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Introduction
On [date of regulation or effective date], the Securities and Exchange Board of India (SEBI) incorporated a “purpose and effect” test into the definition of related party transactions (RPTs) under its Listing Obligations and Disclosure Requirements (LODR). The change permits SEBI to treat a transaction with an independent counterparty as an RPT if its purpose or effect is to benefit or influence a related party. This move aims to thwart creative structuring used to evade regulatory safeguards. For listed companies, auditors, and investors, this marks a significant expansion of oversight into hitherto opaque dealings.
Background / Context
Why Are Related Party Transactions Regulated?
Related party transactions — deals between a
listed entity and firms or persons linked by shareholding, control, or
fiduciary relationships — have long posed governance risks. They can be used to
siphon value, shift liabilities, or favor insiders, often at the expense of
minority shareholders. Regulation is intended to:
·
Ensure disclosure
and transparency
·
Impose independent
oversight (audit committee, shareholder vote)
·
Guard against abuse or conflict of interest
In India, the Companies Act, 2013 and SEBI LODR Regulations (2015) have formed the backbone of
RPT oversight. Over time, SEBI has tightened definitions (e.g. in 2021, 2022)
to capture wider classes of entities, subsidiaries, and to sharpen materiality
norms.
However, regulators and experts observed that
many listed firms avoided scrutiny by routing related-party benefits through
apparently unrelated third parties
or complex chains of agreements — thereby skirting the literal “party to the
transaction” definition. A SEBI Working Group on RPTs emphasized this loophole
and recommended an anti-abuse addition: the purpose and effect test.
Genesis of the “Purpose & Effect” Test
·
The WG Report (January 2020) flagged
transactions structured via shell firms or independent intermediaries where
ultimate benefit would flow to related parties.
·
SEBI’s Board Note and subsequent amendments
introduced a rule under Regulation
2(1)(zc) of LODR that extends the RPT definition to transactions whose
purpose or effect is to benefit
a related party, even if the counterparty is not itself related.
·
This addition is often described as a substance-over-form or anti-abuse principle — putting
regulatory focus on outcomes, not just drafting.
Interim Developments
SEBI has concurrently moved to revise industry standards for RPT disclosures
via a circular issued on June 26, 2025, effective September 1, 2025. This
imposes uniform minimum information that must be placed before audit committees
and shareholders.
Also, SEBI has floated a consultation paper to recalibrate materiality thresholds for RPTs in a turnover-linked framework. Under the current norms, a transaction is material if it exceeds ₹1,000 crore or 10% of consolidated turnover (whichever is lower)
Detailed Explanation of the News
What SEBI Has Stated
SEBI has formalized the “purpose & effect”
test within the definition of RPTs in its regulatory lexicon under Regulation 2(1)(zc) of LODR. Under this
test:
“A transaction with any person [including
independent third parties] the purpose or effect of which is to benefit a
related party, directly or indirectly, shall be considered a Related Party
Transaction.”
Thus, a counterparty need not already be a legally identified
related party. The key call: does the
transaction in fact confer disproportionate advantage or influence to a related
entity?
Key Structural Changes & Tests
1.
Beyond formal party-status
Traditionally, only those counterparty entities already qualifying as “related
parties” were captured. Under the new rule, even an otherwise unrelated party can trigger the RPT regime if
its dealings benefit a related entity.
2.
Substance trumping form
The test forces regulators and auditors to assess the economic effect of a transaction — not merely how
contracts are labelled. Any layering to mask beneficial relationship may be
disregarded in substance.
3. No
blanket carve-out for ordinary course
Unlike some jurisdictions (e.g. UK Premium Listing Rules), SEBI’s version does not explicitly exempt “ordinary course of
business” transactions from the test.
4.
Disclosure and approval escalations
If an arrangement qualifies under this test, the usual governance protocols
apply:
·
Audit committee vetting
·
Shareholder approval (if material)
·
Exclusion of related parties from voting, etc.
5.
