A. RELATED PARTY TRANSACTIONS

 

1. INTRODUCTION

 

A related-party transaction is a business deal or arrangement between two parties, who are joined by a special relationship prior to the deal. Related-party transactions are a common occurrence in the business marketplace. These transactions can have significant influence over any financial decision and consequential impact on profit or loss thus impacting financial position of an entity. However, a number of regulatory procedures are in place in the country to ensure that related- party transactions are conflict-free and do not negatively affect value for shareholders. Since the definitions are not very specific, and no separate record for related party transactions is generally available, it is sometimes difficult for the investigation team to verify the accuracy of information furnished by the DI regarding related party transactions. Therefore, it was considered appropriate to provide guidance to the team which can result in uniform practices for the investigations.

 

2. LEGAL PROVISIONS

 

The Rules

 

A “related” party is defined in the explanation to Rule 2(b) of the Rules as under:

 

Explanation. - For the purposes of this clause, -

 

(i) producers shall be deemed to be related to exporters or importers only if, -

        (a) one of them directly or indirectly controls the other; or

        (b) both of them are directly or indirectly controlled by a third person; or

        (c) together they directly or indirectly control a third person subject to the condition that are grounds for believing or suspecting that the effect of the relationship is such as to cause the producers to behave differently from non-related producers.

 

(ii) a producer shall be deemed to control another producer when the former is legally or operationally in a position to exercise restraint or direction over the latter.

 

This definition is applied in the Directorate to determine if domestic producer in India is related to exporters in subject countries or importers in India. Explanation to Rule 2(b) of the Anti-Dumping Rules, 1995 clearly states that the definition of related party contained therein is specific to that clause only.

 

Customs Valuation Rules, 2007

 

Rule 2(2) of the Customs Valuation (Determination of Value of Imported Goods) Rules, 2007 framed under Customs Act, 1962 provides that persons shall be deemed to be “related” only if:

 

(i) they are officers or directors of one another’s businesses;

(ii) they are legally recognised partners in business;

(iii) they are employer and employee;

(iv) any person directly or indirectly owns, controls or holds five per cent or more of the outstanding voting stock or shares of both of  them;

(v) one of them directly or indirectly controls the other;

(vi) both of them are directly or indirectly controlled by a third person;

(vii) together they directly or indirectly control a third person; or

(viii) they are members of the same family.

 

Explanation I. - The term “person” also includes legal persons.

 

Explanation II. - Persons who are associated in the business of one another in that one is the sole agent or sole distributor or sole concessionaire, howsoever described, of the other shall be deemed to be related for the purpose of these rules, if they fall within the criteria of this sub-rule.

 

The aforesaid definition of related party under the Customs Valuation (Determination of Value of Imported Goods) Rules, 2007 is similar to as contained in the Article 143 of the implementing provisions of Council Regulation (EEC) No 2454/93 of the European Union. Both of these are based on the definition of related party provided under paragraph 4 of Article 15 of the Agreement on Implementation of Article VII of the General Agreement on Tariffs and Trade 1994 (WTO Customs Valuation Agreement). Therefore, this definition of ‘related party’ has been incorporated in the Exporter’s Questionnaire as well as in Application Format for New Shipper Review also.

 

Indian Companies Act,  2013

 

The Indian Companies Act 2013 requires the companies especially Public Limited Companies to disclose all transactions with related parties. It may, however, be noted that the NIP of any company is worked out based on the audited data submitted by the respective company. Related Party has been defined under section 2(76) of The Companies Act, 2013 is as under: 

 

Related party, with reference to a company, means-

 

(i) A director or his relative;

 

(ii) A key managerial personnel or his relative;

 

(iii) A firm, in which a director, manager or his relative is a partner;

 

(iv) A private company in which a director or manager or his relative is a member or director;

 

(v) A public company in which a director or manager is a director and holds along with his relatives, more than 2% of its paid up share capital;

 

(vi) Anybody corporate whose Board of Directors, managing director or manager is accustomed to act in accordance with the advice, directions or instructions of a director or manager;

 

(vii) Any person on whose advice, directions or instructions a director or manager is accustomed to act:

 

Provided that nothing in sub-clauses (vi) and (vii) shall apply to advice, directions or instructions given in professional capacity;

 

(viii) Anybody corporate, which is:

 

     (a) A holding, subsidiary or an associate company of such company;

     (b) A subsidiary of a holding company to which it is also a subsidiary; or

     (c) An investing company or the venture of the company.

 

Explanation- For the purpose of this clause, “investing company or the venture of a company” means a body corporate whose investment in the company would result in the company becoming an associate company of the body corporate.

