Section 188. Related Party Transactions under the Companies Act 2013

Introduction

In today’s dynamic business environment in India, maintaining strong corporate governance and transparency is no longer just a best practice – it’s essential for survival and growth. For businesses of all sizes, from established corporations to burgeoning small enterprises, fostering stakeholder trust is paramount. A critical aspect of this governance framework involves managing transactions that occur between a company and individuals or entities closely associated with it. These are known as Related Party Transactions (RPTs). Recognizing the potential for conflicts of interest and unfair advantage, the Indian legal system specifically regulates these dealings through Section 188 of the Companies Act, 2013. Understanding the nuances of related party transactions under the companies act 2013 is therefore absolutely crucial for ensuring full compliance, steering clear of substantial penalties, and upholding fair, ethical business practices. This knowledge is particularly relevant for small business owners and individuals who often wear multiple hats as directors, shareholders, or key personnel within their companies, as navigating these rules correctly is fundamental to protecting the company’s interests and their own legal standing.

For small business owners looking to set up a systematic approach to compliance, exploring Set Up An Accounting System for My Small Business can be invaluable.

What Exactly Are Related Party Transactions (RPTs)?

Before diving into the specific rules under Section 188, it’s vital to clearly understand who qualifies as a ‘related party’ and what types of transactions fall under the regulatory microscope. The Companies Act, 2013 provides specific definitions to eliminate ambiguity and ensure comprehensive coverage. Misinterpreting these definitions can lead to inadvertent non-compliance, making a thorough grasp essential for anyone involved in corporate management or ownership.

Defining a ‘Related Party’ under the Companies Act, 2013

Section 2(76) of the Companies Act, 2013 meticulously defines who constitutes a ‘related party’ in relation to a company. This definition is broad and encompasses various individuals and entities that could potentially influence the company’s decisions or benefit unduly from transactions with it. Fully understanding related party transactions India begins with identifying these key relationships. A related party includes:

Directors or their relatives: This is perhaps the most straightforward category, covering those formally appointed to the board and their close family members.
Key Managerial Personnel (KMP) or their relatives: KMPs, such as the CEO, Managing Director, Company Secretary, Whole-time Director, CFO, and other designated officers, along with their relatives, are included due to their significant influence on company operations.
Firms where a director, manager, or their relative is a partner: If a director or manager (or their relative) holds a partnership interest in another firm, that firm becomes a related party.
Private companies where a director or manager is a member or director: Any private company where a director or manager of the primary company also holds a position as a member (shareholder) or director is considered related.
Public companies where a director or manager is a director AND holds (along with relatives) more than 2% of paid-up share capital: This applies to public companies where there’s an overlap in directorship, coupled with a significant shareholding by the director/manager and their relatives.
Any body corporate whose Board of Directors, Managing Director, or Manager is accustomed to act on the advice, directions, or instructions of a director or manager of the primary company: This covers situations of indirect control or influence over another company’s management.
Any person on whose advice, directions, or instructions a director or manager of the primary company is accustomed to act: This is the inverse of the above, where an external individual or entity significantly influences the primary company’s directors or managers (excluding advice given in a professional capacity).
Holding, subsidiary, or associate companies: The direct corporate family structure (parent, child, significantly influenced companies) is explicitly included.
A subsidiary of a holding company to which it is also a subsidiary: This refers to ‘fellow subsidiary’ companies under the same parent holding company.
(Note: Certain specific roles like investigating inspectors or administrators appointed under specific laws might also fall under this definition depending on the context.)

Who is a ‘Relative’? The Act, under Section 2(77) read with the Companies (Specification of definitions details) Rules, 2014, defines ‘relative’ quite specifically. It primarily includes:

Members of a Hindu Undivided Family (HUF).
Spouse.
Father (including step-father).
Mother (including step-mother).
Son (including step-son).
Son’s wife.
Daughter.
Daughter’s husband.
Brother (including step-brother).
Sister (including step-sister).

Keeping an updated list of these individuals and entities based on the company’s current structure and management is a foundational compliance step. Small businesses can benefit from insights on compliance through articles such as Company Registration in India.

