Transfer Pricing Regulations for Financial Transactions

Q.1 Which types of financial transactions are covered by the Transfer Pricing Regulations?

A.1 Most common Financial Transactions (FTs) undertaken between Associated Enterprises (AEs) are in the nature of loans and guarantees, as such the scope of discussion in this Article is restricted to Transfer Pricing Regulations (TPRs) pertaining to such transactions. Other types of FTs such as “Cash Pooling” and “Factoring Arrangements” etc. are not discussed in this Article.

Transfer Pricing Regulations world over primarily seek to cover inter-company loans and/or guarantees. Focus on other types of FTs under TPRs is limited.

Q.2 What are OECD’s views on loans to AEs?

A.2 There is no specific guidance in OECD’s Transfer Pricing Guidelines regarding FTs. However, OECD implicitly guides to apply the relevant method in determining the “arm’s length rate of interest” on inter-company loans. Therefore, one needs to look at the jurisdictional transfer pricing rules, if any, in determining the arm’s length rate of interest on intercompany loans between AEs.

Q.3 What are the provisions under the UN Transfer Pricing Guidelines?

A.3 The Department of Economic & Social Affairs of the United Nations has published a “Practical Manual on Transfer Pricing for Developing Nations” (Manual) in 2013. The object of this Manual is to provide clearer guidance on the policy and administrative aspects of transfer pricing analysis by developing countries. The Manual is addressed at countries seeking to apply “arm’s length standard” to transfer pricing issues. Since India has adopted the “arm’s length” principle in its Transfer Pricing regime, the Manual would provide a useful guide.

While the Manual provides a practical guidance on issues faced by developing countries, it has its inherent limitations, in that it represents views of the authors and members of the Sub-committee entrusted with the task of preparing it. Chapter 10 of the Manual represents an outline of particular country’s administrative practices as described in detail by representatives from those countries. Commenting on the practices followed by Indian Transfer Pricing Administration (ITPA), the Manual states (Paragraph 10.4.10 on page 405) that the following practices are followed by the ITPA in determination of the arm’s length pricing of inter-company loans:

• Examination of the loan agreement;
• Comparison of terms and conditions of loan agreement;
• Determination of credit rating of lender and borrower;
• dentification of comparable third party loan agreement;
• Suitable adjustments to enhance comparability

The ITPA prefers to apply the Prime Lending Rate (PLR) of Indian banks for outbound loans (i.e., loans advanced by an Indian Company to its overseas AEs), on the premise that loans are advanced from India in Indian currency which are subsequently converted into foreign currency. This stand is formally accepted and incorporated into the Safe Harbour Rule which provides for acceptable interest rates based on Prime Lending Rates of Indian Banks.

However, the above stand of the Tax Department has been challenged by tax payer and the Tribunal has ruled in favour of the tax payers. (Refer answer to question no. 6 infra).

Q.4 What are the provisions under the Income-tax Act, 1961?

A.4 Explanation to section 92B has been retrospectively amended vide Finance Act 2012 to bring FTs under TPRs in India. Accordingly, the following Clause has been added to the definition of the term “International Transaction”:

“Explanation—For the removal of doubts, it is hereby clarified that—

(i) the expression “international transaction” shall include—

(c) Capital financing, including any type of longterm or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business;

From the above explanation, it is clear that loans and guarantees between AEs are covered under the TPRs of India retrospectively w.e.f. 1st April 2002.

Safe Harbor Provisions as applicable to loan transactions [Notified on 18th Sept. 2013 applicable for Five Assessment Years beginning from AY 2013-14]

Q.5 Under what circumstances interest free loan can be justified?

A.5 Interest free loans prima facie are not at arm’s length as normally a lender would not give any interest free loans to a stranger. However, the lender may justify such loan to its AE on considerations other than interest. For example, if the interest free loan is in the nature of quasi capital, then it can be justified.

In April 2002, the Central Government constituted an Expert Group to recommend transfer pricing guidelines for companies for pricing their products in connection with the transactions with related parties and transactions between different segments of the same company. The Group submitted its Report in August 2002. It generally recommended arm’s length principle except in following cases:

“Exceptions to arm’s length transfer price

• the Board of Directors as well as the audit committee of the Board are satisfied for reasons to be recorded in writing that it is in the interest of the company to do so, and
• the use of a non-arm’s length transfer price, the reasons therefore, and the profit impact thereof are disclosed in the annual report

Remarks: Examples of such exceptional cases could be a company giving an interest free loan to a loss making subsidiary or a company accepting the offer of a controlling shareholder to work as the CEO on a nominal salary.”

