Section 92CE and Section 94B – Analysis and Some Issues

This article deals with some of the issues which warrant
attention with respect to section 92CE and section 94B of the Income-tax Act
1961, (Act) as introduced by the Finance Act 2017. 

Section 92CE – Secondary adjustment in certain cases

1.      As per the memorandum explaining the
provisions of the Finance Bill 2017, the provision has been introduced to align
transfer pricing provisions with the OECD transfer pricing guidelines and the
international best practices. The said memorandum explains that “Secondary
adjustment” means an adjustment in the books of accounts of the assessee
and its associated enterprise to reflect that the actual allocation of profits between
the assessee and its associated enterprise are consistent with the transfer
price determined as a result of primary adjustment, thereby removing the
imbalance between cash account and actual profit of the assessee. The OECD
recognises that secondary adjustment may take the form of constructive
dividends, constructive equity contributions, or constructive loans. India has
opted for form of secondary adjustment i.e. constructive advance.

2.1.   The section provides that the assessee shall
make a secondary adjustment in certain cases only i.e. where the primary
adjustment to transfer price,

a)  has been made suo motu by the assessee
in his return of income; or

b)  has been made by the Assessing Officer (AO)
and accepted by the assessee; or

c)  is determined by an advance pricing agreement
entered into by the assessee u/s. 92CC; or

d)  has been made as per the safe harbour rules
framed u/s. 92CB; or

e)  is arising as a result of resolution of an
assessment by way of the mutual agreement procedure under an agreement entered
into u/s. 90 or 90A.

2.2.    The provisions will apply only if the
primary adjustment exceeds INR one crore and the excess money attributable to
the adjustment is not brought to India within the prescribed time. From the
above, it is clear that the provision will have a limited applicability and
hence there is no need for the panic. In fact, it will be interesting if the
Government publishes the data that in the last decade of transfer pricing
scrutiny, how many cases were covered by aforesaid clauses.

2.3.    As regards clause (b), once the primary
adjustment made by the AO is contested by the assessee in appeal, he will not
be covered by the same even if the appellate authority upheld the adjustment
made by the AO and assessee accepts the said addition.

2.4.    The taxpayer invoking the MAP to resolve the
transfer pricing dispute needs to be mindful of this provision. In fact, there
is a possibility that the taxpayer may be discouraged to resolve the transfer
pricing dispute through MAP because of this provision.

3        The assessee is not required to make any
secondary adjustment in respect of any primary adjustments made in the
assessment year 2016-17 or any of the earlier years. In other words, the
assessee shall make secondary adjustment only in respect of primary adjustment
made in the assessment year 2017-18 and subsequent years. The provision is
applicable in relation to the assessment year 2018-19 and subsequent years.
Thusfore, the assessee is expected to make a secondary adjustment from   AY 18-19 in respect of primary adjustments
made in AY 17-18 or subsequent years.

4        Section 92CE(3) (iv) provides that
“primary adjustment” to a transfer price means the determination of transfer
price in accordance with the arm’s length principle, resulting in an increase
in the total income or reduction in the loss, as the case may be of the
assessee. The wordings of the definition are not clear and do not seem to
reflect legislative intent.

          In my view, primary adjustment is the
increase in the income or reduction in the loss of the assessee as a result of
the computation of income u/s. 92C(4) r.w.s 92. i.e. if the taxpayer has
imported the goods worth INR 100 from its AE and if the AO computes the ALP of
such import at INR 95, he will increase the income of the taxpayer by INR 5 and
the same would be regarded as the primary adjustment. If the case of the
taxpayer falls in any of the cases listed in paragraph 2.1 above, he is
required to make a secondary adjustment.

5.1     What
secondary adjustment is envisaged? and when should the assessee make the
secondary adjustment? In the above case, the assessee has already made payment
of INR 100 towards the import to the AE and the AE is sitting with the fund
representing the primary adjustment i.e INR 5 .The assessee is required to
debit the account of the AE and credit the profit and loss account (P&L
A/C) with the amount of the primary adjustment. If the amount representing the
debit balance in the account of the AE is repatriated to India within the
stipulated time, no further consequence arises. However, if the amount is not
repatriated to India, the said debit balance in the account of the AE would be
deemed to be an advance made by the assessee to the AE and the interest on such
advance is required to be computed in a prescribed manner.

5.2     The timing of the secondary adjustment in
the books would possibly vary from case to case and would depend on the exact
clause of section 92CE(1) under which the primary adjustment is made. If the
primary adjustment is made suo motu by the assessee in his return of
income, the same should be done in the same year. However, if the assessee is a
company and its accounts are closed, it will have to comply with provisions of
the Companies Act and make the adjustment in the books in accordance with the
Companies Act. 

6        Further issues that may arise in this
regard are:

6.1     Whether the credit to P&L A/C would
form part of book profit for the purpose of section 115JB? Considering the
provision of section 115JB and 92CE, it appears that the said credit would form
part of the book profit.