Types of Transactions Covered under Section 188

Once you’ve identified the related parties, the next step is to understand which specific transactions with these parties fall under the purview of Section 188(1). The Act lists several types of arrangements or contracts that require specific approvals if entered into with a related party:

Sale, purchase, or supply of any goods or materials: This covers routine business transactions like buying raw materials from or selling finished goods to a related party.
- Example: A company buying packaging materials from a firm owned by the director’s spouse.
Selling or otherwise disposing of, or buying, property of any kind: This includes transactions involving real estate, machinery, intellectual property, or any other form of company asset.
- Example: A company selling an old office building to its holding company.
Leasing of property of any kind: Renting property to or from a related party falls under this category.
- Example: A company leasing its factory premises from a director who owns the property.
Availing or rendering of any services: This broad category includes professional services, consultancy, maintenance, administrative support, etc.
- Example: A company availing IT support services from a private company where one of its directors is also a director.
Appointment of any agent for purchase or sale of goods, materials, services or property: Engaging a related party to act as an agent for procurement or sales requires scrutiny.
- Example: Appointing a subsidiary company as the sole selling agent for the parent company’s products in a specific region.
Appointment of related party to any office or place of profit in the company, its subsidiary company or associate company: This refers to employing a related party in a paid position within the company or its related entities, where the position carries remuneration beyond just director sitting fees.
- Example: Appointing the CEO’s son to a managerial position with a significant salary in an associate company.
Underwriting the subscription of any securities or derivatives thereof, of the company: If a related party acts as an underwriter for the company’s share issue or other securities, this transaction is covered.
- Example: A director’s investment firm underwriting the company’s Initial Public Offering (IPO).

It’s crucial to note that these transactions need special attention because they involve related parties, regardless of whether the terms appear fair on the surface. The law mandates a process to ensure they are appropriately reviewed and approved.

The Core of Section 188: Rules for Related Party Transactions under the Companies Act 2013

Section 188 establishes a clear governance framework for handling the RPTs listed above. It mandates specific approval mechanisms depending on the nature and scale of the transaction, ensuring transparency and preventing potential misuse of company resources. Understanding these rules is central to compliant corporate behaviour.

Board Approval: The First Step

The foundational requirement under Section 188 is the consent of the Board of Directors. For any transaction covered under Section 188(1) that is not exempt (more on exemptions later), the company must obtain approval from its Board of Directors. This approval cannot be a mere formality; it must be granted via a resolution passed at a duly convened Board meeting. A circular resolution (passed by circulation without a meeting) is generally not sufficient for Section 188 approvals.

A critical aspect of this process involves the concept of ‘interested directors’. Any director who is directly or indirectly concerned or interested in the contract or arrangement with the related party is prohibited from participating in the discussion or voting on the resolution pertaining to that specific transaction. They should ideally not even be present during that agenda item’s deliberation to avoid any perception of influence. This rule underscores the importance of objectivity in the Board’s decision-making process for section 188 related party transactions India. The minutes of the meeting must clearly record the names of directors who did not participate due to their interest.

When is Shareholders’ Approval Required? (Ordinary Resolution)

While Board approval is the baseline, certain RPTs, due to their significance or potential impact, require an additional layer of approval: prior consent from the company’s shareholders. This is obtained by passing an Ordinary Resolution at a general meeting (Annual General Meeting or Extraordinary General Meeting). An ordinary resolution requires a simple majority of votes cast (more votes in favour than against).

The Companies Act empowers the government to prescribe thresholds beyond which shareholder approval becomes mandatory. These thresholds are detailed in Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014 (subject to amendments). As per the current rules, prior shareholder approval is needed if the RPT exceeds any of the following limits:

Type of Transaction	Threshold Triggering Shareholder Approval
Sale, purchase, or supply of goods or materials (directly or through agent)	Exceeds 10% of the annual turnover of the company.
Selling or disposing of/buying property (directly or through agent)	Exceeds 10% of the net worth of the company.
Leasing of property of any kind	Exceeds 10% of the net worth OR 10% of the annual turnover of the company, whichever is higher.
Availing or rendering of services (directly or through agent)	Exceeds 10% of the annual turnover of the company.
Appointment to any office or place of profit in the company, its subsidiary, or associate	Monthly remuneration exceeds INR 2.5 Lakhs.
Underwriting subscription of securities/derivatives	Remuneration payable exceeds 1% of the net worth of the company.

