Outstanding receivables from international transactions held to be within the jurisdiction of TPO; receivables, if not brought back in time, form part of TP analysis for calculation of potential interest loss
In brief :-In a recent ruling in the case of Logix Micro Systems Ltd. Vs. ACIT [2010-TI I-50-ITAT-BANG-TP], the Bangalore Bench of the Income-tax Appellate Tribunal (“Tribunal”), while deciding the case in favour of the Indian Income-tax Department (“Revenue”) with a few amendments, ruled that, when a case is referred to the Transfer Pricing Officer (“TPO”) by the Assessing Officer (“AO”), the TPO is within his limitations to make an adjustment for an inordinate delay in repatriation of receivables of the assessee from its overseas associated enterprise (“AE”). Moreover, for calculation of the adjustments on such potential income loss, the Indian short-term deposit rate of 5% should be used.
The assessee is in the business of software development. It entered into a product development services agreement and a professional service agreement with one of its AE. During the course of transfer pricing (“TP”) assessment proceedings, the TPO upheld all the transactions with the AE to be compatible with the Arm’s Length Price (“ALP”) but proposed an adjustment for the notional income loss incurred by the assessee due to the large amount of receivables outstanding with its AE.
The AO passed an order, incorporating the TP order, against which the assessee appealed before the Commissioner of Income-tax (Appeals) (“CIT(A)”).
The CIT(A) held that, while the TPO is correct in working out the interest attributable to outstanding receivables, the interest has to be computed only on the overflowing interest-free period, i.e., after giving a reasonable interest-free period. Further, the CIT(A) held that the interest should be calculated adopting the London Inter bank Offered Rate/Federal Funds rate (“LIBOR/FED”) as a benchmark rate factoring in the nature and term of the loan, credit standing of the AE, etc.
• 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 transactions.
• The delay in collecting the receivables was due to the difference in billing patterns adopted by the assessee and its AE.
• The assessee, by parking such a huge amount of funds with its AE, is deprived of the funds which would have been otherwise available to the assessee either to pay off its loans or to earn income from appropriate investments.
• While making such adjustment, the Prime Lending Rate (“PLR”) of 10.25% approved by the State Bank of India (“SBI”) should be applied.
The Tribunal held as follows:
• At the outset, the Tribunal rejected the objection raised by the assessee in regard to the jurisdiction of the TPO to examine the overdue receivables and the potential income loss arising therefrom, when the international transactions relating to provision of software development and consultancy services were at arm’s length.
• While referring a file to the TPO for examination of the ALP, an overall examination and analysis of the international transactions was being contemplated and no “piece-meal” examination was intended. Also, the receivables in themselves were generated from international transactions, so the TPO had the jurisdiction to examine the potential interest loss on such receivables and that the receivables need not be viewed as a separate transaction. Thus, the overdue outstanding receivables arising out of the international transactions were rightly examined by the TPO while determining the ALP.
• The argument that the huge amount of receivables was a result of different billing patterns was not substantive, as the assessee could not demonstrate how the difference in the billing patterns of the assessee to its AE and, in turn, the AE to its customers, could contribute to such a large amount of receivables.
• Interest should be calculated for the period overflowing the interest-free period, and thus the period chargeable to interest should be recomputed.
• Further, the potential income loss incurred by the assessee is definitely a factor while considering the financial impact of the international transactions on the income of the assessee. The Tribunal upheld that in case the funds were deployed by the assessee it would earn income at a rate applicable to deposits and not the rate applicable to loans. Accordingly, a reasonable short-term deposit rate of 5% in an Indian context as against the PLR should be considered for the purpose of calculation of such potential interest loss.
Accordingly, the addition made by the TPO/AO was upheld with a few amendments.
By considering the potential loss on the long standing receivables as a genuine adjustment in the course of assessment, the Tribunal has reinforced the principles that the concept of TP cannot be that of an exact science and that constant application of mind has to occur to determine whether a transaction is at ALP or not. The Tribunal has also acknowledged that any argument on facts has to be substantive to be accepted and to provide any logical adjustments for the purposes of transfer pricing. The Tribunal has also clarified that the interest loss on non-receipt of the funds on time cannot be based on the SBI PLR but the interest loss to the assessee by not deploying the funds in appropriate investments should form the basis of computing the notional income. While the Tribunal has considered the concept of charging interest only on the overflowing interest-free period, it has not specified the length of that period. In our view, the period needs to be determined in light of case specific facts and circumstances. One should consider the potential impact of such outstanding trade receivables on the working capital adjustments typically performed while applying the Transactional Net Margin Method.