The other was on compromises, arrangements, mergers and amalgamations. The question was whether those are also covered under section 188 because they involve transfers of property and assets. So that has been clarified now that those are not within the ambit of 188 and rightly so because there is a process in the law for those transactions.  

RPTs: RELIEF?
July Circular

It is clarified that transactions arising out of Compromises, Arrangements and Amalgamations dealt with under specific provisions of the Companies Act, 1956/Companies Act, 2013, will not attract the requirements of section 188 of the Companies Act, 2013

IMPACT: Transactions undertaken via Schemes will not attract Section 188 provisions

The other clarification was on independent directors. If independent directors of a holding company were on the board of a subsidiary they may not have been treated as independent on the subsidiary company. So that has been clarified.

RPTs: RELIEF?
Earlier Rule
Independent Director of Holding company is a Related Party of Subsidiary company

Revised Rule
Independent Director of Holding company is NOT a Related Party of Subsidiary company

Doshi: That is a quick summation, private companies there are some exemptions that could likely be extended to private companies. So, if you look at the draft notification that the MCA put out several weeks ago it did seem to imply that private companies might be saved from the entire impact of Section 188 altogether. Then there is another sort of final notification that is doing the rounds, that say no it is not going to be an absolute save, it is going to be a partial save and only in certain circumstances will private companies not come under the purview of Section 188. What do you make of that change?

RPTs: RELIEF?
June Draft Notification
Section 188 shall not apply to private companies

Revised Draft Notification
Section 188 applies to private companies but deletes restriction on voting by related party  

IMPACT: Expectation that Private companies will be partially exempt

Soni: One would have liked to have a full exemption for private companies from Section 188. Unfortunately this law doesn’t distinguish clearly between entities where there is public interest or not. Therefore I do agree that you should still have some restrictions on private companies which have public interest in terms of loans from financial institutions and so on. So, probably you do need to maintain some restriction and so I think the two exemptions are good.  

Doshi: The two that we think might be the final outcome.

Soni: That might be the final outcome.

Doshi: I know you look at this from a tax point of view Darpan, but nonetheless if you want to weigh in on some of the changes taken place and whether they do the business of full clarity or not?

Mehta: I think Sudhir has covered it quite clearly but the other point was for listed company nothing has changed. If you look at the SEBI listing guidelines, while they are not in effect today companies are still preparing to implement them from October 1 and the thresholds there are the same they were when they were notified in April. The coverage of related parties is as wide as it could be in the Companies Act and even wider and even the coverage of transactions is wider than the Companies Act. So, if I am a listed company, independent director a lot of this is discussion but when it comes to SEBI it is wider, it is more onerous.   

SEBI New Clause 49
All ‘material’ transactions need shareholder approval via special resolution

Material: Transaction exceeding 5% of annual turnover or 25% of networth

No exemption for transactions in the ordinary course of business or at arm’s length

Effective October 2014

Doshi: Lets get to the most material change that has taken place over the last weekend, simply put they have changed the transaction thresholds determining which transactions go to shareholders for approval. The threshold with regards to capital size, that's Rs 10 crores or more has been done away with but on the other hand transaction thresholds have been lowered. What is the net effect of this Sudhir?

RPTs: RELIEF?
RPTs need shareholder approval if
-          Transactions not at arm’s length and not in ordinary course of business
-          Exceed specified thresholds

                                        Earlier                                Revised

Capital Threshold           Rs 10 cr                               Deleted

Sale of Goods                    25%                      Lower of 10% or Rs 100 cr

Sale of Property              10%                      Lower of 10% or Rs 100 cr

Service                            10%                      Lower of 10% or Rs 50 cr

Soni: I think it is a very positive development, it will make the section more easy to comply with, removing the…the paid capital threshold was very low at Rs 10 crores & it would almost mean most companies actually would have to go to shareholders…If they failed the test of ordinary course of business or arm's length then almost surely they would end up with shareholder approval requirement, so that will now not be the case. I think, the transaction thresholds are quite reasonable.