(Note: Turnover or net worth should be considered as per the preceding financial year’s audited financial statements. These thresholds are subject to change, always refer to the latest version of the Rules.)

Similar to the Board meeting rule, a member of the company who is a related party involved in the transaction cannot vote on the ordinary resolution approving that specific contract or arrangement. This ensures that the decision reflects the collective will of the disinterested shareholders. This requirement acts as a key part of the companies act 2013 related party transactions guide for ensuring fairness.

The Arm’s Length Transaction Exception

Section 188 provides a significant exemption from the requirement of obtaining Board or Shareholder approval. The approval mechanisms (both Board resolution at a meeting and shareholder resolution, if applicable) do not apply if the Related Party Transaction meets both of the following conditions:

It is in the ordinary course of the company’s business, AND
It is conducted on an arm’s length basis.

Let’s break down these terms:

Ordinary Course of Business: This refers to activities that are part of the company’s normal, day-to-day operations and are consistent with its established business practices. It implies transactions that are necessary, common, and routine for the type of business the company conducts. Determining this requires considering the nature of the business, its history, and industry norms. For instance, a software company providing coding services to a related entity might be in the ordinary course, but selling its main office building might not be, unless it’s a real estate company.
Arm’s Length Transaction: This is a cornerstone concept in RPT regulation. An arm’s length transaction is one conducted as if the parties were unrelated, acting independently, and pursuing their own best interests. The key indicator is usually the price – it should reflect the fair market value, similar to what would be agreed upon with a completely independent third party under similar circumstances. Proving ‘arm’s length’ often requires demonstrating that the terms (price, credit period, quality, etc.) are comparable to those of similar transactions with non-related parties or are based on objective market benchmarks.

Crucially, both conditions must be met simultaneously for the exemption to apply. If a transaction is at arm’s length but not in the ordinary course of business, or vice versa, the Section 188 approval requirements still apply. Companies relying on this exemption should maintain robust documentation justifying both aspects, especially the arm’s length pricing.

Disclosure is Key

Transparency remains vital even for transactions that might be exempt or have received the necessary approvals. The Companies Act, 2013 mandates disclosure regarding RPTs. Every company must include details of all contracts or arrangements entered into with related parties under Section 188(1) in the Board’s Report that is attached to the company’s annual financial statements.

This disclosure typically needs to cover:

The name of the related party and relationship.
The nature of the contract or arrangement.
The material terms of the contract, including value, duration, etc.
Any advance paid or received.
The justification for entering into such a contract or arrangement.

Importantly, even RPTs conducted on an arm’s length basis and in the ordinary course of business often need to be disclosed in the financial statement notes as per Accounting Standards (like Ind AS 24), and potentially summarized in the Board Report for good governance, even if they were exempt from Section 188 approval requirements. This ensures shareholders and other stakeholders are aware of the extent of dealings with related parties.

Your Compliance Checklist for Related Party Transactions in India

Navigating the requirements of Section 188 can seem complex, especially for small businesses juggling multiple operational demands. However, establishing a systematic approach can significantly simplify compliance for related party transactions in India. Here’s a practical checklist to guide your company:

Step 1: Identify All Related Parties

Action: Regularly review and maintain an exhaustive, updated list of all individuals and entities qualifying as ‘related parties’ based on Section 2(76) definitions and the current shareholding and management structure.

Details: Include directors, KMPs, their known relatives (as defined in Section 2(77)), significant shareholders, holding/subsidiary/associate companies, firms/private companies linked via directors/managers, etc. This list should be formally documented and periodically verified.

Step 2: Identify Potential RPTs

Action: Scrutinize all proposed contracts, arrangements, and transactions involving any party identified in Step 1.

Details: Check if the transaction falls into any of the categories specified under Section 188(1) (sale/purchase of goods/property, leasing, services, agency appointments, office/place of profit appointments, underwriting). Maintain a log or register of potential RPTs under consideration.

