How do startups manage compliance for related party transactions?

Introduction

As a startup founder in India, you often lean on your network for initial support. This might mean leasing office space from a family member, taking a loan from another company you own, or hiring a relative’s firm for marketing. While these arrangements are practical and often born of necessity, they are legally classified as “Related Party Transactions” (RPTs), and they come with a strict set of rules. For any growing business, understanding and managing compliance for related party transactions is not just a legal formality but a cornerstone of good corporate governance. Failing to navigate these regulations can lead to severe penalties, disruptive tax disputes with the authorities, and, most damagingly, a significant loss of investor trust just when you need it most.

Understanding the regulations stipulated under the Companies Act, 2013, and the Income Tax Act, 1961, is absolutely crucial for ensuring your startup operates with transparency and is built for sustainable growth. This comprehensive guide is designed to demystify related party transactions compliance in India specifically for startups. We will break down the essentials, covering what legally constitutes a related party and an RPT, the key legal frameworks you must adhere to, a practical step-by-step process for managing compliance, and a clear overview of the substantial risks involved in non-compliance.

What is a Related Party Transaction in the Indian Context?

Before diving into the complex rules and procedures, it’s essential to first establish a clear understanding of the two core components: who is considered a “related party” and what qualifies as a “transaction” with them. The law defines these terms broadly to ensure transparency and prevent any individual from using their position of influence for personal gain at the company’s expense. For a startup, where personal and professional lines are often blurred in the early stages, having this clarity is the first and most critical step towards building a robust compliance framework. This foundational knowledge is essential for grasping the wider context of Navigating Legal Compliance for Startups in India.

Who is a “Related Party” under the Companies Act, 2013?

The term “related party” isn’t just about close family; the Companies Act, 2013, under Section 2(76), provides a very specific and extensive list of individuals and entities. It’s crucial for every startup to know this definition inside and out to correctly identify all potential RPTs before they even occur. A related party, with respect to a company, includes:

• Directors or their relatives: This is the most common and easily identifiable category. A “relative” itself is a defined term including members of a Hindu Undivided Family (HUF), spouse, and a specific list of close relations like parents, children, and siblings.
• Key Managerial Personnel (KMP) or their relatives: KMP includes the Chief Executive Officer (CEO), Managing Director, Company Secretary, Whole-time Director, Chief Financial Officer (CFO), and any other officer designated as such.
• A firm in which a director, manager, or their relative is a partner: If your director is a partner in an external audit firm or a consultancy firm, any transaction with that firm is an RPT.
• A private company in which a director or manager is a member or director: If a director of your startup is also a director or shareholder in another private company, transactions between the two entities are captured.
• A public company in which a director or manager is a director AND holds, along with their relatives, more than 2% of its paid-up share capital.
• Any body corporate whose Board of Directors, managing director, or manager is accustomed to act in accordance with the advice, directions, or instructions of a director or manager of your company. This is a catch-all provision for entities under the de facto control of your company’s leadership.
• Holding, subsidiary, or associate companies: All transactions within the corporate group structure are considered RPTs.

Actionable Tip: To avoid any oversight, your startup should maintain a formal and regularly updated register of all related parties. This list should be reviewed by the board at least annually or whenever there is a change in directorship or KMP.

Common Examples of RPTs for Startups

Once you have your list of related parties, you need to identify the types of transactions that fall under scrutiny. These are not just high-value deals; even seemingly minor arrangements can qualify. Here are some of the most common examples startups encounter:

• Sale, purchase, or supply of any goods or materials: For instance, if a director’s other company supplies raw materials, software licenses, or office furniture to the startup.
• Leasing of property of any kind: A very common scenario where a founder uses their own personal property as the startup’s first office and charges rent to the company.
• Availing or rendering of any services: This could involve a director’s spouse, who is a graphic designer, providing branding services to the startup, or the startup providing tech support to a subsidiary.
• Appointment of any agent for the purchase or sale of goods, materials, services, or property: If the company hires a real estate agent who is a director’s relative to find office space.
• Appointment of a related party to any office or place of profit in the company: This means hiring a relative of a director for a paid position within the startup.
• Underwriting the subscription of any securities of the company: If a related party entity agrees to underwrite a future share issue.
• Providing loans or guarantees to or from related parties: This includes the startup giving a loan to a subsidiary or a director providing a personal guarantee for a bank loan taken by the startup.

Key Regulations Governing Compliance for Related Party Transactions

Navigating the landscape of compliance for related party transactions requires a solid understanding of three primary legal frameworks in India: The Companies Act, 2013, the Income Tax Act, 1961, and the Goods and Services Tax (GST) law. Each of these statutes looks at RPTs through a different lens—corporate governance, fair expense claims, and correct valuation for tax purposes, respectively. For a startup, compliance is not about satisfying just one of these laws, but about ensuring that every transaction is structured to meet the requirements of all three. Overlooking even one aspect can expose the business to significant financial and legal risks.

