In ongoing commercial transactions amongst multinational group like sale, purchase or transfer of goods/services/assets etc., there arises receivable or payable from one group company to another. This is generally referred to as ‘Overdue Balance’. This overdue balance mainly arises because of delay in recovery for reasons such as business or commercial reasons, market conditions, group policy etc. Long overdue balance receivable is often considered as an indirect way of financing by one group company to another and thus remains under the scanner of tax authorities. Tax authorities try to re-characterize these overdue balances as capital financing arrangement implicating passing off of indirect benefit by one group entity to another. Tax authorities often allege this arrangement as a separate international transaction under section 92B of the Indian Income Tax Act, 1961 (‘ITA’) and thus, pitch for transfer pricing adjustment of notional interest thereon. This is one of the most litigated transfer pricing disputes in India and succeeding paragraphs will deal with its various nuances and possible solutions.
2. Philosophy behind transfer pricing adjustment on overdue balances:
An uncontrolled entity will expect to earn a market rate of return on its working capital investment independent of the functions it performs or products it provides. However, the amount of capital required to support these functions varies greatly, because the level of inventories, debtors and creditors varies. High levels of working capital create costs either in the form of incurred interest or in the form of opportunity costs. Thus, when an entity pays interest by borrowing money but extends free credit period to related group entity thereby passing benefit of implied credit facility or forgoes its opportunity to earn interest on such blocked working capital in the form of longer credit period, in such a third party would not have done so without any benefit accruing to it. To impute such benefit forgone or extra costs incurred, generally transfer pricing provisions are invoked for intra-group transactions pertaining to overdue balances.
3. Provisions in ITA:
The ITA does not define ‘overdue balance’ nor it defines criteria’s fulfilling which resultant payable/receivable balance will be considered as overdue balances.
As per the Clause (c) to Explanation 1 of section 92B of ITA, international transaction shall include ‘capital financing, including any type of long-term or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business.’
Thus, this provision makes it clear that ‘overdue balance receivable’ is not explicitly recognized as international transaction. However, tax authorities try to take shelter under expression ‘receivable’ used in said Explanation and thus proceeds with re-characterization of overdue balance with deemed loan or capital or working capital financing arrangement.
It is also pertinent to take note of Rule 10A of Income Tax Rules which deals with meaning of expressions used in computation of arm’s length price inter-alia term ‘transaction’ to mean as ‘transaction includes a number of closely linked transactions.’ It is also known as the ‘principle of aggregation’. It is a well-established rule in the transfer pricing analysis. This principle seeks to combine all functionally similar transactions wherein arm’s length price can be determined for a number of transactions taken together. The said principle is enshrined in the transfer pricing regulation itself and has also been advocated by the OECD Transfer Pricing Guidelines.
Generally, transactions are said to be closely linked when they are arising out of each other or so inter-dependent and inter-related that they cannot be separated and analysed independently. For example, say Indian group entity who sales goods/services to another foreign group entity and gives credit period of 120 days, usually should have factored in the cost of working capital that is blocked for 120 days into the price of goods/services. In such case, though the sale of goods/service and allowing credit appears to be two independent transactions, if dissected closely would reveal that transaction of allowing credit is integral part of transaction of sale of goods/service and thus is subsumed in the transaction of sale of goods/service itself and cannot be analysed and benchmarked separately.
However, if in case, facts shows that granting credit period is just a means of extending working capital facility to another group entity and such excessive credit period is not as per industry norms or regular credit provided to third party customers, if any, in that case said transaction of allowing credit being not related or dependent on the transaction of sale of goods/service, would warrant independent analysis and benchmarking of said transaction. Refer – Kusum Healthcare Private Limited vs. ACIT – Delhi Tribunal – in ITA No. 6814/Del/2014.
Typically, such type of transfer pricing adjustment is proposed in the hands of Indian company having ‘overdue balance receivable’ and not otherwise. In case of ‘overdue balance payable’, the provision of Section 92(3) of ITA gets triggered which states that transfer pricing provision are not applicable in a case where any income arising from international transaction or any allowance for an expenditure or interest or allocation of any cost or expenses have effect of reducing income chargeable to tax or increase the loss. In case of overdue balance payable, same results in excess expenses in the hands of Indian company which is prohibited as per provision of section 92(3) and thus does not arise. This may however give rise to similar transfer pricing problem to other group entity in its home country wherein tax authorities of those country can allege indirect capital financing.