Step 3: Evaluate – Is it Arm’s Length & Ordinary Course?

Action: For each identified potential RPT, critically assess if it meets both conditions for exemption: being in the ordinary course of business AND conducted on an arm’s length basis.

Details: Document the rationale thoroughly. For ‘ordinary course’, relate it to the company’s core business activities. For ‘arm’s length’, gather evidence – this could include quotes from unrelated vendors/customers for similar transactions, market price benchmarks, independent valuations (especially for property or unique services), or established pricing policies applied consistently to all parties. Lack of robust justification can invalidate the exemption claim later.

Step 4: Obtain Necessary Approvals

Action: If the transaction is not exempt under the arm’s length/ordinary course criteria, proceed with the required approvals before entering into the transaction.

Details:

Board Approval: Present the transaction details to the Board. Ensure the meeting agenda clearly lists the RPT. Record the resolution passed in the minutes, explicitly noting any interested directors who abstained from discussion and voting.
Shareholder Approval: If the transaction value exceeds the prescribed thresholds (Rule 15), seek prior approval via an Ordinary Resolution at a general meeting. Ensure the explanatory statement attached to the meeting notice provides all material facts and justification. Verify that members who are related parties abstain from voting on this resolution.

Step 5: Maintain Documentation

Action: Keep meticulous records related to all aspects of RPT management. Proper documentation is crucial for audits and potential regulatory scrutiny.

Details: Your RPT file should ideally contain:

The updated Related Party list.
Details of each RPT entered into (nature, value, duration, terms).
Documentation supporting the arm’s length pricing and ordinary course of business assessment (if exemption claimed).
Copies of Board meeting agendas, notices, attendance records, and minutes showing resolution passage (or noting abstentions).
Copies of General meeting notices, explanatory statements, attendance records, and minutes showing shareholder resolution passage (or noting abstentions).
Copies of the actual contracts or agreements related to the RPTs.
Relevant statutory registers (like the Register of Contracts or Arrangements in which directors are interested – Section 189).

Step 6: Report and Disclose

Action: Ensure accurate and complete disclosure of RPTs as required by the Companies Act and applicable Accounting Standards.

Details: Prepare the section on RPTs for the Board’s Report, including all necessary details and justifications as per Section 188(2) and relevant rules. Ensure disclosures in the notes to financial statements comply with Ind AS 24 or other applicable accounting standards. Review these disclosures carefully before finalization.

For more detailed insights into handling compliance and ensuring transparency in transactions, refer to the Primary Purpose of Internal Audit in the Modern Organization.

What Happens if You Don’t Comply with Section 188?

Ignoring or improperly handling the requirements of Section 188 can lead to significant adverse consequences for the company, its directors, and potentially other involved officers. The penalties are designed to be deterrents, emphasizing the seriousness with which the law views breaches of related party transaction regulations.

Voidable Contracts

One of the most immediate consequences of non-compliance relates to the validity of the transaction itself. Any contract or arrangement entered into by a company with a related party without obtaining the required consent (either from the Board at a meeting or through a prior Ordinary Resolution from shareholders, when applicable) is voidable at the option of the Board or the shareholders, respectively.

This means the Board (if only Board approval was missed) or the shareholders (if their approval was required and not obtained) can choose to cancel the contract. This can create significant commercial uncertainty and potential disputes, especially if the transaction has already been partially executed. The decision to void rests with the governing body whose approval was bypassed.

Penalties for the Company

The Companies Act, 2013 imposes monetary penalties on companies that contravene the provisions of Section 188. The penalty structure differs based on whether the company is listed or unlisted:

For Listed Companies: The penalty can be a hefty fine, which could be up to twenty-five lakh rupees (INR 2,500,000).
For Other (Unlisted) Companies: The penalty can be a fine of up to five lakh rupees (INR 500,000).

These fines represent a direct financial hit to the company, impacting its profitability and potentially its reputation. Regulators like the Registrar of Companies (ROC) or SEBI (for listed companies) can initiate adjudication proceedings to levy these penalties upon identifying violations during inspections or scrutiny of filings.

