RECENTLY, the concept of Corporate Social Responsibility ('CSR') has become an important matter of discussion at the business / professional forums and in the judiciary. It is becoming a part of core decision making for the management of the company, since its introduction in the Companies Act, 2013 ('the Co's Act').

What is CSR and the provisions relating to same under the Co's Act?

CSR is the commitment by business to contribute towards community and environment in which it operates. The Co's Act mandates that every company having:

- net worth of rupees five hundred crore or more, or

- turnover of rupees thousand crore or more, or

- a net profit of rupees five crore or more,

during any financial year shall constitute a CSR Committee which shall formulate and recommend a CSR policy to spend at least two per cent of the average net profits of the company made during the three immediately preceding financial years on CSR activities 1.

Deduction of CSR expenditure under Income Tax Act, 1961 ('the IT Act')

The general deductions, which are specifically not provided under other sections (i.e. section 30 to 36) of the IT Act, are provided under section 37. In the past, there has been quite a few judicial precedents on allowability of CSR expenses, both in favour and against the taxpayer.

However, the Finance Act, 2014 inserted an explanation to section 37 of the IT Act to clarify that the expenditure incurred on CSR shall not be deemed to be incurred for the purpose of business and profession. It seems that the intention of legislation is to bind the eligible taxpayers to spend a part of their income towards social responsibility, as incurrence of such expense is an application of income. If the deduction towards CSR expenses is allowed, it will defeat the whole purpose.

On other hand, it is essential to note that the expenditure on CSR activities which falls under section 30 to 36 of the IT Act could be still allowed as a deduction subject to fulfilment of prescribed conditions, if any, mentioned therein. Therefore, the corporate taxpayer in India should balance its profit motive with the social responsibility imposed by the legislation.

Profit Level Indicator ('PLI') computation persist as one of the Transfer Pricing audit controversies in India. PLI computation under the Transactional Net Margin Method ('TNMM') requires determination of 'net operating profit' in relation to suitable base i.e. 'operating costs', 'sales', etc. The controversies typically revolve around determination of 'operating cost base'. There are host of Transfer Pricing rulings on PLI arithmetic i.e. whether to consider certain expenses as "operating" or "non-operating". For example, treatment of foreign exchange fluctuations, expenditure on acquisition of a business, prior period expenses, subsidy received, provision for bad debts, write back of provision, etc.

With this background in hindsight, it would be worthwhile to examine whether CSR expenses should be in the nature of 'operating' or 'non-operating' expenses. More importantly because this issue is still not tried and tested during the transfer pricing audits in India.

Whether CSR expenses should be considered 'operating expenses' for PLI computation?

Let's consider an example of a captive Indian company, engaged in providing services to its Associated Enterprise ('AE'), following cost plus remuneration model. In this regard, it is essential to determine whether CSR expenditure should be forming part of operating cost base while computing mark-up to be charged by this Indian company.

As per Rule 10B(1)(e) of the Income Tax Rules, 1962 ('the Rules'), the net profit margin should be computed in relation to 'costs incurred' or 'sales affected' or 'assets employed' by the Company for undertaking such transaction. Further, the Guidance Note on transfer pricing issued by ICAI states that "…it is recommended that operating profit margin may be used instead of net profit margin. Operating profit margin would eliminate the non-operating items (the items of revenue and costs which do not result from routine business operations such as profit on sale of assets, dividend etc.)".

The definition of "operating profit" or "operating expenses" is not provided under the IT Act. However, under the IT Rules related to Safe Harbour provisions 'operating expense' is defined [ CBDT notification dated 18 September 2013] as the cost incurred in relation with the international transaction during the normal course of business and excludes, interalia, the expenses not relating to the normal operations. Further, reference can be made to the OECD guidelines [ ref: para 2.77 and 2.78 of OECD Guidelines] which provides that while arriving at the net profit, only those items which are directly or indirectly related to the transaction (i.e. provision of services) and which are of an operating nature should be considered. Costs and revenues that are not related to the transaction under review should be excluded while determining the PLI.

Accordingly, it could be matter of debate as to whether CSR expenditure are "operating expenses" or "non-operating expenses" for the purpose of PLI computation and determination of Arm's Length Price ('ALP').

There are some judicial precedents in connection with treatment of CSR expenditure as incurred in the course of normal operations and accordingly, can be allowed as a deduction (though prior to amendment to Section 37 of the IT Act) . Some instances are given below:

+ Payment made towards flood relief work, construction of musical fountain etc. [NMDC v. JCIT [2015] 56 taxmann.com 396 (Hyderabad - Trib.)] = 2014-TIOL-1007-ITAT-HYD

+ Amount paid to Green Environment Co-operative Society on account of contribution for common effluent treatment plant with a view to protect assessee's business as ongoing entity [CIT v. Jayendra kumar Hiralal [2010] 327 ITR 147 (Guj.)]