RPTs: RELIEF?
Section 188
-          Exclude transactions done in ordinary course of business & at arm’s length
-          All other RPTs need Audit Committee & Board approval
-          All such RPTS need to be disclosed in Board’s Report
-          All such RPTs need shareholder approval via special resolution if company has Rs 10 cr or more in share capital

or

transaction exceeds prescribed size thresholds
-          Related party cannot vote in special resolution

Doshi: Would you say now that even Rs 100 crores is too low a transaction threshold, because I have heard many in India Inc over the last week complain saying that it goes somepart of the way but not the full way. 100 crores still means that a large number of tranasctions will have to go to shareholders for approval or would you say that to be fair from a governance point of view, Rs 100 Crores is a fairly good limit.

RPTs: RELIEF?
RPTs need shareholder approval if
-          Transactions not at arm’s length and not in ordinary course of business
-          Exceed specified thresholds

                                        Earlier                                     Revised

Capital Threshold           Rs 10 cr                               Deleted

Sale of Goods                    25%                      Lower of 10% or Rs 100 cr

Sale of Property              10%                      Lower of 10% or Rs 100 cr

Service                            10%                      Lower of 10% or Rs 50 cr

% of turnover/networth

Soni: I think it is a fairly good limit considering we have a hurdle before that, it is not like all transactions over Rs 100 Crores go. First you have to cross the test of it not being in the ordinary course of busines and not on arm's length & then you realise that a lot of transactions don’t even come to that stage.

Mehta: Yes I agree with Sudhir, it’s a good qualitative hurdle, ofcourse the subjectivity it brings with it creates a challenge of who wants to take the call whether its ordinary course or arm's length but if the management is comfortable or the board of directors are comfortable, then very few transactions will not pass that hurdle and the kind of transaction that will go, if they are above 100 crores then it is fair for the shareholders to have a look at that.

Soni: For example transactions like sale of property. So Rs 100 crore is a reasonable number to test for.

Mehta: You also have the 10 percent threshold. So it is not that companies who are not large don’t have to comply with below Rs 100 crore. If it is 10 percent of the turnover they still have to comply.

RPTs: RELIEF?
RPTs need shareholder approval if
-          Transactions not at arm’s length and not in ordinary course of business
-          Exceed specified thresholds

                                        Earlier                                 Revised

Capital Threshold           Rs 10 cr                               Deleted

Sale of Goods                    25%                      Lower of 10% or Rs 100 cr

Sale of Property              10%                      Lower of 10% or Rs 100 cr

Service                            10%                      Lower of 10% or Rs 50 cr

Doshi: Whichever is lower?

Soni: Yes, whichever is lower.

Mehta: Yes, whichever is lower. So they still have to comply.

Doshi: So if it is 10 percent and that is lower than Rs 100 crores then in that case that will still have to go to shareholders for approval?

Mehta: Yes, which goes to Mr Sudhir’s point, that you are protecting the shareholders’ interest by specifying that.

Doshi: Fair enough. So I remember through the course of this series every time we have discussed related party transactions either with company lawyers, CFOs, auditors, tax professionals they have all said that actually Section 188 is going to be counterproductive because the number of transactions that will go to shareholders for scrutiny will mean that the focus that shareholders need to have on potentially abusive transactions will get dispersed over having to read through many transactions. I remember the M&M CFO telling me, my related party transactions list that might potentially have to go to shareholders will make up 20 pages of single line entries. So shareholders to go through 20 pages, understand all of that, decide how to vote - will this change mean that fewer sort of transactions will go to shareholders therefore they can focus on the more material ones and hence spot the potentially abusive ones more effectively?

Soni: Unfortunately this change is, though it has been done in the Companies Act, we are not sure whether Securities and Exchange board of India (SEBI) will follow and if you look at the SEBI threshold which says material related party transactions and they do not have a hurdle of ordinary course of a business.

