KPMG FLASH NEWS KPMG IN INDIA The Delhi Tribunal held that corporate guarantee issued for AEs benefit, which did not cost anything to the taxpayer, does not constitute international transaction. The Tribunal also rejected the notional interest adjustment on the share application money advanced to AE 18 March 2014 Background 1 Recently, the Delhi bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of a taxpayer held that the corporate guarantee issued by the taxpayer for the benefit of its associated enterprise (AE), which neither involves any costs nor has any bearing on profits, income, losses or assets of the taxpayer, does not constitute an international transaction within the meaning thereof under section 92B of the Income Tax Act, 1961 (the Act). Based thereon, the Tribunal deleted the adjustment made by the Transfer Pricing Officer (TPO) on account of the issuance of corporate guarantee. Facts of the case Issue of corporate guarantee Taxpayer is engaged in the business of telecommunication services. During the year 2007-08, the taxpayer issued a corporate guarantee to lender bank on behalf of its AE. It seems from the text of the ruling, that during the relevant financial year, the AE did not even raise any borrowings from the lender bank for which the taxpayer had issued the corporate guarantee. On another noteworthy transfer pricing issue, the Tribunal rejected the adjustment of notional interest made by the TPO by re-characterising the share application money advanced by the taxpayer to its AE as an interest-free loan. The Tribunal held that it is not open to the tax authorities to re-characterise the transaction unless it is found to be a sham or bogus transaction. 1 Apart from the corporate guarantee and share application money issues covered in the flash news, several other transfer pricing and corporate tax issues were adjudicated by the Tribunal in this ruling. Those issues are not covered as part of this flash news. Based on its contention that it had not incurred any costs or expenses on account of such guarantee and that it was a part of the shareholder activity, the taxpayer issued the corporate guarantee at nil consideration. However, based on market quote of such corporate guarantee, the taxpayer in it transfer pricing (TP) study determined arm s length commission for issuing such guarantee at the rate of 0.65 per cent per annum of the
guaranteed amount. Based thereon, the taxpayer offered a suo-moto adjustment in its income tax return and offered to tax income from issuance of corporate guarantee. The Transfer Pricing Officer (TPO), relying on Para 7.13 of the OECD guidelines 2 (which state that but an intra group service would usually exist where the higher credit rating were due to a guarantee by another group member ), observed that by issuing the corporate guarantee, the taxpayer had benefitted its AE by increasing its credit rating. To determine the arm s length price (ALP), the TPO applied the Comparable Uncontrolled Price method. Based on data obtained from various banks under Section 133(6) of the Act, the TPO determined an arm s length price of the guarantee commission income at 2.68 per cent plus a mark-up of 200 basis points. The TPO also made a reference to the decision of the Tax Court of Canada in the case of GE Capital Canada 3. On objections raised by the taxpayer, the Dispute Resolution Panel (DRP) rejected such objections and confirmed the transfer pricing additions proposed by the TPO/Assessing officer (AO). On the objection raised by the taxpayer that issuance of corporate guarantee does not attract transfer pricing provision, the DRP rejected the argument based on the grounds that the retrospective amendment to Section 92B of the Act by the Finance Act 2012, makes issuance of a corporate guarantee an international transaction. Notional interest on share application money The taxpayer during the relevant previous year made payments towards share application money to its foreign subsidiaries. The taxpayer did not benchmark these transactions as these were in the nature of share application money payments. The TPO did not question the character of payment, however noted that these amounts were not converted into equity for quite a long time and that the taxpayer has not earned any interest for this period. The TPO treated such amounts as interest-free loans extended to the AEs and considered the transaction to get covered as an international transaction of lending or borrowing money under the provisions of Section 92B of the Act. Consequently, the TPO made adjustment for interest thereon. The DRP agreed with the TPO on this issue and observed that capital locked up for want of transfer of share for reasonably long period would partake the nature of loan. Taxpayer contentions In the cases of transactions with, or on behalf of the AE, where no costs are involved, TP provisions are not attracted. There is no judicial ruling, in the context of Indian TP legislation, which specifically holds that even in respect of the corporate guarantees issued for the benefit of the AE, which do not involve any cost to the taxpayer, adjustment can be made on account of arm s length price determination. With regard to the tax department s reliance on the decision of the Tax Court of Canada in the case of GE Capital Canada, the taxpayer contended that the issue in the present case is to be decided in the light of the domestic legal provisions and Indian jurisprudence need not be in pari materia with Canadian tax laws. On the share application money transaction, the taxpayer contented that the same is not in the nature of international transaction, and hence outside the purview of transfer pricing