Kolkata Tribunal Special Bench Ruling (Tribunal) – Whether an arm's length price adjustment was required to be made in respect of interest free loan granted by the assessee, a non-resident company, to its wholly owned subsidiary in India?
Instrumentarium Corporation Limited, Finland vs. Assistant Director of Income Tax International Taxation I Kolkata [ITA Nos. 1548 and 1549/Kol/2009]
Instrumentarium Corporation Limited (ICL Finland or assessee), is a company incorporated in and tax resident of Finland. ICL Finland is engaged in the business of manufacturing and selling medical equipment, and it has a wholly owned subsidiary in India i.e. Datex Ohmeda India Pvt Ltd (Datex India or associated enterprise or AE) which acts as ICL Finland's marketing arm for its products in India.
The assessee entered into an agreement, duly approved by the Reserve Bank of India, to advance an interest free loan of INR 36 crores to Datex India. The subject matter of dispute was whether the Assessing Officer (AO) was correct in adopting an arm's length interest on the said loan and an arm's length price (ALP) adjustment was required to be made to the income to be brought to tax in the hands of ICL Finland. On the contrary, the assessee was of the view that, for a variety of reasons including the issue of base erosion of Indian tax base, no adjustment should be made on the said transaction.
The assessee did not file any income tax return in India for any of the assessment years, even after the unsuccessful effort of obtaining the advance ruling. Further, the assessee did not even respond to the notices issued under section 148 and under section 142(1) of the Income-tax Act, 1961 (the Act), and the AO proceeded to treat Datex India as a representative assessee and proceeded to finalize the assessment under section 144 r.w.s. 147 of the Act and finalized the arm's length price adjustment of INR 3,88,37,190.
Aggrieved by the addition, assessee carried the matter in appeal before the Commissioner of Income-tax- Appeals [CIT(A)] but without any success, the CIT(A) upheld the AOs order. Further, the assessee preferred an appeal before the Tribunal and the division Bench referred the issue to the Special Bench. The Special Bench framed the question to be answered which is as follows:
Whether, on the facts and in the circumstances of the case, an arm's length price (ALP) adjustment, of Rs 3,88,37,190 for the assessment year 2003-04 and Rs 5,18,95,560 for the assessment year 2004-05, was required to be made, in respect of interest free loan granted by the assessee, a non-resident company, to its wholly owned subsidiary in India?
Contentions of the assessee
- The basic argument of the assessee was that in a situation in which result or consequence of an arm's length price adjustment is erosion of domestic tax base, the provisions of the transfer pricing cannot be invoked i.e. since there was no erosion of tax base in India by the assessee giving an interest free loan to its wholly owned subsidiary Indian company, the provisions of the transfer pricing cannot be invoked.
- The assessee pointed out that if the
computation of interest is imputed to the loan, the net result will
- a withholding tax of 10% on the interest payable,
- a statutory reduction or deductibility of the said expenses which will allow benefit of 36.75% tax to the appellant company, and
- a resultant base erosion of 26.75% to the Indian revenue.
- Reliance was placed on CBDT circular no. 14 of 2001 which states that "..the basic intention underlying the new transfer pricing regulations is to prevent shifting of profits by manipulating prices charged or paid in international transactions, thereby eroding the country's tax base" and that "the new section 92 is, therefore, not intended to be applied in cases where adoption of arm's length price, determined under the regulations, will result in a decrease in overall tax incidence in India in respect of parties involved in the international transactions".
- Further, reliance was also placed on ruling no. 1 of 2007 issued by the Australian Tax Office (ATO) which holds that "ALP adjustments are not required to be made in the cases of interest free loans granted by the non-resident company to the domestic company even if the domestic company is incurring losses."
- The assessee also pointed out that the bar on corresponding deduction adjustments as provided in second proviso to section 92C(4) of the Act, comes into play only when arm's length price is paid to the AE. In the present case, since no payment has been made by the Indian AE, i.e. Datex India, the bar on deduction does not come into play.
