SEBI’s “Purpose and Effect” Test for Related Party Transactions: What Companies and Investors Must Know

Introduction: A New Era for Related Party Transactions in India

India’s corporate governance landscape is undergoing a significant transformation. The Securities and Exchange Board of India (SEBI) has introduced the “purpose and effect” test within the definition of related party transactions (RPTs) under its Listing Obligations and Disclosure Requirements (LODR). Effective from September 1, 2025, this amendment represents a paradigm shift, focusing on economic substance over formal structure.

Why does this matter? For years, companies could route deals through independent intermediaries to bypass RPT scrutiny. With this new test, SEBI can classify a transaction as an RPT even if the counterparty is technically independent, provided the transaction’s purpose or effect benefits a related party. This move is poised to enhance transparency, protect minority shareholders, and strengthen market integrity—but it also poses compliance challenges for companies, auditors, and advisors.

In this article, we’ll break down:

• What constitutes an RPT
• The birth and mechanics of the purpose and effect test
• Key changes in rules and governance
• Practical implications for stakeholders
• Common misconceptions and expert insights
• Steps for compliance and future outlook

By the end, you’ll have a comprehensive understanding of SEBI’s new framework and actionable guidance for navigating it successfully.

 

Understanding Related Party Transactions

What Is an RPT?

A related party transaction (RPT) occurs when a listed company enters into a contract or deal with entities or individuals connected through:

• Shareholding
• Control
• Board membership or fiduciary responsibilities

Common examples include:

• Transactions with promoters or promoter-controlled entities
• Deals with subsidiaries or joint ventures
• Contracts with companies where directors have significant influence

RPTs have always attracted regulatory attention because, without proper oversight, they can:

• Divert value from minority shareholders
• Shift liabilities unfairly
• Favor insiders at the expense of transparency

Historically, SEBI and the Companies Act, 2013, along with amendments in 2015, 2021, and 2022, provided a framework to regulate RPTs and set materiality thresholds. Despite these measures, some companies exploited loopholes, channeling benefits indirectly through independent entities to avoid disclosure.

 

The Birth of the Purpose and Effect Test

The SEBI Working Group on RPTs (January 2020) identified transactions where shell companies or independent intermediaries were used to indirectly benefit related parties. Existing rules focused too heavily on formal relationships and legal definitions, creating gaps in oversight.

SEBI responded by amending Regulation 2(1)(zc) of LODR, introducing the purpose and effect test. Under this rule:

A transaction can be classified as an RPT if its purpose or effect ultimately advantages a related party, even if the counterparty is independent.

This represents a shift from form to substance—a move analysts describe as an anti-abuse principle. No longer can companies rely solely on legal structuring to bypass scrutiny; the real economic impact matters.

 

Key Changes and Rules

1. Broader Scope Beyond Formal Relationships

Previously, only legally recognized related parties triggered RPT disclosure. Now, any party can fall under RPT rules if the transaction ultimately benefits a related entity. This expands regulatory oversight and addresses previous loopholes.

2. Substance Over Form

Contracts labeled as independent are no longer exempt by default. SEBI emphasizes economic outcomes over contractual labels. Complex agreements designed to hide indirect benefits may now fall squarely under RPT regulations.

3. No Automatic Exemption for Ordinary Deals

Unlike some international frameworks, SEBI does not provide blanket exemptions for routine or “ordinary course of business” transactions. Each deal is assessed for its potential indirect benefit to related parties.

4. Governance and Disclosure Protocols

If a transaction meets the purpose and effect criteria, standard RPT governance applies:

• Review by the Audit Committee
• Shareholder approval for material transactions
• Exclusion of related parties from voting

5. Standardized Disclosure Templates

SEBI’s June 2025 circular prescribes:

• Minimum data and reporting formats
• Mandatory valuation certificates
• Disclosure of past dealings and leadership certifications

 

Debates and Challenges

The purpose and effect test is widely praised for curbing regulatory circumvention, but it is not without controversy:

• Potential overreach: Critics argue any deal indirectly benefiting a related party could now require RPT scrutiny, slowing routine operations.
• Legal clarity: Some disclosure requirements were issued via circulars, raising questions about statutory authority.
• Interpretation uncertainties: SEBI has not defined precise thresholds for “effect,” leaving auditors and companies to exercise judgment.
• Ordinary course ambiguity: Routine transactions could become contentious without clear exemptions.

 

Implications for Stakeholders

Investors and Minority Shareholders

The test strengthens protection against hidden favoritism and backdoor value transfers. Minority shareholders gain better visibility into transactions affecting the group, enhancing trust and transparency.

Regulators and Market Integrity

SEBI gains a more powerful tool to detect abuse. Regulators can now enforce compliance based on economic reality rather than legal formalities, promoting market integrity.

Companies and Management

Listed companies must now scrutinize even third-party contracts for indirect benefits. Documentation, justification, and internal approvals are mandatory, adding layers of compliance.

