Business transactions are at the very core of the operations of any business. Every business undertakes exchange of goods, services or money at all stages of its operations. The fundamental aspect of a business transaction is that in involves more than one entity – the business itself and one or more transacting entity. The nature of the transacting entity is crucial as it impacts the terms of the business transaction.
This article looks at meaning of and differences between two types of business transactions based on the nature of the transacting entity – third party transactions and related party transactions.
Definitions and explanations
Third party transactions:
Third party transactions are those business transactions which are undertaken between the business entity and external entity or entities who have no existing relation with the business entity i.e., they are completely unrelated. These entities are third parties.
Third party transactions are generally those which are not influenced in any way and take place at market rates and terms. Day to day transactions of the entity such as purchase from unrelated suppliers, sales to unrelated customers, loans taken from banks etc. all constitute third party transactions.
Related party transactions:
Related party transactions are those business transactions which are undertaken between the business entity and other entities with whom they have a prior or pre-existing relation or connection. These entities are called related parties.
The basis of determining a related party vis-à-vis any business entity is generally if it has the power by virtue of its pre-existing relation to impact the terms of transaction in ways which a third party cannot. So, for example, a regular supplier of the business would not be a related party just because it has transactions with the entity in the past. However, if the supplier is also a major investor in the business then he may qualify as a related party by virtue of its ability to modify the terms of supply to its benefit.
The rules for determining who is a related party for every entity type is determined by the respective laws of each jurisdiction. Some examples have been detailed below:
A company, for example, may have several related parties who are its group companies. In a group company structure, there are multiple levels of companies beginning from a holding company who may have one or more subsidiaries who may further have one or more step down subsidiaries. When the holding company for example undertakes any business transaction with any of these group companies it could qualify as a related party transaction. Furthermore, any substantial shareholder, substantial investor, or key managerial personnel can also be related parties.
Determining related party transactions are mandatory as per accounting and taxation rules of most jurisdictions as they can have a significant impact on the financial position of the entity. These transactions are generally regulated and monitored to ensure there is no business malpractice taking place.
Differences between third party and related party transactions:
The difference between third party and related party transactions has been detailed below:
1. Meaning
- Transactions that are not influenced by any pre-existing relation between the transacting entities are third party transactions.
- Transactions that occur between entities that have a pre-existing relation that can potentially influence the terms of the transaction qualify as related party transactions.
2. Nature of transacting party
- The transacting party is an unrelated party with who the business entity does not have any relation of influence.
- The transacting party is a related party with who the business entity has a pre-existing relation, the effect of which can influence the transaction terms.
3. Examples of transacting parties
- Third parties include unrelated business entities such as unrelated vendors, customers, banks etc.
- Related parties include group companies such as holding, subsidiary or step-down subsidiaries, key management personnel, investors and shareholders that have substantial interest in the business entity etc.
4. Impact on terms of transaction
- Third party transactions generally take place at market rates and the terms are generally determined as per market norms. For e.g., if a business entity takes a loan from an unrelated bank it will be liable to interest at normal market rates.
- Related party transactions may take place at influences rates and terms that differ from market terms. For example, if a company takes a loan from its holding company, it may get the loan at a substantially lower interest rate. In related party transactions the possibility of impacting terms exists but this does not mean that all related party transactions will be influenced. The presence of the possibility of influence is what makes a transaction a related party transaction.
5. Disclosure requirements in financials
- All third-party transactions do not require any separate disclosure in the financial statements of a business entity.
- Related party transactions above a specified threshold need to be separately disclosed by way of a separate schedule appended to the financial statements. The manner and rules of disclosure are determined by the prevailing jurisdictional law.
6. Subject to transfer pricing regulations and scrutiny by tax officials
- Third party transactions are presumed to have taken place at arm’s length i.e., at market rates and thus are not subject to transfer pricing regulations.
- Related party transactions have to be proven to have been taken place at arm’s length. They are thus subject to transfer pricing regulations as well as more in-depth scrutiny by tax officials. Related parties can influence transactions in an attempt to evade tax and thus need to be subjected to more scrutiny.
Conclusion – third party vs related party transactions:
While all transactions are required to be reported appropriately in the financial statements, it is related party transactions that are subject to more stringent accounting and auditing regulations. The main impact of related party transactions are seen in transfer pricing regulations. For example, a business entity in a high tax jurisdiction may sell goods to its related party in a lower tax jurisdiction at a significantly lower price to transfer profits from the high to lower tax jurisdiction. The potential of tax evasion and business malpractice make it important to monitor and regulate related party transactions.
