By Ms. Usha Ganapathy Subramanian and Dr. Ranjith Krishnan
An Overview of The Compliance and Disclosures Regime
When businesses grow and diversify, they tend to branch out into new entities and there could be transactions among these entities, their promoters and other related entities. Very often, these have a commercial rationale. However, a study of corporate frauds the world over reveals how layers of ownership and complex intra-group transactions have been used to hoodwink regulators and tax authorities. Money laundering, tax evasion and corporate frauds more often than not involve an element of related party transactions (RPTs). In fact, layering is a crucial step in the money laundering process to separate the money and the perpetrator as far from the crime as possible.
RPTs are susceptible to abuse because the entities are under the control of promoters and genuine-looking documentation on transactions can be easily generated for the purpose of satisfying the regulatory agencies. Even if these transactions are not used for outright frauds or tax evasion, there will always be a question on whether the transactions are carried out on terms that are fair to all the stakeholders, especially minority shareholders. For example, let us say an entity buys a particular raw material from another group entity even at a slightly-higher-than-market price, it is a wrongful burden on the minority shareholders. The promoters may be controlling both the enterprises and may gain out of the overall transaction by transfer of the tax burden to the other entity, in which the minority shareholders usually do not have a stake and which may be housed in a low-tax jurisdiction. Such Base Erosion and Profit Shifting Practices (BEPS practices) are not just prejudicial to the minority shareholders, but deprive the economies and societies of development capital they could have otherwise had from the tax payments avoided. Internationally, the Organisation for Economic Cooperation and Development has developed an action plan to combat such tax evasion strategies by providing 15 Action Plans; Kenya joined this framework in 2017.1
Further, concepts like related parties, transactions with related parties, arm’s length pricing and ordinary course of business, which are used to identify potentially unfair RPTs and to regulate them,
[1] https://www.kra.go.ke/helping-tax-payers/faqs/oecd-g20-beps-project-inclusive-framework
are malleable to different interpretations, and hence may lead to potential violation of laws, and even if discovered, may lead to prolonged litigation. This is the reason why we have ever-increasing requirements on disclosures and compliance procedures surrounding RPTs.
Legislative and Regulatory Framework Governing RPTs
In this article, we present an overview of the legislative and regulatory framework on RPTs. This includes the Companies Act, 2015[1] with the Companies (General) Regulations, 2015[2], the Capital Markets Act (Cap 485A)[3] and the CMA Code of Corporate Governance Practices for Issuers of Securities to the Public 2015 (Corporate Governance Code)[4]. As far as disclosures in financial statements are concerned, since the Institute of Certified Public Accountants of Kenya (ICPAK) has adopted the International Financial Reporting Standards and IFRS for SMEs for financial reporting[5], the disclosures on RPTs are mandated under IAS 24 also[6]. The Income Tax Act (Cap. 470)[7] and the Transfer Pricing Rules 2006 deal with taxation aspects of RPTs, arm’s length pricing and documentation. Recently, the Kenya Revenue Authority has issued the Draft Income Tax Transfer Pricing Rules, 2023, which expands the scope of transactions subject to TP Rules, among other changes, upgrading the TP Rules, 2006.[8] Prior to this, the Authority mandated disclosures of RPTs in the annual returns to be filed by the corporates, namely the IT2C Return. While the corporate laws spell out the compliance and disclosure requirements in respect of them, the Income Tax Act and the Rules provides for arms’ length pricing under internationally recognized transfer pricing methods and their tax impact.
Managing Related Party Transactions
When it comes to complying with the applicable laws and regulations in respect of RPTs, there are four distinct stages of compliances that arise:
- Identification of related parties
- Identification of potential, ongoing and completed transactions with related parties
- Compliance including obtaining shareholders’ approval
- Disclosures in financial statements and other documents
Identification of Related Parties
Identification of related parties needs to be a thorough exercise undertaken in accordance with both the letter and spirit of law. It may be difficult to get a complete list of the related parties without the cooperation of the directors and the top management. They need to be apprised of the importance of the requirements and be convinced of the need for disclosures and transparency. Different legislative and regulatory frameworks provide different definitions for identification. For example, the definition of related party may be different in the corporate laws, capital market laws, and the taxation laws.