RPTs: RELIEF?
SEBI New Clause 49
All ‘material’ transactions need shareholder approval via special resolution

Material: Transaction exceeding 5% of annual turnover or 25% of networth

No exemption for transactions in the ordinary course of business or at arm’s length

Effective October 2014

Doshi: Yes, there are no exemption for those.

Soni: So unless SEBI were to change the revised Clause 49 we still will face the issue that you mentioned.

Doshi: What will they have to do to change the threshold to bring it closer now to what the MCA thresholds are because they don’t offer any exemption for arms length or in the ordinary course of business transactions and their materiality thresholds are 5 percent of turnover and 25 percent of networth. So, how are they going to be able to align those thresholds to the new thresholds that the MCA has introduced?

Soni: What SEBI will need to do is first introduce the threshold or introduce a hurdle within the revised Clause 49 to say that only transactions which are not in ordinary course or not in arms length they need to offer the same exemption. Otherwise if you have a company selling to its subsidiary and they sell through a subsidiary lets us say then you need to take that transaction to the shareholders which doesn’t make sense.  

Doshi: What do you make of that?

Mehta: I agree with Sudhir but the point that you made which is a larger point is that will shareholders have to dwell on something like this and let us assume SEBI doesn’t change that and one hopes they do, my sense is that the purpose was to have independent directors take up that responsibility. So, if the audit committee and the independent directors are going to sit in judgment on whether the transactions are in the ordinary course of business or are at arms length and they would anyway report them to be so in the board of directors report and there will be a fair bit of disclosure. So, the expectation from the larger group of minority shareholders is that these independent directors have discharged the responsibility cast upon them because there are implications for not doing so. What the shareholders will see is that they will see a discussion in the boards report on why these transactions are considered by the independent directors or the audit committee to be in the ordinary course of business or to be at arms length. If you see the quality of disclosure that is required in the boards report, the forms that their companies are required to file, there will be a fair bit of information. If I was a shareholder I wouldn’t have the expertise to question everything unless it is very patently abusive; there are some examples of that as well. However, if I get that quality of disclosure and if I get the comfort that there is a good set of independent directors there and that that will become the test of which listed companies are going in that direction and giving that comfort to the shareholders. So, I don’t see that it is going to overwhelm.  

Doshi: Darpan, can you explain to me what exactly not in the ordinary course of business and not at arm’s length means, because these two phrases have several companies and their finance teams confused as to how to distinguish between one and the other and whether they can borrow from tax law and apply the same to Companies Act and say, okay, if tax law considers this at arm’s length then I can consider it at arm’s length as well and not have to send it to shareholders?

RPTs: RELIEF?
Section 188

-          Exclude transactions done in ordinary course of business & at arm’s length
-          All other RPTs need Audit Committee & Board approval
-          All such RPTS need to be disclosed in Board’s Report
-          All such RPTs need shareholder approval via special resolution if company has Rs 10 cr or more in share capital

or

transaction exceeds prescribed size thresholds
-          Related party cannot vote in special resolution

Mehta: Even as a transfer pricing expert I would say even though I can apply transfer pricing principles it is actually quite subjective. So the immediate reference point is clearly the income tax law and I just wanted to put that in two buckets.

The first bucket is what reference can you draw from income tax law and what additional flexibilities can you take beyond the income tax law. Interestingly and just spending a moment on what the income tax law looks at it, actually it looks at the transaction price whereas what the Companies Act talk about is that the transaction should be conducted at arm’s length. Price is just one of the factors. So whether the transaction should have been done at all or not, you ask that question for the loan. That is broader in the Companies Act. So if you are talking about a transaction being at arm’s length the pricing part is looked at in the Income Tax Act in a holistic way but in the Companies Act that is going to be a focus as well apart from while the transaction was done in the first place and the board of directors can ask that question.  