However, the same Report identifies “Borrowing or lending on an interest-free basis or at a rate of interest significantly above or below market rates prevailing at the time of the transaction” as one of the undesirable corporate practices related to transfer pricing.

In nutshell, interest free loans may be justified in following circumstances:

• When loan has more of an equity substance than loan i.e. it is in the nature of Quasi Capital.

The Australian Taxation Office in its Discussion Paper on “Intra-group Finance Guarantees & Loans Application of Australia’s Transfer Pricing and Thin Capitalization Rules –June 2008” (paragraph 58 on page 15 of the Paper) has opined that to the extent that the debt funding performs the role of an equity contribution it would seem appropriate that portion of the debt funding be regarded as quasi equity and that it be costed on an interestfree basis, consistent with its purpose and effect. This is in line with the OECD view that the cost of funding a company’s participation is a ‘shareholder activity’ and that it would not justify a charge to the borrowing company.

On  the  peculiar  facts  of  the  case,  (where  loan was  converted  into  equity  upon  receipt  of  RBI approval)  the  Tribunal,  in  case  of  Micro  Inks  Ltd. vs.  ACIT  [2013]  36  taxmann.com  50,  held  that  the loan  provided  was  in  the  nature  of  quasi  capital. One  of  the  interesting  observations  made  by  the Tribunal  was  regarding  consideration  of  the  com- mercial  business  consideration  between  AEs.  The Tribunal  held  that  sustainability  of  business  of  the step  down  subsidiary  in  USA  was  crucial  to  the Indian company (who advanced loan to it) in view of  the  fact  that  the  Indian  company  has  substan- tial  business  transactions  with  it  and  therefore  it would  not  be  appropriate  to  equate  the  relations between  AEs  to  that  of  a  lender  and  a  borrower.

The  above  observations  are  significant  as  in  ear- lier  in  case  of  VVF  Ltd.  [2010]  TII  4  ITAT,  the Mumbai Tribunal held that commercial expediency to  be  irrelevant  as  the  impact  of  any  such  inter- relationship  should  be  neutralised  by  arm’s  length treatment.  Further,  in  the  case  of  Perot  Systems TSI India Ltd. [2010] 130 TTJ 685, the Delhi Tribunal had refused to accept the contention of the as- sessee that the outbound loan  was  quasi  capital in nature on the grounds that no lender  would  lend money to new company or the intention of  the lender company was to earn dividends  and  not interest.

•  Loan is in the nature of a Hybrid Instrument.

The loan may be structured in the form of con- vertible debentures or bonds where there may not be any interest or very low interest for the initial period and may be converted into equity at a later date. This may be resorted by a parent company   to give sufficient time to its subsidiary to make profit without much financial burden.

Every case of thin capitalisation may not be to avoid tax. Sometimes, host countries regulations justify low equity and high debt especially when companies do not want to compromise on liquid- ity. Moreover, loans require less documentation, highly flexible in their repayment and lending in- stitutions also take them at par with equity when they are from AEs.

Q.6If interest has to be charged on inter-company loans, how does one bench mark it? Who shall be the tested party – the borrower or the lender?

Also elucidate on Separate/Standalone Entity Approach vs. Group Entity/On-lending Approach

A.6    Indian Transfer Pricing Regulations do not have special rules (except in case of Safe Harbor Rules) or guidance on benchmarking loan transactions between AEs. However, one needs to apply general provisions of transfer pricing regulations while determining arm’s length interest rate on loans between AEs.

Consider a case where an Indian Company “A” has advanced loan to its wholly owned subsidiary “B” in UAE. While undertaking the benchmarking analysis to determine arm’s length rate of interest, often a dilemma arises as to whether one should look at the rate at which “B” would have  been  able  to  borrow  in UAE market or the rate at which ‘A” would have earned interest, had it advanced loan to    a non-related party. Normally, Indian Entity is used as a tested  party and also it being the assessee under the Indian Transfer Pricing Regulations, benchmarking of in- terest charged is done from Indian Entity’s point   of view. In the given example, what company “A” would have earned had it given a loan to non AE would be relevant. For determining income of “A” in an arm’s length scenario, sources of funds  of “A” i.e., cost of funds (i.e. whether it is back to back loan or out of internal accruals), foreign ex- change risks, risk of default, availability of internal or external CUP etc. would be relevant.