Key observations and decision of the Tribunal:
- The Tribunal stated that according to section 92(3) of the Act, what is to be seen is impact on profits or losses for the year in consideration itself, as it is to "be computed on the basis of entries made in the books of accounts in respect of previous year in which the international transaction was entered into.", thus the impact on taxes for the subsequent years is irrelevant.
- It found no basis to the assessee's plea that, if there is an enhancement to an income, corresponding deduction cannot indeed be given to the related AE, but if an altogether new income is brought to tax in the hands of the assessee, as a result of ALP adjustment, corresponding deduction is required to be given to the Indian AE.
- The second proviso to section 92C(4) of the Act constitutes a bar against lowering income of the non-resident AE, as a result of lowering the deduction in the hands of the Indian AE, rather than enabling a higher deduction in the hands of the Indian AE as a result of increasing non-resident AE's income.
- The tax administration cannot be expected to have clairvoyance of whether or not Indian AE will actually make sufficient profits in the next eight AYs which will subsume the losses incurred by the assessee and the benefit of tax shield, even if any, was, therefore, wholly hypothetical.
- One has to interpret the law as it exists and not as it ought to be. The lawmakers may have preferred a bird in the hand over two in the bush but that is a policy issue. In any event, nothing in the world can match the exactitude of hindsight but the trouble is that it inherently comes a bit too late.
- It distinguished the ATO ruling vis-a-vis section 92 of the Act and stated that unlike the provisions of section 92, wherein use of arm's length principle is mandatory in computation of income arising to an assessee from the international transactions, Section 136 AD of the Australian Income Tax Assessment Act 1936 (AITA), a computation of income on the basis of arm's length price is discretionary for the Commissioner in as much as it comes into play in respect of an international transactions between the AE1.
- It also placed reliance on the extracts from ATO ruling 94/142 where the Commissioner has discretion whether or not to apply section 136AD of the AITA. On the contrary the Indian transfer pricing regulations do not give any such discretion to the tax administration for the application of arm's length price in computation of profits arising from international transactions.
- It also distinguished the AITA such that consequential adjustments are permissible in certain conditions under section 136AF of the AITA, and no such adjustments are permissible under the Indian Act.
- The CBDT circular (supra) relied on by the assessee only states the intent of the legislature in so many words. However, it is not an order, direction or instruction to the field authorities to the effect that section 92 is not to be applied when overall tax incidence in India, in respect of the parties involved in the international transaction, will decrease.
- It placed reliance on the decision of Kolkata Bench in the case Tata Tea Ltd Vs JCIT [(2003) 87 ITD 351 (Kol)], and stated that even if the intent of the legislature is that the transfer pricing provisions should not to be invoked in the cases where there is lowering of the overall profits of all the AEs connected with the transactions; since the words of the statutory provision did not translate the said intent into the law, it is not open to hold that even when there is no erosion of Indian tax base, transfer pricing provisions are not to be applied, especially in the light of the legal provisions as stated under section 92(3) of the Act.
- It also placed emphasis on the fact that mere possibility of a set off of future profits, against the losses incurred by the AE, cannot be taken into account for such a computation about overall tax impact, nor the time value of money can be ignored in the said computation.
- It further distinguished the decision of Hon'ble SC in the case of DIT Vs Morgan Stanley & Co Ltd [(2007) 292 ITR 416 (SC)], as the said case was on a wholly unrelated issue of PE profit attribution and their Lordships were deciding the scope and impact of a tax treaty provision, and in that context certain observations of macro importance were made.
- It stated that, if the observation of the Hon'ble SC in the case of Morgan Stanley (supra) is followed then every payment by the Indian AE to the non-resident company will be outside the ambit of ALP adjustment because whatever is earned by the non-resident company from the Indian AE will be tax neutral i.e. whatever is added to the income of the non-resident will stand reduced from the income computation of the Indian AE but then such an approach is alien to Indian transfer pricing legislation.
