Entire law on transfer pricing implications of (i) allowing excess credit to AE’s on account of sale of goods and (ii) issue of corporate guarantee to AEs (after insertion of Explanation i(c) to s. 92B by FA 2012) explained (Dec 3, 2015)
The Tribunal had to consider two issues:
(i) Whether if goods are sold to an Associated Enterprise and the AE is allowed a credit period which is higher than the credit period allowed to independent enterprises, i.e. non AEs, an ALP adjustment is warranted in respect of the ‘excess credit period’ allowed to the AE;
(ii) Whether an arm’s length price adjustment is permissible on account of corporate guarantees given by the assessee in respect of its AEs.
HELD by the Tribunal:
As regards the interest on the excess credit period:
(i) If the international transaction of exports of goods which has been benchmarked on TNMM basis is duly accepted by the TPO, making an adjustment for interest on excess credit allowed on sales to AEs will vitiate the picture, inasmuch as what has already been factored in the TNMM analysis, by taking operating profit figure which incorporate financial impact of the excess credit period allowed, will be adjusted again separately as well because the interest levy for late realization of debtors is inextricably connected with the sales and is also part of operating income. When such an interest is includible in operating income and the operating income itself has been accepted as reasonable under the TNMM, there cannot be an occasion to make adjustment for notional interest on delayed realization of debtors. One can understand separate adjustment for excess credit period when the arm’s length price for exports has been benchmarked on the CUP basis but not in a case when the arm’s length price of the exports has been benchmarked on the basis of TNMM. The very conceptual foundation, for separate adjustment for delayed realization of debtors and on the facts of this case, is thus devoid of legally sustainable merits;
(ii) The other aspect of the matter is that a separate adjustment for delayed realization of debtors can, even in a fit case, can only be made only to the extent the credit period allowed to the associated enterprises is more than the credit period allowed to independent enterprise in respect of the same or materially similar transactions. In the present case, it is an undisputed position that semi finished goods, as sold to Micro USA, is not sold to any other independent enterprises. The assessee did have trading transactions in respect of the finished goods with trading subsidiaries in China and Hong Kong but it is not even the case of the TPO that excessive credit period was allowed to these AEs vis-à-vis the credit period allowed to independent enterprises, nor any ALP adjustment has been recommended in connection with the same. This fact, if anything, shows that the credit period allowed to the AEs is comparable with credit period of non AEs in respect of similar goods. To compare credit period in respect of finished goods with the credit period in respect of semi-finished goods, is, therefore, somewhat fallacious in approach and untenable in law. In our considered view, merely because there is a delay in realization of debts cannot be reason enough to make an addition as long as such a delay is peculiar to the transactions with AEs. The adjustment before us is an adjustment to arrive at an arm’s length price and unless there is something, more than sweeping generalizations as implicit in the arguments before us, to at least indicate that such a delay in realization of debts in similar transactions is absent in arm’s length transactions, these adjustments cannot be made even when sales are benchmarked on CUP basis. The delay in realization of debts, resulting in a continuing debit balance, is not a standalone international transaction per se, but is a result of the international transaction as it only reflects that the related payment has not been made by the debtor.
(Micro Inks Ltd Vs ACIT [(2013)144 ITD 610 (Ahd)]. Aztec Software & Technology Services Pvt Ltd Vs ACIT [(2007) 107 ITD SB 141 (Bang)] Sony Ericsson Mobile Corporation Pvt Ltd Vs ACIT [(2015) 374 ITR 118(Del)] Nirma Industries Limited Vs DCIT [(2006) 283 ITR 402 (Guj)] referred)
As regards the corporate guarantee:
(iii) Even if we accept the contention of the Departmental Representative that issuance of a corporate guarantee amounts to a ‘provision for service’, such a service needs to be re-characterized to bring it in tune with commercial reality as “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”. No bank would be willing to issue a clean guarantee, i.e. without underlying asset, to assessee’s subsidiaries when the banks are not willing to extend those subsidiaries loans on the same terms as without a guarantee. Such a guarantee transaction can only be, and is, motivated by the shareholder, or ownership considerations. No doubt, under the OECD Guidance on the issue, an explicit support, such as corporate guarantee, is to be benchmarked and, for that purpose, it is in the service category but that occasion comes only when it is covered by the scope of ‘international transaction’ under the transfer pricing legislation of respective jurisdiction. The expression ‘provision for services’ in its normal or legal connotations does not cover issuance of corporate guarantees, even though once a corporate guarantee is covered by the definition of international transaction’, it is benchmarked in the service segment. In view of the above discussions, OECD Guidelines, as a matter of fact, strengthen the claim of the assessee that the corporate guarantees issued by the assessee were in the nature of quasi capital or shareholder activity and, for this reason alone, the issuance of these guarantees should be excluded from the scope of services and thus from the scope of ‘international transactions’ under section 92B.
