In many Indian mid-sized companies, the promoter group is woven into daily operations. The factory stands on land owned by a family member, a sister concern buys a large share of output, group staff share an office, and funds move between entities as needed. None of this is unusual or necessarily improper. But when an outside investor acquires the business, those arrangements may change or end, and the target's reported margins, cash flow and even revenue may change with them.
This article explains how related party transactions (RPTs) are identified and tested in financial due diligence, the legal and tax framework that shapes the review, and how dependency on the group is converted into a standalone view of earnings. It is intended for investors, promoters and finance teams preparing for a transaction.
Key points at a glance
- RPTs are reviewed for economic substance and dependency, not only for disclosure in the financial statements.
- The disclosed list of related parties under Ind AS 24 or AS 18 is a starting point; the review often finds entities and transactions beyond it.
- Compliance with Section 188 and Sections 185-186 of the Companies Act, 2013 is checked, as non-compliance can affect the validity of transactions.
- Non-market pricing is adjusted to arrive at a standalone EBITDA that reflects the business after the deal.
- Balances with related parties are analysed for recoverability and may be settled before closing or treated as debt-like.
What counts as a related party?
Several overlapping definitions apply, and due diligence works with the widest relevant set:
| Framework | Provision | Relevance in due diligence |
|---|---|---|
| Companies Act, 2013 | Section 2(76); approval under Section 188; loans under Sections 185 and 186 | Board and shareholder approvals, validity of contracts, register of contracts |
| Accounting | Ind AS 24 (or AS 18 for companies under Indian GAAP) | Disclosure of parties, transactions and balances |
| Listed entities | Regulation 23 of SEBI (LODR) Regulations, 2015 | Audit committee approval; shareholder approval for material RPTs (materiality thresholds were revised by SEBI in 2025) |
| Income tax | Section 40A(2)(b) and transfer pricing provisions (Sections 92 to 92F) of the Income-tax Act, 1961, and the corresponding provisions of the Income-tax Act, 2025 | Disallowance of excessive payments; arm's length pricing for international and specified domestic transactions |
Step 1: Identify and map all related parties
The review starts with the disclosed list in the financial statements and extends it using director and shareholder records, MCA filings of promoter entities, the register of contracts in which directors are interested (Form MBP-4), bank statements and the vendor and customer masters. Common search methods include matching addresses, PAN, GSTIN, phone numbers and bank accounts across the masters.
All transactions are then mapped by type and by entity: sales, purchases, rent, royalty or brand fees, management and shared service charges, loans and advances, guarantees and cost reimbursements.
Step 2: Test commerciality and arm's length pricing
For each material flow, the question is whether the terms match what an unrelated party would accept. Typical tests include:
- Comparing prices and credit terms with those for third-party customers or suppliers of the same product.
- Benchmarking rent against market rates for comparable premises.
- Reviewing any transfer pricing documentation and benchmarking studies already prepared.
- Checking whether shared services (staff, office, IT, vehicles) used by the target are charged at all.
- Reviewing interest on loans to and from related parties against market rates.
Practical point: Under Section 188, transactions in the ordinary course of business and at arm's length do not need board or shareholder approval under that section, but the company must be able to show both conditions. Where approvals were required and not obtained, the contract is voidable at the option of the board or shareholders, and the matter is usually addressed through a condition precedent or ratification before closing.
Step 3: Assess dependency on the group
Dependency is often a larger risk than pricing. Due diligence asks:
- What share of revenue comes from group entities, and would those customers continue buying on the same terms after the deal?
- Does the target rely on group entities for key inputs, licences, brand, distribution or staff?
- Are contracts with the group documented, and for what term?
- Would the business be viable if group support were withdrawn?
Where group revenue is significant, the buyer often seeks long-term supply agreements with the promoter entities as a condition of the deal.
Worked example: arriving at standalone EBITDA
Consider a packaging company with revenue of ₹100 crore and reported EBITDA of ₹15 crore. The review finds:
- A group company buys 30% of output (₹30 crore) at prices 5% above those charged to third parties. The premium is ₹30 crore × 5/105 ≈ ₹1.43 crore.
- The factory is owned by the promoter and is rent-free. Market rent is benchmarked at ₹0.9 crore a year.
- Accounts and HR staff employed by a sister concern work for the target without any charge. The cost attributable to the target is ₹0.4 crore.
- The target pays the promoter's family trust a brand fee of ₹0.6 crore, which will end on closing because the brand is being assigned to the target.
| Item | ₹ crore |
|---|---|
| Reported EBITDA | 15.00 |
| Less: price premium on group sales | (1.43) |
| Less: market rent for factory | (0.90) |
| Less: cost of shared staff | (0.40) |
| Add: brand fee ending on closing | 0.60 |
| Standalone EBITDA | 12.87 |
The standalone margin falls from 15% to about 13%. The adjustment for group sales also highlights a risk: if the group company reduces volumes after the deal, the business loses not only the premium but part of its revenue base. That risk is dealt with through contracts and structure rather than through EBITDA alone.
Step 4: Review balances with related parties
Outstanding balances often reveal informal funding. The review checks:
- Long-outstanding receivables from group entities, which may be funding in disguise and whose recoverability is uncertain.
- Interest-free or undocumented loans and advances, which raise questions under Sections 185 and 186 of the Companies Act and on tax treatment.
- Payables to the promoter or group that are effectively quasi-equity.
- Guarantees given by the target for group borrowings, which may need to be released before closing.
Such balances are typically either settled before closing or treated as debt-like or cash-like items in the price mechanism.
Frequently Asked Questions on Related Party Transactions in Due Diligence
Why are related party transactions important in due diligence?
Because they can inflate or depress margins, hide funding arrangements and create dependency on the promoter group. After a change in ownership, those terms may not continue.
What is standalone EBITDA?
It is EBITDA adjusted to reflect the business operating independently of its promoter group, with related party transactions at market terms and costs of shared services included.
Does Section 188 apply to all related party transactions?
Section 188 covers specified types of contracts with related parties. Transactions in the ordinary course of business and at arm's length are exempt from its approval requirements, but the company must be able to support both conditions.
What is the tax risk in non-arm's length related party transactions?
Excessive or unreasonable payments to specified persons can be disallowed under Section 40A(2)(b) of the Income-tax Act, 1961 (and the corresponding provision of the Income-tax Act, 2025), and international or specified domestic transactions are subject to transfer pricing rules.
How are related party balances treated in the deal price?
Receivables and loans from related parties are often required to be settled before closing, or deducted as debt-like items if recovery is uncertain; payables to promoters may be treated as debt.
How are hidden related parties identified?
By matching addresses, PAN, GSTIN, bank accounts and contact details across customer and vendor masters with promoter and director records and MCA filings.
Conclusion
Related party transactions are rarely the problem in themselves; the issue is whether reported performance depends on terms that will not survive the transaction. Mapping every flow, testing commercial terms and converting the findings into a standalone EBITDA gives the investor a view of the business as it will actually operate.
For promoters, documenting group arrangements, charging for shared services and settling informal balances ahead of a transaction makes the review faster and the reported numbers easier to rely on.
This article is intended for general information and knowledge sharing only and does not constitute professional advice or solicitation of any kind. Provisions are summarised as of September 2026. Readers should refer to the relevant provisions, regulations and judicial pronouncements for their specific facts.