 

(ix) Such other person as may be prescribed;

 

Sub-section 77 of Section 2 defines relative as under:

 

Relative, with reference to any person, means anyone who is related to another, if:

 

(i) they are members of a Hindu Undivided Family;

(ii) they are husband and wife; or

(iii) one person is related to the other in such manner as may be prescribed;

 

Rule 4 given in the Companies (Specification of Definitions Details) Rules, 2014 provides the List of Relatives in terms of Clause (77) of section 2. Accordingly, a person shall be deemed to be the relative of another, if he or she is related to another in the following manner, namely:

 

(1) Father: Provided that the term “Father” includes step-father;

(2) Mother: Provided that the term “Mother” includes the step-mother;

(3) Son: Provided that the term “Son” includes the step-son;

(4) Son’s wife;

(5) Daughter;

(6) Daughter’s  husband;

(7) Brother: Provided that the term “Brother” includes the step-brother;

(8) Sister: Provided that the term “Sister” includes the step-sister.

 

Income Tax Act, 1961

 

The Companies Act 2013 does not prescribe any methodology to calculate price on arm’s length basis (Section 188). However, the Income Tax Act prescribes the following methods to compute arm’s length price under section 92C:

 

 

(i) Comparable Uncontrolled Price Method;

(ii) Resale Price Method;

(iii) Cost Plus Method;

(iv) Profit Split Method;

(v) Transaction Net Margin Method;

(vi) Such other methods as may be prescribed by the board.

 

Under the  Comparable  Uncontrolled  Price  Method  (CUP),  the  price  is adjusted so that there are no differences between the related transaction and the comparable uncontrolled transactions. This price adjustment accounts for differences, if any, between the related transaction and comparable uncontrolled transactions or between the parties entering into such transactions, which could materially affect the price in the open market. The adjusted price is taken to be Arm’s Length Price in respect of the product/asset transferred or services provided. This method is used in case it is for a product or service i.e. to compare prices charged for product transferred or a service that is provided.

 

Resale  Price  Method  is  used  when  product  is  purchased  or  services  are obtained from related entities and the same are further sold to unrelated enterprises. Under this method, the price at which the service or product obtained by a related entity and resold to an unrelated one is identified and adjusted by the amount of normal gross profit margin accruing to the entity or to an unrelated enterprise from the purchase and resale of the same or similar product. The price so arrived at is further reduced by the expenses incurred by the enterprise in connection with the purchase and sale of the property. The adjusted price arrived at is taken to be arm’s length price in respect of the purchase of product or obtaining of the services by the enterprise from the related entity.

 

The Cost Plus Method is generally applied in cases where there are semi- finished goods which are sold between related parties or joint facility agreements etc. Under this method, the direct and indirect costs of production incurred by the enterprise in respect of products transferred or service related entity, are determined and the amount of a normal gross profit mark-up to such costs arising from the transfer or provision of the same or similar products or services by the enterprise, or by an unrelated enterprise, in a comparable uncontrolled transaction, or a number of such transactions, is determined. The normal gross profit mark-up is adjusted to take into account the functional and other differences, if any, between the related transaction or the specified domestic transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect such profit mark-up in the open market. The sum so arrived at is taken to be an Arm’s Length Price in relation to the supply of the product or provision of services by the enterprise.

 

The Profit Split Method is mainly used in transactions which deal with unique intangibles or in transactions that are multiple in nature and therefore, cannot be evaluated separately to determine arm’s length price as they are interrelated. Under this method, the combined net profit of the related entities arising from the related transaction in which they are engaged, are determined. The relative contribution made by each of the related entities to the earning of such combined net profit, is then evaluated on the basis of the functions performed, assets employed or to be employed and risks assumed by each entity and on the basis of reliable external market data which indicates how such contribution would be evaluated by unrelated entities performing comparable functions in similar circumstances. The combined net profit is then split among the related entities in proportion to their relative contributions. The profit thus apportioned to the related entity is taken into account to arrive at arm’s length price in relation to the related transaction.

 

The Transactional Net Margin Method (TNMM) requires establishing comparability level at a broad functional level. It requires comparison between net margin derived from operation of the uncontrolled parties and net margin derived by a related entity on similar operation. Under this method, the net profit margin realised by arelated entity from a related transaction is computed in relation to a particular factor such as costs incurred, sales, assets utilized, etc. The net profit margin earned by a related entity is compared with net profit margin of uncontrolled transactions to arrive at arm’s length price.

