Family businesses and closely held companies run on related party transactions. Premises leased from a promoter. Materials bought from a brother’s firm. Services rendered to a group company. Very little of this is improper, and almost none of it is disclosed as carefully as the Companies Act requires.
Section 188 does not prohibit these transactions. It requires that they be approved by people who are not conflicted, and recorded. The compliance failures that follow are rarely about the substance of a deal. They are about a resolution nobody passed.
Who counts as a related party
Section 2(76) defines the term, and it is wider than intuition suggests. It covers, among others:
- a director or key managerial personnel, or their relatives;
- a firm in which a director, manager or their relative is a partner;
- a private company in which a director or manager, or their relative, is a member or director;
- a public company in which a director or manager is a director and holds, with relatives, more than two per cent of the paid-up share capital;
- a body corporate whose board, managing director or manager acts on the directions of a director or manager of the company;
- a person on whose advice a director or manager is accustomed to act;
- holding, subsidiary and associate companies, and fellow subsidiaries.
“Relative” is separately defined and includes spouse, parents, children and their spouses, siblings and members of a Hindu undivided family.
The practical consequence is that a company frequently has more related parties than its board has identified. The first step in getting section 188 right is a current, maintained list — not one prepared once at incorporation. Keeping it current is a routine part of corporate law compliance rather than an annual exercise.
The seven transactions the section covers
Section 188(1) applies to contracts or arrangements with a related party in respect of:
- sale, purchase or supply of any goods or materials;
- selling or otherwise disposing of, or buying, property of any kind;
- leasing of property of any kind;
- availing or rendering of any services;
- appointment of any agent for purchase or sale of goods, materials, services or property;
- appointment of a related party to any office or place of profit in the company, its subsidiary or associate company;
- underwriting the subscription of any securities or derivatives of the company.
Anything within these seven heads requires the consent of the Board by a resolution passed at a meeting. Consent by circulation does not satisfy it.
Where the company has an audit committee, approval of that committee is also required under section 177, and the committee may grant omnibus approval for repetitive transactions subject to conditions.
The exemption that swallows most of the rule
This is the provision that decides most real cases, and it is the one most often asserted without being established.
The fourth proviso to section 188(1) provides that nothing in the sub-section applies to transactions entered into by the company in its ordinary course of business where the transactions are on an arm’s length basis.
Two conditions, both of which must be satisfied. A transaction that is on arm’s length terms but not in the ordinary course of business does not qualify. Nor does one in the ordinary course that is not at arm’s length.
Ordinary course of business is not established by frequency. A company that regularly lends money to its promoter is not thereby in the lending business. The question is whether the transaction falls within the company’s actual line of business, judged against its objects, its history and what it holds itself out as doing.
Arm’s length means a transaction between two related parties conducted as if they were unrelated and had no conflict of interest. Establishing it requires evidence — comparable quotations, market rates, a benchmarking note, a valuation. An assertion in the minutes that the transaction was at arm’s length, with nothing behind it, is a conclusion rather than a basis.
The discipline worth adopting is simple: where the exemption is relied on, the file should contain the material that establishes both limbs, created at the time. Reconstructing a benchmarking exercise three years later, during an inspection, is a poor position.
The Rule 15 thresholds
Where the exemption does not apply, board approval alone may not be enough. Rule 15(3) of the Companies (Meetings of Board and its Powers) Rules, 2014 prescribes limits above which prior approval of the members by resolution is required:
| Transaction | Threshold requiring shareholder approval |
| Sale, purchase or supply of goods or materials | 10 per cent or more of turnover |
| Selling, disposing of or buying property | 10 per cent or more of net worth |
| Leasing of property | 10 per cent or more of turnover |
| Availing or rendering of services | 10 per cent or more of turnover |
| Appointment to any office or place of profit | Monthly remuneration exceeding ₹2,50,000 |
| Underwriting the subscription of securities or derivatives | Remuneration exceeding 1 per cent of net worth |
Two points of computation. The limits are applied to turnover or net worth as per the last audited financial statements. And the transaction is measured on an aggregate basis for the financial year, not per contract — several supplies to the same related party across the year are added together.