6.2     Whether the section envisages a
identification of the AE which can be correlated to the primary adjustment and
rule out the mandate to carry out secondary adjustment in other cases?

          In practice, an assessee enters into
various transactions with different AEs and the TPO makes an overall adjustment
following TNM method without identifying the exact transaction or the AE. In
such cases, a question will arise as to which AE’s account is to be debited for
secondary adjustment. Should the adjustment be prorated to various AEs? If the
primary adjustment cannot be identified with an AE, a view may be taken that
the obligation to carry out secondary adjustment does not arise.

6.3   Whether the debiting the account of the AE
with the primary adjustment be regarded as constructive payment? If yes, it may
further require examining the applicability of the provisions of section
2(22)(e) especially when the AE holds more than the threshold level of shares in
the Indian company.

          It must be noted that the deeming
fiction are to be strictly construed and should be confined to the purpose for
which they are enacted. Hence, the primary adjustment which is deemed to be an
advance made by the assessee to its AE should be confined to that only and
should not be extended to any other provision.

6.4     The section requires adjustment in the
books of account of the AE also. Whether the same is warranted, whether the
same is in the control of the assessee and what if it is not carried out in the
books of the AE? If the adjustment is not carried out in the books of the AE,
then the assessee has not carried out the secondary adjustment as envisaged
u/s. 92CE(1) and further consequences in accordance with law should follow.

6.5     The section provides that the assessee
shall make the secondary adjustment, i.e. the assessee is under an obligation
to carry out secondary adjustment. What if the assessee does not make such
adjustment? Whether the existing provisions under the Act are enough to empower
the revenue authorities to make such adjustment when the assessee does not make
such adjustment?

        Currently, there is no separate penal
provision for non-compliance with section 92CE. However, one needs to examine
whether there is an under reporting or misreporting of the income within the
meaning of section 270A when the assessee does not carry out the secondary
adjustment when it is under an obligation to carry out the same.

7    Recently, revenue has made primary
adjustment in the case of nonresident associated enterprises (AE) and such
adjustment has been upheld by the Tribunal i.e. the non-resident should have
earned more royalty from the Indian resident assessee. The newly inserted
section 92CE requires the assessee to repatriate the excess money attributable
to primary adjustment to India. Thus, obviously there cannot be any secondary
adjustment when the primary adjustment is made in the case of foreign AE, since
there cannot be any question of repatriation to India in such cases. In fact,
logically it may require the Indian resident to remit the amount to the non
resident AE representing primary adjustment. This becomes an additional
argument to advance the case of the assessee that primary adjustment cannot be
made in the case of foreign AE.

8       The language of the section needs
attention of the draftsmen so as to bring home the intent and also to provide
clarity and certainty. The following may be noted in this respect:

8.1     In addition to the other terms, the section
defines the term “primary adjustment” and “secondary adjustment”. It may be
noted that sub-section (1) provides that the assessee shall make a secondary
adjustment where there is a primary adjustment to transfer price in certain
cases. However, neither the term “transfer price” nor the term “primary
adjustment to transfer price” is defined either in the section or in the
relevant chapter.

8.2     There is no link between sub-section (1)
and sub-section (2) of the section and hence there is an apprehension that the
deeming fiction of treating the amount representing the primary adjustment as
advance and further consequence as provided in sub-section (2) is applicable to
all cases and not confined to those covered by sub-section(1). However, If
sub-section (2) is interpreted in this manner, then consequence of sub-section
(1) would stop at passing the entry in the books of the assessee. The debit
balance in the books need not be repatriated and would be treated in accordance
with the other provisions. The above does not seem to be the intention. The
intention of the legislature is achieved only when both sub sections are read
together. However, this anomaly in the drafting needs to be corrected.

Section 94B – Limitation on Interest deduction in certain
cases

9        The provision has been introduced to
address the issue of thin capitalisation. The memorandum explaining the
provisions of the Finance Bill 2017 states “A company is typically financed or
capitalised through a mixture of debt and equity. The way a company is
capitalised often has a significant impact on the amount of profit it reports
for tax purposes as the tax legislations of countries typically allow a
deduction for interest paid or payable in arriving at the profit for tax
purposes while the dividend paid on equity contribution is not deductible.
Therefore, the higher the level of debt in a company, and thus the amount of
interest it pays, the lower will be its taxable profit. For this reason, debt
is often a more tax-efficient method of finance than equity. Multinational
groups are often able to structure their financing arrangements to maximise
these benefits. For this reason, the country’s tax administrations often
introduce rules that place a limit on the amount of interest that can be
deducted in computing a company’s profit for tax purposes. Such rules are
designed to counter cross-border shifting of profit through excessive interest
payments, and thus aim to protect a country’s tax base……….”

        In view of the above, it is proposed
to insert a new section 94B, in line with the recommendations of OECD BEPS
Action Plan 4, to provide that interest expenses claimed by an entity to its
associated enterprises shall be restricted to 30% of its earnings before
interest, taxes, depreciation and amortisation (EBITDA) or interest paid or
payable to associated enterprise, whichever is less.

