Related Party Transactions: Companies Act Rules and Board Approval

What Are Related Party Transactions Under the Companies Act?

A Related Party Transaction (RPT) is any contract, arrangement, or transaction entered into by a company with a person or entity classified as a related party under the Companies Act, 2013. These transactions are regulated under Section 188 because the inherent conflict of interest - where one person influences both sides of a deal - can lead to company resources being diverted for personal benefit at the expense of minority shareholders.

The regulatory framework for RPTs operates through three primary legal instruments: Section 188 of the Companies Act, 2013 (governing approval requirements), Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014 (prescribing monetary thresholds), and Regulation 23 of the SEBI LODR Regulations, 2015 (imposing additional obligations on listed companies). Every director, Company Secretary, and CFO must understand these provisions to maintain annual compliance and avoid personal liability.

Who Is a Related Party? Section 2(76) Definition

Section 2(76) of the Companies Act, 2013 defines eight categories of persons and entities that qualify as related parties. Identifying all related parties is the first step in RPT compliance - miss one, and the company risks entering into unapproved transactions.

For listed companies, SEBI's definition is broader. Under Regulation 2(1)(zb) of the LODR Regulations, related parties additionally include any person in the promoter or promoter group, entities holding 20% or more shares in the listed entity, and any entity covered under the Ind AS 24 relationship definition.

Types of RPTs Covered Under Section 188

Section 188 lists seven specific transaction types that require compliance when conducted with a related party. Each type has a corresponding threshold under Rule 15 that triggers mandatory shareholder approval.

Transactions in the ordinary course of business and at arm's length prices are exempt from shareholder approval under Rule 15(3). However, they still require board and Audit Committee approval. The term "ordinary course of business" means transactions that are routine, regular, and part of the company's normal operations - not one-off or extraordinary deals.

Board Approval Process: Step-by-Step

The RPT approval process follows a structured four-level hierarchy. Skipping any level creates a compliance gap that can make the entire transaction voidable.

Step 1: Director Disclosure via Form MBP-1 (Section 184)

Every director must disclose their interest in other entities through Form MBP-1 at the first board meeting of each financial year, or whenever their interest changes. This disclosure covers directorships, memberships, and partnerships in other entities. It helps the company proactively identify which future transactions will qualify as RPTs.

Step 2: Audit Committee Pre-Approval (Section 177)

For companies with an Audit Committee (mandatory for listed companies and prescribed classes of public companies), every RPT must first be approved by the Audit Committee. The Committee evaluates the transaction terms, verifies arm's length pricing, and determines whether the transaction serves the company's interest. For repetitive transactions, the Committee can grant an omnibus approval valid for one financial year.

Step 3: Board Resolution Under Section 188(1)

The Board of Directors must pass a resolution approving the RPT at a duly convened board meeting. The interested director must declare their concern and must not participate in the discussion or vote. The board resolution must record the nature of the transaction, the related party involved, the arm's length basis, and the material terms.

Step 4: Shareholder Approval (When Thresholds Are Exceeded)

If the transaction value exceeds Rule 15 thresholds, the company must pass an ordinary resolution at a general meeting. For listed companies, related parties cannot vote on this resolution regardless of whether they are directly a party to the transaction. The explanatory statement annexed to the notice must disclose the transaction's material facts.

Arm's Length Pricing: Methods and Documentation

The arm's length principle is the foundation of RPT compliance. Every transaction with a related party must be priced as if it were conducted between independent, unrelated parties in comparable circumstances. The arm's length standard applies under both the Companies Act (for corporate governance) and the Income Tax Act (Sections 92 to 92F) for transfer pricing.

Five Prescribed Pricing Methods

1. Comparable Uncontrolled Price (CUP) Method: Compares the RPT price with prices in similar transactions between unrelated parties. Most reliable when direct comparables exist.
2. Resale Price Method (RPM): Starts with the resale price to an unrelated buyer, then subtracts an appropriate gross margin. Used when the related party resells goods without significant value addition.
3. Cost Plus Method (CPM): Adds a market-appropriate markup to the supplier's direct and indirect costs. Common for manufacturing and service transactions within a group.
4. Transactional Net Margin Method (TNMM): Compares the net profit margin from the RPT with margins in comparable uncontrolled transactions. Most frequently used in Indian transfer pricing assessments.
5. Profit Split Method (PSM): Allocates combined profits from the transaction based on each party's relative contribution. Used when both parties contribute unique intangibles.