Revised RPT standards effective Sept 1, 2025
SEBI’s June 2025 circular sets out minimum disclosure templates, standardizes
data formats, and mandates valuation certificates, past dealings history, and
certifications from leadership.
What Was Challenged or Debated
·
There is concern about overreach: every transaction that ends up benefiting a
related party could fall captive to RPT rules — potentially bogging down
routine operations.
·
Critics say SEBI used a circular to enforce part of this regime (e.g. disclosure
standards), raising questions about statutory backing and legal enforceability.
·
The lack of an explicit carve-out for “ordinary
course” deals means borderline transactions might become contentious.
· Auditors and companies may struggle with interpretation uncertainty — where to draw the line on what “effect” qualifies.
Impact Analysis
Who Benefits
·
Minority
Shareholders / Investors
Gains in protection from back-door structuring and hidden favoritism. Better
oversight where value might be transferred indirectly.
·
Regulators
& Market Integrity
This test strengthens SEBI’s ability to curb abuse and enforce governance
beyond technical loopholes.
Who May Face Strain
·
Listed
Companies / Management
Higher compliance burden, tougher scrutiny of even third-party deals. Strategic
transactions with commercial synergies may require deeper justification.
·
Auditors /
Chartered Accountants / Legal Advisors
Greater onus to provide judgment-based opinions, document reasoning on
“purpose/effect,” evaluate whether benefits accrue to related parties.
·
SMEs /
Smaller listed firms
The expanded scope could disproportionately burden smaller organizations with
limited in-house governance infrastructure.
Practical Implications by Stakeholder
|
Stakeholder |
Key Implications |
Suggested Response |
|
Management / Boards |
Reassess contracts even with unrelated counterparties;
advance vetting and economic mapping |
Deploy internal “purpose/effect” screening, document
benefit flows |
|
Audit Committees / Independent
Directors |
Need deeper technical evaluation of each RPT proposal |
Engage valuation experts, legal counsel; insist on rationale and
disclosure |
|
Finance / Tax Teams |
More granular documentation, detailed disclosure,
supporting certifications |
Maintain transaction-level benefit analysis, backup data,
prepare for scrutiny |
|
Auditors / CAs |
Heightened audit risk; subjective judgments may be challenged |
Adopt robust internal audit protocols, corroborative evidence,
disclosure review |
|
Investors / Analysts |
Better visibility into hidden related-party flows;
improved trust in corporate governance |
Scrutinize disclosures, challenge ambiguous benefit
claims |
Moreover, in practice:
·
A company contracting an outsourced services firm (not a related
party) may now be drawn into RPT scrutiny if that service firm channels benefit
to a promoter-controlled subsidiary.
·
Routine procurement deals may require more
documentation where overlaps exist across group entities.
·
M&A or carve-out or group synergies
involving third‐party contracts may need pre-evaluation under the new test.
Businesses will need to build “benefit-flow mapping” models — tracing how a contract could advantage related parties indirectly.
Common Misunderstandings
·
“Only
direct contracts with related parties matter.”
False — even third-party contracts may count if the purpose or effect favors a
related party.
·
“Ordinary
course transactions are exempt automatically.”
No such blanket exemption exists under the SEBI version of the test.
·
“Purpose
and effect test kills all group-level synergies.”
Not necessarily — genuine, proportionate, non-prejudicial benefits may still
stand if properly documented.
·
“The
counterparty must be connected to a related party.”
Not required — the counterparty can be fully independent.
·
“This test
is purely hypothetical, no one will be caught.”
In reality, SEBI’s intention is to use this as an anti-abuse tool; enforcement
and challenge are possible.
Expert Commentary
As one seasoned corporate law specialist put
it:
“The purpose and effect test forces
companies to reconcile form and substance in their group dealings. It raises
the bar for boilerplate commercial justifications and compels deeper economic
mapping. While it imposes compliance load, its salutary effect lies in curbing
stealth value transfer.”
From my perspective, the test is a welcome albeit heavy-handed tool. The onus now lies—in practice—on boards, auditors, and management to build a defensible narrative around every connected transaction. It may also prompt greater use of pre-filing opinions, third-party valuations, and even regulatory pre-clearances in borderline cases.
