Navneet Singal

Transfer Pricing: Rate for benchmarking in respect of the loan given to AE’s outside India – Whether it should be LIBOR or interest rate prevailing in India?

Whenever we look for a Transfer Pricing comparable in respect of the loan giving to AE’s outside India, it was always an issue that which party should be taken as Tested Party and what rate should be taken as benchmarking rate. Whether it should be LIBOR or interest rate prevailing in India?
In the Judgment of Aurionpro Solutions Ltd. vs. ACIT, Range – 4(3), Mumbai, ITA No. 7872 (Mum.) of 2011, ITAT Mumbai has held that for purpose of determination of Arm’s Length Price, tested party is always assessee and not its Associate Enterprise (AE), LIBOR is acceptable for benchmarking loans given by Indian company to its foreign AEs, instead of interest rates prevailing in India. However, it has been mentioned by the ITAT that in its view, the safest comparable, which can be taken as Arm’s Length interest rate in such a case would be the interest on FD with the bank for a term equivalent to the term for which the loans were given to the AEs.

It mentioned further that though in principle the view of DRP i.e. that only inbound loans taken by Indian entities from outside India were to be benchmarked with LIBOR and interest rate prevailing in India on corporate bond should be taken for benchmarking the loan transaction is acceptable, however, since the issue of LIBOR has been considered and decided by the Tribunal in various cases as relied upon by the assessee, therefore, to maintain the rule of consistency, the decision of the coordinate Benches of this Tribunal is followed and LIBOR is accepted for benchmarking interest on interest free loans to AEs.

Facts of the Case:

1. The assessee has given loans to its Associated Enterprises (AEs) in USA, Singapore and Bahrain. It is engaged in the business of software development and web designing services.

2. The assessee claimed that there was no relationship of lender and borrower as the advances were given to 100% subsidiaries and since the assessee got business from the AEs, the transaction were on commercial consideration and there was no motive to evade tax.

3. The assessee benchmarked the transactions at cost plus zero mark-up, using cost plus method, as no cost was claimed to be incurred by the assessee.

4. The TPO did not accept the contentions of the assessee and benchmarked the loans at dollar denominated LIBOR plus mark-up of 3 per cent.

5. DRP held that only inbound loans taken by Indian entities from outside India were to be benchmarked with LIBOR. It took interest rate prevailing in India on corporate bond for benchmarking the loan transaction, holding that the taxpayer was the tested party and prevalent interest rate that could have been earned by the taxpayer by advancing loan to an unrelated party in India with same financial health as that of the tax assessee’ s AE was to be considered.

The ITAT Mumbai held that

1. The first contention of the assessee was that the advance was given to the AEs towards working capital and the assessee was getting good business from the AEs; therefore, having commercial consideration, no adjustment of transfer price was justified. This contention of the assessee cannot be accepted because, though it may be an objective behind the Transfer Pricing Regulation that the profits taxable in India are not shifted out of India by manipulating the price charged between the AEs; however, as per the Transfer Pricing Regulations, there is no such condition of existence or non-existence of commercial consideration between the assessee and the AEs.

2. Further, in the case in hand, the advance does not represent the credit period extended to the AEs in respect of the business transaction; but it is a transaction of advancing loans to the AEs, which falls under the ambit of international transactions as per the terms of section 92B whereby the ‘international transaction’ means a transaction between two or more associated enterprises, inter alia lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises.

3. Having treated the transaction as international transaction, the only question which remains to be considered and adjudicated is Arm’s Length rate of interest. So far as the question of most appropriate method for determining the ALP is concerned, the same is also settled by the various decisions as relied upon by the assessee wherein it has been held that in case of benchmarking of interest on the loans to the AEs, CUP is the most appropriate method for determining the ALP. Even, the assessee has not challenged the method adopted by the authorities below for determination of the ALP in the case of the assessee.

4. The question arises whether LIBOR or prevailing market rate in India could be considered for determining the Arm’s Length interest rate in respect of the loans advanced by the assessee to the AEs. The TPO had adopted LIBOR plus 3 per cent as ALP for the rate of interest on the loan transaction in this case; whereas the DRP took the bond rate prevailing in Indian market and treated the AE as below BBB rating bond and, accordingly, determined the rate at 14 per cent as ALP. Under the Transfer Pricing Regulations, an international transaction has to be compared with an uncontrolled transaction between unrelated parties which means that an international transaction is tested with the transaction, if the assessee could have entered into a similar transaction with unrelated third party and thereby the income the assessee would have earned from a similar transaction with an uncontrolled party. Thus, the same income is expected or deemed to have been earned from the transaction with the AEs. The underlining principle of determining the ALP is based on the transaction between the unrelated parties. Therefore, tested party for the purpose of determination of ALP is the assessee and not the AEs.

5. In the case in hand, the assessee advanced loans to the AEs without charging any interest; therefore, the transaction has to be tested with a situation, had the assessee invested or advanced or deposited the said amount with an unrelated third party and thereby the income, which would have been earned by the assessee is expected to have been earned from the transaction of advancing loans to the AEs. Thus, the effect of transaction on the income of the assessee is to be seen and considered and not effect on the cost or income of the AE. Therefore, the tested party is always the taxpayer and not the AE. None of the factors under the Transfer Pricing Regulations require to consider whether the AEs would have incurred or earned more or less; but it is always considered whether the assessee had earned more or less by doing a similar transaction with an unrelated parties.

6. The factors prescribed for inclusion or exclusion of comparable to determine the ALP are also based on the comparison of the assessee with the chosen entities and the AE has no role in the exercise of selecting the comparable. Thus, in our view, the interest that would have been earned by the assessee by advancing or placing the said amount with unrelated parties would be the Arm’s Length interest in relation to the interest free loans/advances to the AE. The safest comparable, which can be taken as Arm’s Length interest rate in such a case would be the interest on FD with the bank for a term equivalent to the term for which the loans were given to the AEs.

7. That in case of FD with the Bank, the investment is safe as it is free from risk of credit and interest. On the other hand, if the loan/advance is given to the unrelated party, then always there is some risk of credit and interest involved in such transaction. There is one more reason for taking the FD as an appropriate and good comparable because the lending rate by financial institutions/bank varies depending upon the credit rating of the borrower and further on the guarantee and security provided to secure the loans.

8. The view of DRP on this issue is acceptable in principle, however, since the issue of LIBOR has been considered and decided by the Tribunal in various cases as relied upon by the assessee (supra); therefore, to maintain the rule of consistency, the decision of the coordinate Benches of this Tribunal is followed and LIBOR is accepted for benchmarking interest on interest free loans to AEs. Since the LIBOR is a rate applicable in the transactions between the banks and further the loans advanced by the bank to clients are secured by security and guarantee; therefore, a loan which has been advanced without any security or guarantee as in the case of the assessee has to be benchmarked by taking the Arm’s Length interest rate as LIBOR plus. Though the TPO took ALP as LIBOR + 3 per cent; however, the appropriate rate would be LIBOR plus 2 per cent. The Assessing Officer /TPO is directed to determine the Arm’s Length interest by considering the LIBOR plus 2 per cent on the monthly closing balance of advances during the financial year relevant to the Assessment year under consideration.

9. In the result, the appeal of the assessee is partly allowed.

Recently in the case of PMP Auto Components P. Ltd v. DCIT (ITA No. 1484/Mum/2014 & ITA No. 1506/Mum/2014), the Tribunal has directed the AO/TPO to consider LIBOR plus 2 % relying on the Tribunal ruling in Aurionpro Solutions Ltd.

(Author may be contacted at navneet.singal@gmail.com )

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