Article 2
In
this era of globalisation, many Indian companies are setting up with the thrust
of capturing global market. In order to expand globally, many Indian companies
have either acquired companies abroad or have set up their own subsidiaries.
Equity could be one of the ways of funding this overseas expansion. However, in
certain instances, loan funding from parent company could require lesser
documentation, could be easier from a repayment perspective and hence relatively
simple. Where such loans to the subsidiaries are interest free, a point to be
considered is whether pursuant to the provisions of the transfer pricing
regulations as contained in S. 92 to 92F of Chapter X of the Income-tax Act,
1961, any interest income is to be imputed in the hands of the Indian parent
company.
There are recent rulings on this subject. For example, in the case of Perot
Systems TSI India Ltd. v. DCIT, (2010 TIOL 51) (Delhi Tribunal) and VVF
Limited v. DCIT, (2010 TIOL 51) (Mumbai Tribunal). It would be interesting
to note the observations made by the Tribunal while deciding the matter and the
key points for consideration emerging out of these rulings.
1. Perot Systems TSI India Ltd.
v. DCIT,
(2010 TIOL 51) (Delhi Tribunal) :
Facts :
The assessee was engaged in the business of designing and developing
technology-enabled business transformation solutions, providing business
consulting, systems integration services and software solutions and services.
The assessee had extended foreign currency loans to its associated enterprises
(‘AEs’) situated in Bermuda and Hungary. Both the entities were in start-up
phase. The loans were used by AEs for long-term investment in step-down
subsidiaries. The loans, which were interest free in nature, were granted after
obtaining the relevant approval from the Reserve Bank of India (‘RBI’).
The Assessing Officer (‘AO’) made a reference to the Transfer Pricing Officer (‘TPO’)
for determination of the arm’s-length price (‘ALP’). The TPO held that the loan
transaction was not at arm’s length. The TPO imputed interest on the loan
transaction as part of the transfer pricing assessment.
The TPO applied the Comparable Uncontrolled Price (‘CUP’) method for
determination of the ALP. The TPO used the monthly LIBOR rate and added the
average basis points charged by other companies while arriving at the
arm’s-length interest rate of LIBOR + 1.64% and thereby proposed an upward
adjustment for interest in relation to the loan transaction. The AO gave effect
to the adjustment made by the TPO in his order.
The assessee appealed before the Commissioner of Income-tax (Appeals) [‘CIT(A)’]
against the transfer pricing adjustment made. The CIT(A) upheld the order of the
AO and also denied the benefit of plus/minus 5% as provided under the proviso to
S. 92C(2) of the Income-tax Act, 1961 (‘the Act’).
Assessee’s contentions :
The assessee raised the following key contentions especially on the economic and
business expediency front to substantiate the reasons for not charging
interest :
(a) The loans provided were in the nature of quasi-equity and were used for
making long-term investments in step-down subsidiaries. The intent of extending
loan was to earn dividends and not interest.
(b) Both the entities were in the start-up phase and no lender would have lent
money to a start-up entity.
(c) The loans were granted after seeking RBI approval.
(d) The loan granted to the Hungarian subsidiary is treated as equity under the
Hungarian thin capitalisation rules and no deduction is allowed to the Hungarian
entity on payment of interest.
e) The income connotes real income and not fictitious income. The assessee placed reliance on Authority for Advance Rulings delivered in the case of Vanenburg Group B.V. for the proposition that in the absence of any income, transfer pricing being machinery provisions shall not apply.
Tribunal ruling:
The Tribunal upheld the ruling of the CIT(A) and decided the matter in favour of the Revenue. The Tribunal made the following comments/observations while ruling in favour of the Revenue:
a) The Tribunal examined the loan agreement and stated that they could not find any feature in the loan agreement which supports the contention that such a loan was in the nature of quasi-equity. The Tribunal further observed that it was not the case that there was any technical problem that the loan could not have been contributed originally as capital if it was actually meant to be capital contribution.
b) The Tribunal stated that if the assessee’s contention that interest-free loans granted to AEs should be accepted without adjustment for notional interest, it would tantamount to taking out such transactions from the purview of S. 92(1) and S. 92B of the Act.
c) The Tribunal dismissed the assessee’s contention that the loans were granted out of commercial expediency and economic circumstances did not warrant the charging of interest. The Tribunal also dismissed the assessee’s proposition that only real income should be taxed and noted that these arguments could not be accepted in the context of Chapter X of the Act.
d) The Revenue contended that the loan granted to the group entity in Bermuda was made with the intention of shifting profits to Bermuda which is a tax haven. The Tribunal concurred with the Revenue’s contention that this transaction would result in shifting profits from India, resulting in bringing down the tax incidence for the group and hence this was concluded to be a case of violation of transfer pricing norms.
e) The Tribunal agreed with the Revenue’s contention that the RBI approval of any transaction is not sufficient for Indian transfer pricing purposes and the character and substance of the transaction needs to be judged in order to determine whether the transaction is at arm’s length. The RBI approval does not put a seal of approval on the true character of the transaction from an Indian transfer pricing perspective.
f) The Tribunal also held that the assessee would not be entitled to the benefit of plus/ minus 5% as provided under the proviso to S. 92C(2) of the Act. The Tribunal held that only one LIBOR rate has been applied, which has been adjusted for some basis points and this cannot be equated with more than one price being determined so as to apply the aforesaid proviso.
