RPTs: Wholly-owned but not wholly- exempt

– Application of RPT controls for transactions with Wholly owned Subsidiaries

– Payal Agarwal, Partner | corplaw@vinodkothari.com

Enterprise Level v/s Entity Level: Paradox of a Wholly owned Subsidiary 

Wholly owned Subsidiaries (WoS) form a particular paradox in corporate laws with two contradictory positions – (a) the transactions entered into between the holding company and its WoS are viewed as transactions within a group, thus, permitting a seamless flow of resources between the two without any objection, looking at an “enterprise” level whereas, (b) limiting the access of the shareholders and creditors of the holding company and the WoS to the respective entity’s resources, thereby separation of the two at an “entity” level. 

Disregarding ‘entity’ concept over ‘enterprise’ concept: exemptions w.r.t. WoS 

Section 185 of CA 2013 exempts any financial assistance to the WoS from the compliance requirements under the section, and the limits on loans, guarantees, investments or provision of security under section 186 do not apply for transactions with WoS. Section 177(4)(iv) and 188 of CA 2013, pertaining to RPT controls, also extend certain exemptions for transactions with WoS. Reg 23(5) of SEBI LODR also exempts transactions with WoS as well as between two WoS from approval requirements, at both the Audit Committee and shareholders’ level. Reg 37A of SEBI LODR contains an exemption from shareholders’ approval requirements for sale, lease or disposal of an undertaking to the WoS. In each of the aforesaid provisions, the underlying presumption remains the same – the accounts of the WoS are consolidated with that of the holding company, and hence, the flow of resources remain within the same ‘enterprise’, despite change of ‘entity’. Thus the law takes an ‘enterprise’ wide view instead of an ‘entity’ level view while providing for such exemptions. 

Factors reinforcing the concept of separation of entity

On the other hand, the outreach of shareholders of a company is limited at an ‘entity’ level, that is to say, the shareholders of the holding company do not have access to the general meetings of the WoS. Similarly, the creditors of each entity do not have any recourse against the other entity. For instance, where the holding company has outstanding dues, but there are resources at the WoS level, can the creditors reach to the assets of the WoS? The answer is no. Similarly, a vice versa situation is also not possible. In fact, under the Insolvency and Bankruptcy Code too, the assets of the subsidiary are kept outside the purview of the liquidation estate of the holding corporate debtor [Section 36(4)(d)]. 

Further, the board of a WoS is different from its holding company. The board of the holding company does not have any rights over the board of the subsidiary. Therefore, under these situations, transactions between the holding company and its WoS, though between companies that are 100% belonging to the same group, cannot be viewed as completely seamless or free from any corporate governance concerns.   

RPTs between holding company and WoS: can the ‘enterprise’ approach be taken?

The aforesaid discussion makes it clear that while an ‘enterprise’ wide approach is taken in granting exemptions to WoS, the separation of legal entities cannot be completely disregarded, because the outreach of the shareholders, creditors and the board of directors remain limited. Now from the point of view of related party transactions, can it be argued that the transactions between a holding company and WoS are without any restraint altogether? For example, does the concept of arm’s length has no relevance in case of a transaction between a holding company and WoS? 

Concept of arm’s length and relevance in transactions with WoS

A light touch regulation or inapplicability of certain controls or approvals does not mean that arm’s length precondition becomes unnecessary. If such a view is taken, then the flow of resources between the holding company and the WoS will be completely without any fetters, thus breaching the concept of corporate governance at an entity level. For instance, can the board of directors of the holding company be absolved from its responsibilities to safeguard the assets of the holding company where the same flows to the subsidiary without any consideration? The answer surely is a no. Both ‘entity’ level and ‘enterprise’ level are significant, and hence, one cannot disregard the separation of legal entities, particularly, in the context of protection of assets of the entity (also see discussion under Role of Board below). 

As regards the concept of arm’s length, the same is omnipresent – required to be ensured in transactions with related parties as well as unrelated entities. The meaning of arm’s length transaction, as defined under SA 550 pertaining to Related Parties, is as follows:

A transaction conducted on such terms and conditions as between a willing buyer and a willing seller who are unrelated and are acting independently of each other and pursuing their own best interests.

Therefore, ‘independence’ and ‘own interests’ are important elements of an arm’s length transaction. If compromised in RPTs with WoS, absence of arm’s length criteria could lead to uncontrolled flow of wealth from the holding company to WoS, and may also lead to abusive RPTs. 

Are WoS structures immune from abuse?: Deploying WoS as a stop-over for abusive RPTs 

The exemptions w.r.t. transactions with WoS make the same prone to misuse, through use of the WoS as a conduit or a stop-over for giving effect to arrangements with non-exempt RPs. For instance, a listed entity in the FMCG sector is required to provide financial assistance to its upstream entities (promoter group entities). There may be a lack of business rationale and commercial justification for such a transaction, and therefore, it is highly unlikely that such a transaction would get the approval of the AC. Therefore, in order to give effect to the transaction, the company may route the same through its WoS, and thus escape RPT controls at its AC level. The WoS may, in turn, pass on the benefit to the promoter group entities, through a series of transactions, in order to cover the real character of the transaction (see figure below).  

A guidance note published by NFRA also, requires identification of indirect transactions, including through ‘connected parties’. In order to ensure no such indirect transactions have occurred, the management is expected to establish procedures to identify such transactions, and to obtain periodic confirmations from the directors, promoter group, large shareholders and other related parties that there are no transactions that have been undertaken indirectly with the listed company or its subsidiaries or its related parties.