- It further stated that the assessee's reference to Article 141 of the Constitution of India, and emphasizing that the law laid down by Hon'ble SC in Morgan Stanley's case (supra) binds the forum, as indeed all the courts in India, were perhaps wholly out of place inasmuch as the question before Hon'ble SC was altogether different.
- Based on all the above observations, the Tribunal declined to accept the base erosion argument of the assessee in principle nor did they find anything in the facts on record to even support the factual elements embedded in the plea of the assessee company.
- It further stated that the commercial expediency of a loan to subsidiary is wholly irrelevant in ascertaining arm's length interest on such a loan.
- It distinguished the decision of the Hon'ble SC in the case of SA Builders Ltd Vs CIT [(2007) 288 ITR 1 (SC)], such that in that case borrowed funds were utilised for the purposes of business, and, accordingly, whether interest on borrowings for funds so used can be allowed as a deduction in computation of business income of the assessee.
- It also distinguished the decision of the Hon'ble SC in the case of CIT Vs Shoorji Vallabhdas & Co [(1962) 46 ITR 144 (SC)]. The proposition in that case was in the context of tax laws in general whereas, transfer pricing provisions, being anti abuse provisions with the sanction of the statute, come into play in the specific situation of certain transactions with the associated enterprise.
- It further rejected various judicial precedents on which assessee had placed reliance as none had relevance on computation of ALP of loan given to an AE.
- It also supported the findings of the AO that the interest was all along charged by the assessee on its loans to its Indian AE but, for some unexplained reasons, the assessee had stopped charging interest from the AY 2003-04.
- It stated that, in the assessee's case, there was no re-characterization of the transaction, as the transaction continued to be a loan transaction and the substitution of zero interest by arm's length interest does not alter the basic character of transaction. The question of re-characterization arises only when the very nature of transaction is altered, such as capital subscription being treated as loan or such a trade advance received being treated as a borrowing.
- It rejected the plea of the assessee that when the assessee has not reported any income from a particular international transaction, the ALP adjustment cannot compute the same. The computation of income on the basis of arm's length price does not require that the assessee must report some income first, and only then it can be adjusted for the ALP.
- It also distinguished the assessee's reliance on the decision of Hon'ble Bombay High Court such that, the case of Vodafone India Services Limited Vs ACIT [(2015) 368 ITR 1 (Bom)] deals with a situation in which the international transaction was inherently incapable of producing the income chargeable to tax as it was in the capital field, on the contrary, in the case of assessee the consideration for a loan, i.e. interest, is inherently in the nature of income.
- It stated that Section 92(1) is not an adjustment mechanism; it is a computation mechanism.
- The Tribunal concluded that even when no income is reported in respect of an item in the nature of income, such as interest, but the substitution of transaction price by arm's length price results in an income, it can very well be brought to tax under Section 92. It rejected the plea of the assessee that no arm's length price adjustments can be made in respect of the interest free advances granted by the assessee to its Indian AE.
- It further stated that so far as quantification of the arm's length price adjustment is concerned, the same had to be dealt with the division bench as no arguments, with respect to the quantification part, were advanced before them. It also stated that it was also open to the parties to take up any other issue, not specifically dealt with above, before the division bench in accordance with law.
- Thus, the Tribunal restored back the matter to the division bench for deciding the appeal in light of all the above observations.
The Tribunal has dealt in detail on the concept of base erosion which was relied by the assessee, as its main argument that attribution of income to the foreign associated enterprise, under transfer pricing law, on account of interest on loan given; would automatically mean a deduction granted in law to the Indian associated enterprise. This so, because Sir Issac Newton's third law of motion that, "Every Action has an Equal and Opposite Reaction" does not apply to interpretation of law, as the limits of law is based on what is enshrined in the legislation and not on the basis of a logical exercise. The other aspects on the issue would probably evolve in time.
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