Delhi High Court: 6 April 2015, Sanjiv Khanna
Entire law on determining ALP of transaction of loan of money to AE discussed
The assessee advanced a loan to its whollt-owned subsidiary in the USA. The assessee selected the Comparable Uncontrolled Price method (CUP) to benchmark the interest received on the loan and claimed that the interest received at the rate of 4% was comparable with the export packing credit rate obtained from independent banks in India. The TPO held that the arm‘s length interest rate should be taken as 14% p.a. This was reduced to 12.20% by the DRP by adopting the Prime Lending Rate fixed by the Reserve Bank of India. On appeal by the assessee, the Tribunal relied on Siva Industries and Holding, Tech Mahindra, Tata Autocomp Systems etc and upheld the assessee’s claim. On appeal by the department to the High Court, the appeal was dismissed:
(i) The reasoning recorded by the TPO suffers from a basic and fundamental fallacy. Transfer pricing determination is not primarily undertaken to re-write the character and nature of the transaction, though this is permissible under two exceptions. Chapter X and Transfer Pricing rules do not permit the Revenue authorities to step into the shoes of the assessee and decide whether or not a transaction should have been entered. It is for the assessed to take commercial decisions and decide how to conduct and carry on its business. Actual business transactions that are legitimate cannot be restructured. It is not uncommon for manufacturers cum exporters to enter into distribution and marketing agreements with third parties or incorporate subsidiaries in different countries for undertaking marketing and distribution of the products (CIT versus EKL Appliances Limited (2012) 345 ITR 241 (Delhi) referred);
(ii) Two exceptions have been allowed to the aforesaid principle and they are (i) where the economic substance of a transaction differs from its form and (ii) where the form and substance of the transaction are the same but arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner;
(iii) The assessee’s act of incorporating a subsidiary in United States was done with the intention to expand and promote exports in the said country and was a legitimate business decision. The transaction of lending of money by the assessee to the subsidiary, should not be seen in isolation, but also for the purpose of maximising returns, propelling growth and expanding market presence. The reasoning of the TPO ignores the said objective facet. Transfer pricing rules treat the domestic AE and the foreign AE as two separate entities and profit centres, and the test applied is whether the compensation paid for the products and services is at arm‘s length, but it does not ignore that the two entities have a business and a commercial relationship. The terms and conditions of the commercial business relationship as agreed and undertaken are not to be rewritten or obliterated. Transfer pricing is a mechanism to undo an attempt to shift profits and correct any under or over payment in a controlled transaction by ascertaining the fair market price. This is done by computing the arm‘s length price. The purpose is to ascertain whether the transfer price is the same price which would have been agreed and paid for by unrelated enterprises transacting with each other, if the price is determined by market forces. The first step in this exercise is to ascertain the international transaction, which in the present case is payment of interest on the money lent. The next step is to ascertain the functions performed under the international transaction by the respective AEs. Thereafter, the comparables have to be selected by undertaking a comparability analysis. The comparability analysis should ensure that the functions performed by the comparables match with the functions being performed by the AE to whom payment is made for the services rendered.
(iv) Rules 10B and 10C of the Income Tax Rules, 1962 indicate factors that ought to be taken into account for selection of the comparables, which necessarily include the contractual terms of the transaction and how the risks, benefits and responsibilities are to be divided. The conditions prevailing in the market in which the respective parties to the transactions operate, including the geographical location and the size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition, are all material and relevant aspects. If we keep the aforesaid aspects in mind, it would be delusive not to accept and agree that as per the prevalent practice, subsidiary AEs are often incorporated to carry on distribution and marking function. This is not an unusual but common. Once this is accepted, then we cannot accept the reasoning given by the TPO that the transfer pricing adjustment could restructure the transaction to reflect maximum return that a party could have earned and this would be the yardstick or the benchmark for determining the interest payable by the subsidiary AE. This is not what Chapter X of the Act and Rules mandate and stipulate. The aforesaid provisions neither curtail the commercial freedom, nor do they bar or prohibit a legitimate transaction. They permit transfer pricing adjustment so as to bring to tax what would have been paid for the transaction in the same or similar comparable circumstances by an independent third party.
(v) This ratio and rationale, when applied to the facts of the present case, would mean that the transfer pricing determination would decide what an independent distributor and marketer, on the same contractual terms and having the same relationship, would have earned/paid as interest on the loan in question. What an independent party would have paid under the same or identical circumstances would be the arm’s length price or rate of interest. What the assessed would have earned in case he would have entered into or gone ahead with a different transaction, say with a party in India, is not the criteria. What is permitted and made subject matter of the arm‘s length determination is the question of rate of interest and not re-classification or substitution of the transaction.
(vi) The comparison, therefore, has to be with comparables and not with what options or choices which were available to the assessed for earning income or maximizing returns. Importantly, the TPO, DRP and the Assessing Officer have all accepted that the respondent assessee had adopted and applied CUP Method for computing arm‘s length interest payable by the subsidiary AE. To this extent, there is no lis or dispute.
(vii) We express our inability to accept that commercial expediency and related benefits have no connection or relationship with the rate of interest. In terms of Clause (c) and (d) to Rule 10B (2), contractual relations or terms, and other material facts should be recognized. Having said so, we do accept the force of the alternative argument advanced that this fact could be of marginal significance and effect. It would be for the assesse to show and prove that a transaction separately benchmarked, included consideration for the lower interest rate being paid.
(viii) We do not agree with the finding recorded by the TPO that the comparable test to be applied is to ascertain what interest would have been earned by the assessed by advancing a loan to an unrelated party in India with a similar financial health as the taxpayer‘s subsidiary. The aforesaid reasoning is unacceptable and illogical as the loan to the subsidiary AE in the instant case is not granted in India and is not to be repaid in Indian Rupee. It is not a comparable transaction. The finding of the TPO that for this reason the interest rate should be computed at 14% per annum i.e. the average yield on unrated bonds for Financial Years (FY, for short) 2006-07, has to be rejected.
(ix) The question whether the interest rate prevailing in India should be applied, for the lender was an Indian company/assessee, or the lending rate prevalent in the United States should be applied, for the borrower was a resident and an assessee of the said country must be answered by adopting and applying a commonsensical and pragmatic reasoning. We have no hesitation in holding that the interest rate should be the market determined interest rate applicable to the currency concerned in which the loan has to be repaid. Interest rates should not be computed on the basis of interest payable on the currency or legal tender of the place or the country of residence of either party. Interest rates applicable to loans and deposits in the national currency of the borrower or the lender would vary and are dependent upon the fiscal policy of the Central bank, mandate of the Government and several other parameters. Interest rates payable on currency specific loans/ deposits are significantly universal and globally applicable. The currency in which the loan is to be re-paid normally determines the rate of return on the money lent, i.e. the rate of interest. (UN Model Double Taxation Convention Between Developed and Developing Countries & OECD Model Convention Commentary, Chapter 10 of the U.N. Transfer Pricing Manual etc considered)