4. Factors to be kept in mind:
Based on the above discussion, it is advisable to keep following factors in mind while dealing with issue of ‘overdue balances’ from transfer pricing perspective –
a. Nature of business and its model:
It is important to understand which goods/services the company deals in. Further, if majority or substantial sale of the entity is to another group entity and such another group entity has strong presence in its home country thereby giving higher opportunity for large volume of sales, no third party would be willing to charge interest on amount receivable from such a key customer i.e. Group entity and would rather invest in relationship by allowing better credit terms in expectation of more business and profits. Refer – Kusum Healthcare – Delhi Tribunal – in ITA No. 6814/Del/2014
b. Industry Practice:
It is important to understand and document the prevailing industry practices regarding trade credit. Ay, if giving 150 days credit is generally prevalent trade practice, in such case, an Indian company giving trade credit of 150 days though appears to be high but juxtaposed with industry trend, would justify. Refer – Mastek Limited vs. Addl. ClT – Ahmedabad Tribunal –in ITA No. 3120/Ahd/2010.
c. Market Conditions:
If the market condition is weak and economy is in turmoil, in such case to have higher turnover, probably one may have to give higher credit period to buyer and if same can be documented, would help justifying said credit period.
d. Similar transactions with third party customers:
If an entity is engaged in commercial transactions with group entity as well as third party unrelated customers and if the entity is giving credit facility of 150 days to both group entity as well as third party unrelated customers, in such case, it justifies such longer credit period to group entity. Refer – DCIT Vs Indo American Jewellery Ltd. – Mumbai Tribunal – in ITA No. 5872/Mum/2009. However, if there is disparity amongst the credit period allowed to third party customer and group entity, in such case, transfer pricing addition is warranted.
e. Financial position of the lender company:
The prime argument of tax authorities warranting notional interest addition is had that amount invested in bank, the company would have earned interest income. This may be an erroneous argument. If the company who gives credit period proves that it is not earning any interest income on any other third party advances or balances kept in current account with bank and it further can proves that it is a debt free company and it has not utilized borrowed funds to pass on credit facility to the other group entity, in such case, said transaction can be strongly defended. Refer – Bechtel India Private Limited – Delhi Tribunal – in ITA No. 1478/Del/2015 dated 21.12.2015.
f. Working capital adjustment:
If while benchmarking international transaction of sale/purchase of goods/service, working capital adjustment is imputed which in turn factors in balance receivable, in such scenarios, one can argue against imputation of transfer pricing adjustment of notional interest. Refer – CIT vs. EKL Appliances Ltd – Delhi High Court – 345 ITR 241
g. Higher Profitability that comparable:
Based on the benchmarking analysis and required transfer pricing documentation, if it can be proved that the operating profit margin earned from international transactions with group entity is higher than the comparable companies, in such case, plea may be taken for no adverse transfer pricing adjustment for overdue interest. Refer – Kusum Healthcare Private Limited vs. ACIT – Delhi Tribunal – in ITA No. 6814/Del/2014
h. Devaluation of foreign currency:
If it can be proved with facts and figures that due to devaluation of the home currency of the foreign company, its liability to pay has substantially increased towards Indian company and in such scenario, a third party would have asked for discount or waiver to compensate the situation, in such case, higher credit period can be justified.
i. Netting off impact of receivable and payable:
It may also happen that on one hand Indian entity is to receive on sale of goods and other hand liable to pay on account of service or say import of raw materials. In such situation, amounts can be net off and then situation needs to be analysed whether it warrants addition of notional interest or not. Refer – Technimont ICB House Vs DCIT – Mumbai Tribunal – in ITA No. 487/Mum/2014.
Generally, balance receivable is an integral part of transaction of sale of goods/service and thus aggregated to benchmark together. However, in specific circumstances, delayed credit period warrants independent and standalone benchmarking. While independently benchmarking transaction of balance receivable, various factors such as business model, prevailing industry practice, availability of third party data, comparable data etc. are crucial. A strong transfer pricing documentation would help in defending longer credit period and avoiding trouble of notional transfer pricing adjustment of interest on account of overdue balances.
Author acknowledges valuable discussions with CA Govind Agrawal from Sastakar Vaidya & Co, Pune.