Transfer Pricing: Obligation to charge interest on overdue payments
In the recent ruling of M/s Logix Micro Systems Ltd.1, the Bangalore Income Tax Appellate Tribunal (“Tribunal”) held that outstanding receivables from international transactions would form part of the transfer pricing analysis for calculation of the potential interest loss.
M/s. Logix Micro Systems Ltd. (”Logix India”), an Indian company is a 100% subsidiary of Logix America Inc.USA (“Logix USA”) engaged in the business of software development in the field of providing business and technology solutions. Logix India entered into two separate agreements with M/s. Homestar LLC (“Homestar”), wherein Logix US held 76% of the shares in this company. As a result of such holding pattern Logix India and Homestar were termed as associated enterprise (“AE”).
For the relevant year, the return of income reflected a loss and the matter was brought before the Transfer Pricing Officer (“TPO”), it was found that a total amount of INR 77,323,619 was shown as debts receivable from its Homestar USA, out of which an amount of INR 55,225,261 was outstanding for more than six months. The TPO held by way of “parking the huge amount” at the disposal of Homestar, Logix India deprived itself from the funds which otherwise would have been available in its hands. As a result, this adversely affecting the profitability M/s. Homestar LLC (“Homestar-USA”) of Logix-India and the TPO computed an interest income of INR 5,660,486, calculated at Prime Lending Rate (“PLR”) of 10.25% as a reasonable amount attributed to the funds parked and did not given way to Logix-India’s contention that such delay in collecting the receivables as a consequence of the difference in billing patterns adopted by the AEs.
The Commissioner of Income Tax (“CIT”) upheld the findings of the TPO that the outstanding receivables were legally due to Logix-India and in a way constituted an “interest free loan” availed by the AE in USA. However, he held that interest must be computed according to the LIBOR/US-FED rate as opposed to PLR, since the funds were borrowed by Homestar in US. He also directed that a reasonable period be allowed for collection of outstanding dues and only the interest for the period overflowing the reasonable time limit be computed. Logix-India appealed against the CIT’s order, in its entirety, before the Tribunal. The tax authorities too appealed against the decision of the CIT that the LIBOR/US-FED rate be used for calculation of the interest amount.
The taxpayer contented that the reference made to the TPO relates only to the point of ALP and it does not include the potential income loss arising from the aspect of delay in collecting the receivables. Hence, the outstanding balance of the receivables should be viewed as a separate transaction different from the international transaction. The taxpayer also justified the delay in collecting the receivables by stating that it was due to the difference in billing pattern adopted by the taxpayer and it’s AE. Thus, the taxpayer contended that the actions of the TPO were without jurisdiction and against law.
Decision of the Tribunal
The Tribunal held that the purpose behind the ALP analysis is to curb tax evasion and therefore, the transaction should be viewed holistically by the TPO and a piece meal approach cannot be adopted. The outstanding receivables i.e., funds parked outside is the financial result of the international transactions concluded between the AEs and therefore, the income effect arising, to that outstanding receivables is a crucial aspect of ALP. Thus, the outstanding balance of receivables is neither separate nor independent from the international transaction but forms part it.
With respect to the taxpayer’s contention that the difference in billing cycles contributed to a time lag in collection the Tribunal dismissed the contention on the ground that such an explanation was more logical than substantive in nature. Further, they stated that if such contention was to be accepted, it would lead to a conclusion that the taxpayer was financing the business of the AE, who did not possess enough working capital to pay the taxpayer and instead was dependent on its own clients clearing its outstanding dues. Thus, the taxpayer would in their view be held to be financing the business of the AE by accommodating dating a delayed remittance of receivables.
The Tribunal clarified that while normally the general rule when it comes to taxation was that one must assess tax on only the “actual” income and not the “probable” income earned, but the said rule did not apply in the instant case, since in the present case the TPO was bound to examine the financial impact of the international transactions concluded by the taxpayer with its AE in USA as it a consequence of not bringing the receivables in India. The potential loss on account of delay in collection was definitely a factor to be considered while evaluating such financial impact. The Tribunal went on to distinguish a formal loan transaction and parking of funds by not collecting the receivables within the normal period and stated that the factors that are taken into account to calculate the ALP interest for the former might not be applicable for the latter.
The transactions being interest free, the CIT had adopted the LIBOR rate for calculating the interest. The Tribunal held that it was the potential loss of the taxpayer in India which contributed to the additional income attributable to him and thus it would be appropriate to adopt a reasonable rate of interest as per Indian standards. PLR was not the correct rate in their view, since this was not a transaction in the nature of a loan, and thus they held that the rate to be adopted should be that which would be available to the taxpayer on short-term deposits. The Tribunal upheld the CIT’s direction that a reasonable period must be provided as interest-free period and no interest should be calculated for such period. However, after such period, interest is to be calculated by applying a reasonable deposit rate of interest rate at 5% comparing it to a short term deposit.
The Bangalore Tribunal appreciated the fact that if the funds are repatriated into India within the normal period, the taxpayer would have been in a position to inter alia earn some income from an appropriate investment of those repatriated funds. As a result of the parking of funds with the AE for which no interest was paid in India on the borrowed funds, the taxpayer had indeed suffered a notional loss.
Logically, the Tribunal held that the interest loss on the non-recipient of funds on time should not be based on the SBI PLR but the interest loss to the taxpayer must be computed with respect to the non deployment of the funds in appropriate investments. However, while the Tribunal has considered charging interest only on the overflowing interest-free period, it has not specified what in its view would be a reasonable interest-free period. This in turn could cause confusion, since the revenue authorities could adopt varying standards with respect to the same.
This judgment also raises an interesting conundrum, especially in light of the recent decision of the Mumbai Tribunal2. The decisions of both the Tribunals are seemingly contradictory on the issue of whether “outstanding payments” constitutes an international transaction and thereby should be taken into account while computing the ALP. In our earlier analysis of the decision of the Mumbai Tribunal, we observed that the Mumbai Tribunal by not sufficiently justifying the reason as to why a debit balance would not have an impact on the profits and income of the taxpayer, had not set a strong precedent in this aspect. The Bangalore Tribunal decision in our view is based on sounder logic. Nonetheless given that the contradictory decisions have been given by parallel benches in separate states, no clear legal position emerges as to which point of view would eventually be treated as settled legal position. It would be interesting to see the approach adopted by the higher courts in the respective cases.
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1 (2011) 37 (II) ITCL 235.
2 ITA No.: 6597/Mum/09, Assessment year: 2004-05