+ Development of infra structural facilities of villages and construction of a new market to organize self-help groups that would certainly promote the business of the assessee [CIT v. Karnataka Financial Corpn. [2010] 326 ITR 355 (Kar.)] = 2010-TIOL-27-HC-KAR-IT

+ Expenditure on installation of traffic signals at various parts of city in order to secure free movement of its employees so that they reached office in time [CIT v. Infosys Technologies Ltd. [2014] 360 ITR 714/223 Taxman 469/43 taxmann.com 251 (Kar.)] = 2013-TIOL-507-HC-KAR-IT

Further, one may say that the incurrence of CSR expenditure is enforced by an Indian law and are akin to other statutory expenses viz. audit fees, tax audit fees, expenses on other regulatory requirements, etc. Additionally, unlike Donation, CSR expenses are not voluntary in nature. Therefore, such expenditure can be regarded as expenditure necessarily and statutorily required for carrying on the business and hence operating in nature. Therefore, such expenses can be either claimed as a re-imbursement from the overseas parent or it can be recovered from the AE along with the arm's length mark-up.

Moreover, while undertaking benchmarking analysis, there could be practical difficulties in identifying CSR expense in case of comparable companies, unless it is disclosed as a separate line item in the financial statements. Moreover, the financial data extracted from the databases may not have CSR expenses as separate line item in the Profit & Loss Account of the comparable companies. Accordingly, it would be impractical to exclude such expense from cost base of the taxpayers. In such a scenario, for comparability purpose, the Indian tax authorities may perceive to consider CSR expenditure as operating expenses and may allege its recovery from the AE alongwith arm's length mark-up.

Whether CSR expenses should be considered 'non-operating expenses' for PLI computation?

One may take a view that the expenditure on CSR may be considered to be 'non-operating' while computing the PLI, in view of the fact that such expenses are not allowed as a tax deductible expense post the amendment under section 37 of the IT Act.

However, it can be construed that there is no direct correlation between allowance/disallowance of a particular expenditure under the IT Act vis-a-visits classification as 'operating' or 'non-operating'. While computing PLI of a company, the amount as per the books of account is normally considered and not the amount allowed as deduction under the IT Act where there is a difference, for example, depreciation, expenditure on scientific research, etc. Further, certain expenses are allowed under IT Act only on payment basis viz. contribution by employer to provident/superannuation/gratuity fund, bonus or commission paid to employees, etc. However, even in case where such expenses are disallowed, such expenses are considered as operating in nature while computing the PLI.

In case of a typical cost plus model of a service company, AE of the Indian taxpayer may not be willing to remunerate for CSR expenses as it may consider that such expenses are not in relation to the service transaction. In such scenario, the taxpayer will have to bear the brunt of CSR expenses, impacting its net profit margin downwards. Eventually, the taxpayer would chose to consider a proposition to consider CSR expense as 'non-operating expense' while computing its PLI for benchmarking purpose.

However, this view of considering CSR as 'non-operating expenditure 'for PLI computation could lead to litigation.The revenue officers may take a diverse view to consider CSR expenditure as 'operating expenses' in light of the above discussions.

Conclusion:

As the CSR norms are introduced recently, it has not yet made its debut in the arena of Indian transfer pricing litigation. However, one may expect some kind of litigation in due course as it is likely to impact many corporate taxpayers. It may, therefore,be appropriate to consider CSR spending as 'operating expense 'while computing the PLI to avoid tedious litigation.

The corporate taxpayers may be required to consider the aforementioned aspects while formulating their transfer pricing policy with group companies.

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1. The permissible CSR activities are provided in Schedule VII of the Co's Act are given below:

-  Eradicating extreme hunger and poverty;

-  Promotion of education;

-  Promoting gender equality and empowering women;

-  Reducing child mortality and improving maternal health

-  Combating human immunodeficiency virus, acquired immune deficiency syndrome, malaria and other diseases;

-  Ensuring environmental sustainability;

-  Employment enhancing vocational skills

-  Social business projects;

-  Contribution to the Prime Minister's National Relief Fund set up by the Central Government or the State Governments for socio development and relief and funds for the welfare of the Scheduled Castes, the Scheduled Tribes, other backward classes, minorities and women: and

Such other matters as may be prescribed