Companies should maintain valuation reports, market price comparisons, or independent third-party quotes to support arm's length pricing. This documentation is critical during statutory audits, transfer pricing assessments, and any regulatory inquiry.

Audit Committee's Role in RPT Oversight

The Audit Committee serves as the first line of defence against conflicted RPTs. Its responsibilities extend beyond one-time approvals to continuous monitoring.

Core Responsibilities

• Prior approval: Review and approve every proposed RPT before it reaches the Board
• Omnibus approval: Grant blanket approvals for routine RPTs, specifying the related party name, transaction nature, maximum amount, duration, and arm's length price basis
• Quarterly review: Monitor all transactions under omnibus approvals every quarter to verify compliance with approved terms
• Arm's length verification: Evaluate pricing documentation and confirm transactions are at market rates
• Materiality assessment: Determine whether RPTs cross the material threshold requiring shareholder approval

For listed companies, SEBI requires that at least two-thirds of Audit Committee members must be independent directors, and the chairperson must be independent. This composition ensures objective evaluation of RPTs without influence from interested parties.

Disclosure Requirements: Form AOC-2 and Financial Statements

RPT disclosure obligations are spread across multiple documents. Missing any one creates a compliance gap that auditors and regulators will flag.

Form AOC-2 - Board's Report Annexure

Form AOC-2 must be annexed to the Board's Report every year. It discloses all RPTs in two categories: transactions at arm's length and transactions not at arm's length. For each entry, the form requires the related party's name, transaction nature, duration, salient terms, approval date by the Board and Audit Committee, and amount paid as advance (if any).

Ind AS 24 - Financial Statement Disclosures

Under Indian Accounting Standard (Ind AS) 24, financial statements must disclose: the nature of the related party relationship, transaction types and volumes during the year, outstanding balances at the balance sheet date, terms and conditions (including whether at arm's length), provisions for doubtful debts, and expenses recognized for bad debts from related parties.

Register of Contracts - Section 189

Every company must maintain a register of contracts or arrangements in which directors are interested under Section 189. This register must be placed before the Board at every board meeting, signed by all directors present, and include the director's name, contract details, nature of interest, transaction amount, and approval particulars.

SEBI Requirements for Listed Companies

Listed companies operate under a dual compliance framework - the Companies Act and SEBI LODR Regulations. SEBI's requirements are stricter in every aspect.

Penalties for Non-Compliance With Section 188

The penalty framework for RPT violations operates at three levels - the transaction itself, the individuals responsible, and the company as an entity.

• Transaction becomes voidable: The Board or shareholders can void any RPT entered without proper approval
• Director/employee liability: Imprisonment up to 1 year and a fine of ₹25,000 to ₹5 lakh for any director or employee who authorized the unapproved RPT
• Company penalty: Fine of ₹25,000 to ₹25 lakh for the company itself
• Indemnification: The concerned director must indemnify the company for any loss arising from the voided transaction
• Section 184 violation: Directors who fail to disclose interests in Form MBP-1 face imprisonment up to 1 year and fines of ₹50,000 to ₹1 lakh
• SEBI penalties (listed companies): Monetary fines, disgorgement of unlawful gains, debarment from the securities market, and adverse compliance observations affecting credit ratings
• Transfer pricing adjustments: The Income Tax Department can adjust RPT pricing under Sections 92 to 92F, resulting in additional tax liability, interest under Section 234B/C, and penalties up to 200% of the tax on adjusted income

Shareholders can also file a class action suit under Section 245 of the Companies Act or approach the NCLT under Sections 241-242 for oppression and mismanagement if RPTs are used to divert company funds.

Exemptions and Relaxations

The Companies Act provides specific exemptions to reduce the compliance burden for genuine intra-group transactions and certain company types.

