Reviewed by Aug 27, 2020| Updated on
What is a Related Party Transaction?
A related party transaction is a two-party contract which is accompanied by a pre-existing business relationship or mutual interest.
For example, it would be a related party agreement to have a contract between a major shareholder of a company and the company if such shareholder agrees to renovate the offices of the company.
Companies also aim to establish business relationships with parties they are familiar with or have common interests. While these kinds of transactions are legal, they may pose a conflict of interest or lead to another illegal situation.
Therefore, related party transactions have to be approved by agreement of management or board of directors of the company. If unchecked, the misuse of related party transactions could result in fraud and financial ruin for all parties involved.
Related Party Transactions in India
In India, various regulations clearly outline the definition of a related party transaction. It helps to ensure that they are conflict-free. In the case of a company, it helps to ensure that it does not negatively affect the shareholders' value or its profits.
The Institute of Chartered Accountants of India (ICAI) introduced Accounting Standard 18- 'Related Party Disclosures' and made it mandatory for businesses to report related party transactions in the financial statements. Apart from this, various laws refer to these transactions.
Section 188 of the Companies Act, 2013
Let us learn the provision with an illustration. Assume that in a company, M/s PQR Ltd, Mr P, Q, and R are directors. The related parties for the company shall be the directors themselves and their relatives, such as the spouse, stepfather, mother, stepmother. It also covers son, son's wife, stepson, daughter, daughter's husband, brother, stepbrother, sister, and step-sister.
Furthermore, related parties can be the key managerial personnel of the company, such as the manager, CEO, CFO, CTO, or managing director.
It extends to the firm or private company in which this director or the manager is a partner or shareholder or director. If such company is a public company, then it will be termed as a related party if the director/relative holds more than 2% of its paid-up capital.
Holding, subsidiary, or associate companies are also covered. Companies with common management/ownership are also related. Any sale, purchase, lease, rent, or hiring, taking place between the M/s PQR company and the above parties shall be termed as a related party transaction.
Clause 49 of the SEBI also provides for some procedural conditions for related party transactions. It describes a related party transaction as a transaction involving resource/service/obligation transfer. The scope is higher than that of the Companies Act, 2013.
Section 40 A (2) in the Income Tax Act, 1961
A notification that a related party transaction took place during the year serves no function unless one is aware of the terms of the transaction and the tax consequences.
Section 40 A(2) of the Income Tax Act disallows the expenditure incurred with related parties if the assessing officer finds that the expenditure is unnecessary and unfair.