So if I focus now on the pricing then clearly the income tax law has Section 92, it has a transfer pricing section which has been there for 10 years and we will talk about the litigation on that and what that impact has but the code is a fair code. It is aligned with international guidelines. There are some deviations per se but is broadly aligned with the international guidelines. The practice of it by the income tax authorities has been a challenge but if I apply the code in spirit and if I am the management it will help me to give comfort to my audit committee or my board of directors or my shareholders that I have applied this guidance in the Income Tax Act. These are the various things the Section 92 requires me to look at when I am evaluating whether a transaction is at arm’s length or not and here is the analysis I have done, what are the functions and risks of the parties, what are the terms of the transactions, what is the credit period and what are the margins each party is earning, what is the past data, do I have a third party alternative.

So the code is actually quite robust and there are some constraints. So I will come to the constraints then. So when I look at the constraints, the Income Tax Act talks about testing the transaction after it has happened. So it says that you have done a transaction and it looks at the transaction for the full financial year, so you can aggregate similar transactions even if they are happening across multiple parties which is a flexibility that the Companies Act may or may not give you. However, the Income Tax Act looks at a series of transactions which are similar, it aggregates them and it tests whether applying one of the five methods the margins earned from those transactions are at arm’s length or not. The Companies Act requires you to get the transactions approved before they happen. So the timing is important.

Doshi: How do you resolve or reconcile that?

Mehta: What you do is you apply the principle but the data that you would use or the inputs that you would use would be the past data.  

Doshi: But that would only help if it was a recurring transaction, if it is not a recurring transaction then?

Mehta: Let us take the example of sale of a business or sale of an undertaking. Even in the Income Tax Act, when you have to test whether the transaction is at arms length, you will in practice produce a report which is done by an independent valuer applying one of the appropriate principles of valuation that are relevant for that transaction of sale of undertaking and you would conclude that that transaction is at arms length. That is not going to be different under the Companies Act. You would probably do exactly the same thing.  

So, there is a fair bit to borrow from the code but some constraints and two that come to my mind is one is the Income Tax Act says, you should look at only the current financial year data of the benchmarks. I am not going to be constrained by that when I am giving that comfort under the Companies Act. If I think it’s more appropriate to look at three years data or five years data, I think we should use it; that flexibility we should have.  

The Income Tax Act says arms length means within the arithmetic mean; at the arithmetic mean or within range of the arithmetic mean. This is contrary to what they international guidance says and India is going to change that too very soon which has been announced. However, irrespective of that, even if that was not a case I would have actually gone to the international guidance, looked at interquartile range and applied it for the Companies Act.  

So, while the code is there, the spirit of the code is there you also have reference to international transfer pricing guidance and combining that management can give comfort that broadly this is at arms length.  

Doshi: As an auditor, are you comfortable Sudhir, with the companies determining whether the transaction is at arm’s length or not by applying tax law principles to the transaction for a companies act purpose?

Soni: I think the tax law is guide but as Darpan explained from the timing of the transaction, you cannot follow some of the classical methods that they use in tax for example, the transaction net margin method which aggregates transactions and you calculate the margin at the end of the year that sort of a method is not probably what is likely to be applied in the context of…

Doshi: Because you have to look at each transaction individually.

Soni: Yes, each transaction, each contract and each customer or each party with whom you are transacting. So you don’t have that level of aggregation. But otherwise the principles in tax are certainly those which we can apply for example, the comparable uncontrolled price method that is certainly the best possible method that you can do. Or you have in fact the other method, you have a choice in fact, good part of the companies act today is it is not prescriptive on what is the basis to determine the arm’s length. So I think it is a determination made by the judgement of the directors in the meeting and as long as they can document the rationale for their decision

Doshi: It will be fabulous because now directors have to be tax experts as well to be able to understand whether the right principles are being applied from tax law in making this distinction about arm’s length and in the court - in the ordinary course of business this is still something one can apply common sense too but arm’s length is fairly technical. So you have to be able to understand tax principles to be able to apply this same here and say I agree with management, this is at arm’s length and therefore I don’t think it needs to go to shareholders, that is going to be terribly complex.

Soni: One of the biggest concerns that companies face today is this requirement of prior approval by audit committees.