 

The Arm’s Length Price is determined under Section 92C (1) of the Income Tax Act by using the most appropriate method. The Most Appropriate Method is best suited method to the facts and circumstances of each particular transaction. If an enterprise entered into various transactions with different related entities, then the same method will not be applicable to all the transactions. The Most Appropriate Method will be selected considering the facts and circumstances of each and every transaction to find out appropriate Arms’ Length Price.

 

3. OPERATING  PRACTICE  FOR INVESTIGATION

 

The AD Rules have defined related parties for the purposes of DI standing, however, no guidance has been provided beyond that. As the related party transactions have great ramifications for all the interested parties, the comments and observations of the statutory auditors in the audited accounts may be relevant for trade remedy investigations.

 

The purpose of seeking information regarding related party transactions is to ensure that the transactions between two related parties are conducted are at arm’s length, so as to avoid any distortions in costs. The arm’s length pricing of a related party transaction ensures that both parties in the transaction are acting in their own self-interest and are not subject to any pressure from the other. It ensures that parties to the transaction are on an equal footing.

 

In view of lack of specific instructions for determination of arm’s length price, the investigating team should seek details from the respective DI on the subject matter with supporting evidences and audited records. The investigation team should look into the details of the related party transactions and segregate those transactions, which are not at arm’s length pricing and appropriately adjust them for NIP computation.

 

A clarification has been issued regarding the definition of related parties in case of questionnaire for Anti-dumping investigation for producer/exporter/related importer vide Trade Notice No. 9/2018 dated May 10, 2018 (copy attached):

 

B. RATIONALE OF REASONABLE RETURN ON CAPITAL EMPLOYED IN COMPUTATION OF NON-INJURIOUS PRICE  (ROCE)

 

1. INTRODUCTION

 

The issue regarding reasonability of 22% return on Capital Employed in case of domestic industry for determination of the Non-Injurious Price (NIP) under the Indian anti-dumping laws have been repeatedly raised by various stakeholders. The Exporters claim that this percentage is very high, whereas the domestic industry often complains that 22% return on capital employed is not attractive enough to promote ‘Make in India’ especially as their costs are impacted due to optimization carried out by DGAD in working out NIP.

 

The NIP is presently worked out based on the optimized cost of production of the domestic industry with 22% ROCE. This return is presumed to be a reasonable return (pre-tax) on average capital employed for the product towards recovery of interest, corporate tax and profit. NIP is supposed to be that level of price which the industry is expected to have charged under normal circumstances in the Indian domestic market during the Period defined. This price would enable reasonable recovery of cost of production and a reasonable profit after nullifying adverse impact of dumping.

 

It may further be mentioned here that the sole purpose of fixing the NIP is to apply the “lesser duty rule” envisaged under Rule 4 of the Anti-Dumping Rules, 1995. Therefore, the objective of anti-dumping duties is to protect the affected industry from dumped imports while ensuring that there is no over- protection which may jeopardize the user industry’s interests or facilitate windfall profits. As a matter of fact, overwhelmingly large products covered by the anti-dumping duties happen to be industrial inputs, where user industry often complains that excessive anti-dumping duties may make them un-competitive. Therefore, the “lesser duty rule” is a robust mechanism to balance the interests of the industry affected by dumping on the one hand and the user industry on the other. In any case, the objective of anti-dumping laws is not to ensure benchmark profitability, which may depend on several factors including the production efficiencies, competition, technology, financing costs etc.

 

2. BASIS OF FIXATION OF 22% RETURN ON CAPITAL EMPLOYED

 

The Anti-Dumping Rules don’t prescribe any specific rate of return. However, the Return Rate @ 22% is understood to have been applied ab-initio i.e., from the very beginning. It is understood that the notional rate of return @ 22% was originally based on the provisions of the Drug (Prices Control) Order, 1987. Para 3 (2) of the said order at that time read as under:

 

(2) While fixing the price of a bulk drug under sub-paragraph (1) the Government may take into consideration a post-tax return of 14 per cent on net worth or a return of 22 per cent on capital employed or in respect of a new plant  an internal rate of return of 12 per cent based on long term marginal costing depending upon the option for any of the specified rates of return that may be exercised by the manufacturer of a bulk drug:

 

Provided that the option with regard to the rate of return once exercised by a manufacturer shall be final and for any change in the said rate of return prior approval of the government shall be necessary.

