Transfer Pricing Aspects of Financial Transactions in India
Over last few years, several multinational enterprises have established their presence in India. The globalisation has also encouraged Indian companies to expand their footprint globally. Such increased activity of multinational enterprises has contributed to cross border movement of funds and capital from/into India.
The tax authorities view movement of funds among associated enterprises (‘AEs’) of multinational enterprise group as a mechanism used by taxpayers to shift profits from one jurisdiction to the other. As per them, this may be achieved by enhanced interest deductions for tax purposes or shift of income earning potential which may not be at arm’s length basis. Accordingly, in recent past, the financial transactions have attracted increased scrutiny of Indian tax authorities from transfer pricing standpoint.
The major financial transactions in Indian transfer pricing context are inter-company loans leading to interest income/expense transactions, guarantee transactions and conversion into equity of hybrid instruments.
We will discuss each transaction, its related technical aspects and Indian jurisprudence in below paragraphs. We shall then also discuss certain practical difficulties faced by taxpayers and tax authorities.
Inter-company loans:
In last few years, the loans granted by Indian companies to their subsidiaries abroad have attracted transfer pricing scrutiny of Indian tax authorities. This is because, in many cases, the loans granted are interest free loans. Further, in cases, where interest is levied, the Indian tax authorities have challenged the rate of interest which is based on Libor+/Euribor+ basis points. As per them, the interest rate should be based on prime lending rate (PLR) of the main nationalised bank in India. This is because the interest rate as per Libor+/Euribor+ basis points in controlled transactions may range from 3%-6%, while the PLR of main nationalised bank in India ranges from 9% – 12%.
In many cases, the taxpayers benchmark the interest income transactions by aggregating the same with other controlled transactions so as to demonstrate the arm’s length nature of profitability from such combined transactions using transaction net margin methods (TNMM). Such approach is consistently challenged by tax authorities.
In respect of interest free loans given by Indian holding companies to their subsidiaries, the taxpayers have been contending that, such loans are in nature of quasi equity and may be considered in nature of shareholder’s activity. However, the tax tribunal in case of Perot Systems TSI (ITA No. 2320, 2321, 2322 of 2008) rejected the argument of the taxpayer that, loans were quasi equity and in reality were not in nature of loans by holding that, there was no reason why the loans were not contributed as share capital if they were actually meant to be share capital contribution. In this case, the taxpayer had argued that, no interest was charged on loans to subsidiaries on account of commercial expediency as the subsidiaries were in start-up phase and the loans were thus in nature of investments. However, court rejected this argument by holding that, argument of commercial expediency is invalid in case of inter-company transactions and transfer pricing regulations require all controlled transactions to be benchmarked so as to meet the arm’s length test.
However, the recent decision of tax tribunal in the case of Micro Inks (ITA No. 2873/10), the tribunal has accepted the argument of the taxpayer that, guarantee given by Indian taxpayer to its subsidiary abroad in order to enable it to raise funds is in nature of shareholder’s activity. This decision would also be applicable for inter-company loan transactions. We would discuss this decision in subsequent paragraphs.
The tax authorities have been rejecting the interest income/expense benchmarking by application of TNMM by holding that, under the Indian transfer pricing regulations only the closely linked controlled transactions can be aggregated for benchmarking purposes. In majority of the cases, the taxpayers were seen to be unable to substantiate reasons for aggregating interest income/expense transactions with other uncontrolled transactions which led to rejection of TNMM.
On the other hand, there is growing acceptability among both tax authorities and tax tribunals (Perot Systems TSI, Aithent Technologies ITA No.3647/2007 and VVF Ltd ITA No.673/2006) for internal Comparable Uncontrolled Price (CUP). This involves evaluating whether borrowing entity has also borrowed funds from unrelated borrower especially bank. Surprisingly, there is very less jurisprudence in respect of cases involving external CUP. However, in practise, the transfer pricing practitioners do apply external CUP for inter-company loan transactions which involve searching for comparable transactions on external databases having regard to credit rating of the borrowing entity.
In respect of interest rate to be adopted for benchmarking the loans given by Indian taxpayers to their subsidiaries abroad, the tax tribunal in several cases (Siva Industries ITA No. 2148/2010, Tech Mahindra ITA No. 1176/2010, Four Soft ITA No. 1495/2010) has held that, interest rate prevailing in borrower’s jurisdictions should be used for transfer pricing benchmarking or rate setting in controlled transactions. Accordingly, the courts have upheld the use of Libor or Euribor for benchmarking the interest income in case of inter-company loan transactions as opposed to PLR adopted by tax authorities. The logic for adopting such interest rate is that, if the borrower AE entity had borrowed in foreign currency from a local lender in its jurisdiction, then such local lender would have charged the rate prevailing in such jurisdiction rather than adopting the PLR existing in parent entity country i.e. India. Accordingly, the internal CUP can be only obtained with respect to loans given to borrower entity jurisdiction and not lending entity jurisdiction.
Guarantee transactions:
In India, the disputes in respect of guarantee transactions are mainly in respect of legal interpretation of definition of controlled transactions covered for transfer pricing applicability under regulations. The definition of controlled transaction does not expressly cover guarantee transaction. However, the definition does take into account service transaction and residuary category of transactions which are not expressly covered within definition but have bearing on profits, losses, income and assets of the taxpayer. Therefore, the taxpayers often take arguments that, guarantee transactions cannot be characterised as service and in transactions where no guarantee fee has been charged by parent company from its subsidiary, the transaction cannot be considered as controlled transaction as such transaction does not have any bearing on profits, income, losses or assets of the taxpayer providing guarantee.