Role of board

The role of the board towards avoiding conflicts of interests is deep-rooted under the corporate laws and securities laws, under various applicable provisions. For instance, the directors have a responsibility towards safeguarding the assets of the company and for preventing and detecting fraud and other irregularities [Section 134(5)(c) of CA 2013]. Section 166 of CA 2013 specifies the duties of directors. These include, among others, the duty to act in good faith in order to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company [Section 166(2)]. 

The key functions of the board, as contemplated under Reg 4 of LODR, also includes monitoring and managing potential conflicts of interest of management, members of the board of directors and shareholders, including misuse of corporate assets and abuse in related party transactions. 

Scope of Exemption under Applicable Laws

As stated above, Reg 23(5) of SEBI LODR exempts RPTs entered into between a holding company and its WoS from the approval requirements of both the AC and the shareholders. 

Apart from Reg 23 of LODR, the RPT provisions are contained under Section 177 and 188 of CA 2013. Under section 177(4)(iv) of CA 2013, all RPTs require approval of the AC. The fourth proviso to the said sub-section exempts RPTs entered into with WoS from AC approval requirements. However, the said exemption is not absolute. The proviso reads as follows: 

Provided also that the provisions of this clause shall not apply to a transaction, other than a transaction referred to in section 188, between a holding company and its wholly owned subsidiary company.

Thus, the exemption for RPTs with WoS does not apply in case of a transaction referred u/s 188 of CA 2013. In other words, where an RPT with WoS triggers approval requirements u/s 188, the same will also be required to be approved by the AC u/s 177 first. 

Meaning of “a transaction referred to in section 188”

Section 188(1) of CA 2013 provides a list of 7 types of transactions. The list is wide enough to cover almost all types of transactions, except financial assistance in the form of loans etc. However, section 188 becomes applicable, only, in cases where any one or more of the two most crucial elements of a transaction are missing – (i) ordinary course of business and (ii) arm’s length terms. In cases where a transaction does not meet the ordinary course of business or the arm’s length criteria, the same is referred to the board of directors u/s 188 of CA 2013, and requires prior approval of the board. 

The fifth proviso to section 188(1) also contains an exemption for RPTs between the holding company and its WoS. Note that the said exemption is applicable only with respect to the approval of the shareholders, the approval of board is still required for RPTs that lack one of the two elements stated above, even though with WoS.

Provided that no contract or arrangement, in the case of a company having a paid-up share capital of not less than such amount, or transactions not exceeding such sums, as may be prescribed, shall be entered into except with the prior approval of the company by a resolution:

XXX

Provided also that the requirement of passing the resolution under first proviso shall not be applicable for transactions entered into between a holding company and its wholly owned subsidiary whose accounts are consolidated with such holding company and placed before the shareholders at the general meeting for approval:

The conditional exemption given u/s 177 and the absence of any exemption from board’s approval u/s 188 clearly confirms the requirement of ensuring arm’s length terms in transactions with WoS. 

Expectations from AC 

The AC is the primary decision-making authority in respect of matters relating to related party transactions. NFRA, the audit regulator of the country, has published the Audit Committee – Auditor Interactions Series 3 dealing with audit of Related Parties. The guidance sets out potential points on which the AC may interact with the auditors in the context of RPTs. Where a company avails exemptions w.r.t. AC and shareholders’ approval, the guidance note requires documentation of the rationale for not obtaining Audit Committee’s and Shareholders’ approvals. 

Thus, the AC is expected to be the scrutinising authority in ensuring that the terms on which a transaction is proposed to be entered into with a WoS are at an arm’s length, which, in turn, would require bringing the transaction before the AC, if not for approval, then for a pre-transaction scrutiny and information. 

Disclosures in financial statements 

Ind AS 24 pertaining to Related Party Disclosures require disclosures  to be made in the financial statements that the RPTs were made on terms equivalent to those that prevail in arm’s length transactions. However, such disclosure can be made only if such terms can be substantiated. Note that the Ind AS 24 does not contain any exemption for WoS. In the absence of a strict scrutiny of RPTs with WoS for satisfaction of arm’s length basis of the terms of the transaction, such an assertive statement in the financial statements for arm’s length of the terms is not possible.  

Dealings with WoS: the suggested approach

In view of the expectations from the AC, board and the auditors, and the potential risks of abusive RPTs using WoS as an intermediary, the following approach may be undertaken before entering into a transaction with WoS: 

• A pre-transaction scrutiny may be conducted by the AC for RPTs to be entered into between the holding company and its WoS. This should include all the necessary details as may be required by the AC, such as, nature of transaction, terms of the transaction, total expected value of the transaction etc. 
• Based on such scrutiny, the AC may give its comments or recommendations where the same has any concerns. Necessary modifications may be carried out to address the comments of the AC, in order to make the transaction commercially viable for the holding company. 
• Where the proposed transaction is not in (a) ordinary course of business or (b) not at an arm’s length basis, the same will require approval of the AC. The AC will refer the transactions to the board for approval u/s 188. 
• Every RPT entered into between the holding company and its WoS should, as a part of the quarterly review, be reported back to the AC. Any alteration in terms or value of the transactions should be brought to the notice of the AC. 
• As required under Reg 23(9) of the LODR, the transactions with WoS to be reported to the SEs on a half-yearly basis. 

Read more:

Related Party Transactions- Resource Centre

Bo[u]nd to ask before transacting: High value debt issuers bound by stricter RPT regime

FAQs on Standards for minimum information to be disclosed for RPT approval