2. VVF Limited v. DCIT (2010 TIOL 51) (Mumbai Tribunal):
Facts:
The assessee had two wholly-owned subsidiaries (associated enterprises) in Canada and Dubai, to whom interest-free loans had been extended. The assessee used CUP as the most appropriate method to benchmark this transaction and determined the arm’s-length price for the interest as Nil. It is pertinent to note that the assessee had taken foreign currency loan from the ICICI Bank at the rate of LIBOR plus 3% for investing in subsidiaries abroad.
The case was referred to the TPO. The TPO took into account details of borrowings by the assessee from different sources and arrived at a conclusion that the loan transactions were made out of a cash credit facility extended by Citibank at an interest rate of 14%, the same rate should be considered as ALP. Accordingly, the AO made an upward adjustment by adopting a rate of interest of 14% per annum as the ALP.
The assessee preferred an appeal before the CIT(A) and the CIT (Appeals) upheld the action of the AO.
Assessee’s contentions:
The assessee contended that since it had sufficient interest-free funds, it was justified in not charging the interest on loans given to the overseas group entities. Further, the loan was given out of commercial expediency. The assessee also argued on the principle of real income as there was no real income which can be brought to tax.
Tribunal ruling:
The Tribunal upheld the stand of the AO. While up-holding the stand of the AO, the Tribunal made the following observations:
a) The purpose of making arm’s-length adjustments is to nullify the impact of the inter-relationship between the enterprises.
b) The Tribunal held that it was irrelevant whether or not the loans were provided from interest-free funds or out of interest-bearing funds. It went on to say that CUP method seeks to ascertain the arm’s-length price taking into consideration the price at which similar transactions have been entered into. CUP method has nothing to do with the costs incurred. Thus, whether there is a cost to the assessee or not in advancing interest-free loan or whether it was commercially expedient is irrelevant in this context.
c) The Tribunal held that the appropriate CUP for benchmarking this transaction would be the interest rate charged on foreign currency lending. Thus, interest rate charged on the domestic borrowing is not the appropriate CUP in the instant case.
d) The Tribunal considered the financial position and credit rating of the subsidiaries to be broadly similar to the assessee. Accordingly, the Tribunal considered the rate at which the ICICI Bank has advanced the foreign currency loan to the assessee as ALP in the instant case.
Analysis:
The aforesaid rulings are very crucial for the simple reason that both the rulings stipulate that interest-free loan given by the Indian entity may not be viewed as at arm’s length from Indian transfer pricing perspective. This could have a significant impact on the Indian companies providing financial assistance to its overseas subsidiaries/group entities without charging any interest. Accordingly, a number of issues arise, which need to be analysed.
It is true that ordinarily, independent parties dealing with each other will not provide interest-free loans to each other. However, it would be incorrect to lay down a general principle of law that all cases of interest-free loan to subsidiaries would be non-compliant with the arm’s-length principle. The facts of each case could vary and there could be economic or commercial reasons for not charging the interest. These should be analysed independently before reaching the conclusion on the arm’s-length nature of the interest-free loan transaction.
The substance of the transaction should be given due credence. It is relevant to note that the argument on ‘quasi-equity’ was not per se rejected by the Tribunal in the case of Perot Systems. In fact, the Tribunal examined the loan agreement to as-certain the true nature of the loan transaction. The Tribunal could not find anything in the agreement which was suggestive of the fact that the loan was in effect quasi-equity. Thus, the moot point here is to demonstrate that in substance the funding instrument has characteristics of an equity as against debt. If it can be demonstrated that the economic substance of the loan is closer to equity than debt, an issue for consideration would be whether the loan is in the nature of equity so as to justify non-charging of interest. For example, if it can be demonstrated that no independent lender would have lent money to a subsidiary (on the basis of its stand-alone financial status) and the parent entity lends money to such a subsidiary, and hence the parent entity is exposed to significant risk, then the risk so assumed by the parent company could be far higher than what a pure lender of funds would be willing to undertake. The moot point therefore is whether the risk profile of such a loan transaction is closer to that of an equity transaction, and thereby making the same ‘quasi-equity’ in economic substance.