10.1   It provides that the deduction towards interest
incurred by an Indian company or permanent establishment of a foreign
company (specified entity or borrower) in respect of any debt issued by its non-resident
AE (specified lender) will be restricted while computing its income under the
head “profits and gains of business and profession”. The deduction will be
restricted to 30% of earnings before interest, taxes, depreciation and
amortisation (EBITDA) or the actual interest whichever is less.

10.2   The restriction will be applicable only if
the borrower incurs expenditure by way of interest or of similar nature
which exceeds INR one crore in respect of debt issued by the specified lender.
In other words, when such payment is less than INR one crore, the claim for
interest will not be restricted to 30% of EBIDTA. i.e If the EBIDTA is one
crore and such payment is 40 lakh, the claim for interest will not be
restricted under this section. The restriction is also not applicable to
borrower which is engaged in the business of banking or insurance.

10.3   At times, the restriction will apply even if
the debt is issued by a third party which is not an AE. This will be the case
when the AE (resident or non-resident) provides an express or implicit
guarantee in respect of the debt or it places deposit matching with loan fund
with the third party. In such a case debt which is issued by a third party shall
be deemed to have been issued by an AE.

11    The amount so disallowed will be carried
forward and will be eligible for deduction for the next eight assessment years.
However, the deduction for the carried forward amount will be allowed in the
same manner subject to the same upper limit.

12.1   The provision is applicable only when the
expenditure towards “interest or of similar nature” exceeds INR one
crore. The term interest is defined u/s. 2(28A) of the Act. However, a question
may arise as to what can be included within the term “of similar nature”? It
may be noted that the term “debt” has been defined and one can draw on this
definition so as to understand what other nature of payments are likely to be
covered by the term “of similar nature.”

12.2   Section 94B(5)(ii) states that “debt” means
any loan, financial instrument, finance lease, financial derivative, or any
arrangement that gives rise to interest, discounts or other finance charges
that are deductible in the computation of income chargeable under the head
“Profits and gains of business or profession.”

12.3   It needs to be noted that the restriction
towards deduction is applicable to only “interest” expenditure, though for the
purpose of applying threshold limit of INR one crore, one needs to take into
account expenditure of similar nature together with interest.

13      The section provides for the cases when
the debt will be deemed to be issued by the AE. One such case is when there is
an implicit guarantee provided by the AE to the third party lender.
This provision has the potential to create litigation and hence there needs to
be a very clear guidance as to what are the circumstances that could be
regarded as provision of implicit guarantee.

14.1   Whether a special provision dealing with
interest in section 94B excludes applicability of section 92 to such interest
payment? It does not seem to be so. Thus, there can be situations when there is
interplay of both the sections. i.e EBIDTA of the Indian company is INR 20
crore and the interest payment to AE is INR 10 crore. Such interest is paid
@10%. Arm’s length interest rate determined u/s. 92 is 6.5%. This would lead to
an adjustment of INR 3.5 crore u/s. 92. Section 94B would restrict the
deduction of interest to 30% EBIDTA i.e 6 crore. Thus, the income of the Indian
company would be increased by INR 7.5crore.(3.5 crore u/s. 92 and 4 crore u/s.
94B). This leads to an absurd result and does not seem to be intention of the
law.

14.2   In my view, the base for disallowance u/s.
94B should be substituted after giving effect to the adjustment u/s. 92 i.e to
6.5 crore from 10 crore. This will have the effect of restricting the
disallowance u/s. 94B to 50 lakh resulting into an aggregate adjustment of only
4 Crore. Thus, any increase or decrease in the adjustment u/s. 92 will have
consequential impact on the limitation u/s. 94B. The interplay needs to be
clarified by CBDT with examples. 

15      In the above example, section 92CE
requires the assessee to make a secondary adjustment of 3.5 crore in respect of
the primary adjustment made u/s. 92. The Indian company is required to charge
interest on the said deemed advance. Thus, there will be a debit to the
interest account and credit to the interest account in respect of the same
lender in subsequent years. Can such debit and credit be net off while applying
provisions in subsequent years? This question will not arise if the assessee
maintains only one account of the AE in its books and passes the debit entry
for the deemed advance in the same account.

16      The deduction towards interest is
restricted only when the lender is non-resident. In other words, if the lender
is a resident AE, the restriction will not apply. Would it meet the provision
of non-discrimination article in a treaty when the non-resident is a resident
of a treaty country?

          Relevant extract of Article 24(4) of
the OECD and UN model convention (both are identical) is reproduced hereunder
for ready reference:

24(4)
Except where the provisions of paragraph 1 of Article 9, paragraph 6 of Article
11 or paragraph 4 of Article 12, apply, interest, royalties and other
disbursements paid by an enterprise of a Contracting State to a resident of the
other Contracting State shall, for the purpose of determining the taxable
profits of such enterprise, be deductible under the same conditions as if they
had been paid to a resident of the first-mentioned State…..