Penalties for Directors/Officers

The responsibility for ensuring compliance doesn’t rest solely on the company as an entity. Directors or any other officers of the company who are considered ‘in default’ (i.e., responsible for the non-compliance) face personal liability. If a director or any other employee enters into or authorises a contract or arrangement in violation of Section 188 provisions:

For Listed Companies: Such director or employee can be liable for imprisonment for a term which may extend to one year OR a fine which shall not be less than twenty-five thousand rupees (INR 25,000) but which may extend to five lakh rupees (INR 500,000), or both.
For Other (Unlisted) Companies: Such director or employee can be liable for a fine which shall not be less than twenty-five thousand rupees (INR 25,000) but which may extend to five lakh rupees (INR 500,000).

The prospect of personal fines and even potential imprisonment underscores the critical need for directors and key management personnel to be fully aware of and adhere to Section 188 requirements.

Recovery from Directors

Beyond penalties, the Act provides a mechanism for the company to recover losses caused by non-compliant RPTs. If any contract or arrangement is entered into by a director or any other employee in contravention of Section 188, and the company incurs a loss as a result, the company has the right to proceed against that director or employee.

The director or employee responsible for the unauthorised transaction may be required to indemnify the company for the loss suffered. This means they could be personally liable to make good the financial damage caused to the company due to their failure to follow the mandated procedures for RPT approval. This provision aims to ensure accountability and protect the company’s financial interests from unauthorized dealings favouring related parties.

Why Small Businesses Must Pay Attention to RPT Rules

While the complexities of corporate law might sometimes seem overwhelming for Small and Medium Enterprises (SMEs), the rules surrounding Related Party Transactions under Section 188 are particularly pertinent. Adherence isn’t just about avoiding legal trouble; it’s fundamental to building a sustainable and trustworthy business. Ignoring these rules can have disproportionately large negative impacts on smaller entities.

Firstly, Transparency & Trust are invaluable assets for any business, especially SMEs seeking funding or partnerships. Properly managing and disclosing related party transactions under companies act India demonstrates a commitment to good corporate governance. Banks, potential investors, and even major customers are increasingly scrutinizing governance practices. A clean record on RPTs builds credibility and makes the business a more attractive proposition for financing and strategic alliances. Conversely, poorly managed RPTs can raise red flags, suggesting potential conflicts of interest or siphoning of funds, thereby eroding trust.

Secondly, Avoiding Legal Trouble is critical for resource-constrained SMEs. The penalties for non-compliance under Section 188 – significant fines for the company and personal liability (including fines and potential imprisonment) for directors – can be crippling. Beyond the direct financial cost, legal disputes and regulatory actions consume valuable management time and legal fees, diverting focus and funds away from core business activities. Proactive compliance is far more cost-effective than dealing with the fallout of violations.

Thirdly, ensuring Fair Value in all transactions protects the company’s financial health and the interests of all stakeholders, including minority shareholders if any. RPT rules, particularly the emphasis on arm’s length pricing, help prevent situations where company resources are sold too cheaply to, or procured too expensively from, related parties. This safeguards the company’s profitability and ensures that value generated benefits the company as a whole, not just a select few connected individuals or entities.

Finally, establishing robust processes for handling RPTs early on lays a Good Governance Foundation. As a small business grows, its transactions and relationships inevitably become more complex. Having clear policies and procedures for identifying, approving, and documenting RPTs from the outset creates a culture of compliance and ethical conduct. This foundation is crucial for scaling the business effectively, attracting professional management, and potentially preparing for future milestones like seeking venture capital or an IPO. Adherence to Section 188 is not just a legal formality; it’s a strategic imperative for the long-term health and reputation of small businesses in India.

For business owners planning to expand or incorporate new entities, understanding the initial compliance checklist is essential. You can refer to Company Registration, Opportunities, and Strategic Growth to learn more about the steps.