Auditors and Legal Advisors

Professional advisors need to:

• Map potential benefit flows
• Provide judgment-based opinions
• Ensure transactions do not favor related parties disproportionately
• Validate documentation with valuation reports and memos

SMEs and Smaller Listed Firms

Expanded RPT rules may disproportionately affect smaller companies with limited governance infrastructure. Compliance costs, administrative effort, and external advisory fees are expected to rise.

 

Practical Implications

Some scenarios illustrating the new rules:

1. Outsourced services: A company hires an independent service provider. If the provider indirectly benefits a promoter-controlled subsidiary, the contract could be treated as an RPT.
2. Procurement deals: Routine overlaps across group entities require detailed documentation and benefit-flow mapping.
3. M&A transactions: Third-party deals in mergers or carve-outs may need pre-evaluation to assess indirect benefits.

Firms must create benefit-flow models, tracing contracts to ensure transparency and compliance.

 

Misconceptions and Clarifications

• Only direct contracts? False. Third-party agreements are captured if they benefit a related party.
• Ordinary course exemption exists? No automatic exemption; proportionality and non-prejudicial impact must be documented.
• All group synergies blocked? No. Genuine commercial benefits are acceptable with documentation.
• Counterparty connection required? Not necessary; even independent parties can trigger the test.
• The test is theoretical? No. SEBI intends this as an enforceable anti-abuse tool.

 

Expert Perspectives

A corporate law expert notes:

“The purpose and effect test forces companies to reconcile form with substance. It raises the bar for commercial justifications and demands detailed economic mapping. Compliance may be heavier, but the test is crucial to prevent stealth value transfers.”

Boards, auditors, and management are now responsible for building defensible narratives for every transaction. This may include:

• Pre-filing opinions
• Third-party valuations
• Regulatory pre-clearances for borderline cases

 

Steps for Companies to Ensure Compliance

To navigate the new rules effectively, companies should:

1. Map potential benefits from all contracts, including third parties.
2. Engage legal, tax, and valuation experts to verify independence and fairness.
3. Maintain detailed documentation—flowcharts, memos, approvals.
4. Update governance charters and RPT policies to reflect the purpose/effect lens.
5. Monitor SEBI guidance and judicial interpretations to refine internal compliance practices.

 

Looking Ahead: The Future of RPT Regulation

The purpose and effect test represents a broader trend toward substance-focused oversight in corporate regulation.

Key expectations include:

• Judicial and regulatory clarifications defining “effect” thresholds
• Companies seeking statutory exemptions for bona fide, arm’s length transactions
• SEBI consultations on materiality thresholds to balance compliance with business efficiency
• Evolution of market practices through precedent, internal policies, and interpretations

 

FAQs

Q1: When does the test apply?
Applies under Regulation 2(1)(zc) of SEBI LODR. Transactions with indirect benefits to related parties are captured post-amendment.

Q2: Are all transactions now RPTs?
No. Only transactions providing disproportionate benefits to related parties are covered.

Q3: Are ordinary course deals exempt?
Not automatically. Documentation must show benefits are typical, proportionate, and non-prejudicial.

Q4: What approvals are required if triggered?

• Audit committee review
• Shareholder approval for material deals
• Disclosures using standard formats, including valuations and past dealings

Q5: What happens if a company fails to comply?
Non-classification may lead to penalties, regulatory censure, or voided transactions, especially if challenged by shareholders or SEBI.

 

Conclusion: Navigating a Substance-Focused Regulatory Era

SEBI’s purpose and effect test transforms the landscape of related party transactions in India. Formal labels no longer determine scrutiny; economic impact does.

• Investors gain stronger protections against hidden favoritism.
• Companies must adopt robust compliance frameworks, map benefit flows, and maintain detailed documentation.
• Auditors and advisors must exercise judgment, validate independence, and justify economic outcomes.

The test signals a future where substance outweighs form. Companies that anticipate regulatory focus, maintain rigorous documentation, and proactively manage indirect benefits will thrive. Those that ignore the changes risk penalties, shareholder disputes, and reputational damage.

At Manika TaxWise, we help companies navigate evolving SEBI regulations with comprehensive advisory, compliance mapping, and audit-ready documentation, ensuring transparency, sustainability, and governance excellence.

 

References

1. IRCCL — Critically Analyzing the Purpose and Effect Test for RPTs
2. Corporate / Legal Blog — Purpose & Effect Test for RPTs: Audit Committee Guidance
3. KPMG FirstNotes — SEBI Notifies Revised RPT Industry Standards
4. Acuity Law — SEBI’s Updated Guidelines for RPTs
5. AZB Partners — LODR Amendments on Related Party Provisions
6. LiveMint / Reuters — SEBI Proposes Relief for Large Firms on RPT Norms
7. Vinod Kothari Blog — Repetitive Overhaul: RPT Regime Updates
8. BCAJ Online — Related Party Transactions: Purpose & Effect Test
9. Lexology / ELP Commentary — Ensuring Transparency in RPTs

 

Author Bio:
Manoj Kumar, Founder of Manika TaxWise — With 11+ years in accounting, taxation, and corporate advisory, Manoj helps companies comply with SEBI regulations, optimize governance, and safeguard investor interests. Manika TaxWise specializes in corporate compliance, tax planning, and advisory services for listed and private entities across India.