RPTs: RELIEF?
Section 188
-          Exclude transactions done in ordinary course of business & at arm’s length
-          All other RPTs need Audit Committee & Board approval
-          All such RPTS need to be disclosed in Board’s Report
-          All such RPTs need shareholder approval via special resolution if company has Rs 10 cr or more in share capital

or

transaction exceeds prescribed size thresholds
-          Related party cannot vote in special resolution

Doshi: Now I can see why exactly because this is a difficult call to have to make. I have a question, it might come out too simplistically…Darpan,  for instance, from what I understand, both international and domestic tax principles sort of lay out if you are offering a guarantee to a group company, what the cost of that guarantee should be and if you meet those requirements then your transaction is considered to be at arm’s length and so then you are on the right side of transfer pricing law as opposed to the wrong side. If the same cost or if the same benchmark was applied to whether you are considering whether a guarantee must go to shareholders for approval or not, so you are well within the right side of the transfer pricing law when it comes to the cost of that guarantee, would you by extension then also be at arm’s length when it comes under companies act. Can A be equal to B?

Soni: That test needs to be applied at least at a party and a transaction level. So if you are saying I am satisfying the test under tax law on the basis of an aggregate of transactions across the…

Doshi: Aggregate we have dealt with, I am saying an individual transaction.

Soni: Yes, then it is quite likely that it would meet the test even for the companies act.

Doshi: You can apply the principles almost on an equal basis so to speak for companies act?

Soni: That is right.

Mehta: Just want to add one layer to that which is while the income tax act talks about the pricing, he can always question why did you do the transaction in the first place. So arm’s length means not only the pricing but whether you would have done that transaction.

Doshi: Arm’s length is not necessarily just pricing at arm’s length but doing the transaction at arm’s length in all other manners. I think that gives me a fairly good idea where we stand today when it comes to RPT. Let me ask both of you to summarise in a sense what the net effect of this companies act with all the changes that we have seen happen in RPTs, what is it going to mean for companies and I am talking across large listed companies, private companies based on what exemptions they get, how are they going to deal with this here onwards?

Soni: If the private companies get the exemptions that are proposed either in the first draft or the second draft then things should be relatively easier for them to comply with. For the listed companies if you put the companies act and the SEBI law together, I think it is still a challenge…

Doshi: Unless SEBI puts in both those exemptions which is in the ordinary course of business & at arm’s length.

Soni: Even there, there is still one challenge and that is the prior approval by audit committees. So audit committees are beginning to feel extremely burdened by the transactions that could come to them. There is a possible interpretation there and if I can take a minute on this is that an audit committee is a sub-committee or the board of directors. Essentially if transactions are not in the ordinary course of business or not at arm’s length, it is only in that situation that they go to the board of directors. So there is a point of view that only such transactions should go to the audit committee because you cannot have a terms of reference of the audit committee beyond the reference of the board, which is a logical interpretation. If that is the case then the burden on the audit committees would also be lesser. So that is one. I think the second thing going forward, one of the relaxations that one should look for is it wholly owned subsidiaries…

Doshi: You want even more relaxations?

Soni: I think in the definition of related parties, I am surprised to see wholly owned subsidiaries are treated as related parties.

Doshi: If you are transacting with 100 percent subsidiary, why do you have to go to shareholders for approval if at all?

Soni: That is right.

Doshi: Darpan, are you going to spend most of your time training board members to understand transfer pricing principles and therefore understand what arm’s length is all about?

Mehta: Yes. But you asked what is the key takeaway and I think it is about the documentation, which is probably the effort that listed India is looking at and it is actually & I agree with you, it is a little overwhelming but I hope that it is one time in a sense that if 90 percent of the transactions are recurring then we are going through a transition phase where this one time effort will cover 90 percent of what you need to comply with in the future and if some things are out of the ordinary, some things are abusive then we have said it earlier, we want corporate governance, we want shareholders to look at it and if it needs to go through the rigours of the law then let it go through that. So that is the optimistic future I am looking to.

 
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