This Tax Alert summarizes a recent ruling of Hyderabad Income Tax Appellate Tribunal (ITAT) in the case of Four Soft Pvt Ltd, Hyderabad (Taxpayer) on transfer pricing (TP) issues arising from the issuance of a corporate guarantee to banks in favor of associated enterprises (AEs). The Taxpayer, an Indian company, provided a guarantee to a third party bank on behalf of its foreign subsidiary. The Taxpayer did not charge its subsidiary a guarantee fee for provision of such corporate guarantee. During audit proceedings, the Transfer Pricing Officer (TPO) imputed a TP adjustment of 3.75% as an arm’s length guarantee fee. The TPO determined the rate based on the commission charged by an unrelated bank for providing a bank guarantee to customers. The Taxpayer relied on the ITAT’s ruling in its own case for an earlier year to argue that the provision of a guarantee is not an international transaction to which the TP provisions apply.
The ITAT held that the corporate guarantee provided by the Taxpayer to its AE falls within the ambit of ”international transaction” as per the Indian Tax Law (ITL) post retrospective amendment to the definition by Finance Act, 2012. However, with regard to pricing for the guarantee, the ITAT observed that the bank guarantee cannot be used as a comparable benchmark to a corporate guarantee provided by a group company and thus, remanded the matter back to the TPO to determine the arm’s length price (ALP) for the corporate guarantee.
The ITAT has also adjudicated on other TP issues such as selection of comparable companies and appropriateness of reliance on segmental margins with respect to provision of software development services, arm’s length interest on a loan provided to an overseas subsidiary and re-characterization of equity into a loan. Except for the matter pertaining to selection of certain comparable companies wherein the ITAT recorded its findings, the remaining matters were remanded to the Assessing Officer (AO)/ TPO with directions for fresh consideration.
One of the fundamental fact patterns in the evolution of international transfer pricing concepts and rules involves an enterprise’s use of a financial resource belonging to an associated enterprise. An aspect of the use of money relates to the use of a credit enhancement instrument, which typically arises in the context of guarantees of the obligations of one controlled entity by another. Although the OECD Transfer Pricing Guidelines, 2010 acknowledge the role of the use of money in transfer pricing matters, they do not yet provide specific guidelines regarding how such issues are to be addressed and resolved. Nonetheless, the elements that are typically important in evaluating transfer pricing issues involving the use of money within multinational enterprise groups can be outlined by drawing on general arm’s-length principles.
Whether the mere presence of a guarantee support to an AE is subject to TP provisions has been a contentious issue in the Indian context. The ITL was amended in 2012 to clarify that provision of a guarantee to an AE is an international transaction. However, in a recent ruling, the Delhi ITAT ruled that despite the amendment, a guarantee would not by itself constitute an international transaction as the guarantor does not incur any costs while extending the guarantee. This ruling of the Hyderabad ITAT takes a different view of the amendment and therefore, has not followed its earlier decision on this matter in the Taxpayer’s own case.
However, the issue of whether a charge should be imposed for provision of a guarantee is primarily a factual inquiry. Taxpayers should undertake a factual review of their intercompany guarantee arrangements to determine which conclusion can be applied to their fact pattern. While the ruling does not address the issue relating to manner in which an ALP may be determined for a guarantee transaction, the ITAT has rejected the TPO’s approach of obtaining price quotations from banks as an approach for pricing related party guarantee transactions.