Global Tax Alert (News from Transfer Pricing) | 17 March 2014
Delhi Tribunal rules on transfer pricing aspects of intra group financing transactions
The Delhi Income-tax Appellate Tribunal (Tribunal), in a ruling1 in the case of M/s. Bharti Airtel Limited (Taxpayer) has adjudicated on transfer pricing (TP) issues arising from the issuance of a corporate guarantee, loans to associated enterprise (AEs) and contribution to share capital. The Taxpayer, an Indian company, provided a guarantee to a third party bank on behalf of its foreign subsidiary for which the Taxpayer did not charge a fee. The Taxpayer contended as it did not incur any costs in providing the guarantee, there was no requirement for it to charge a fee to the subsidiary under the transfer pricing provisions. During audit proceedings, the Transfer Pricing Officer (TPO) imputed an arm's length guarantee fee by applying the Comparable Uncontrolled Price (CUP) method and considered the commission charged by independent banks as a benchmark. The Tribunal, considering the facts of the case, held that the corporate guarantee provided by the Taxpayer, which does not involve cost to the Taxpayer, does not have a bearing on profits, incomes, losses or assets of the Taxpayer and hence the transaction does not fall within the definition of “international transaction” as provided in the Indian Tax Law (ITL). The Tribunal accordingly ruled that under the facts of the case, transfer pricing provisions do not apply to the provision of the guarantee and therefore the TP adjustment imputing an arm's length guarantee fee is not warranted.
With regard to interest on the loan provided by the Taxpayer to its AEs, the Tribunal rejected the TPO's approach of determining the arm's length interest rate. The Tribunal ruled that the arm's length interest rate should be determined based on rates prevailing with respect to currency in which the loans are made.
Further, with regard to the capital contribution made by the Taxpayer to its AEs, the Tribunal rejected the TPO's approach of determining the arm's length interest rate by treating these payments partly as that of an interest free loan. The Tribunal ruled that an arm's length price adjustment based on that hypothesis was not legally sustainable on merits as the TPO has not brought on record anything to show that an unrelated share applicant was to be paid any interest for the period between making the share application payment and allotment of shares.
The Taxpayer is an Indian company engaged in the provision of telecommunication services. During the financial year 2007-08, the Taxpayer had the following international transactions: (a) issuance of a corporate guarantee on behalf of its AE; (b) interest on the loan advanced to its AEs; and (c) contribution to share capital in its AEs. During audit proceedings, the TPO made adjustments to the above international transactions.
With respect to the corporate guarantee issued by the Taxpayer on behalf of its AE guaranteeing the repayment of a working capital facility advanced by a bank, the Taxpayer contended that it had not incurred any costs or expenses on account of issue of such guarantee and the guarantee was issued as a part of the shareholder activity. Accordingly, there was no requirement to charge a guarantee fee under the TP provisions. The Taxpayer, however, in its TP documentation study determined 0.65% as an arm's length guarantee fee based on market quote for such corporate guarantee and offered this income to tax.
During the TP audit, the TPO observed that by issuing the corporate guarantee, the AE's credit rating benefited from association to the Taxpayer and the Taxpayer, was therefore, required to receive arm's length consideration. The TPO relied on Para 7.13 of the OECD TP Guidelines (OECD TPG), which state that “but an intra–group service would usually exist where the higher credit rating were due to a guarantee by another group member.” The TPO benchmarked the transaction by applying the CUP method, and accordingly, determined the arm's length price of the guarantee commission income at the rate of 2.68% plus a mark-up of 200 basis points. In applying the CUP method, the TPO relied on data obtained from various banks by exercising power granted under the ITL to obtain information not publicly available. The TPO also relied on the decision of the Tax Court of Canada in the case of GE Capital Canada Inc. vs. The Queen (2009 TCC 563). Accordingly, a TP adjustment was made with respect to the differential guarantee fee.
