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Companies Act Diary: Part 5

Published on Thu, May 22,2014 | 23:04, Updated at Thu, May 22 at 23:04Source : 

By: Jamil Khatri, Deputy Head of Audit & Global Head of Accounting Advisory Services, KPMG

Related Party Transactions:  Working Through The New Requirements

With the requirements relating to approval of related party transactions now in place, most companies are streamlining their processes to meet the new requirements.  This note discusses some approaches that we are seeing in practice.   

As most readers may be aware, the Companies Act 2013 (the Act) widens the definition of related parties beyond those contemplated by the Accounting Standards or the 1956 Companies Act.  In addition to entities within the same business group, the new definitions cover several entities where Directors, Key Managerial Personnel (KMP’s) of the company, or their relatives may have an interest.  The SEBI amendment to Clause 49 of the Listing Agreement, which becomes effective 1 October 2014, further extends the definition of related parties.  While some of these related parties may be identified based on information available with the company, in several instances, this may require an evaluation of companies where significant shareholders, directors, KMP’s or their relatives may have an interest.  This may not be an easy evaluation for several companies.  Companies need to put in place a process for identifying all related parties to ensure that all current and potential transactions are correctly identified.  This may involve obtaining additional information or confirmations from key shareholders, directors and KMP’s.  This is not a one-time exercise and the list would need to be regularly and proactively updated.  Further, processes would need to be put in place to ensure that all potential transactions with such companies are captured and monitored for obtaining necessary approvals.

We have seen some robust discussions at recent audit committee meetings on the approach for approval of such related party transactions.  Many audit committees are requiring management to disclose and place for approval all existing related party transactions despite the fact that some of these transactions may be grandfathered and not covered by the approval requirements under the Act.  Similarly, there have been significant discussions on whether prospective transactions need pre-approval or whether a post-facto approval would suffice.  While the Act does not specifically require pre-approval from the audit committee, a combination of the requirements under Clause 49 (which mandate pre-approval) and the requirement for certain transactions to be pre-approved by the Board & shareholders based on the audit committee’s assessment, would practically mean that most related party transactions need to be pre-approved by the audit committee.  Another area of debate has been the manner in which the pre-approval of the audit committee should be obtained.  While several companies are working through approaches for approval through circular resolutions, certain material transactions may require careful planning and approval at physical meetings of the audit committee.

After determining the transactions to be approved by the audit committee and the manner of seeking such approval, companies need to determine which transactions require approval from the Board and/or the non-related party shareholders (for convenience referred to as minority shareholders in this note).  Companies need to navigate between the requirements of the Act, which require transactions that are either not in the ‘ordinary course’ or not on an ‘arms length’ basis to be approved by the Board/shareholders; and the requirements of Clause 49 which prescribe that all ‘material’ related party transactions be approved by the minority shareholders.  We have seen several discussions on what audit committees are reasonably willing to accept as ‘ordinary course’ and the nature of documentation that audit committees are expecting from management to demonstrate ‘arms length’.  Many companies are using transfer pricing studies obtained for tax purposes as a starting point to demonstrate arms length.  However, situations turn complex where the transfer pricing adopted is under dispute with the tax authorities.  Further, not all transactions requiring audit committee approval may have been covered by the transfer pricing documentation requirements.  For listed companies, this assessment is relevant only for transactions that are not material (less than 5% of annual turnover or 20% of net worth), since Clause 49 requires minority shareholder approval for all transactions beyond these thresholds.  While there is widespread acknowledgement that requiring approval from non-related party shareholders will strengthen hands of minority shareholders, reduce promoter abuse and improve governance; there are concerns that these provisions could also lead to abuse of power by the minority or an inordinate delay in the decision making process.

It is likely that over time, all stakeholders will get used to the new requirements and establish processes to smoothen implementation of the new requirements.  This is also generally likely to improve the level of governance within corporate India.  However, it is important that regulators respect good faith assessments made by management & audit committees, particularly on assessments around arms length nature of transactions.  Further, there is a fair case to exclude transactions with 100% subsidiaries from these requirements, since governance considerations are not relevant in these cases and tax considerations are in any case covered by relevant transfer pricing regulations.


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