THE India TP story so far…

The present day Indian Government has laid emphasis on "Ease of doing business". Under this initiative of the Government, the Finance Ministry has ushered in several tax reforms to make India a tax friendly jurisdiction. In line with the same objective, the Central Board of Direct Taxes (CBDT) has in the recent past introduced Safe Harbor Rules, risk based approach for scrutiny of cases and Advance Pricing Agreement (APA). In particular, with the favorable amendments in the Safe Harbor Rules and with APAs being concluded for various transactions, there seems to be a gradual decline in TP litigation. However, legacy issues continue. In this article, we discuss one recurring issue- the treatment of inter company receivables for the purpose of transfer pricing.

Brief background

In the recent past, the issue of outstanding inter-company receivables has been receiving special attention from the tax authorities. It is seen that:–

- the tax officers typically call for ageing details of trade receivables arising out of inter-company transactions;

- where such receivables are outstanding for more than the standard credit period extended to debtors (related or unrelated party), tax officers have shown a tendency to impute a notional interest;

- the notional interest is generally the SBI Prime Lending Rate (PLR) / bond yield rate/ government securities, as the case may be.

While tax experts and practitioners have different opinions on this matter, it is pertinent to consider the following practical aspects while dealing with the same.

Practical aspects

1) Whether the transaction is an international transaction?

In order to answer the above, we shall refer to the explanation given in Section 92B of the Income Tax Act, 1961 (The Act) to the definition of international transaction (relevant extract):

"……..Section 92B…… [Explanation.—For the removal of doubts, it is hereby clarified that -

(i) the expression “international transaction” shall include -

(c) capital financing, including any type of long-term or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business;

Therefore, it seems that the intent of the law makers is to cover receivable as an international transaction.

2) Aggregation approach

Inter-company receivable balances typically arise out of primary inter-company transactions in the form of sale of goods or services. Tax payers take the view that once the Arm's Length Price (ALP) of the said primary inter-company transactions are determined / established, analyzing the inter-company receivable balances separately or imputing notional interest on the same is not warranted.

Further, the interest component on delayed receivables is accounted for in the working capital adjustment while analyzing the primary transaction. Accordingly, some taxpayers adopt the approach of aggregation wherein the primary transactions and their ALP would factor in the issue of notional interest.

The key considerations captured in various judicial precedents that support the above view / approach are discussed below:

- Interest income is normally associated only with the lending or borrowing of money and not with sale (of goods and services). Hence, the ALP is determined is qua the 'sale price'

- Once ALP is determined in respect of the sale transactions, it may be deemed to be covering all the elements and consequences of the transaction.

- Payment terms are an integral part of any commercial transaction, and the transaction value takes into account the terms of payment, such as permissible credit period.

- TP adjustment cannot be made on hypothetical and notional basis until and unless there is some material on record that there has been under charging of real income.

- Once working capital adjustment is granted, no separate adjustment on account of outstanding receivables is maintainable.

However, the assessing authorities take a contrary view by re-characterizing the outstanding inter-company receivables as loans and imputing interest on the same.

3) Re-characterization of transaction

Is re-characterization of transaction a trend or a logical approach? During litigation process, it is not uncommon on the part of tax authorities to re-characterize primary transaction. For example, share application money paid maybe alleged as an interest free loan.

In a similar manner, outstanding receivables are deduced as disguised loans, which are further subjected to interest adjustments.

In this regard, the following paragraph of OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations – July 2017 are relevant:

1.120 In performing the analysis, the actual transaction between the parties will have been deduced from written contracts and the conduct of the parties. Formal conditions recognised in contracts will have been clarified and supplemented by analysis of the conduct of the parties and the other economically relevant characteristics of the transaction (see Section D.1.1).

Where the characteristics of the transaction that are economically significant are inconsistent with the written contract, then the actual transaction will have been delineated in accordance with the characteristics of the transaction reflected in the conduct of the parties.

The non-recognition of a transaction that possesses the commercial rationality of an arm's length arrangement is not an appropriate application of the arm's length principle. Restructuring of legitimate business transactions would be a wholly arbitrary exercise the inequity of which could be compounded by double taxation created where the other tax administration does not share the same views as to how the transaction should be structured . It should again be noted that the mere fact that the transaction may not be seen between independent parties does not mean that it does not have characteristics of an arm's length arrangement.

If this view is accepted, the examination should be solely based on the actual transaction as undertaken and structured by the entities.On the contrary,the primary transaction is often substituted with loan or similar transactions without any regard to the economic relevance of the primary transaction.

What needs to be considered is the business arrangements and credit period, and whether these arrangements factor in the interest component for the excess credit period. Where there is a provision to charge interest, it is important that the terms are honored when the business is conducted (third party vis-à-vis associated enterprise)

4) Normal vs excess credit

Another crucial factor while dealing with the same issue is the credit policy extended to associated enterprises vis-à-vis third parties.

Tax payers should ideally maintain consistency in the payment period allowed to all the parties. Further, the policy of charging / non-charging of interest by the tax payer should be equally applied to both related parties and third parties.

Any major deviations in the business policy may lead to adjustments by the tax authorities leading to potential litigation.

5) Other factors

There are several other factors that may be considered over and above the key factors mentioned in the preceding paragraphs.

- Appropriate comparability adjustments maybe undertaken on the primary transactions as a safeguard against unwarranted TP adjustments

- It has to be substantiated with facts and figures that higher earnings of the tax payer vis-à-vis comparable companies would take care of interest component, if any.

- When a tax payer being the parent entity doesn't incur any liability to fund its working capital requirements, it may grant excess credit period to the associated enterprise as compared to third party out of its obligation as a shareholder.

Concluding remarks:

It is often said that transfer pricing is not an exact science and therefore there may be some subjective elements. Taxpayers will therefore face challenges. Thus, it is imperative for them to maintain all the agreements and material documentations to provide for a persuasive defense to the tax authorities.

As enunciated by courts, a TP adjustment cannot be made on conjectural basis until and unless there are some material evidences that validate the under charging of real income. However,with the introduction of secondary adjustment and general anti-avoidance rules (GAAR), it would be interesting to see how the litigation surrounding notional interest on outstanding receivables pans out.

(The authors, CA Nisha Karkera and CA Saurabh Kothari are tax professionals and the views expressed herein are their personal views.)