Conclusion / Action Steps
SEBI’s addition of the purpose and effect test marks a
structural shift in how related party transactions are regulated. No longer
will the lens be confined to formal party definitions; the economic impact and benefit flows must
now withstand scrutiny. For minority shareholders and market integrity, this is
a positive step. For listed companies and advisors, it translates into sharper
diligence and rigorous documentation.
Key
expectations ahead:
·
Litigation or regulatory challenges will clarify
how narrow or expansive “effect” is interpreted.
·
Companies may push for a statutory or rule-level
carve-out for bona fide, arm’s length, ordinary deals.
·
SEBI’s forthcoming consultation on materiality
thresholds may ease compliance burdens while preserving substance-based
oversight.
·
Market practice will evolve with precedent,
internal policies, and judicial interpretations.
Action
steps for stakeholders:
1.
Map potential
benefit flows from any contract, even with unrelated parties.
2.
Engage
valuation, tax, and legal experts to validate claims of independence.
3.
Document the
rationale rigorously — flowcharts, memos, internal approvals.
4.
Update
governance charters and RPT policies to embed the purpose/effect test
lens.
5.
Monitor
regulatory guidance or judicial decisions to refine internal
interpretations.
In a regulatory environment increasingly focused on substance over form, adaptation, foresight, and disciplined record-keeping will become the differentiators between compliant firms and those exposed to challenge.
FAQs
Q1:
When does this “purpose and effect” test apply?
This test applies under Regulation
2(1)(zc) of SEBI LODR. Effective from the relevant amendment
(post-April 2023), it allows SEBI to treat even non-related party contracts as
RPTs if their purpose or effect benefits a related party.
Q2:
Does every transaction now become an RPT?
No. Only those in which the purpose or
effect is judged to confer disproportionate
or preferential benefit to a related party will be captured. Genuine
commercial transactions with incidental or non-prejudicial benefit may be
excluded through well-documented justification.
Q3:
Are ordinary course business deals exempt?
Not automatically. SEBI’s version does not
include an unconditional carve-out for ordinary course transactions. However, a
company may argue that the benefit is typical, proportionate, and not
prejudicial.
Q4:
What extra disclosure or approvals are required if this test is triggered?
All standard RPT governance comes into play:
·
Audit committee evaluation
·
Shareholder approval (if material)
·
Disclosures in prescribed formats (valuation,
past dealings, leadership certifications) under SEBI’s 2025 circulars.
Q5:
What happens if a company fails to classify a purpose/effect transaction as an
RPT?
It could lead to regulatory censure, penalties, or challenged transactions
being declared void or subject to recovery, especially if minority shareholders
raise objections or SEBI initiates enforcement.
References / Source Links
1.
“Critically Analyzing the Purpose and Effect Test for
RPTs” — IRCCL
2.
“Purpose & Effect Test for RPTs – How should Audit
Committees navigate it?” — Corporate / Legal blog
3.
KPMG FirstNotes: “SEBI notifies revised RPT Industry
Standards”
4.
SEBI’s Updated Guidelines for RPTs — Acuity Law
5.
“LODR amendments on ‘Related Parties’ – some practical
challenges” — AZB Partners
6.
“SEBI’s New Disclosure Norms for Related Party
Transactions” — TLH Law
7.
“Amendments to Listing Regulations regarding Related
Party Provisions” — AZB Partners
8.
“SEBI moots major relief for big firms on related party
transaction norms” — LiveMint / Reuters
9.
“Repetitive Overhaul: RPT regime to get softer” — Vinod
Kothari blog
10. “SEBI
Issues Circular on Industry Standards for RPT Disclosures” — Lexology
11. “Related
Party Transactions: The Purpose & Effect Test” — BCAJ Online
12. “Ensuring
Transparency in RPTs: SEBI’s Latest Mandates Explained” — Lexology / ELP
commentary
13. “RPT Disclosure Standards: Regulator’s Ongoing Quest for Balance” — Lexology