The Companies Act, 2015 deals with the subject more from the angle of managing conflict of interest. It defines the persons who are connected with a director in section 122, which includes members of his family as defined in section 123, bodies corporate with which the director is connected as defined in section 124, a trustee of a trust in which the director or a person connected with him is a beneficiary, a person who is acting as a partner of the director or the connected persons, a firm in which the director is a partner or in which the connected persons are partners, or the partner is a firm in which the director or a connected person is a partner. Section 125 defines when a director is connected with or controlling a body corporate, section 126 defines when bodies corporate are associated, and so on.
The Income Tax Act (Cap. 470), under section 18, provides that a person is related to another if he participates directly or indirectly in the management, control or capital of the business of the other or if the same third person participates so for both or if an individual, who participates so in the business of one, is associated by marriage, consanguinity or affinity to an individual who participates so in the business of the other. The Act also provides for ascertainment of gains and profits of business in a preferential tax regime and filing of country-by-country report for multinational enterprises. The Transfer Pricing Rules 2006 defines ’Related enterprises’ in a similar manner on the basis of direct or indirect participation in the management, control or capital of the other or a common participation in both by the same third person.
As per the IAS 24 Related Party Disclosures, a related party is defined in a wide manner covering all relationships where there could be an element of significant influence or control. It includes a person or a close member of that person’s family if that person has control, joint control or significant influence over the entity or is a member of the reporting entity or its parent. It also refers to an entity that belongs to the same group as the reporting entity, that is, a parent, subsidiary, fellow subsidiary, or if it is an associate or joint venture or is controlled, singly or jointly, or significantly influenced or managed by a person. Two entities are related parties if both are joint ventures or if one is an associate and the other is a joint venture of the same third party. It also includes post-employment benefit plans.
The overarching principle here is the identification of an element of exercise of control or significant influence by a person over the reporting entity or vice-versa or an element of proximity of relationship with the entity in a manner that enables such exercise. Control generally can be taken to mean the ability to direct the policy decisions of an entity, whereas significant influence can be taken to mean the ability to participate in decision-making.
Identification of related parties should be done on a de-facto basis and not just on the basis of the rules laid down. Since different departments of an entity may be handling compliance under the different laws, there needs to be an understanding of the substantive import of the provisions on an entity-wide basis.
Identification of Transactions with Related Parties
Identification of potential and existing transactions with related parties is the next step. The CMA Corporate Governance Code defines the term ‘related party transaction’ as: “a business deal or arrangement between two or more parties who are joined by a special relationship prior to the deal and includes, a business transaction between a major shareholder, or any company in which he holds shareholding, and the company.”[9] IAS 24 succinctly puts it as: “A related party transaction is a transfer of resources, services or obligations between a reporting entity and a related party, regardless of whether a price is charged.” The Companies Act, 2015 specifies various circumstances, contracts and arrangements in respect of which compliance and disclosure requirements have been put in place.
While identification of existing transactions is necessary for presentation and disclosure aspects, identification of potential transactions is paramount to ensure compliance with laws that necessitate prior disclosure and approval and as a good governance practice. All the departments of an entity must be apprised of the rigours of law and the policy of the company in respect of RPTs. The exercise of identifying potential and existing transactions must not be done by any department in isolation and most importantly, must involve the directors and the management.
Identification of these transactions is also necessary for the purpose of ensuring the price is charged on an arm’s length basis and for maintenance of transfer pricing documentation based on the OECD Transfer Pricing Guidelines. This is all the more important for conglomerates having related entities across different tax jurisdictions. The Transfer Pricing Regulations 2006 provides for the following specific methods of measurement of arm’s length price: comparable uncontrolled price method, resale price method, cost-plus method, profit-split method, transactional net margin method and finally, if the above methods cannot be used, such other method as may be prescribed by the Commissioner from time to time.[10] Further, Transfer Pricing Documentation, including country-by-country report, master file and local file as mandated under section 18D of CAP 470 is required to be filed by specified ultimate parent or constituent entities of a multinational enterprise group with specified gross turnover within the specified timelines and the Transfer Pricing Rules require having in place a transfer pricing policy.
It must be remembered that even transactions where no price is charged must be taken into account. In fact, these must especially be taken into account considering such transactions are mostly likely not at arm’s length, for the purpose of identification, compliance and disclosure.
