Section 188 of the Companies Act, 2013 exempts a related party transaction from the shareholder approval requirement where the transaction is at arm's length and in the ordinary course of business. The exemption is not a blanket tax exemption. A transaction that satisfies the Section 188 arm's length and ordinary course tests may still be subject to transfer pricing adjustment under the Income-tax Act, 1961, and a transaction that is adjusted under the transfer pricing regime may not satisfy the Section 188 test.
The Two Tests
The Section 188 arm's length test asks whether the transaction is on terms that would have been agreed between unrelated parties. The ordinary course test asks whether the transaction is in the ordinary course of the company's business. The two tests are cumulative; a transaction that is at arm's length but outside the ordinary course, or in the ordinary course but not at arm's length, does not qualify for the exemption.
The transfer pricing regime under Section 92 of the Income-tax Act applies to transactions between associated enterprises. The regime requires the transaction to be at arm's length, and it prescribes the methods for determining the arm's length price. The transfer pricing analysis is more granular than the Section 188 analysis; it requires benchmarking, documentation, and, in some cases, an advance pricing agreement.
The Divergence
A transaction can satisfy the Section 188 arm's length test without satisfying the transfer pricing arm's length test. The Section 188 test is applied at the time of the transaction, and it is based on the board's or the audit committee's assessment. The transfer pricing test is applied at the time of the assessment, and it is based on the benchmarking study. A transaction that the board considered to be at arm's length may be adjusted by the transfer pricing officer if the benchmarking shows that the price was not at arm's length.
Conversely, a transaction that is adjusted under the transfer pricing regime may still satisfy the Section 188 test, because the Section 188 test is directed at the approval requirement, not at the tax liability. The adjustment under the transfer pricing regime does not automatically invalidate the Section 188 exemption, but it may raise questions about the board's assessment.
The Documentation
A company that relies on the Section 188 exemption should maintain a record of the arm's length and ordinary course analysis. The record should include the comparable data, the pricing analysis, and the rationale for the conclusion. The transfer pricing documentation should be maintained separately, and it should comply with the requirements of Section 92D and the rules.
The two documentation streams serve different purposes, but they should be consistent. A company that takes one position for Section 188 and a different position for transfer pricing creates a risk of regulatory scrutiny and penalty.
Call to Action
Anuj Desai & Associates advises companies on the interaction between Section 188 and the transfer pricing regime—from the arm's length and ordinary course analysis and the documentation to the transfer pricing benchmarking and the defence of a transfer pricing adjustment. If your company has significant related party transactions, we can help you align the two compliance streams.
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