 

It can be seen that the said Drug (Prices Control) Order, 1987 offered three alternatives to the domestic industry for return purposes i.e., (i) a post-tax return of 14 per cent on net worth or (ii) a return of 22 per cent on capital employed or (iii) in respect of a new plant an internal rate of return of 12 per cent based on long term marginal costing depending upon the option for any of the specified rates of return that may be exercised by the manufacturer of a bulk drug. However, for NIP working only the option of 22% rate of return is uniformly applied in case of all units including new units. It appears that uniform rate of return has largely been applied to avoid arbitrariness or the element of subjectivity. It is further added that the Drug (Prices Control) Order, 1987 is not in force as on date. Further, no break-up of 22% is available. Based on the available information, the break-up is understood as under:

 

Debt-Equity Ratio	2:1
Interest Rate	18%	12.00
Income Tax Rate	52.50%
Notional Post Tax Return on Net Worth	14%	9.73
Total		21.73 say 22.00

 

Impact of Optimization under existing NIP Rules

 

As per Annexure-III of the Anti-Dumping Rules, 1995, the following optimizations are considered for working out the NIP, namely:

 

The best utilization of raw materials by the constituents of domestic industry, over the past three years period and the period of investigation, and at period of investigation rates to nullify injury, if any, caused to the domestic industry by inefficient utilization of raw materials;

 

The best utilization of utilities by the constituents of domestic industry, over the past three years period and period of investigation, and at period of investigation rates to nullify injury, if any, caused to the domestic industry by inefficient utilization of utilities;

 

The best utilizations of production capacities, over the past three years period and the period of investigation, and at period of investigation rates to nullify injury, if any, caused to the domestic industry by inefficient utilization of production capacities.

 

As regards optimization, it may be added that the rate of anti-dumping duty is fixed for the benefit of all the units manufacturing PUC in a country. Therefore, normalization may be necessary to arrive at the reasonable costs of the domestic units after excluding internal inefficiencies (non-dumping) affecting the performance of any company. In other words, optimization as per Annexure-III may be necessary to promote efficiency and generally there should not be much variation in year to year average per unit raw material/utilities consumption unless there is breakdown or closure of plant or change in technology or non-stabilization of plant due to enhancement in capacity etc. Incidentally, it may be added here that sometimes optimization is difficult especially in case of material retardation, where previous year details are not available or if the actual capacity utilization is very low during the entire injury period.

 

Interestingly, similar adjustments seem to be also followed in the methodologies adopted by the Authorities in European Union also, while determining the representative target price. The relevant extracts of para 8.3.3.1 of EU Anti-Dumping Law and Practice by Edwin Vermulst are as under:

 

The costs of production of individual Community producers may vary widely.   In order to determine the costs of production of Community producers for purposes of constructing the target price, the Community authorities have sometimes used the cost of production of the most efficient Community producer, or excluded certain of the least efficient producers. In  other  cases, costs of a representative produceror the weighted average costs of production of all Community producers were used. In EFMA,  the  CFI  held that:

 

The profit margin to be used when calculating the target price that will remove the Injury in question must be limited to the profit margin which the Community industry could reasonably count on under normal conditions of competition, in the absence of dumped  imports.

 

In other cases, the Commission has made adjustments to EU producers’ costs.

 

It is clear from the above that the EC has also used the cost of production of the efficient community producer. However, there is not much clarity about the complete practice generally adopted by the EC. On the other hand, the policy adopted by DGAD for transparent optimization is to consider the performance of respective constituents of Domestic Constituent companies only. No adjustment is made for inter-se variations in efficiency amongst the constituents of DI. In other words, weighted average NIP which is worked out for all the units, includes impact of high cost domestic producers also.

 

Incidentally, even though the costing methodology followed by USA is not transparently available, Chapter 9 of the United States Anti-Dumping Manual states inter-alia with respect to Direct Materials Cost with respect to Exporter’s cost of production as under:

 

Direct Materials Costs

 

Direct materials costs include the acquisition costs of all materials that are identified as part of the finished product and may be traced to the finished product in an economically feasible way.

 

The aforesaid indicates that the “economically feasible” direct material costs only are considered, which may be yet another terminology for “optimization”. Further, the costing methodology followed in India allows all indirect costs as per books of accounts including corporate overheads, and other misc. expenses, whereas USA Anti-Dumping Manual provides for examination of each element of cost in computation of cost of production. The relevant excerpt with respect to “Fixed Manufacturing Overhead costs” is provided below:

 

Fixed Manufacturing Overhead Costs: Fixed manufacturing overhead costs include those production costs that generally do not vary in total with changes in the volume of merchandise produced at a given level of operations. Fixed manufacturing overhead costs may include the costs incurred for building or equipment rental, depreciation, supervisory labor paid on a salary basis, plant property taxes, and factory administrative costs. In addition, fixed manufacturing overhead costs include research and development (R&D) costs which relate specifically to the subject merchandise.

