Hyderabad Tribunal rules on transfer pricing aspects of corporate guarantee

Executive summary

This Tax Alert summarizes a recent ruling of Hyderabad Income Tax Appellate Tribunal (ITAT) in the case of Four Soft Pvt Ltd, Hyderabad (Taxpayer) [TS-104-ITAT-2014(HYD)-TP]¹ 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.

Detailed discussion

Background

The Taxpayer is an Indian company engaged in the provision of software development and information technology enabled services to its AEs. The taxpayer had provided a guarantee to a third party bank on behalf of its overseas subsidiary in the Netherlands. The Taxpayer did not charge a fee to its AE for provision of the guarantee.
In addition, the Taxpayer inter-alia reported the following international transactions (i) provision of software services to AEs; and (ii) interest on a loan advanced to a subsidiary in the Netherlands. Based on the TP study undertaken, the Taxpayer had concluded that its international transactions were at arm’s length under the ITL. With respect to the provision of software services, the Taxpayer applied the Comparable Uncontrolled Price (CUP) method by comparing the hourly man hour rate charged to AEs vis-à-vis non AEs in the study. It has also undertaken a supplementary analysis based on the Transaction Net Margin Method (TNMM) to substantiate the arm’s length nature of its international transactions. Further, the Taxpayer had also converted a loan provided to the Netherlands subsidiary into equity with the approval of the Reserve Bank of India.
The TPO rejected the TP study maintained by the Taxpayer and made adjustments to the international transactions as follows:

• • With respect to the corporate guarantee provided by the Taxpayer on behalf of its overseas subsidiary to the bank, the TPO proceeded to determine the ALP at the rate of 3.75% based on guarantee rates charged by a third party bank to its customers and accordingly, made an adjustment to the income of the Taxpayer.
• • The TPO rejected the CUP method adopted by the Taxpayer and selected TNMM as the most appropriate method to determine the ALP with respect to international transactions pertaining to provision of software development services. The TPO applied additional filters and gathered additional data resulting in the selection of 26 companies as comparables with an average operating margin of 26.36% and accordingly made an adjustment.
• • With respect to the loan given by the Taxpayer in foreign currency to its subsidiary, the TPO rejected the interest rate of 8.3% charged by the Taxpayer and determined the arm’s length interest rate at 14% by applying the rate of domestic corporate bonds.
• • In relation to the loan that was converted into equity share premium on existing equity shares, relying on the Delhi ITAT decision in the case of Perot Systems TSI India Ltd vs. DCIT (2010-TIOL-51-ITAT-Del), the TPO held that subsequent conversion of a loan to equity will not change the character of the transaction because when the parties entered into the transaction it was only a loan transaction. Accordingly, the TPO re-characterized that portion of the equity as a loan and imputed an arm’s length interest rate of 14%.

The Dispute Resolution Panel (DRP) rejected the objections raised by the Taxpayer against the aforesaid adjustments and the matter went on appeal before the ITAT.

ITAT ruling

Provision of Corporate Guarantee

The Taxpayer argued that the corporate guarantee is an additional guarantee provided by the parent company and it does not involve any cost or risk to the shareholders. Since the corporate guarantee was given keeping in view the paramount business interest of the parent company, there is no requirement to charge a guarantee fee. The Taxpayer also argued that the retrospective amendment to section 92B of the ITL, by Finance Act, 2012 does not enlarge the scope of the term ”international transaction” to include the corporate guarantee in the nature provided by the Taxpayer. The issue is also covered in favor of the Taxpayer by virtue of the order passed by the ITAT in its own case for FY 2005-06.²
The Tax Authority, on the other hand, contended that the transaction of providing the corporate guarantee is covered by the definition of international transaction after the retrospective amendment made by Finance Act 2012. Therefore, the transaction was subject to TP provisions and needed ALP determination.
After considering the rival submissions, the ITAT concurred with the contention of the Tax Authority that the corporate guarantee of the nature provided by the Taxpayer is covered under the expanded definition of international
transaction post amendment to ITL. It distinguished its earlier decision in the Taxpayer’s own case, on the ground that the decision was made prior to the amendment to Section 92B of the ITL. In this regard, the Hyderabad ITAT referred to the decision of the Mumbai bench in the case of Mahindra & Mahindra vs. DCIT [TS-408-ITAT-2012408-ITAT-2012(Mum)] wherein the bench had an occasion to consider a similar argument made wherein it held that if the amendment to section 92B is with retrospective effect, then the impact of the earlier decision of Hyderabad ITAT in the case of Four Soft Ltd [TS-518-ITAT-2011518-ITAT-2011(HYD)-TP] relevant to an earlier year should be ignored.
As regards the quantum of guarantee fee to be charged, the ITAT was of the view that a corporate guarantee provided by the Taxpayer cannot be compared to a bank guarantee provided by third party banks and therefore, the rate charged by banks cannot be applied to determine the ALP for the guarantee provided by the Taxpayer. It referred to the decision of Mumbai ITAT in the case of Glenmark Pharmaceuticals³ wherein a distinction between a bank guarantee and corporate guarantee was made and 0.53% was held as the appropriate arm’s length guarantee fee. Further, the Hyderabad ITAT in the case of Infotech Enterprises Ltd,⁴ while considering the identical issue followed the rationale in the case of Glenmark Pharmaceuticals and remitted the issue back to the TPO to decide the quantum of the corporate guarantee. The ITAT accordingly remanded the matter back to the TPO for determining the arm’s length guarantee fee.

Other issues

The ITAT remitted the other issues back to the AO/ TPO based on the following directions for fresh consideration:

• • To determine the ALP of comparable companies based on comparable specific directions provided in the ruling;
• • To determine the arm’s length interest by applying LIBOR + percentage points and to also specifically consider the Taxpayer’s offer of LIBOR +2% ; and
• • To consider afresh the issue of re-characterization of equity into loan after properly examining the whole agreement and other relevant facts.

Implications

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.⁵ 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.

Endnotes

1. This Alert discusses only the key transfer pricing issues and does not cover other tax issues addressed by the ITAT in the case of the Taxpayer.

2. M/s. Four Soft Ltd ITA No. 1495/HYD/2010. Refer to EY International Tax Alert alert dated 14 September 2011.

3. TS-329-ITAT-2013(Mum)-TP.

4. ITA No. 115/Hyd/2011 and ITA No. 2184/Hyd/2011 dated 16 January 2014.

5. Delhi ITAT in a recent decision in the case Bharti Airtel Limited (TS-76-ITAT-2014(DEL)-TP). Refer to EY Global Tax Alert, Delhi Tribunal rules on transfer pricing aspects of intra group financing transactions, dated 17 March 2014