As stated earlier, in such a scenario, Indian Transfer Pricing Administration would prefer to apply Prime Lending Rate of the Company  A’s  bank  in  India  as an external CUP as loan would be advanced  from India in Indian currency rather than LIBOR or EURIBOR. The idea seems to arrive at opportunity cost of earning, i.e., if Company “A” would have advanced similar loan to Company “B” in India, what would have been the rate of interest?

On  similar  facts,  in  case  of  Bharti  Airtel  Ltd.  vs. ACIT  [2014]  43  taxmann.com  150  (Del.  Trib.),  the assessee  contended  that  the  loans  were  given  in foreign  currencies  and  in  the  international  market where  the  bank  lending  rates  are  based  on  LIBOR rates. Hence, the LIBOR rate should be considered for determining the arm’s length interest rate. The Tribunal  upheld  the  contentions  of  the  assessee.

In case of M/s. Siva Industries & Holdings Ltd. vs. ACIT [(I.T.A. No. 2148/Mds/2010) paragraph 11], the Chennai Tribunal held that “Once the transaction between the assessee and the Associated Enter- prise is in foreign currency and the transaction is   an international transaction, then the transaction would have to be looked upon by applying the commercial principles in regard to international transaction. If this is so, then the domestic prime lending rate would have no applicability and the international rate fixed being LIBOR would come into play. In the circumstances, we are of the view that it LIBOR rate which has to be considered while determining the arm’s length interest rate in respect of the transaction between the assessee and the Associated Enterprises”.

Thus, one has to benchmark the Indian entity and find out what interest it would have earned, had it advanced loan to an independent entity operating in same circumstances, located in the same market and on similar terms and conditions. In the process one also needs to benchmark the borrower based on the separate entity approach taking into account the circumstances in which it operates.

General Rules of Transfer Pricing Analysis suggest that one needs to arrive at arm’s  length  inter-  est rate as if Company “B” is an independent/ standalone entity. Here one needs to examine various factors such as terms and tenor of loan, guarantee offered, nature of interest rate such as fixed vs. floating, the overall financial market in UAE, credit rating of “B”, nature of loan instru- ment i.e., whether pure loan or hybrid instrument with conversion option etc. Thus if “A” were to lend to any  other  independent  entity  operating  in UAE with similar terms and conditions, then what it would have earned or if there is any  other comparable data already available in public domain then that may be used.

In real life situations company “B” would be able  to borrow at LIBOR linked rate. Therefore, the starting point of benchmarking analysis would be LIBOR which may further be fine tuned consider- ing various factors other discussed above.

Thus, one may conclude that while arriving at the arm’s length interest rate especially in case of outbound loans from India, one may take LIBOR/ EURIBOR, as the case may be, as base rate and make adjustments to arrive at arm’s length interest rate taking into account facts  and circumstances in the country in which the borrower AE operates.

It may however be noted that the Safe Harbor Rules in India does  not  support  above  view  and it requires Indian entity to apply the interest rate based on the Base Rate of State Bank of India . (Refer answer to Q.4 supra). It may also be noted that Safe Harbor Rules prescribes “acceptable price/ range of margins and/or rate of interest” without determining arm’s length price,  margin or interest. More often than not, unilateral Safe Harbor Rule results in litigation in the opposite country as the acceptable range in one country would  lead  to loss of revenue  in the other country.

Group Entity or On-lending Approach
Another approach which is followed  is  known as Group Entity or On-lending Approach. In this case, the taxpayer has a central treasury which raises loan at the group level and then allocates funds to various subsidiaries. In this case,  there  will not be a separate evaluation of subsidiary’s borrowing capacity or credit rating as the loan is advanced at the group level and therefore implic- itly subsidiary assumes the same credit  rating  as its parent. This approach makes sense in real life commercial/financial world.

However, the standalone entity approach is widely practiced as it supports arm’s length standard. Even OECD prefers this approach.

Australian Transfer Pricing Rules
The  Australian  Transfer  Pricing  Rules  have  been comprehensively amended for the first time in past 30  years  vide  Tax  Laws  Amendment  (Countering Tax  Avoidance  and  Multinational  Profit  Shifting) Act  2013.

