Court : ITAT Delhi
Brief : * The Taxpayer, a company incorporated in India, was engaged in the business of designing and developing technology-enabled business transformation solutions and providing business consulting, systems integration services and software solutions and services.
* The Taxpayer advanced interest-free foreign currency loans to its AEs, located in Bermuda and Hungary, which were start-up in nature with no significant business activities. Further, the funds were used for making long-term step-down investments in subsidiaries.
* As per the arm’s length principle under the TP provisions of the Income Tax Act, 1961, any income arising from an international transaction between AEs shall be computed having regard to the arm’s length price (ALP).
* The Taxpayer was of the view that the interest-free loans were extended as capital contribution to the AEs and, therefore, were in the nature of quasi-equity. Hence, not charging interest was acceptable under the TP provisions.
* The Tax Authority took a view that grant of a loan was an international transaction and not charging interest was not consistent with the arm’s length principle. It was observed that unrelated parties in normal business relations may not advance an interest-free loan since it would result in the lender assuming risks of a loantransaction , without expecting any return. Further, the grant of loans to the AE located in Bermuda would result in shifting of profits outside India to a tax haven. In view of the above, the Tax Authority made adjustments in the Taxpayer’s income as per the TP provisions of theIncome Tax Act, 1961.
* On an appeal by the Taxpayer to the first appellate authority, the Taxpayer’s contentions were rejected. Aggrieved by the above, the Taxpayer preferred an appeal before the ITAT.
Contentions of the Taxpayer
* Placing reliance on the decisions in the cases of CIT v KRMTT Thiagaraja Chetty & Co. [24 ITR 525 (SC)]; Morvi Industries Ltd. v CIT [82 ITR 835 (SC)], it was contended that income means real income and not fictitious income and since the Taxpayer had not earned any income in India, the same may not be taxed. Further, in the absence of any income, the TP provisions of theIncome Tax Act, 1961, being machinery provisions, shall not apply.
* No other party would have granted interest-free loans to the AEs as they were in a start-up stage and the debt-equity ratio of such AEs was not comfortable.
* The interest-free loans are in the nature of quasi-equity and, hence, the transaction of granting interest-free loans is at an ALP. Reference was made to the TP guidelines issued by Organisation for Economic Co-operation and Development (OECD), providing that it is legitimate to consider the economic substance of the transactions. The transactions have been said to be commercially expedient and loans are granted to support the subsidiary and obtain returns in future. The Taxpayer had full control over its subsidiary which reduced the credit risk.
* The loans had been duly granted by the approval of the Reserve Bank of India (RBI). The Income Tax Act, 1961 and the OECD guidelines support the contention that the effect of government control/intervention should be considered while determining the ALP.
* Under the thin capitalization rules of Hungary, any debt in excess of thrice the equity of a company is treated as equity and not as debt. This being the circumstances in the present case, no deduction was allowable to the Hungarian entity for payment of interest. Hence, there existed impossibility of performance with regard to payment of interest.
Citation : Perot Systems TSI vs. DCIT, Decided BY:(ITAT Delhi, Appeal No. I.T.A 2320, 2321 ,2322/Del/2008, Assessment year: 2002-03, 2003-04, 2004-2005.
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Ruling of the ITAT
* The agreements between the parties indicate that the amount advanced is in the nature of a loan and there are no special features which suggest that it should be treated as capital.
* The TP principle aims at determining the pricing in situations of cross-border international transactions between AEs. The concept of real income cannot be applied in this scenario.The case laws cited by the Taxpayer may not be relied upon since the same are rendered in the context of domestic transactions and not in the context of international transactions governed by the TP provisions of theIncome Tax Act, 1961.
* Borrowing or lending of money between AEs is an international transaction, subject to the TP provisions, and income arising from the international transaction should be determined as per the TP provisions of the Income Tax Act, 1961.
* One of the AEs is situated in a tax haven and not charging interest by the Taxpayer from the AE would result in higher income in the hands of the AE and the Taxpayer’s income in India would reduce by the corresponding amount. This would bring down the overall tax incidence of the group and it is a classic case of violation of the TP norms where profits are shifted to tax havens or low tax regimes to bring down the aggregate tax incidence of a multinational group.
* The ITAT observed that :
1. Reference to the OECD TP guidelines and the Hungarian thin capitalization rule is misplaced since the same is given in different contexts.
2. The RBI’s approval does not put a seal of approval on the true character of the transaction from the perspective of the TP regulation. The purpose, guidelines and rules for the RBI’s approval are completely different from those of the TP rules under theIncome Tax Act, 1961. Hence, the RBI rules cannot be applied for the purpose of TP under the Income Tax Act, 1961.
* The ITAT upheld the decision of the first appellate authority and ruled that interest-free loans between AEs would be subject to the TP provisions and notional interest determined under arm’s length principle can be taxedin the hands of the lender.
Comments: This ITAT ruling has interpreted the application of the TP provisions, based on the underlying TP principle which aims to assess whether or not pricing of transactions between related parties has been determined based on arm’s length principle. This ruling also clarifies that reliance on the OECD TP guidelines for interpreting Indian TP rules would need to consider the context of the guidelines as well as the limitations of relying on Government/statutory approval as a basis for supporting arm’s length nature of an arrangement. In light of this ruling, taxpayers may need to review their inter-company arrangements to assess if any international transactions could arise pursuant to the arrangements, for which an ALP determination would be required.