Conclusion

Navigating the landscape of corporate compliance in India requires careful attention to detail, and Section 188 of the Companies Act, 2013, dealing with Related Party Transactions, is a cornerstone of this framework. We’ve explored what constitutes an RPT, identifying both the ‘related parties’ and the types of transactions covered. We delved into the critical governance mechanisms mandated by the Act – the necessity for Board approval (with interested directors abstaining) and, for significant transactions exceeding specific thresholds, the requirement for prior shareholder approval via an Ordinary Resolution (with interested members abstaining). The crucial exemption for transactions conducted in the ‘ordinary course of business’ and on an ‘arm’s length basis’ was highlighted, along with the non-negotiable need for proper disclosure in the Board’s Report. The serious consequences of non-compliance, ranging from voidable contracts to substantial penalties for companies and personal liability for directors, underscore the importance of adherence.

For every Indian company, regardless of size, understanding and diligently managing related party transactions under the companies act 2013 is not optional; it is fundamental to ethical operations, legal compliance, and building stakeholder trust. Small businesses, in particular, stand to gain significantly by embedding these principles into their operations early on, fostering transparency and setting the stage for sustainable growth.

Is your company confidently managing its Related Party Transactions? Are your documentation and approval processes robust enough to withstand scrutiny? Don’t leave compliance to chance. Review your RPT policies and procedures today. If you have any doubts or need expert guidance on navigating Section 188 or other Companies Act requirements, TaxRobo is here to help. Contact us for professional assistance with compliance, accounting, auditing, and ensuring your Related Party Transactions are handled correctly. Visit TaxRobo Online CA Consultation Service for personalized advice.

Frequently Asked Questions (FAQs)

Q1: Who is considered a ‘relative’ under the Companies Act, 2013 for RPTs?

Answer: Under Section 2(77) read with the relevant rules, a ‘relative’ includes members of a Hindu Undivided Family (HUF), a spouse, and specific lineal ascendants and descendants: father (including step-father), mother (including step-mother), son (including step-son), son’s wife, daughter, daughter’s husband, brother (including step-brother), and sister (including step-sister). It’s a defined list used consistently for identifying related parties when directors or KMPs are involved.

Q2: What does ‘arm’s length transaction’ mean in the context of Section 188?

Answer: An ‘arm’s length transaction’ refers to a deal conducted between two parties as if they were unrelated, acting independently and in their own self-interest. The key characteristic is that the terms and conditions (especially pricing) reflect fair market value, similar to what would be agreed upon with an independent third party in a comparable transaction. Demonstrating arm’s length pricing is crucial if a company seeks exemption from Section 188 approval requirements, provided the transaction is also in the ‘ordinary course of business’.

Q3: Can a director or shareholder who is a ‘related party’ vote on the resolution for their transaction?

Answer: No, participation is restricted to ensure unbiased decisions. An ‘interested director’ (one who is related to the party involved in the transaction or otherwise interested) cannot participate in the discussion or vote on the Board resolution approving that specific RPT. Similarly, a ‘related party member’ (a shareholder who is a related party) is prohibited from voting on an Ordinary Resolution required at a general meeting for approving an RPT that crosses the prescribed thresholds.

Q4: Are transactions between a holding company and its wholly-owned subsidiary exempt from Section 188 approval requirements?

Answer: There’s a specific exemption regarding shareholder approval. The proviso to Section 188(1) states that the requirement to obtain shareholder approval (via Ordinary Resolution) does not apply to transactions entered into between a holding company and its wholly-owned subsidiary (100% owned) whose financial statements are consolidated with the holding company and presented to the shareholders at the general meeting. However, the requirement for Board approval (via resolution at a meeting) still generally applies, unless the transaction also qualifies for the separate exemption of being in the ordinary course of business AND conducted on an arm’s length basis.

Q5: What basic records should a company keep for related party transactions under the companies act 2013?

Answer: Companies must maintain comprehensive records. Key documents include:

An updated list of all related parties.
A register detailing all RPTs entered into (often maintained as part of the Register of Contracts or Arrangements under Section 189), specifying the nature, terms, value, and duration.
Minutes of Board meetings clearly showing the resolution passed for RPT approval and noting directors who abstained due to interest.
Minutes of General meetings showing the Ordinary Resolution passed (if required) and noting related party members who abstained from voting.
Supporting documents justifying any claim that a transaction was conducted on an arm’s length basis (e.g., comparative quotes, valuation reports).
Copies of the actual contracts or agreements governing the RPTs.
Disclosures made in the Board’s Report and Financial Statements.

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