The approval must be prior. A resolution passed after the transaction does not satisfy the requirement, though the consequences of that are dealt with below.
What private companies do differently
A notification issued in 2015 exempted private companies from the second proviso to section 188(1), which prevents a member who is a related party from voting on the resolution.
The effect is that in a private company, a related party who is also a member may vote on the resolution approving the transaction. In a public company, that member may not.
This is a meaningful relaxation for closely held businesses, where the related party frequently holds most of the equity, and without it the approval route would be impossible to use. It does not relax anything else: the board resolution, the thresholds, the disclosure and the penalty all continue to apply. Our note on company compliance covers the wider set of obligations that sit alongside this one.
Section 184(2) separately requires an interested director to disclose the interest and not participate in the board meeting discussing the transaction. For a private company the participation restriction is relaxed where the director discloses the interest, but the disclosure obligation itself remains.
Disclosure in AOC-2
Every contract or arrangement entered into under section 188 must be referred to in the Board’s Report, with a justification, in Form AOC-2.
The form has two parts: contracts not at arm’s length, and material contracts at arm’s length. A company that has relied on the ordinary-course-and-arm’s-length exemption should be able to explain why a transaction appears — or does not appear — in the relevant part.
AOC-2 is filed as part of the annual accounts, so it travels with the annual ROC filings and sits on the public record. It is among the first documents examined when related party dealings come into question, which makes it worth completing deliberately rather than as a formality.
What happens when approval was not taken
Section 188(3) supplies the consequence, and it is more serious than a penalty.
Where a contract or arrangement is entered into by a director or any other employee without the consent of the Board or approval by resolution, and it is not ratified by the Board or by the members within three months from the date of the contract, the contract is voidable at the option of the Board or, as the case may be, of the shareholders.
Two consequences follow. The contract can be avoided, which is a commercial exposure to the counterparty as much as to the company. And where the contract is with a related party to any director, or is authorised by any other director, the directors concerned must indemnify the company against any loss incurred — a personal liability under section 188(4).
The three-month ratification window is the practical point. A transaction identified late can still be regularised, but only inside it. Discovery during a year-end audit is frequently outside it.
The penalty
Section 188(5), following decriminalisation in December 2020, imposes a penalty rather than imprisonment:
- for a listed company, ₹25 lakh; and
- for any other company, ₹5 lakh.
The penalty falls on the director or employee who entered into or authorised the contract in contravention.
The removal of the imprisonment element has been read in some quarters as a softening. It is better read as a change in the form of the consequence rather than its seriousness — a ₹5 lakh personal penalty on a director of an unlisted company is not a nominal amount, and it sits alongside the voidability and indemnity consequences, which are frequently larger.
The same transaction under three other laws
Section 188 is not the only provision watching a related party transaction, and a company that satisfies it can still be exposed elsewhere.
Income tax. Section 40A(2)(b) permits disallowance of expenditure to a specified person where it is excessive or unreasonable having regard to fair market value. The concept of a specified person overlaps with, but is not identical to, the Companies Act definition. Our note on business taxation covers the wider computation issues.
GST. Supplies between related persons and between distinct persons are treated as supplies even without consideration, and valuation follows prescribed rules rather than the price agreed. A transaction priced at a nominal amount between group entities can carry a GST liability computed on a different figure altogether.
Accounting standards. Related party disclosures are required in the financial statements under the applicable standard, on a definition that differs again from both of the above.
Three definitions, three sets of consequences, one transaction. Reconciling them is part of what corporate governance means in practice, and it is done at the time the transaction is structured rather than afterwards.
Contact Now – +919034263307
Visite websites – taxationlegaladvisor.in
