Delhi HC upholds Tribunal ruling - TPO not empowered to restructure transaction; Agreed commercial terms to be respected in determining arm's length interest rate charged, Indian PLR not applicable for foreign currency loans

Facts

On the much debated issue of the manner of determination of the arm’s length interest rate for outbound loans denominated in foreign currency, the first High Court (HC) judgement has been delivered by the Delhi HC in the case of Cotton Naturals (I) Private Limited¹ (taxpayer). While doing so, the HC has reconfirmed certain established principles and also provided direction on tax authorities’ powers to restructure transactions and interpretation of global guidance in this regard.

The taxpayer, engaged in the business of manufacture and exports of rider apparels, had advanced a loan to its associated enterprise (AE) in the US @ 4% per annum. The AE, to whom the loan was granted, was a subsidiary undertaking distribution and marketing of the taxpayer’s products. The loan, foreign currency denominated, was granted by the taxpayer to its AE during financial year (FY) 2002-03 to meet the working capital requirements of the AE in order to continue its business activities smoothly. The interest rate was contended to be on an arm’s length basis by the taxpayer on the basis that the rate was comparable to the export packing credit rate obtained from independent banks in India. Confirming the order of the Transfer Pricing Officer (TPO) and also factoring the Dispute Resolution Panel’s (DRP) directions, the Tax Officer recomputed the arm’s length rate of interest in line with domestic Prime Lending Rate (PLR) in India, being the taxpayer’s opportunity return on the funds if deployed in the domestic market. The Income-tax Appellate Tribunal² (Tribunal) ruling was in favour of the taxpayer, against which the Revenue filed an appeal before the HC.

High Court ruling

While the HC blessed some of the principles laid down by various Tribunals in the past on the subject matter, it also provided direction on certain important additional factors around comparability and international guidance. The key principles from the HC Ruling are as follows:

1. Commercial expediency needs to be recognised, and the transaction cannot be restructured

The HC held that by viewing the transaction of foreign currency loan advanced in isolation, and in not appreciating the commercial relationship between the taxpayer and its AE, the TPO (relying on the Bangalore Tribuinal ruling in the case of Logic Micro Systems Limited v. ACIT (ITA No. 423/Bang/2009) has actually stepped into the shoes of the taxpayer and restructured the transaction to determine the maximum return it can earn on such loan amount from other sources. The TPO has erred in doing so as he has gone beyond his role, which was restricted to determining the arm’s length nature of a transaction undertaken as is, by ignoring the commercial expediency in the transaction.

In ruling the above, the HC has relied on the ruling in the case of CIT v. EKL Appliances Limited [2012] 209 Taxman 200, and further referred to its ruling in the case of Sony Ericsson Mobile Communications India Private Limited v. CIT (ITA No. 16/2014). The HC also relied on the UN Model Double Taxation Convention between Developed and Developing Countries. The issue of commercial expediency has been dealt with by various Tribunals in the past (including outside the context of financial transactions), and in favour of taxpayers in many cases.

2. Guidance on comparability

a) Comparability analysis to be undertaken in line with Rule 10B and Rule 10C of the Income-tax Rules, 1962 (Rules)

The HC said that since it was a prevalent practice among multinational companies to incorporate subsidiaries outside India for undertaking functions such as distribution and marketing, in view of Rule 10B and Rule 10C of the Rules, the comparison has to be with what independent entities would pay under identical circumstances, and not with the choices available to the taxpayer for earning the maximum returns by restructuring the transaction. This also supports the principle that the interest rate from an arm’s length perspective needs to be benchmarked from the borrower’s perspective (along with the terms of the loan such as currency, tenure etc.) and that the parameters would be consistent for inbound and outbound loans.

Applying the Rules, the HC has gone a step further and made an observation on the year of data to be used for comparability, i.e., it should be the data pertaining to the financial year in which the international transaction had been entered into, which in the instant case was FY 2002-03, when the loan was advanced. Payment of interest (which was also an international transaction) would have reference to the year in which the loan was granted. A detailed guidance has not been provided by the HC since the issue was not raised before it during the proceedings.

The HC also commented that it was erroneous to apply Reserve Bank of India’s (RBI) Master Circular as arm’s length rates, as these were special schemes floated by the RBI to encourage and facilitate exports.

b) Indian lending rate vs foreign currency lending rate
 
Arm’s length interest rate needs to be the market-determined rate applicable to the currency in which the loan has to be repaid. In this respect, the HC referred to Klaus Vogel’s recommendation on the Double Taxation Conventions (Third Edition). That position has been accepted by various Tribunals in the past, as referred to in the current HC judgement.

3. Guidance on the Indian Administration’s viewpoints expressed in the United Nations Practical Manual on Transfer Pricing for Developing Countries (Manual)

The HC has agreed to the systematic steps of determining the arm’s length interest rate on loans as outlined in the Manual, that stipulate examination of loan agreements, terms, credit rating of the lender and the borrower, and comparable third party arrangements with suitable adjustments. It has however, disagreed with the Indian Administration’s specific viewpoints on use of PLR for outbound loans, being contrary to accepted international tax jurisprudence.

Key takeaways

Besides recognising important global best practices in the financial transactions domain around determination of interest rates, the HC, through this judgment, has provided critical direction to a wider universe of taxpayers by adjudicating that tax authorities are generally not empowered to restructure transactions, and highlighting the relevance of commercial relationships in determining arm’s length prices.

Transfer Pricing has been an area that has seen significant tax litigation in India. Hence this judgment will go a long way towards guiding and providing clarity to taxpayers, and as a step forward in the evolution of transfer pricing in the domain of financial transactions and beyond.