It is not uncommon for companies to enter into transactions with shareholders, members of the management board, and supervisory board, or for a subsidiary to enter into transactions with the parent company and other companies within the same group. Although these are legal transactions, they often provoke conflicts of interest or other forms of illegality.

Broadly speaking, transactions with related parties are transactions concluded between persons who have a prior legal and/or business connection. These are legal transactions that are common in the operations of small, medium, and large trading companies.

There is a frequent tendency in business to engage in transactions with known partners to keep the business process more easily under control, so it is not unusual for companies to enter into transactions with shareholders, members of the management board, and supervisory board, or for a subsidiary to enter into transactions with the parent company and other companies within the same group. Although these are legal transactions, they often provoke conflicts of interest or other forms of illegality.

The world-renowned scandals of Enron and Parmalat have brought to the forefront the risks that transactions among related parties are used to siphon off assets for private benefit to the detriment of the company’s assets, and thus to the detriment of investors. In professional jargon, this practice is known as ‘tunneling’.

There are many examples of tunneling in the post-privatization era in Central Europe, including Croatia, during a time of inadequate regulations on preventing conflicts of interest and management accountability for bankruptcy. An interesting example was the massive industrial complex Škoda Works in Plzeň, Czech Republic. Fraud, along with failures in management strategy, resulted in bankruptcy (2001), followed by the restructuring of the company. The accused manager was later acquitted by the court, stating that ‘such practice was common at that time’.

Transactions among related parties are also recognized as a frequent instrument of tax evasion, where the pricing policy between related parties affects the amount of corporate income tax and value-added tax. For these reasons, today’s legal and tax regulations around the world pay special attention to legal transactions between related parties and are constantly being refined.

Stricter Regulation

The relationships between the trading company and its members/shareholders, members of the management board, supervisory board, and relationships among related companies are regulated by the Companies Act, the statute, or the social contract of the trading company. Transparency of transactions with related parties is achieved through the application of accounting regulations, specifically the International Financial Reporting Standards (IFRS).

The amendment to the Companies Act in 2019 incorporated the Directive on Shareholder Rights in Listed Companies into the Croatian legal system, and Articles 263a – 263d regulate transactions with related parties concerning joint-stock companies whose shares are listed on a regulated market for trading.

Related parties are ‘related enterprises or persons’ in the sense of the International Financial Reporting Standards, which have been adopted based on the currently valid edition by Commission Regulation (EC) No. 1126/2008 of November 3, 2008, on the acceptance of certain international accounting standards in accordance with Regulation (EC) No. 1606/2002 of the European Parliament and Council (OJ L 320, November 29, 2008, p. 1), which was last amended by Regulation (EU) 2018/519 (OJ L 87, April 3, 2018, p. 3). Therefore, to determine who is considered a related party, the provisions of IAS 24, which governs the disclosure of related parties, will be relevant.

Who are ‘related parties’

The mentioned standard stipulates that related parties will be considered as a person or entity that directly or indirectly, through one or more intermediaries, has control over the reporting entity or has an interest that gives it significant influence or has joint control, or is an associated entity of the reporting entity, a joint venture in which the reporting entity has an interest, a member of the management of the entity or its parent, a close family member, and an entity controlled by members of management and/or close family members.

Control implies the power to govern the financial and operating policies of the entity so as to obtain benefits from its activities. Significant influence implies the power to participate in decisions about financial and operating policies, but not control over those policies. IAS 24.10 requires that in considering relationships among entities, attention must be directed to substance over form, not just the legal form of the relationship. Therefore, attention must necessarily be directed to the economic substance of the mutual relationship. In some cases, determining related parties can be extremely complex.

Transactions among ‘related parties’

The Companies Act defines transactions with related parties as legal transactions and actions whereby an asset or some other property value is transferred, encumbered, or assigned to related parties for consideration or free of charge. Omission is not considered a legal transaction.

Furthermore, the law also provides a negative definition of transactions with related parties, stipulating that transactions with related parties are not regular transactions that the company undertakes with related parties under normal market conditions. Companies whose shares are listed on a regulated market for trading are required to conduct an internal procedure to regularly verify whether the company has conducted business with related parties in accordance with normal market conditions.