With respect to the loan given by the Taxpayer to its AEs, the TPO determined the arm's length interest rate to be the interest rate that could be earned by the Taxpayer by advancing a loan to an unrelated party in India with the same financial health as that of the Taxpayer's subsidiaries. The Taxpayer contended that the loans were in foreign currencies and in the international market, the bank lending rates are based on LIBOR rates. Hence, the LIBOR at 7.33% should be considered as the arm's length interest rate. The TPO, however, proceeded to determine the arm's length interest rate at 14%. The TPO determined the rate by adding a mark-up of 400 basis points to LIBOR to account for the credit rating of the AE, a further mark-up of 300 basis point to LIBOR to account for transaction costs and an additional upward adjustment to account for certain other differences. The TPO also relied upon the corporate bond rates on Indian Rupee denominated debt to support the determination of the arm's length interest rate.
During FY 2007-08, the Taxpayer made a contribution to the share capital of its foreign subsidiaries. The Taxpayer did not benchmark the said transaction as the payments were in the nature of capital contributions. However, during the course of the audit proceedings, though TPO did not question the character of payment, the TPO noted there was a significant delay in allotment of shares to the Taxpayer. Hence, the TPO treated the contributions as interest free loans for the period between the dates of payment and the date on which shares were actually allotted. The TPO thereafter imputed an arm's length interest on the amounts deemed as an interest free loan at 17.26%.
In response to the TPO order, the Taxpayer filed its objections with the Dispute Resolution Panel (DRP), an alternate dispute resolution mechanism under the ITL. The DRP upheld the TP adjustment proposed by the TPO.
The Taxpayer filed an appeal before the Tribunal, the second-level appellate authority, against the TP adjustments.
Ruling of the Tribunal
a) Issue of corporate guarantee to its AE
Prior to the amendments brought in by the Finance Act, 2012, the definition of the term “international transaction” in the ITL was unclear as to the inclusion of certain globally acknowledged transactions such as corporate guarantees and business restructuring. Hence, tax courts in India were adopting varying approaches with regard to this interpretation. The Finance Act, 2012 added explanations to the primary definition of international transactions to include dealings in tangible/ intangible property and services, intragroup financing (including corporate guarantees) and business restructuring.
Considering there is lack of transfer pricing precedents in India with respect to issue of corporate guarantees, the Tribunal considered it appropriate to begin by dealing with the fundamental question of whether issuance of corporate guarantees, which do not involve any costs to the taxpayer, can be subjected to the Indian transfer pricing regulations.
Reviewing the definition of the term “international transaction”, the Tribunal held that in order for the transaction to be an “international transaction” subject to TP, the transaction should be such as to have a bearing on profits, income, 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 the term “international transaction.” The Tribunal held that the precondition of a transaction having bearing on profit, losses or assets of an enterprise cannot be dispensed with even after the explanations added to the definition of the international transaction by Finance Act 2012 since such explanations are merely clarifications.
The Tribunal further held the onus is on the revenue authorities to demonstrate the transaction has a “bearing on profits, income, losses or assets” of the enterprise. Such an impact on profits, income, losses or assets has to be on a real basis, whether in the present or in the future, and not on a contingent or hypothetical basis. Furthermore, there has to be some evidence on record to indicate, even if not to fully establish, that an international transaction has some impact on profits, income, losses or assets. Taking into consideration the facts of the case, the Tribunal held that such conditions were not satisfied. The Tribunal also observed that in the facts of the case the AE had not resorted to any borrowings from the bank.
Accordingly, the Tribunal held that a corporate guarantee issued without a charge is outside the ambit of 'international transaction' and transfer pricing provisions do not apply to such arrangements, even after the amendment introduced by the Finance Act, 2012.
b) Interest on loan to AEs
The Tribunal observed the identical issue had come up for adjudication in the immediately preceding FY 2006-07, and held the same judgment would apply for the current year as well. The Tribunal in its earlier judgment held that the advances to subsidiaries were in foreign currencies i.e., in British Pounds (GBP), US Dollars (USD) and Canadian Dollars (CAD). In these circumstances, the interest rates on Rupee bonds and debts have no relevance at all. It is a fundamental principle that interest is time value of money and when inflation pressure on a currency is lower, as is the case with most strong currencies, the time value of money, i.e., interest, tends to be lower too. Therefore, interest rates on Rupee loans cannot be compared with interest rates on strong currencies like the GBP, USD and CAD. As for TPO's observation that since the tested party, i.e., lender, was the taxpayer, India is the relevant market to determine interest that could be earned by the taxpayer by advancing a loan to an unrelated party, the Tribunal held that the interest rate on foreign currency loans are qualitatively different, and therefore, one has to compare the interest that the taxpayer would have earned on foreign currency loans and not on Rupee denominated loans. The Tribunal also observed the basis of determining the mark-up on LIBOR by the TPO and other adjustments made by the TPO are not cogent and therefore not sustainable.
