January 12, 2011
Transfer Pricing: No obligation to charge interest on overdue payments
In a recent ruling by the Mumbai Income Tax Appellate Tribunal (“Tribunal”) held that overdue payments from an associated enterprise cannot be treated as an international transaction for the purposes of transfer pricing, and hence no interest need be charged on the same.
The taxpayer was an Indian company, engaged in the business of marketing of airtime, available on television programs, cricket and other sports events. It was also into the business of production of television serials. Its associated enterprise was a Singaporean company, which had to make certain payments to the taxpayer which were overdue and for which no interest was charged by the tax payer. As a practice, the tax payer neither charged any interest on the debit balances with independent parties nor paid any interest to international creditors. For the purpose of ascertainment of the arm’s length price, the said transaction was referred to the Transfer Pricing Officer (“TPO”) and the TPO observed that charging of interest on outstanding balances, after 30 day period would be the expected arm's length transaction given that the tax payer and the Singaporean company were associate enterprises for the transfer pricing purposes.
Based on this, the TPO made an adjustment of INR 12,51,175 and the notional interest was quantified based on the adoption of interest at 2.19% LIBOR on the overdue amount beyond 30 days. This was subsequently confirmed by the Commissioner of Income Tax (Appeals) (“CIT (A)”). The assessee appealed against the order of the CIT (A) before the Tribunal.
Therefore, the issue before the Tribunal was whether an ALP adjustment in respect of interest not charged by the assessee on the debit balances, overdue for a period beyond 30 days to an associated enterprises was justified or not.
Decision of the Tribunal
At the outset, the Tribunal reiterated the principle that any income arising from an international transaction has to be computed in accordance with the arm’s length price (“ALP”) and that this exercise includes the allowance for any expense or interest arising from an international transaction as well. The key element as per the Tribunal was that an ALP adjustment could be made only in respect of an “international transaction” as defined under the Income Tax Act, 1961 (“ITA”). The Tribunal opined that a continuing debit balance was not an “international transaction” but a result of an international transaction. Further, a ‘continuing debit balance’ reflects that the payment, even though due, has not been made by the debtor and also it is not necessary that a payment is to be made as soon as it becomes due.
It was highlighted by the Tribunal that the factors like ‘terms of payments’ and ‘accepted business practices’ play a role in influencing payments in respect of commercial transactions
Unlike a loan or borrowing, it is not an independent transaction which can be viewed on standalone basis. What can be examined on the touchstone of arm’s length principles is the commercial transaction itself, as a result of which the debit balance has come into existence, and the terms and conditions, including terms of payment, on which the said commercial transaction has been entered into.
The Tribunal examined the residuary clause of the definition of “international transaction” under Section 92B of the ITA Act, i.e., whether the debit balance would have a bearing on the profits, incomes, losses or assets of the tax payer. In this regard, it was held that the debit balance would not constitute an international transaction, as there was nothing on record to reflect that as a result of not realizing the debts from associated enterprises, there can be any impact on the profits, incomes, losses or assets of the tax payer and therefore, the overdue accounts receivable balance from associated enterprise cannot be termed as an international transaction per se, but can be said to be a "result" of an international transaction and so there is no need to benchmark the transaction at ALP.
The Tribunal pointed that even if continuing debit were treated as “international transaction”, the right course of applying the CUP method in the case of non charging of interest on overdue balances, would have been by comparing this not charging of interest with other cases in which the assessee has charged interest on overdues with independent enterprises (internal CUP) or with the cases in which other enterprises have charged interest, in respect of overdues in respect of similar business transactions, with independent enterprises (external CUP). No such exercise has been carried out in this case.
Based upon the above reasoning, the Tribunal held that the ALP adjustments cannot be made and held that the impugned addition of INR 12, 51,175 was unsustainable in law.
This is an interesting judgement, with respect to an area, where there is a paucity of Indian judicial precedents.
Even though, the conclusion drawn by the Tribunal seems apt, it is quite unclear as to why the continuing debit balances between the associated enterprises cannot be termed as an international transaction as the interest component would normally have a bearing on the profits and income of the tax payer.
The Tribunal is correct in suggesting that if the instant transaction was an international transaction then the internal CUP method would be used for the non-charging of the interest on such payment overdues. The Tribunal itself emphasised that the business practices play a pivotal role in any commercial transaction however, with respect to the application of external CUP method, the Tribunal has not examined the industry comparables with regard to the continuing debit balances. Nonetheless, it is advisable for companies to maintain both internal as well as external comparables to avoid any future dispute relating to transfer pricing.
Although, the amount involved is not large, given the significance of the issue, it is likely that the Tax Department would go in appeal against the order of the Tribunal as this judgement would have an impact on the terms of payments between the associated enterprises and set a strong benchmark for future transfer pricing cases involving overdue payments. Many taxpayers would be keenly following the progress of this case.
Watch this space for further developments in this matter.
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