 

Complaints regarding lesser returns in case of old plants

 

The Capital Employed for return purposes consists of Net Fixed Assets and the Working Capital. It is sometimes complained by the domestic industry that the returns are lower in case of old plants due to written down value of plant and machinery. However, it may be clarified here that per unit costs are generally higher in old plants based on old technology as their consumption norms are also higher. Further, DGAD goes as per the actual costs as per the books of accounts under applicable accounting standards to avoid subjectivity and arbitrariness. This also allows a transparent methodology, which is followed in all cases. Incidentally, the amount of working capital also varies from one unit to other and from industry to industry. Since no adjustment is done in case of inter-se variations in working capital in the audited books of accounts, it may not be appropriate to notionally amend the figure of NFA as per books of accounts. At the same time, it is pertinent to note that no adjustment is done in case of new plants also where 22% return is allowed from day one.

 

Notional Incidence of Income Tax Paid

 

It may be worth mentioning here that units in SEZ areas, 100% E.O.Us, and units in backward areas etc. may be availing tax holiday benefits etc. However, these units are also allowed the same rate of return. Further, many of the companies escape paying income tax through various tax saving strategies. Therefore, the incidence of actual tax rate paid may vary from company to company. However, return allowed by DGAD includes the notional impact of income tax irrespective of actual payments. Therefore, this additional tax not actually paid by the respective company may be additional margin to domestic industry.

 

Practice followed by EU in determination of Reasonable Return

 

As per the available information, EU determines the profit margin obtained by the industry during the part of the injury investigation period, in which the dumped and/or subsidized imports did not have any negative effects on the situation of the Union industry. This time span is often a period during which the imports of the product concerned were either absent or did not reach significant volumes. In other words, the profit margin used to calculate the target price that will remove the injury in question must be limited to the profit margin which the domestic industry could reasonably count on under normal conditions of competition, in the absence of the dumped imports.

 

Practice followed by Fertilizer Ministry in determination of Reasonable Return:

 

The Policy Parameters for the 7th (from 1.7.1997 to 31.03.2000) and 8th (from 1.4.2000 to 31.3.2003) Pricing Periods indicate that the fertilizer Ministry has been allowing a return of 12% with notional income tax rates.

 

Return On Net Worth

 

Post-tax return on the net-worth, which comprises equity and free reserves for the urea activity only, under the existing system of priority on the balance outstanding as on 30.06.1997 for the 7th pricing period, and as on 31.03.2000 for the 8th pricing period, would be considered at 12 per cent.

 

In respect of new grass-roots and expansion units (wherever final/provisional/ adhoc retention price has been notified), the free reserves would be treated as equity from the date of commercial production.

 

The method of calculation of return on net-worth on the basis of notional tax liability subject to adjustment of actual rate of corporate tax notified by the Government on year to year basis and at the rate of return of 12 per cent shall continue for the 7th and 8th pricing periods. Should there be a change in the method in favour of adoption of actual tax in place of notional tax, the same shall be adopted as and when decided upon.

 

However, the Fertilizer Ministry also allowed the nominal percentage as Vintage Allowance to old plants for a small period. This may have merit to compensate for the lower depreciation amount in old plants.

 

Practice followed by Ministry of Finance in determination of Reasonable Return:

 

Department of Expenditure, Ministry of Finance considers 12% post tax return on net worth for determination of fair prices. However, interest is generally paid on actuals subject to verification and justification in these cases;

 

It is important to note that all the practices cited above are in the context of fixation of prices or return to specific industry. The purpose of ascertaining a rate of return in the anti-dumping context is only to ensure that there is no over- protection which may be detrimental to the domestic user industry and not in the overall interest of industrial growth. The practices of other regimes are not directly relevant to that extent.

 

Reasonable interest rate on loans

 

As regards rates of interest paid by any company, it is very difficult to suggest a reasonable rate of interest as these may vary significantly from company to company based on the past track record of the respective company and its promoters, profitability and brand name etc. Further, long term funds through issue of bonds may be cheaper than the rate of interest paid to banks on working capital loans. Similarly, funds raised in the foreign currency are generally cheaper. However, these may involve the exchange risk or the hedging cost.

 

Merits in existing methodology

 

The existing methodology has been applied during the last almost 20 years, perhaps with some exceptions. As stated earlier, the main merit of the existing methodology is consistency and avoidance of any kind of arbitrariness.

 

It may be mentioned here that ideally, determination of sector wise/industry wise Normal Return percentages as followed in the EU may need enormous database which is reliable and updated. This may be difficult in the present scenario, where reliable data is very difficult to get. Further, anti-dumping duties are generally for subsets of product group, for which separate rates of return may not be available.

 

Source: Manual Of Operating Practices For Trade Remedy Investigations