provisions. Tax department s contentions The taxpayer s proposition that the issuance of corporate guarantees does not constitute an international transaction itself, goes against the very fundamentals of the TP legislation which seeks to determine the profits that the taxpayer would have made if the transactions with AEs were entered into at an arm s length price with a third party. There are a large number of judicial precedents from the coordinate benches rejecting similar arguments. There are judicial precedents from foreign judicial forums, such as the decision from the Tax Court of Canada, in the case of GE Capital Canada upholding arm s length price determination in similar cases. On the share application money transaction, the TPO took a view that any independent entity would not have left the share application money without the same being converted into equity within a reasonable period or receiving interest on the same. 2 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration issued by The Organisation for Economic Co-operation and Development 3 GE Capital Canada Inc v. The Queen (2009 TCC 563)
The tax department relied upon the decisions of coordinate benches in the cases of VVF Ltd 4 and Perot Systems TSI India Ltd 5, wherein the transactions under consideration were admittedly in the nature of interest-free loan. The coordinate benches in both these rulings rejected the notion of interest-free loans and upheld the tax department s adjustment of arm s length interest on such transactions. Tribunal ruling Issue of corporate guarantee In order to be covered as an international transaction under clause (c) 6 and clause (e) 7 of the Explanation to Section 92B, the transactions should be such as to have bearing on profits, incomes, losses or assets of such enterprise. The clause (c) includes transactions related to capital financing including guarantee transactions. Situations wherein a transaction has no bearing on profits, incomes, losses or assets of taxpayer, such transaction will be outside the ambit of expression international transaction. This aspect is highlighted in clause (e) of the Explanation dealing with restructuring and reorganisation, wherein it is acknowledged that such an impact (on the profits, income, losses or assets) could be immediate or in future. In relation to the above, the Tribunal observed that the Explanation to Section 92B, which was inserted with retrospective effect from 1st April 2002 vide Finance Act, 2012, states that it is merely clarificatory in nature in as much as it is for the removal of doubts. Based thereon, the Tribunal concluded that the Explanation does not alter the basic character of definition of international transaction under Section 92B and the Explanation is to be read in conjunction with the main provisions, and in harmony with the scheme of the provision under Section 92B. Therefore, the precondition about impact on profits, income, losses or assets of such enterprises is a pre-condition embedded in Section 92B(1) itself. 4 VVF Ltd v. DCIT (2010 TIOL 55 ITAT Mum TP) 5 Perot Systems TSI India Ltd v. DCIT (2010 TII 55 ITAT TEL TP) 6 clause (c) of the Explanation to section 92B includes transactions of 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. 7 clause (e) of the Explanation to section 92B includes of business restructuring or reorganisation, entered into by an enterprise with an associated enterprise, irrespective of the fact that it has bearing on the profit, income, losses or assets of such enterprises at the time of the transaction or at any future date. On the precondition about impact on profits, income, losses or assets, the mere fact that impact is not immediate, but on a future date, would not take the transaction outside the ambit of international transaction. However, this precondition would not get satisfied if the impact is only contingent. The important distinction between the two categories - contingent and future, is that while latter is a certainty, and only its crystallization may take place on a future date, there is no such certainty in the former case. For the present case, the Tribunal held that it is an undisputed position that corporate guarantees issued by the taxpayer to the lender bank did not even have any impact on profits, income, losses or assets because no borrowings were resorted to by the AE from this bank. Based on all of the above, the Tribunal held that the issuance of corporate guarantees in question, which did not involve any costs to the taxpayer and does not have any bearing on profits, income, losses or assets of the taxpayer, is outside the ambit of international transaction, and directed the AO to delete the adjustment on account of corporate guarantee. The Tribunal also held that the onus is on the revenue authorities to demonstrate that the transaction is of such a nature as to have bearing on the profits, income, losses or assets of the taxpayer. Such an impact has to be on real basis, even if in present or in future, and not on contingent or hypothetical basis. On relevant judicial precedents, the Tribunal held that none of those relied upon by the tax authorities, the scope of international transactions under Section 92B(1) has come up for examination. Thus, such judicial precedents cannot be relied upon. A judicial precedent cannot be an authority for dealing with a question which has not even come up for consideration in that case. The Tribunal also rejected the tax authorities reliance on international judicial precedence (the case of GE Capital Canada). In this relation, the Tribunal observed that the domestic law provisions in Canada are quite at variance with the Indian TP legislation.