However, the company’s statute may prescribe otherwise, meaning that the company itself may stipulate that it will also consider such transactions as transactions with related parties and apply the same procedures prescribed by law for transactions with related parties. In that case, it will not be necessary to conduct an internal procedure to determine whether these are regular transactions concluded under market conditions.

Prior Consent and Disclosure

The supervisory board of a company whose shares are listed on a regulated market for trading must consent in advance to transactions that the company conducts with related parties if the value of that transaction alone or together with other transactions that the company has conducted with the related party in the last twelve months before the transaction exceeds 2.5 percent of the sum of long-term and short-term assets determined by the last annual financial statements. Long-term and short-term assets are determined in accordance with the accounting regulations in force at the time of application.

If the supervisory board denies prior consent to a transaction with related parties, the management may request that the decision of the general assembly replaces the prior consent of the supervisory board. A shareholder is excluded from voting on that decision if they are also a related party with whom the company is conducting business.

Companies whose shares are listed on a regulated market for trading must promptly publish on their websites transactions with related parties for which consent is required or in another manner that allows the public access to the notice. The notice on the company’s website must be publicly available for at least five years from the date of publication. It must contain all essential information necessary to assess whether the transaction is appropriate from the perspective of the company and shareholders who are not related parties. The content of the notice includes at least information about the nature of the relationship with the related party, the names of the related parties, the date, and the value of the transaction.

How Tax is Paid

Due to the impact that transactions among related parties can have on business results, and thus on the tax base for corporate income tax and the tax base for value-added tax, tax regulations also require that these transactions be conducted according to the arm’s length principle, i.e., under market conditions.

The General Tax Act defines related parties as two or more natural or legal persons that represent a single risk for the execution of obligations from the tax-debt relationship because one of them has, directly or indirectly, control over the other or others, or has significant influence over the other or others, or are mutually related in such a way that there is a high probability that due to the deterioration or improvement of the economic and financial condition of one person, the economic and financial condition of one or more other persons may deteriorate or improve because losses, profits, or payment capabilities can be transferred between them, or if they represent a single risk by continuously conducting activities in the same space using the same equipment.

Additionally, Article 13, paragraph 2 of the Corporate Income Tax Act stipulates that related parties for the purposes of that law are considered to be persons in which one person participates directly or indirectly in the management, supervision, or capital of another person, or the same persons participate directly or indirectly in the management, supervision, or capital of the company.

When Transactions are Recognized

Contracts and business relationships between related parties will be tax-recognized only if other persons, who are not in such a mutual relationship, would determine such contractual conditions or establish such business relationships under the same or similar circumstances (Article 49, paragraph 3 of the General Tax Act), which means that the application of the arm’s length principle is mandatory.

In relation to business between related resident and non-resident parties, the Corporate Income Tax Act explicitly stipulates (Article 13, paragraph 1) that if prices or other conditions that differ from prices or other conditions that would be agreed upon between unrelated parties are agreed upon in their business relationships, all profits in the amount that would have been realized if it were about relationships between unrelated parties are included in the tax base of the related parties.

The same rule applies to transactions between related resident parties if one of the related parties has a privileged tax status, i.e., pays corporate income tax at rates lower than the prescribed rate or is exempt from paying corporate income tax, or has the right to transfer tax losses from previous tax periods in the tax period.

Transfer Pricing

Business relationships between related parties will only be recognized if the taxpayer possesses and, at the request of the Tax Administration, provides data and information about related parties and business relationships with those parties, the methods used to determine comparable market prices, the reasons for selecting specific methods, and the manner in which adjustments are made. The methods applied to determine comparable market prices are prescribed in Article 13, paragraph 3 of the Corporate Income Tax Act: the comparable uncontrolled price method, the cost-plus method, the profit split method, and the net profit method.

The issue of transfer pricing among related parties is one of the current topics among financial directors of trading companies, which is not surprising considering the estimate that as much as 63 percent of global turnover is generated by multinational companies that have established related legal entities around the world.