The Companies Act, 2013: Section 188

Section 188 of the Companies Act, 2013, is the primary regulation governing the approval and disclosure of RPTs. Its entire purpose is to ensure that such transactions are transparent and do not disadvantage the company or its minority shareholders. The core principle underpinning this section is the concept of an Arm’s Length Transaction (ALP). This means that the terms and conditions of the RPT must be fair and comparable to what they would be if the transaction were conducted between two completely unrelated parties in the open market. The Act mandates a strict, multi-layered approval process to enforce this principle.

The approval process can be broken down as follows:

1. Audit Committee Approval: For companies that are required to constitute an Audit Committee (e.g., listed companies, public companies with certain capital/turnover), all RPTs require prior approval from this committee.
2. Board Approval: Every RPT must be approved by a resolution at a meeting of the Board of Directors. Crucially, any director who is interested in the transaction (i.e., they or their relative are the “related party”) is not allowed to be present during the discussion or vote on that specific resolution.
3. Shareholder Approval: If an RPT exceeds certain monetary thresholds, it requires additional approval from the shareholders through an Ordinary Resolution. The interested related party shareholders are not permitted to vote on this resolution. The key thresholds are:
   • Sale, purchase, or supply of goods or materials: Exceeding 10% of the company’s annual turnover.
   • Leasing of property: Exceeding 10% of the company’s net worth or 10% of its annual turnover.
   • Availing or rendering of services: Exceeding 10% of the company’s annual turnover.
   • Appointment to an office or place of profit: If the monthly remuneration exceeds ₹2.5 lakhs.

Furthermore, the Act mandates detailed disclosure of all RPTs in the Board’s Report that is sent to shareholders. This disclosure must include the name of the party, the nature of the relationship, the type of transaction, and the amount involved. For more details, you can refer to the official statute on the Ministry of Corporate Affairs website.

The Income Tax Act, 1961: Section 40A(2)

While the Companies Act focuses on corporate governance, the Income Tax Act is concerned with the financial legitimacy of expenses. Section 40A(2) empowers the Income Tax Assessing Officer to scrutinize payments made to related parties. The core concept here is to prevent companies from inflating expenses to reduce their taxable profits. If your startup makes a payment to a related party for an expense—such as a director’s salary, rent for a founder’s property, or professional fees to a relative’s firm—and the Assessing Officer deems that amount to be excessive or unreasonable compared to the fair market value, the excess amount can be disallowed.

The impact of such a disallowance is direct and painful: the disallowed portion of the expense is added back to the company’s income, which increases its total taxable profit. This, in turn, leads to a higher corporate tax liability, along with potential interest and penalties for underpayment of taxes. This makes it a crucial aspect of managing compliance issues in startups India, as a tax dispute can drain valuable resources and time. For more information, you can visit the Income Tax Department website.

GST Implications on RPTs

The Goods and Services Tax (GST) adds another layer of complexity to RPTs. A fundamental principle of GST is that tax is levied on the “transaction value.” However, when parties are related, there is a risk that they might undervalue a transaction or provide goods/services for free to avoid paying GST. To counter this, the GST law has specific valuation rules for transactions between related persons. Under these rules, GST is chargeable on the “open market value” of the goods or services supplied, regardless of the price actually charged.

Here’s a practical example that illustrates a common pitfall in how startups handle compliance India: Imagine your tech startup provides free IT maintenance and support services to its newly formed subsidiary. Even though no invoice is raised and no money changes hands, this is considered a “supply” under GST between related persons. The startup is legally required to determine the open market value of those IT services (i.e., what it would have charged an unrelated client) and pay GST on that value. Failing to do so can lead to a demand for the unpaid tax, interest, and penalties during a GST audit. Knowing How to File GST Returns Online: A Step-by-Step Guide of the GST Filing Process & Procedure is essential to prevent such scenarios.

A Step-by-Step Guide to Managing Related Party Transactions Compliance in India

Knowing the rules is one thing; implementing them effectively is another. For a busy startup, creating a systematic process is the key to staying compliant without getting overwhelmed. A proactive, process-driven approach not only ensures you meet legal requirements but also builds a culture of transparency and good governance from day one. This makes your startup more credible and attractive to future investors, partners, and auditors. Here is a practical, step-by-step guide to help you manage your RPTs effectively.

Step 1: Identify and Maintain a Register of Related Parties

The absolute first step is to know who your related parties are. You cannot comply with the rules if you don’t even know when they apply. Your startup must create and diligently maintain a formal register of all its related parties as defined under the Companies Act, 2013. This should not be an informal mental list but a structured document that is formally acknowledged by the company. This register should be a living document, reviewed and updated at every board meeting or at least once every quarter. For each related party, the register should capture key details such as their full name, the nature of their relationship with the company (e.g., “Spouse of Director X,” “Subsidiary Company”), and their PAN and GSTIN details for financial and tax reference.

