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Comparable uncontrolled price is the most appropriate method for determining the arm’s length price of interest on loans
In brief
In a recent ruling in the case of Aithent Technologies Pvt. Ltd.,1 (the tax payer) the Delhi Bench of the Income-tax Appellate Tribunal (the Tribunal), while restoring the matter to the file of the assessing officer/transfer pricing officer (AO/TPO) for fresh adjudication, expressed the opinion that the comparable uncontrolled price (CUP) method was the most appropriate method to ascertain the arm’s length price (ALP) of an interest-free loan given by the taxpayer to its US subsidiary, and for that purpose, assessment of the credit quality of the borrower, estimation of a credit rating and evaluation of the terms of the loan are relevant.
1 Aithent Technologies Pvt. Ltd. v. ITO [2010-TII-134-ITAT-DEL-TP]
In addition, the Tribunal rejected the taxpayer’s contention of factoring in the notional interest on such loan with its primary activity of development and sale of software under the transactional net margin method (TNMM) analysis.
Facts
• The taxpayer is engaged in the development and sale of software to its US Subsidiary, i.e. associate enterprise (AE). The AE undertakes the functions of marketing and customisation while the taxpayer is responsible for contract execution and product development.
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• During financial year (FY) 2001-02, in addition to the primary international transaction of sale of software to its AE, the taxpayer had given interest-free loans2 to its AE periodically amounting to INR 73.9 million.
• The taxpayer had considered the TNMM as the most appropriate method for benchmarking both transactions. With respect to the loan transaction, the taxpayer had inferred that no external uncontrolled price was available.
Therefore, to benchmark the transaction, a notional interest3 amount of INR 3.15 million was deducted from the software development income while computing the operating margin earned by the taxpayer on the international transaction of sale of software. As the margin was better than that of the comparables, the taxpayer concluded that both transactions met the arm’s length standard.
• During transfer pricing (TP) assessment proceedings, the TPO concluded that the loan transaction was an entirely separate transaction, not in conjunction with the primary activity of the taxpayer and hence merited a separate analysis.
• The TPO proceeded to make an adjustment of INR 3.15 million, being the notional interest cost considered, to the income of the taxpayer which was subsequently upheld by the Commissioner of Income-tax (Appeals).
Taxpayer’s contentions
• The taxpayer has contended that the TPO, while arriving at a conclusion, had ignored the principle of commercial expediency.
2 Denominated in USD
3 The taxpayer had made an assumption that the loan would fetch an interest rate of 10% as per the lending rate authorised by the Reserve Bank of India.
• The AE is a wholly-owned subsidiary of the taxpayer and both companies are completely aligned in their business operations and have an exclusive arrangement whereby the entire development and execution of off-shore projects of the AE were outsourced to the taxpayer. The loan was given with the objective of growth and expansion of business that would be to the benefit of the taxpayer.
• It was incorrect to conclude that the loan transaction was an entirely separate transaction, not in conjunction with the primary activity of the taxpayer and to disregard the method adopted by the taxpayer to justify the ALP, that being TNMM.
• The loan amount originated from interest-free funds that were contributed in the form of share application money by an investor and therefore, there was a justification for not charging interest to the AE.
Revenue’s contentions
In addition to the findings of the TPO, the revenue placed reliance on the decision of the Delhi Tribunal in the case of Perot Systems TSI (India) Ltd.4 which also dealt with an interest-free loan transaction.
Tribunal Ruling
• The Tribunal held that it was indisputable that the loan transaction was an independent transaction, requiring determination of an ALP.
4 Perot Systems TSI (India) Ltd. v. DCIT [210-TIOL-51-ITAT-DEL]
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• Placing reliance on the decision of the Delhi Tribunal in the case of Perot Systems TSI (India) Ltd., the Tribunal has opined that the CUP method was the most appropriate method to ascertain the ALP of the loan transaction.
• Further, as observed in the aforementioned case, the Tribunal has held that whether the funds were advanced out of interest bearing funds or interest of interest-free advances or were commercially expedient to the taxpayer or not, was wholly irrelevant.
• For the purpose of applying the CUP method, assessment of the credit quality of the borrower, estimation of a credit rating and evaluation of the terms of the loan such as period of loan, the amount, the currency, interest rate basis, and any additional input such as convertibility and finally estimation of arm’s length terms of the loan based upon the key comparability factors and internal and/or external comparable transactions are relevant.
• Considering that neither the taxpayer nor the revenue had examined the applicability of the CUP method as the most appropriate method, the Tribunal restored the matter to the file of the AO/TPO for fresh adjudication with directions to recompute the arm’s length price, following the CUP method, keeping in view various judicial pronouncements.
Conclusion
This ruling of the Delhi Tribunal is an important pronouncement in the context of benchmarking of loan transactions including the methodology to be adopted and the various factors that a taxpayer would need to keep in perspective while carrying out such analysis. These include:
• Loan transactions should be evaluated on an independent basis.
• The CUP method is the most appropriate method to ascertain the arm’s length price of a loan transaction.
• Cost is not a factor that is to be considered for application of the CUP method.
Rather the price and accordingly factors that impact the price would be relevant.
Also, a noteworthy point in this context is that neither the taxpayer (nor therefore the revenue) has discussed the issue of quasi-equity as an aspect in this analysis.
Given the various rulings5 that have been pronounced so far on inter-company financial transactions, it is becoming increasingly important for taxpayers to undertake a comprehensive arm’s length analysis to ensure that they have a defendable position and avoid protracted litigation.
5Siva Industries & Holdings Ltd. v. ACIT [2011-TII-67-ITAT-MAD-TP]
Perot Systems TSI (India) Ltd. v. DCIT [210-TIOL-51-ITAT-DEL]
VVF Ltd. v. DCIT [2010-TIOL-55-ITAT-MUM]
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