Hence, there is no merit in the approach of the TPO to determine the arm's length interest rate by reference to Indian currency loans given in India.
c) Capital contribution to AEs
The Tribunal held there was no dispute on the characterization of the payment made by the Taxpayer to its AEs as the TPO accepted these were in the nature of payments for share application money, and thus, of capital contributions. The question before the Tribunal was whether there is a deeming fiction envisaged under Indian transfer pricing legislation on treating part of share application money as an interest free loan to AEs. In this regard, the Tribunal noted there was no provision enabling deeming fiction under the Indian transfer pricing regulations.
Further, the Tribunal observed there is no finding about what is the reasonable and permissible time period for allotment of shares. Even if one was to assume there was an unreasonable delay in allotment of shares, the capital contribution could have, at best, been treated as an interest free loan for such a period of “inordinate delay” and not the entire period between the date of making the payment and date of allotment of shares. This aspect of the matter is determined by the relevant statute, which is different than that of an interest free loan on a commercial basis between the share applicant and the company to which the capital contribution is being made.
Hence, the Tribunal held it was unreasonable and inappropriate to treat the transaction as partly in the nature of an interest free loan to the AE since the TPO did not bring any evidence an unrelated share applicant would be paid any interest for the period between making the share application payment and allotment of shares. Accordingly, the Tribunal held an ALP adjustment based on that hypothesis was not legally sustainable on its merits.
One of the fundamental fact patterns in the evolution of international transfer pricing concepts and rules involves an enterprise's use of a financial resource belonging to an associated enterprise. Although the OECD Transfer Pricing Guidelines, 2010 acknowledge the role of the use of money in transfer pricing matters, they do not yet provide specific guidelines regarding how such issues are to be addressed and resolved. Nonetheless, the elements that are typically important in evaluating transfer pricing issues involving the use of money within multinational enterprise groups can be outlined by drawing on general arm's-length principles.
Intercompany lending and related financial transactions are being more intensively audited by the Indian revenue authorities. Transfer pricing of intercompany loans and guarantees are increasingly being considered some of the most complex transfer pricing issues in India, according to the India Country specific chapter of the UN Practical Manual on Transfer Pricing for Developing Countries. The chapter suggests that the Indian tax administration may consider the interest rates prevailing at the situs of the lender/ guarantor when determining the arm's length interest rate or guarantee fee.
Guarantee transactions are difficult to characterize for transfer pricing purposes because they may involve an analysis of mixed elements of the time value of money and shareholder activity. Guarantee transactions may further raise the question of whether the facility confers a specific benefit on the recipient or a general benefit to the entire controlled group of companies. Accordingly, the issue of whether a charge should be imposed for provision of a guarantee is primarily a factual inquiry. Taxpayers should undertake a factual review of their intercompany guarantee arrangements to determine which conclusion can be applied to their fact pattern.
In determining an arm's-length rate of interest, all relevant factors concerning the controlled and uncontrolled transactions should be taken into account, including the principal amount and duration of the loan, the security involved, the borrower's credit standing, and the interest rate prevailing at the situs of the lender or creditor for comparable loans between unrelated parties. This ruling recognizes the relevance of interest rates prevailing in the international markets as being an important factor in determining an arm's length interest rate.
1. TS-76-ITAT-2014(DEL)-TP. This alert discusses only the transfer pricing issues and does not cover other tax issues dealt with by the Tribunal in the case of this Taxpayer.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (India), Bangalore
- • Rajendra Nayak
+91 80 4027 5454
Ernst & Young LLP (India), New Delhi
- • Vijay Iyer
+91 11 6623 324
EYG no. CM4267