A person resident of India under the Income-tax Act, 1961 (‘the IT Act’) is liable to tax in India on his global income [see end note 1]. The resident, when transacting with its Associated Enterprise (AE) is obliged to offer to tax, the income arising from such international transaction, as computed having regard to Arm’s Length Price [see end note 2] (ALP).
A person who is a non-resident of India is subject to tax in India (a) on receipt of income in India (b) on actual accrual of income in India and (c) on deemed accrual of income in India [see end note 3]. If the income taxable in India is earned by him from his AE then, the non-resident is also obliged to comply with Indian Transfer Pricing (TP) Regulations. While the requirement of compliance with transfer pricing regulations by all the AEs involved in a transaction has been a subject matter of intense debate and practically, many foreign AEs do not comply with TP regulations in India, a recent ruling of a Special Bench of Kolkata Tribunal emphasises the requirement of compliance with Indian TP regulations by non-residents even where they do not receive any income because of their relationship with Indian AE.
Background of the issue
As per the facts of the recently reported tax ruling [see end note 4] a non-resident entity provided interest free loan to its Indian subsidiary. Had it charged some interest, the same would have been chargeable to tax in India either on account of actual accrual or deemed accrual and the issue would have been limited to its arm’s length nature. A question arose as to whether the non-resident entity is obliged to offer to tax an arm’s length interest income even when the loan is extended without any interest. The Special Bench of Income Tax Appellate Tribunal, Kolkata held that an arm’s length interest has to be taxed in India in such a case.
The facts of another taxpayer, who was an intervener before the Special Bench, involved payment of fee to its AE for receiving technical services. During the transfer pricing assessment of the resident AE, the amount of payment for services was found to be lower than the permissible range under ALP rule. The tax officer held that differential amount is taxable in the hands of non-resident AE under source rule and accordingly enhanced the income of non-resident AE, without of course granting a higher deduction to Indian payer.
This fact situation would prevail in many transactions entered into by a person resident of India with its AE hence this decision is of immense significance in Indian TP landscape. The present article seeks to discuss the arguments from both sides, kinds of transactions that could be affected by this ruling and the approach that needs to be adopted by taxpayers going forward.
In this ruling the taxpayer took following arguments:
- Payment by Indian entity of an arm’s length interest would have resulted in erosion of Indian tax base. Quantum of tax impact (loss to Indian revenue) by claiming interest expense is higher than the tax impact (gain to Indian revenue) on the imputed interest income. Hence it is not in the interest of Indian tax administration to insist on payment of interest.
- Indian TP regulations apply only on the income arising (or expense incurred) in a transaction with AE. It cannot be applied where no income has actually arisen. This argument was supported by the famous decision of Vodafone [see end note 5] wherein receipt of share premium was held to be outside the domain of TP regulations as no income arises on account of issue of shares at premium.
Tax Tribunal rejected the above contentions holding that it is not required to examine the tax impact on an aggregate basis by netting of the gain on taxing arm’s length interest with loss on granting interest deduction. Apparently, to some extent at least, the tribunal was influenced by the fact that Indian taxpayer was incurring losses and there would not have been any loss to revenue on enhancing this loss in a situation of claiming interest deduction. On a plain reading of statute, the Special Bench of the Tribunal held that the non-resident AE of an international transaction would also be subject to Indian Transfer Pricing regulations and accordingly concluded that the non-resident AE would be subject to tax in India on the income that would have accrued to him, even if it was not actually accruing or received. The Special Bench of the Tribunal also held that the Indian Tax Authorities are however not obliged to grant a deduction of interest as the same was not claimed in books of account, absent an actual payment [see end note 6].
Other possible arguments
There can be other arguments to support the position adopted by taxpayer which have not so far been explored in Indian courts.
Domestic TP legislation is narrower in scope than tax treaty
Article 9 of the tax treaties between India and other countries is typically founded on OECD Model. That Article is worded to cover all kinds of situation wherein the tax base is eroded due to relationship between transacting entities. This is because of usage of catch-all phrase “any profits which would, …., have accrued to one of the enterprises,..”. In contrast, the provision of Indian TP regulations read as “Any income arising from an international transaction shall be computed having regard to the arm's length price” and thus can cover only an income ‘arising’ not that could have arisen but for the relationship. Further, its scope is restricted to computation and no deeming fiction is built in law to deem the shortfall from ALP as resulting in accrual of income.
Transfer Pricing provisions of Treaty is narrower in coverage as against domestic TP legislation
While this issue has been debated extensively by international tax experts yet there does not seem to be any authoritative conclusion on this. Some scholars are of the view that owing to use of word ‘profit’, the scope of Article 9 is confined to such other articles using the same word. In contrast, the Articles that use the word ‘income’ or ‘gain’ are immune from operation of Article 9. This proposition needs to be tested in Indian courts.
Further arguments can be explored depending on the facts of a particular case.
Several kinds of transactions are undertaken between Indian entities and their overseas entities which if revisited in the context of this recent ruling would require reconsideration of the tax positions taken. These would include:
- Sending expatriates to India
- Allowing the Indian AE to use same trade-mark, brand-name without any license fee
- Rendering some administrative assistance to newly set-up subsidiaries without any cross charge. This usually happens, as subsidiary may not have financial capability to make payment in initial years of its set-up
To elaborate a bit, if expatriates are sent to work in Indian subsidiaries, a consideration for that, if charged, could be taxable in India as fees for technical services (‘FTS’). FTS is taxable in India on source basis. Tax is levied on gross basis, usually at 10%. Sometimes the cost of expatriates is reimbursed by Indian entity without a mark-up. Such structures would now be questioned by tax authorities. Thus one needs to review existing positions in this regard.
Considering the potential risk this ruling can have, one needs to undertake a holistic review of its tax positions. It would thus be a good idea to:
- Carry out a detailed exercise of discovering transactions with AEs that are not being captured in financial books currently (e.g. use of trade-mark etc).
- Review the current margins /prices and evaluate the transactions wherein payment is significantly lower than ALP.
- Examine the tax impact of restoring current transaction prices / margins within the permissible range of deviation [see end note 7].
- Evaluate the potential exposure to past transaction and evolve a strategy for dealing with past.
- Decide a future course of action considering the above as well as BEPS Action Plans.
[The author is a Director, Direct Tax Practice, Lakshmikumaran & Sridharan, Bangalore]
- Section 5(1) of the IT Act
- Section 92 of IT Act
- Section 5(2) of the IT Act
- Instrumentarium Corporation Limited v. ADIT, Kolkata  71 Taxmann.com 193 (Kol SB)
- Vodafone India Services (P) Ltd. v. Union of India 228 Taxman 25 (Bom HC)
- It can also be noted that section 92(3) of IT Act specifically prevents a downside adjustment of profits by applying ALP principle
- Presently, Indian TP regulations mandate no adjustment if the international transaction is undertaken within 35th percentile to 65th percentile of the dataset subject however to certain conditions [See Rule 10CA of Income Tax Rules, 1962]