Step 2: Establish a Formal RPT Policy

To institutionalize your compliance process, it’s highly advisable to draft and adopt a formal Related Party Transaction Policy. This doesn’t need to be a hundred-page legal document; a simple, clear policy that is understood by all directors and KMP is sufficient. This policy should outline the company’s philosophy on RPTs, the process for identifying them, the detailed approval matrix (who approves what—Audit Committee, Board, Shareholders), and the documentation required for justification. Having a written policy is a powerful tool. It demonstrates a serious commitment to good governance to auditors, investors, and regulatory authorities, proving that your approach to compliance management in startups India is proactive, not reactive.

Step 3: Justify the “Arm’s Length Price” with Proper Documentation

This is the most critical step in defending your RPTs against scrutiny from both auditors and tax officers. The burden of proof is on the company to demonstrate that every transaction was conducted at an “arm’s length price” (ALP). This justification cannot be based on assumptions; it must be backed by solid, contemporaneous documentation. Your goal is to create a file for each significant RPT that proves its market fairness.

• For Services or Goods: Before entering into a transaction with a related party, obtain at least two written quotes from independent, unrelated vendors for the same or similar services/goods. These quotes serve as your benchmark for justifying the price paid to the related party.
• For Asset Purchases or Leases: For high-value transactions like buying property or machinery, it is best practice to get a formal valuation report from a registered valuer. This provides an impartial, expert opinion on the fair market value.
• For Loans Given or Received: Use prevailing market interest rates as a benchmark. You can document this by taking printouts of interest rates offered by banks for similar types of loans at that point in time.

Step 4: Follow the Correct Approval Protocol

Once a transaction is identified and its pricing justified, it must go through the formal approval process as mandated by the Companies Act and your own RPT policy. Meticulous documentation of this process is non-negotiable. Ensure that the minutes of the board meeting clearly record the details of the proposed RPT, the justification for entering into it, the pricing benchmarks considered, and the text of the resolution passed. Crucially, the minutes must explicitly state that the interested director(s) recused themselves from the discussion and abstained from voting. If the transaction requires shareholder approval, the notice sent out for the general meeting must include a detailed explanatory statement with all relevant facts about the proposed transaction to enable shareholders to make an informed decision.

Step 5: Ensure Accurate Disclosure

The final step in the compliance lifecycle is disclosure. All RPTs that occurred during the financial year must be accurately reported in the company’s financial statements and the Board’s Report. This task should be done in close collaboration with your company secretary and statutory auditor to ensure that the disclosures comply with the relevant accounting standards (specifically Ind AS 24, which deals with related party disclosures). The disclosures need to be comprehensive, covering the relationship, transaction details, amounts outstanding, and any specific terms and conditions. Transparent and accurate disclosure is the ultimate testament to a company’s commitment to corporate integrity.

The Risks of Non-Compliance and How to Prepare for Audits

While managing RPTs might seem like a bureaucratic burden, the consequences of ignoring these regulations are far more severe. Non-compliance is not a minor oversight; it can trigger significant financial penalties, legal action, and irreparable damage to your startup’s reputation. Understanding these risks is crucial for appreciating the importance of a robust compliance framework. Furthermore, being well-prepared for what auditors will look for can transform a stressful audit process into a smooth, routine check-up, allowing you to focus on growing your business.

Penalties Under the Companies Act, 2013

The Companies Act imposes stringent penalties for contravening the provisions of Section 188. These penalties are designed to be a strong deterrent and apply to both the company and the defaulting directors personally, making them directly accountable. The penalties differ based on the type of company:

• For Listed Companies: The penalty for the company can be up to ₹25 lakh. For every director who is in default, the personal penalty can be up to ₹5 lakh.
• For Other Companies (including most startups): The penalty for the company can be up to ₹5 lakh. For every director in default, the personal penalty can be up to ₹50,000.

Beyond these financial penalties, there is another significant risk: any RPT entered into without the required approvals is voidable at the option of the company. This means the board or shareholders can choose to cancel the contract, which could lead to major business disruptions and legal disputes, especially if the transaction was critical to operations.

What Auditors Look for During Compliance Audits for Startups India

During a statutory or internal audit, related party transactions are always a focus area. Auditors are trained to look for red flags that might indicate a lack of transparency or potential harm to the company’s interests. Being prepared with a comprehensive documentation file is the key to a smooth audit. Your auditor will almost certainly ask for the following:

• The Register of Related Parties: They will use this as their master list to cross-check against all transactions.
• The formal RPT Policy: To assess if the company has a defined process and if it was followed.
• Board and Committee Minutes: To verify that proper approvals were obtained and that interested directors correctly abstained from voting.
• Agreements and Contracts: The legal documents governing the transactions with related parties.
• Supporting Evidence for Arm’s Length Pricing: This is crucial. They will want to see the independent quotes, valuation reports, or market research you conducted to justify the pricing.
• Disclosures in Financial Statements: They will meticulously check if the disclosures in the notes to accounts are accurate and complete as per Ind AS 24.