Wholly-Owned Subsidiary Exemption

Transactions between a holding company and its wholly-owned subsidiary whose accounts are consolidated with the holding company are exempt from board and shareholder approval requirements under the proviso to Section 188(1). These transactions must still be disclosed in Form AOC-2 and financial statements, and the arm's length principle applies.

Ordinary Course of Business Exemption

Under Rule 15(3), RPTs in the ordinary course of business and at arm's length prices are exempt from the requirement of shareholder approval. Board and Audit Committee approval is still required. "Ordinary course of business" means routine, regular transactions that form part of the company's normal operations.

Government Company Relaxation

Contracts between two government companies are exempt from shareholder approval requirements if the Comptroller and Auditor General (CAG) is the auditor of both companies. Board approval and arm's length documentation requirements still apply.

RPT Compliance Checklist for Directors

Directors bear personal liability for RPT violations. Use this checklist to maintain compliance throughout the financial year.

1. File Form MBP-1 disclosing all interests at the first board meeting of each financial year and upon any change in interest
2. Maintain an updated related party register - review at the start of each financial year against the Section 2(76) definition
3. Obtain Audit Committee approval before entering any RPT, or obtain omnibus approval for routine transactions
4. Pass a Board resolution for each RPT with the interested director abstaining from discussion and voting
5. Monitor threshold limits - calculate cumulative RPT values against Rule 15 thresholds quarterly to determine if shareholder approval is needed
6. Document arm's length pricing with valuation reports, market comparisons, or independent third-party quotes
7. Update the Section 189 register and present it at every board meeting for director signatures
8. Prepare Form AOC-2 for annexure to the Board's Report before the Annual General Meeting
9. Ensure Ind AS 24 disclosures in the financial statements reviewed by the statutory auditor
10. Review the RPT policy annually and update for regulatory changes (mandatory for listed companies, recommended for all)

Working with a Virtual CFO or dedicated compliance team ensures that none of these steps are missed during the financial year. RPT compliance is an ongoing obligation, not a year-end activity.

Practical Scenarios: How RPT Rules Apply

Scenario 1: Company Leases Office From a Director's Property

If a private limited company leases its office premises from a property owned by its director, this is an RPT under Section 188. The director must abstain from voting on the board resolution. If the annual lease value exceeds 10% of net worth or 10% of turnover, shareholder approval by ordinary resolution is required. The rent must be benchmarked against market rates in the same locality.

Scenario 2: Subsidiary Buys IT Services From Holding Company

When a subsidiary avails IT services from its holding company, this is an RPT. If the holding company is listed, the listed entity's Audit Committee must approve the transaction under SEBI LODR. The transaction must be at arm's length, and if classified as material (exceeding ₹1,000 crore or 10% of consolidated turnover), shareholder approval is required with related parties excluded from voting.

Scenario 3: Director's Relative Appointed as Paid Consultant

Appointing a director's relative as a paid consultant requires board approval under Section 188. The interested director cannot participate in the vote. If monthly remuneration exceeds ₹2.5 lakh, shareholder approval is mandatory. The consulting fees must be comparable to what an independent consultant with similar qualifications would charge - documented with at least two independent quotes.

Summary

Related Party Transactions are one of the most regulated areas of Indian corporate governance. The compliance framework under Section 188 of the Companies Act, 2013, supported by SEBI LODR Regulations for listed entities, requires companies to identify related parties under Section 2(76), obtain multi-level approvals (Audit Committee → Board → Shareholders), price transactions at arm's length, and disclose everything in Form AOC-2 and Ind AS 24 financial statements.

The stakes are high: directors face personal liability including imprisonment up to 1 year, fines up to ₹5 lakh, and indemnification obligations. Companies face fines up to ₹25 lakh and the risk of transactions being voided. For listed companies, SEBI can impose additional penalties including disgorgement and market debarment.

At IncorpX, our corporate compliance team helps businesses across India structure RPT policies, draft board resolutions, prepare Form AOC-2 disclosures, and maintain annual compliance - so directors can focus on business decisions without regulatory risk.