The  new  rules  are  applicable  for  income  year  on or  after  1st  July  2013.  The  new  rules  provide  for independent/standalone  party  approach.  Australia also has Thin Capitalisation Rules in place. The new rules provide that in order to determine the arm’s length  conditions  between  two  AEs  on  the  same footing  as  they  may  exist  between  two  indepen- dent enterprises, one may need to consider issues such as whether independent entities operating in comparable  circumstances  would  have  advanced loans  with  the  same  or  similar  characteristics, provided  various  forms  of  credit  support,  sought to  refinance  at  a  different  market  interest  rate, issued  shares  or  paid  dividends.

In short, the taxpayers need to:

•    Assess if the quantum of debt meets arm’s length conditions.

•    Consider if the capital structure (debt/equity mix) is arm’s length.

•    Re-consider the interest rate with regard to fac- tors such as the impact of the rate on profits    of the company, and whether or not the rate     is adjusted as the parent company’s cost of funds changes.

Q.7 Are there any judicial precedents in India  on  the above issue?

A.7So far decisions on the issue of inter-company loans have come from Tribunals only. Ratios laid down by various decisions are as follows:

Other Relevant Decisions:

•    Tata Autocomp Systems Ltd. vs. ACIT [2012] 21 taxmann.com 6 (Mum.)
•    Aurinpro Solutions Ltd. vs. ADCIT [2013] 33 taxa- mann.com 187 (Mum.)
•    Mascon Global Ltd. vs. DCIT ITA No. 2205/
MDS/2010
•    Four Soft Limited vs. DCIT – TS-518-ITAT-201 (Hyd)
•    DCIT vs. Tech Mahindra Ltd. [2011] 12 taxmann. com 132(MUM.)
•    Aithent Technologies (P.) Ltd. vs. ITO [2012] 17 taxmann.com 59 (Del)
•    Mahindra & Mahindra vs. DCIT – TS-408-ITAT- MUM-2012
•    Cotton Naturals (I) (P.) Ltd. vs. DCIT [2013] 32 taxmann.com 219 (Del-Trib)
•    Hinduja Global Solutions Ltd. vs. ADCIT – TS-147- ITAT-MUM-2013
•    ITO vs. Maharishi Solar Technology Pvt. Ltd. TS- 306-ITAT-2012-DEL

for outbound loans. At  times  benchmarking of inbound transactions is more crucial than outbound as it results in base erosion, interest being deductible expense.

Though  India  does  not  have  Thin  Capitalisation Regulations  in  place,  it  has  robust  Foreign  Ex- change  Laws  which  regulates  borrowing  from overseas.  Borrowing  from  overseas  shareholder requires  minimum  25  %  of  shareholding.  There  are several  restrictions  for  use  of  borrowed  money as  well  as  the  sectors  which  can  borrow.  For example  only  real  sector  (i.e.  industrial  sector), infrastructure  sector  and  certain  service  sectors such  as  software,  hospital  and  hotel  are  allowed to  borrow  from  overseas.  Borrowing  for  general corporate  purpose  or  for  working  capital  require- ment  is  practically  banned.

The biggest benchmarking or safe harbor limit (so to say) is contained in “all-in-cost borrowing limit” prescribed under the Foreign Exchange Manage- ment Act, 1999 (FEMA). Since RBI does not allow payment of interest beyond this limit, generally payment of interest at the rate  prescribed  by RBI should be considered as arm’s length. One may draw support for this contention from  the  fact that the Indian Safe Harbor Rules prescribes the acceptable limit of minimum interest to be charged for loans advanced by Indian entity  (i.e. for outbound loans) but does not prescribe limit
 
From the above case laws, it is apparent that different tribunals have taken divergent views. Transfer pricing cases being  more  facts  based,  it is difficult to arrive at standard conclusion and perhaps that is why transfer pricing analysis is regarded as an “art” and not a “science”.

However, Tribunals have upheld application of LIBOR rate for determination of arm’s length inter- est rate in contradiction of Indian Transfer Pricing Administration’s stand of applying PLR of Indian Banks. It would be interesting to see how this jurisprudence develops further at higher forums.

Inbound Loans

Q.8 What are the provisions applicable to inbound loans?

A.8    The same transfer pricing rules and regula- tions apply to inbound loans as are applicable or maximum interest that may be allowed as deduction on inbound loans.

Present limits of all-in-cost borrowing under External Commercial Borrowing (ECB)  route  are  as follows:

All-in-cost limit includes rate of interest, other fees and expenses in foreign currency except commit- ment fee, pre-payment fee, and fees payable in Indian Rupees.