Policies and Approvals
Ideally, for public companies, the process of approving RPTs should include audit committee’s approval, followed by the Board’s approval. Shareholders’ approval must be obtained wherever material transactions are proposed to be undertaken. The CMA Corporate Governance Code requires companies to frame their policies in respect of RPTs and managing conflict of interest and requires prior audit committee and board approvals. Under the Companies Act, 2015, the audit committee of quoted companies is vested with the responsibility of “establishing standards of business conduct and ethical behaviour for directors, managers and other personnel, including policies on private transactions, self-dealing, and other transactions or practices of a non-arm’s length nature.” The Companies Act, 2015 also necessitates duty to disclose by directors if the transaction is one in which they are directly or indirectly interested in or concerned with, and where there could be a conflict of interest. A broad overview of the requirements in the Companies Act, 2015 for managing conflicts of interest is given below:
- The Act, particularly, section 146, places emphasis on the duty of the directors to avoid situations of potential conflicts of interest, especially in respect of exploitation of any property, confidential information, position of director, opportunities in or for the company. It also spells out the procedures pursuant to compliance of which the above duty shall not be deemed to be infringed. This involves authorization by other directors in the case of private companies, and in case of public companies, involves authorization of other directors and members who do not have personal interest for transactions valued at 10% or more of the assets of the company. Breach of the duty, inter alia, entails civil consequences as given in section 148.
- Further, a director being interested in a particular contract or arrangement with the company or a contract the company has already entered into, necessitates making disclosures to other directors and in case of public company, to the members within 72 hours. Contravention of this amounts to an offence and is liable on conviction to a fine.
- Requirements for members’ approval for substantial property transactions is given under section 158.
- Section 168 necessitates approval by members for related arrangements also, that is, entering into arrangements whereby another person enters into a transaction but, which if entered into by the company, would have necessitated members’ approval.
Disclosures on RPT and conflict of interest
IAS 24 requires disclosures in the financial statements on the nature of related party relationships as well as information on those transactions and outstanding balances and commitments. The CMA Corporate Governance Code requires board to have disclosure policies and procedures and mentions key areas in which disclosures on all RPTs is also required. The Regulations under the Companies Act, 2015 require disclosure in the directors’ report on the details of material interests of directors in transaction, arrangement or contract.
Conclusion
As new regulatory requirements are ushered in, newer ways of structuring entities and transactions are invented and undertaken, and as this happens and comes to the fore with the unearthing of new frauds, perhaps, months or years later, the law again tries to keep up with the crimes and updates itself. This will be an endless chicken-and-egg story.
Auditors and Company Secretaries of group businesses have to be aware of the various RPTs and be on the lookout for signs of fictitious parties or transactions, and exercise professional judgement and skepticism. They also have to be open to the idea that a transaction which serves the interests of the promoters may or may not be in the best interests of the company.
Building fairness and transparency in the realm of RPT is a major step in nation building itself. Despite all the accelerated deployment of newer technologies and improved versions of reporting and governance standards, we are still witnessing instances of frauds and governance failures. This is because the spirit of corporate governance is something that cannot be merely legislated into the minds of the boards. The human mind, particularly the one which is reinforced with greed and fear, is capable of devising various methods to circumvent laws and monitoring systems. To counter this requires the most crucial element of human intelligence itself: instinct, backed by courage. And this is where the presence of accounting and auditing professionals becomes not just relevant but a sine qua non.
[1] http://kenyalaw.org:8181/exist/kenyalex/actview.xql?actid=No.%2017%20of%202015#part_XXV
[2]http://kenyalaw.org:8181/exist/kenyalex/sublegview.xql?subleg=No.%2017%20of%202015#/akn/ke/act/ln/2015/239/part_VII
[3] http://kenyalaw.org:8181/exist/kenyalex/actview.xql?actid=CAP.%20485A#part_V
[4] https://www.cma.or.ke/download/35/guidelines/4323/code-of-corporate-governance-practices-for-issuers-of-securities-to-the-public-2015-code.pdf
[5] https://www.icpak.com/wp-content/uploads/2015/09/COUNCIL-STATEMENT.pdf
[6] https://www.ifrs.org/issued-standards/list-of-standards/ias-24-related-party-disclosures/
[7] http://kenyalaw.org:8181/exist/kenyalex/actview.xql?actid=CAP.%20470
[8] https://www.kra.go.ke/images/publications/Draft-Income-Tax-Tranfer-Pricing-Rules-2023-revised.pdf
[9] https://www.cma.or.ke/download/35/guidelines/4323/code-of-corporate-governance-practices-for-issuers-of-securities-to-the-public-2015-code.pdf
[10] https://www.oecd.org/ctp/transfer-pricing/transfer-pricing-country-profile-kenya.pdf
Ms. Usha Ganapathy SubramanianPractising Company SecretaryChennai, India
Dr. Ranjith KrishnanSustainability ConsultantMumbai, India