The Tribunal observed that there can be number of situations in which an item may fall within the description set out in the clause (c) of Explanation to Section 92B, and yet it may not constitute an international transaction as the condition precedent with regard to the bearing on profit, income, losses or assets set out in Section 92B(1) may not be fulfilled. While the Tribunal cited a few examples, it mentioned that the common theme of such situation would be when the taxpayer extends an assistance to the associated enterprise, which does not cost anything to the taxpayer and particularly for which the taxpayer could not have realized money by giving it to someone else during the course of its normal business, such an assistance or accommodation does not have any bearing on its profits, income, losses or assets, and, therefore, it is outside the ambit of international transaction under Section 92B (1) of the Act. In the instant case, having concluded that the issuance of corporate guarantee does not constitute an international transaction, the Tribunal did not see the need to address the other objections raised by the taxpayer on the same issue viz., the corporate guarantee was issued to fulfil the shareholders obligation of the taxpayer and it did not lead to any additional risk for the taxpayer etc. Notional interest on share application money application money, the applicant is not allotted the shares. It is not open to the revenue authorities to re-characterise the transaction unless it is found to be a sham or bogus transaction. In the present case, the subscribed shares capital has indeed been allotted to the taxpayer and the transaction is thus accepted to be genuine in effect. The Tribunal held that the TPO has not brought on record anything to show that an unrelated share applicant was to be paid any interest for the period between receipt of the share application money and allotment of shares, the impugned ALP adjustment is devoid of legally sustainable merits. On the judicial precedents relied upon by the tax department, the Tribunal held that coordinate bench rulings in the cases of VVF Ltd and Perot Systems TSI India Ltd cannot be relied in the instant case as none of those rulings dealt with the issue as to whether a capital contribution can be deemed to be partly an interest-free loan and partly as capital contribution. In both these coordinate bench rulings, the respective assesses had advanced interest-free loans to their AEs. Our comments The Tribunal observed that the TPO has not disputed that the impugned transactions were in the nature of payments for share application money, and thus, in the nature of capital contributions. The TPO did not make any adjustment with regard to the ALP of the capital contribution but treated these transactions partly as interest free loan, for the period between the dates of payment till the date on which shares were actually allotted, and partly as capital contribution, i.e. after the subscribed shares were allotted by the subsidiaries. The Tribunal held that there is no finding about what is the reasonable and permissible time period for allotment of shares, and even if one was to assume that there was an unreasonable delay in allotment of shares, the capital contribution could have, at best, been treated as an interest free loan for such a period of inordinate delay and not the entire period between the date of making the payment and date of allotment of shares. Further, even if the ALP determination was to be done in respect of such deemed interest free loan on allotment of shares under the CUP method, it was to be done on the basis as to what would have been the interest payable to an unrelated share applicant if, despite having made the payment of share The Tribunal dealt with two very important aspects in this ruling issuance of corporate guarantees and notional interest on share application money. The ruling is important in the context of interpretation of whether issuance of corporate guarantees constitutes an international transaction, especially given the various debatable aspects provided in the clarificatory explanation inserted in Section 92B of the Act, with retrospective effect, by the Finance Act 2012. In this relation, the Tribunal ruled that such transaction can be covered under the clause of capital financing only if the pre-condition of present or future impact on profits, income, losses or assets of the taxpayer is fulfilled. The Tribunal also importantly differentiated between future impact and contingent impact on the profit, income, losses or assets. The ruling excludes such situations where the possibility of guarantee default can only be a hypothetical or a contingent situation, from being covered under the ambit of international transaction. While the ruling mentions the fact that the beneficiary AE did not even raise any borrowing from the lender bank in whose favour the corporate guarantee was issued by the taxpayer, the extent of relevance of this fact or the weightage assigned by the Tribunal to this fact is not clear.
The majority of the Tribunal s findings as summarised above, are in the context of interpretation of the corporate guarantee as a capital financing transaction. The ruling however, does not seem to have analysed whether the issuance of corporate guarantee can be characterised as a service transaction. In that context, it would be important to evaluate whether a similar transaction between third parties would have entitled the guarantor to earn an arm s length commission, irrespective of whether the guarantee is invoked or not. The Tribunal also extended the above-mentioned principle to receivables outstanding from AEs or debts to AEs that may arise during the course of business. In this relation, the Tribunal in an example mentioned that where receivables are out of cost-free funds and the debit balances related to AEs do not cost anything to the taxpayer, such cases would not constitute an international transaction. It would be interesting to see the applicability of the ratio of this decision in the context of other capital financing transaction issue of equity shares, where the share valuation issues are already under intense debate and highpitched litigations. On the issue related to notional interest on share application money, the Tribunal affirmed that it is not for the tax department to re-characterise transactions unless it is found to be a sham or bogus transaction.
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