(iv) Of course, once a transaction is held to be covered by the definition of international transaction, whether in the nature of the shareholder activity or quasi capital or not, ALP determination must depend on what an independent enterprise would have charged for such a transaction. In this light of these discussions, we hold that the issuance of corporate guarantees in question was not in the nature of ‘provision for services’ and these corporate guarantees were required to be treated as shareholder participation in the subsidiaries.
(v) As for the words ‘provision for services” appearing in Section 92 B, and connotations thereof, this expression, in its natural connotations, is restricted to services rendered and it does not extend to the benefits of activities per se. Whether we look at the examples given in the OECD material or even in Explanation to Section 92 B, the thrust is on the services like market research, market development, marketing management, administration, technical service, repairs, design, consultation, agency, and scientific research, legal or accounting service or coordination services. As a matter of fact, even in the Explanation to Section 92 B- which we will deal with a little later, guarantees have been grouped in item ‘c’ dealing with capital financing, rather than in item ‘d’ which specifically deals with ‘provision for services’. When the legislature itself does not group ‘guarantees’ in the ‘provision for services’ and includes it in the ‘capital financing’, it is reasonable to proceed on the basis that issuance of guarantees is not to be treated as within the scope of normal connotations of expression ‘provision for services’. Of course, the global best practices seem to be that guarantees are sometimes included in ‘services’ but that is because of the extended definition of ‘international transaction’ in most of the tax jurisdictions. Such a wide definition of services, which can be subject to arm’s length price adjustment, apart, “Transfer Pricing and Intra Group Financing – by Bakker & Levvy” (ibid) notes that “the IRS has issued a non binding Field Service Advice (FSA 1995 WL 1918236, 1 May 1995) stating that, in certain circumstances, a guarantee may be treated as a service”. If the natural connotations of a ‘service’ were to cover issuance of guarantee in general, there could not have been an occasion to give such hedged advice. This will be stretching the things too far to suggest that just because when guarantees are included in the international transactions, these guarantees are included in service segment in contradistinction with other heads under which international transactions are grouped, the guarantees should be treated as services, and, for that reason, included in the definition of international transactions. That is, in our considered view, purely fallacious logic. In our considered view, under Section 92 B, corporate guarantees can be covered only under the residuary head i.e. “any other transaction having a bearing on the profits, income, losses or assets of such enterprise”. It is for this reason that Section 92 B, in a way, expands the scope of international transaction in the sense that even when guarantees are issued as a shareholder activity but costs are incurred for the same or, as a measure of abundant caution, recoveries are made for this non chargeable activity, these guarantees will fall in the residuary clause of definition of international transactions under section 92B. As for the learned Departmental Representative’s argument that “whether the service has caused any extra cost to the assessee should not be the deciding factor to determine whether it is an international and then gives an example of brand royalty to make his point. What, in the process, he overlooks is that is that Section 92B(1) specifically covers sale or lease of tangible or intangible property”. The expression “bearing on the profits, income, losses or assets of such enterprises” is relevant only for residuary clause i.e. any other services not specifically covered by Section 92 B.
(v) With respect to specific mention of the words in Explanation to Section 92B which states that “For the removal of doubts, it is hereby clarified that (i) the expression “international transaction” shall include…….. (c) capital financing, including any type of long -term 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.” There is no dispute that this Explanation states that it is merely clarificatory in nature inasmuch as it is ‘for the removal of doubts’, and, therefore, one has to proceed on the basis that it does not alter the basic character of definition of ‘international transaction’ under Section 92 B. Accordingly, this Explanation is to be read in conjunction with the main provisions, and in harmony with the scheme of the provisions, under Section 92 B. Under this Explanation, five categories of transactions have been clarified to have been included in the definition of ‘international transactions’. The first two categories of transactions, which are stated to be included in the scope of expression ‘international transactions’ by the virtue of clause (a) and (b) of Explanation to Section 92 B, are transactions with regard to purchase, sale, transfer, lease or use of tangible and intangible properties. These transactions were anyway covered by transactions ‘in the nature of purchase, sale or lease of tangible or intangible property’. The only additional expression in the clarification is ‘use’ as also illustrative and inclusive descriptions of tangible and intangible assets. Similarly, clause (d) deals with the “provision of services, including provision of market research, market development, marketing management, administration, technical service, repairs, design, consultation, agency, scientific research, legal or accounting service” which are anyway covered in “provision for services” and “mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises ”. That leaves us with two clauses in the Explanation to Sect ion 92 B which are not covered by any of the three categories discussed above or by other specific segments covered by Section 92 B, namely borrowing or lending money. The remaining two items in the Explanation to Section 92 B are set out in clause (c) and (e) thereto, dealing with (a) capital financing and (b) business restructuring or reorganization. These items can only be covered in the residual clause of definition in international transactions, as in Section 92B (1), which covers “any other transaction having a bearing on profits, incomes, losses, or assets of such enterprises”. It is, therefore, essential that in order to be covered by clause (c) and (e) of Explanation to Section 92 B, the transactions should be such as to have bearing on profits, incomes, losses or assets of such enterprise. In other words, in a situation in which a transaction has no bearing on profits, incomes, losses or assets of such enterprise, the transaction will be outside the ambit of expression ‘international transaction’. This aspect of the matter is further highlighted in clause (e) of the Explanation dealing with restructuring and reorganization, wherein it is acknowledged that such an impact could be immediate or in future as evident from the words “irrespective of the fact that it (i.e. restructuring or reorganization) has bearing on the profit, income, losses or assets of such enterprise at the time of transaction or on a future date”. What is implicit in this statutory provision is that while impact on “profit, income, losses or assets” is sine qua non, the mere fact that impact is not immediate, but on a future date, would not take the transaction outside the ambit of ‘international transaction’. It is also important to bear in mind that, as it appears on a plain reading of the provision, this exclusion clause is not for “contingent” impact on profit, income, losses or assets but on “future” impact on profit, income, losses or assets of the enterprise. The important distinction between these two categories is that while latter is a certainty, and only its crystallization may take place on a future date, there is no such certainty in the former case. In the case before us, it is an undisputed position that corporate guarantees issued by the assessee to the various banks and crystallization of liability under these guarantees, though a possibility, is not a certainty. In view of the discussions above, the scope of the capital financing transactions, as could be covered under Explanation to Section 92 B read with Section 92B(1), is restricted to such capital financing transactions, including inter alia any guarantee, deferred payment or receivable or any other debt during the course of business, as will have “a bearing on the profits, income, losses or assets or such enterprise”. This pre-condition about impact on profits, income, losses or assets of such enterprises is a pre-condition embedded in Section 92B(1) and the only relaxation from this condition precedent is set out in clause (e) of the Explanation which provides that the bearing on profits, income, losses or assets could be immediate or on a future date. These guarantees do not have any impact on income, profits, losses or assets of the assessee. There can be a hypothetical situation in which a guarantee default takes place and, therefore, the enterprise may have to pay the guarantee amounts but such a situation, even if that be so, is only a hypothetical situation, which are, as discussed above, excluded. When an assessee extends an assistance to the associated enterprise, which does not cost anything to the assessee and particularly for which the assessee could not have realized money by giving it to someone else during the course of its normal business, such an assistance or accommodation does not have any bearing on its profits, income, losses or assets, and, therefore, it is outside the ambit of international transaction under section 92B (1) of the Act.
(‘OECD Transfer Pricing Guidelines for Multinational Enterprise and Tax Administrations’, ‘OECD Report on Attribution of Profits to Permanent Establishments’, decision of the Tax Court of Canada in the case of G E Capital Canada Vs Her Majesty the Queen [(2009) TCC 563], Bharti Airtel Limited Vs ACIT [(2014}63 SOT 113 (Del)] Redington India Limited Vs ACIT [(2014) 49 taxmann.com 146] (Chennai)], Redington India Ltd Vs JCIT [(2015) 61 taxmann.com 312 (Chennai)], Videocon Industries Ltd Vs ACIT [(2015) 55 taxmann.com 263 (Mum)], Redington India Limited Vs ACIT [(2014) 49 taxmann.com 146] (Chennai)],Redington India Ltd Vs JCIT [(2015) 61 taxmann.com 312 (Chennai)], Videocon Industries Ltd Vs ACIT [(2015) 55 taxmann.com 263 (Mum)], CIT Vs Everest Kanto Cylinders Limited [(2015) 119 DTR 394 (Bom)], Vodafone India Services Limited Vs Union of India [(2013) 37 taxmann.com 250 (Bombay)], Foursoft Limited (ITA No. 1903/Hyd/2011), Mahindra & Mahindra Ltd Vs DCIT (54 SOT URO 146 Hyd), Prolific Corporation Ltd Vs DCIT [(2015) 68 SOT 104 (Hyd)], Aditya Birla Minacs Worldwide Ltd vs DCIT [(2015) 56 taxmann.317 (Mumbi)], Aditya Birla Minacs Worldwide Ltd vs DCIT [(2015) 56 taxmann.317 (Mumbi)] referred)