The stand of the taxpayer that, guarantee transactions wherein taxpayer has not charged guarantee fee from its AE and has not incurred any cost for provision of guarantee do not have any bearing on profits, income, losses and assets of the taxpayer and hence, do not constitute controlled transaction was upheld by tax tribunal in the decisions of Bharti Airtel (ITA 5816/12) and Micro Inks (ITA 2873/10).
Further, in Micro Inks, the tax tribunal has held that, inter-company guarantee transactions without guarantee fee charge cannot be regarded as service transactions, as in uncontrolled transaction, no financial institution would provide guarantee without security being underlying asset. Therefore, as per court, the inter-company transaction under consideration was motivated due to shareholder or ownership consideration.
The most important aspect of Micro Inks ruling is that, it has recognised the concept of shareholder’s activity given by OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (‘OECD TP Guidelines’). The tax tribunal relying on examples has held that, the taxpayer has discretion to decide the manner in which it wished to funds its subsidiary and in case the taxpayer has given guarantee to its subsidiary for financing its operations then, such guarantee is in nature of shareholder’s activity, while on the other hand, in case the guarantee is given to subsidiary in order to make further acquisitions / investments, then such guarantee cannot be considered as shareholder’s activity.
Further, the court has ruled that, taxpayer’s stand from inception should be that, transaction is in nature of shareholder’s activity and hence, it has not recovered fee from its AE.
However, the tax tribunal has observed in cases where taxpayer has incurred cost in respect of provision of guarantee or has charged guarantee fee from its AE, such transaction falls within the definition of controlled transaction as the transaction has bearing on profits, income, losses or assets of the taxpayer.
Interest on outstanding receivables:
The Indian transfer pricing regulations also consider receivables as controlled transactions. Accordingly, the interest on receivables needs to be benchmarked to meet arm’s length test.
Taxpayers have been using CUP method in order to demonstrate that, terms of interest charged on receivables are same for both controlled and uncontrolled transactions and hence, interest earned from AEs on receivables meet arm’s length test.
On the other hand, in cases where CUP do not exist, the taxpayers aggregate the interest on receivables with the controlled transactions from which such interest emanate so as to benchmark the same using TNMM, RPM or CPM method. Further, profit for TNMM purposes is adjusted to take into account the working capital of the comparable companies.
Both the above approaches are upheld by tax tribunals.
Capital account transactions:
In year 2013, the tax authorities challenged the transactions of issue of shares by Indian subsidiaries to their holding companies abroad. The tax authorities challenged the valuation of shares and alleged that, shares were undervalued and hence they treated the difference between alleged fair value and value at which shares were issued as receivable/loan granted to foreign holding company. Further, the tax authorities also imputed notional interest on such loan/receivable. The taxpayers who were affected on account of such adjustments were Shell India, Vodafone India, Leighton India, Essar group.
It is important to note that, Indian transfer pricing regulations do not provide the blanket power to tax authorities to re-characterize the transaction. The only mandate of tax authorities is to determine the arm’s length price of the controlled transaction. Also there is no provision in regulations for making secondary adjustment of notional interest. Further, the Indian transfer pricing regulations are only applicable to transactions which have bearing on income or expense. The transaction of issue of shares is a capital account transaction and does not have any bearing on taxable income of the taxpayer. Hence, such transaction does not attract taxation in India. Accordingly, the Bombay High Court in the case of Vodafone India (WP No.871 of 2014, Bombay HC) held that, the transaction of issue of shares is a capital account transaction and as it does not attract taxation, the transfer pricing provisions do not apply to such transaction. Further, the court has upheld the taxpayer’s argument that, Indian transfer pricing regulations do not contain specific provisions for making secondary adjustment. The Indian government has accepted the decision of Bombay High Court and has directed the tax authorities to refrain from making adjustments in respect of transactions involving issue of share capital.
Accordingly, transfer pricing provisions do not apply to capital account transactions like issue of bonds, convertible debt, preference shares etc.
However, in case the convertible debt is converted into equity shares then, the Indian regulations consider such transaction as transfer of capital asset and hence, the gains arising from such transaction need to meet arm’s length test.
Practical difficulties/challenges faced by taxpayers in benchmarking financial transactions:
One of the major challenges faced by the taxpayers is availability of comparables in respect of financial transactions involving inter-company loans and guarantee transactions. Some taxpayers make use of databases to find comparables. However, these specialised databases are not widely available with all the taxpayers. Further, as these databases are not available with tax authorities, the authorities are reluctant to accept databases.
Another difficulty which is faced by taxpayers is unavailability of credit rating of newly started subsidiaries. Though such credit rating can be computed synthetically using databases like Moody’s Riskcalc, the financial data in respect of past year may not be available or the subsidiary may be in deep losses. The tax authorities may not accept such synthetic credit rating. Also the practices like notching up of credit rating of strategically important subsidiaries are not recognised by tax authorities.
The tax authorities also do not recognise the halo effect in respect of guarantee transaction so as to recognise the implicit benefit received by the recipient of loan on account of being part of MNE group.
Conclusion:
It is expected that, importance of financial transactions from transfer pricing standpoint would continue to grow. While substantial jurisprudence has been laid down by tribunals in respect of transactions involving financial transactions, it is important that, such jurisprudence is duly followed by both taxpayers and tax authorities. Tax authorities need to conduct audit of such transactions from open mind. Also it is important for government to equip the tax authorities with infrastructure and know-how to conduct effective transfer pricing audit of financial transactions. Further, the aim of tax authorities while conducting audit is to determine the arm’s length nature of the transaction rather than making arbitrary transfer pricing adjustments.