Para 1.37 of the OECD Transfer Pricing Guidelines is relevant to note in this context as it states that:
“However, there are two particular circumstances in which it may, exceptionally, be both appropriate and legitimate for a tax administration to consider disregarding the structure adopted by a taxpayer in entering into a controlled transaction. The first circumstance arises where the economic substance of a transaction differs from its form. In such a case the tax administration may disregard the parties’ characterisation of the transaction and re-characterise it in accordance with its substance. An example of this circumstance would be an investment in an associated enterprise in the form of interest-bearing debt when, at arm’s length, having regard to the economic circumstances of the borrowing company, the investment would not be expected to be structured in this way. In this case it might be appropriate for a tax administration to characterise the investment in accordance with its economic substance with the result that the loan may be treated as a subscription of capital.”
In fact, the Australian transfer pricing rules have laid down certain guiding principles to determine whether a particular loan transaction should be treated as equivalent to equity. Some of these factors are rights and obligations of lender and similarity with the rights and obligations of an equity holder, repayment rights whether subordinate to claims of other creditors, the debt equity ratio of the borrowing entity, etc.
In order to demonstrate the economic substance of the transaction, it would thus be important to appropriately document all the features of the funding instrument in the agreement/arrangement.
Moreover, the observation of the Tribunal in case of VVF that the credit rating of the subsidiary is broadly similar to that of the parent entity is in contradiction to the ruling of the Tax Court of Canada in its recent landmark ruling in case of GE Canada, on the subject of guarantee fees. The Court in this case, after examining the evidence and testimony of several expert witnesses, stated that the higher credit rating for the parent company does not automatically translate into a similar credit rating for the subsidiary. This essentially means that the risk profile of a subsidiary from a lender’s perspective could be quite different from that of the parent company, and this factor would need to be considered while determining the economic substance of the loan to the subsidiary i.e., debt or ‘quasiequity’.
Further, it is noteworthy that the Tribunal, while denying the benefit of plus/minus 5% in the case of Perot Systems, failed to recognise that the aver-age basis points figure added to LIBOR was arrived at considering the average of various basis points charged by a set of comparable companies. The Tri-bunal proceeded on the basis that LIBOR reflects only one rate and since only one rate has been used, the proviso to S. 92C(2) does not apply. LIBOR1 is a daily reference rate based on the interest rates at which banks borrow unsecured funds from other banks in the London wholesale money market. Thus, it is pertinent to note that LIBOR itself is determined based on the average of certain rates prevalent at a particular point of time. Thus, the assumption that LIBOR is only one rate may not be correct. Further, the ‘plus figure’ to LIBOR was determined based on the average of various basis points. Thus, consider-ing that a set of prices was considered, it is arguable, with due respect, that the benefit of plus/ minus 5% should have been given to the assessee.
Another important point emerging out of this ruling is that the approval obtained from other Govern-ment authorities does not necessarily approve the arm’s-length nature of the given transaction under the Indian TP regulations. In cases of payment of interest on ECB or royalty payout, quite often the RBI approval or the ceiling rate prescribed by the RBI under the respective regulation is taken as a bench-mark for determining the arm’s-length nature of such transaction. In view of this ruling, the approach of benchmarking placing reliance on approval from government authorities may need to be revisited.
The Tribunal in the case of Perot Systems also discussed the aspect of thin capitalisation rules prevalent in the borrower’s jurisdiction. In view of the Tribunal, the thin capitalisation rules prevalent in the borrower’s jurisdiction would not have any impact on the arm’s-length determination of the interest transaction in India. It is relevant to note that thin capitalisation rules in most of the jurisdictions generally prescribe the acceptable debt equity ratio. These rules only restrict the deductibility of interest for tax purposes if the debt exceeds the prescribed debt equity ratio but there is no restriction on the interest payout. This could be one of the factors which could have led the Tribunal to disregard the contention on thin capitalisation. Having said that, it is important to note that so far as thin capitalisation aspects are concerned, the grant of interest-free loan could incidentally lead to double taxation situation. The interest is deemed to accrue at arm’s length in the hands of the Indian lender and yet the loan recipient entity is unable to claim a deduction due to local thin capitalisation regulations in the home country resulting in double taxation. Thus, this aspect should also need to be taken into consideration.
Conclusion:
The rulings discussed hereinabove could have significant practical implications. The rulings on grant of interest-free loan would impact many Indian companies which have given interest-free loan to its overseas subsidiaries/group companies on account of various business reasons.
Though the aforesaid rulings stipulate that interest-free loan given to overseas group entities may not be viewed as at arm’s length, it is important to look at the economic substance of the transaction. A generalised principle cannot be laid down that in all cases of interest-free loan, interest needs to be imputed. It is thus important that the business case around such transaction is robustly built adducing sufficient economic and commercial basis. It is equally important to document the nature of the funding instrument appropriately in the agreement such that it clearly brings out the true character of the funding instrument i.e., whether it is a debt or a quasiequity. Needless to say, a robust transfer pricing study covering these aspects would be of para-mount importance.
Finally, one needs to wait and watch to see how the higher appellate authorities adjudicate on some of the observations made by the Tribunal and whether the higher appellate authorities would give some respite to the taxpayers. Till then, the taxpayers have to be extremely cautious while entering into interest-free transactions, especially in light of the aforesaid rulings.