Pro Tip: Don’t wait for the auditor to ask. Proactively organize this information in a dedicated “RPT Compliance File” for the financial year. This simple act of organization demonstrates strong internal controls and makes the process of compliance audits for startups India significantly more efficient and hassle-free. For more detail, you can read about Preparing for a Tax Audit: Best Practices.

Conclusion

For Indian startups navigating the exciting but challenging path of growth, managing compliance for related party transactions is a non-negotiable element of building a resilient and trustworthy business. It’s far more than just a box-ticking exercise; it’s a fundamental pillar of good corporate governance that protects the company, its founders, and its investors from significant risks. The key to success lies in a simple but powerful four-step process: Identification of all related parties, Justification of every transaction at Arm’s Length, obtaining proper Approval from the board and shareholders, and ensuring transparent Disclosure in all financial reports.

By embedding this process into your startup’s DNA from the very beginning, you do more than just avoid hefty penalties and complex tax demands. You build a foundation of trust, integrity, and transparency that makes your startup immensely more attractive to sophisticated investors, strategic partners, and top-tier talent. Therefore, don’t view related party transactions compliance in India as a restrictive hurdle. Instead, see it as a strategic stepping stone towards building a robust, respectable, and ultimately more valuable enterprise that is built to last.

Navigating these complex startup compliance regulations in India can be challenging, especially when your focus is on innovation and growth. Let TaxRobo’s team of experts help you establish strong compliance frameworks from the ground up, so you can focus on what you do best. Contact us today for a consultation to secure your startup’s future.

Frequently Asked Questions (FAQs)

1. Is a transaction with a director’s brother-in-law a related party transaction?

The term “relative” under the Companies Act, 2013, has a very specific definition as per Section 2(77) read with the rules. This list includes the spouse, parents (including step-parents), children (including step-children), and siblings. A brother-in-law (sister’s husband) or sister-in-law (brother’s wife) is not directly included in this definition of a relative. Therefore, a transaction solely with a director’s brother-in-law may not automatically qualify as an RPT. However, it’s crucial to check if that person falls into any other category of a related party (e.g., if they are a KMP in the same company or a director in a subsidiary). It is always best to consult the precise legal definition to be certain.

2. What is the “Arm’s Length Principle” in simple terms?

In simple terms, the Arm’s Length Principle (ALP) means that the terms of a transaction between two related parties should be the same as if they were two strangers negotiating in an open market, each acting in their own best interest. For example, if your startup leases an office space from one of its directors, the rent paid by the startup should be the same as the prevailing market rent you would pay to an unknown landlord for a similar-sized property in the same locality. The goal is to ensure the company is not overpaying or receiving less than fair value just because the other party is related.

3. Does my startup need shareholder approval for every single transaction with a related party?

No, not every single transaction requires shareholder approval. This is a common misconception. Shareholder approval via an Ordinary Resolution is only mandated when the value of a specific type of transaction crosses certain monetary thresholds defined in the Companies (Meetings of Board and its Powers) Rules, 2014. For most day-to-day or smaller-value RPTs that fall below these limits, a properly documented approval from the Board of Directors (and the Audit Committee, if your company has one) is sufficient.

4. What if my startup gives an interest-free loan to another company owned by the same founder?

This is a classic RPT that triggers scrutiny under multiple laws. Under the Companies Act, this transaction requires proper approval from the Board (and potentially shareholders if the loan amount is significant). Under the Income Tax Act, this is a major red flag. The tax officer can invoke “deemed interest” provisions, calculating a “notional interest” income at market rates and adding it to your startup’s taxable profit, thereby increasing your tax liability. Finally, under GST, this could be seen as a financial service provided, and GST implications may arise. It is almost always advisable to charge a market-based interest rate on such loans and document it properly.

5. How can a small startup get a valuation report without spending too much?

This is a practical concern for early-stage startups. While a formal valuation from a registered valuer is the gold standard for high-value transactions (like property or business transfers) and is highly recommended, it may not be feasible for every small RPT. For smaller, routine transactions, you can build a strong justification file yourself. This can include printouts of property listings from real estate websites for similar assets (to justify rent), screenshots of vendor pricing or formal quotes from multiple unrelated vendors (for services/goods), and printouts from bank websites showing current lending rates (for loans). The key is documenting your diligent research to prove you tried to ascertain the fair market price. For any significant or high-risk transaction, however, investing in a professional valuation is a necessary compliance cost that can save you much more in potential penalties later.