Govt guidelines to clarify ‘arm’s length’, ‘ordinary course of business’ definitions

Similarly, though the term “ordinary course of business” has been used at various places in the new Act, it has primarily drawn attention because of its significance in the case of related-party transactions.

According to the Act, if a related-party transaction is not in “ordinary course of business” or not on an “arm’s length basis”, the company concerned has to pass a board resolution for such a transaction.

The company might also need to obtain minority shareholders’ approval in certain cases where they cross a material threshold prescribed by the ministry of corporate affairs (MCA).

For non-compliance with this law, there are strict punishments, including penalties and in certain cases imprisonment.

A transaction is generally described as being on an arm’s length basis when a buyer and a seller act independently and have no relationship with each other. The concept is used to ensure both parties in the deal are acting in their own interest and are not subject to any pressure from the other party.

Similarly, ordinary course of business covers the usual transactions, customs and practices of a certain business. But industry wants clear definition of these terms, so that any subjectivity can be ruled out.

According to experts, as there is no clear definition of these two terms, companies are in a state of confusion and in fear of increased litigation due to inherent subjectivity. “There is a lot of anxiety in the corporate world; it is like shooting in the dark,” said Pankaj Chadha, partner in a member firm of EY Global.

“Consider royalty payments, for example. It can be taken as ordinary course of business for a company like Maruti Suzuki but one might view it differently in the case of, say, a Tata group company,” said Yogesh Sharma, partner (assurance), Grant Thornton India LLP.

According to various experts, guidelines in this regard would increase the ease of doing business. “One hopes the guidelines are exhaustive and illustrative to envisage various scenarios and prescribe their treatment under the companies Act, rather than giving broad directions in this regard,” said Girish Vanvari, Co-head of tax at KPMG in India. Also, to avoid conflicts, it would be essential to maintain consistency with the existing principles of ‘arms length’ under the Income Tax Act, he added.

The Income Tax Act prescribes various methods to compute the ‘arms length price’. These methods have inherent subjectivity relating to the computation mechanism of the arms length price (such as choice of comparable, etc), which is one of the major factors leading to litigation.

According to Vanvari, because of the closeness of relationship between the parties, there can be genuine difficulties in determining what arm’s length is, “especially where it is not possible to find wholly comparable transactions among unconnected parties”. This will ultimately create conflicts. The Vodafone and Shell transfer-pricing cases, in which the Bombay High Court recently ruled in favour of the companies, are the latest examples.

It must also be noted that the guidelines for these terms have a different purpose in the context of the Companies law. “Determination of arm’s length price under Companies Act is for avoiding any conflict of interest, while under the I-T Act this determination is for mitigating tax avoidance,” said Arun Chhabra, director, Grant Thornton Advisory Pvt Ltd.

Other countries like the US and UK, which are members of the Organization for Economic Cooperation and Development (OECD), have agreed to achieve a fair division of taxing profits through a certain framework.

OECD has established a framework by laying down the broad principles for determining the arm’s length price for purposes of transfer pricing. This is followed by its member countries.

To address international double taxation, transactions among connected parties should be treated for tax purposes by reference to the amount of profit that would have arisen if the same transactions had been executed by unconnected parties. This is the arm’s length principle in OECD that all member countries have to follow.

“Transfer pricing regulations in the US and UK have now reached a mature stage, unlike in India where it is a relatively new piece of legislation (introduced in 2001),” said Vanvari.

The guidelines will be part of the government’s efforts to address concerns of the industry over the new Companies Act. Recently, the Cabinet cleared 14 changes to the Act, to make doing business in India easier. At present, India stands 142nd among 189 countries in terms of ease of doing business, according to a recent World Bank report.

The amendments include replacing ‘special resolution’ with ‘ordinary resolution’ for minority shareholders’ approval to related-party transactions. This means the companies concerned would require the consent of only 50 per cent of the minority shareholders present, instead of the 75 per cent prescribed in the current law.

Industry seeks more clarity

• In the new Companies Act, the terms “arm’s length basis” or “arm’s length’s transaction” are introduced only in connection with “related-party transactions”
• Similarly, though the term “ordinary course of business” has been used at various places in the new Act, it has primarily drawn attention because of its significance in the case of related-party transactions
• According to the Act, if a related-party transaction is not in “ordinary course of business” or not on an “arm’s length basis”, the company concerned has to pass a board resolution for such a transaction

The article appeared in Business Standard. The article can be found here.