Interest on Continuing Debit Balance Notional or Real

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Customer Care No. 91-11-45562222
Interest on Continuing Debit Balance Notional or
Real
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• Introduction
• Over the years since the introduction of the
  Indian Transfer pricing regulations, the transfer
  pricing audits based on the experience and
  learnings gained have seen numerous
  interpretations of the provisions, thereby
  leading to transfer pricing adjustments. The
  Indian transfer pricing litigation scenario has
  seen the trend of adjustments shifting from mere
  dispute on comparable companies to larger issues
  such as location savings, management cross
  charges, intangibles, share valuations, business
  restructuring, etc.
• One such issue being the continuing debit balance
  in the financials of multinational companies
  (MNC). Globally due to the financial exigencies,
  the MNCs often commercially require to defer the
  payables / receivables. The continuing debit
  balance / receivables have been treated by the
  tax authorities as an international transaction
  and thereby sought to impute arm's length
  interest on receivables outstanding from the
  associated enterprise (AE) that were not realized
  within the credit period.

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• The Section 92B of the Indian transfer pricing
  regulations provides the coverage of the
  transactions that could be treated as
  international transaction. Vide Finance Act 2012,
  a clarificatory Explanation was inserted with
  retrospective effect from 1 April 2002. By virtue
  of the said Explanation, inter alia the
  expression 'international transaction' included
  capital financing such as 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.
• In spite of the clarification being provided, the
  question whether the continuing debit balance is
  an international transaction or not has been
  contested by both the Assessee and the Revenue.
  In this relation, various judicial rulings have
  held in favour of the Assesseethat the continuing
  debit balance is not an international transaction
  and that there is no legal justification for
  imputing notional interest when there is no real
  income arising in the hands of the Assessee.
  Though, the clarificatory Explanation has as such
  over-ruled the said rulings which held that
  outstanding receivables is not an international
  transaction, there are some of the following
  instances of favorable rulings which were
  pronounced after April 2012 (even though
  pertaining to assessment year prior to April
  2012)
• (a) Indo American Jewellery Ltd - The Bombay HC
  held that if there is complete uniformity in the
  act of the taxpayer in not charging interest from
  both the AE and the non AE and the delay in
  realization of the export proceeds in both the
  scenarios is the same, then no notional interest
  should be charged on delayed receipts of the
  export proceeds.
• (b) Evonik Degussa India P. Ltd. - The Mumbai
  ITAT held that the TP adjustment cannot be made
  on hypothetical and notional basis until and
  unless there is some material on record that
  there has been under charging of real income.

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• (c) Gold Star - The Mumbai ITAT held that
  allowing credit period to the AE for realization
  of the sale proceeds is not a separate
  international transaction but is intrinsically
  linked to the sale transaction to the AE.
• (d) Kusum Healthcare (P) Ltd v ACIT - The Delhi
  ITAT held that where the transaction with the AEs
  earns higher margins as compared to the
  comparable companies, then such high margins
  compensates for credit period extended to the AEs
  and accordingly no adjustment is required.
• Yet again, in the recently adjudicated ruling by
  the Mumbai Tribunal in the case of Rusabh
  Diamonds, it has been held that outstanding
  receivables is not an international transaction
  and also as long as the sales are benchmarked on
  Transaction Net Margin Method ('TNMM'), there
  cannot be any occasion to make a separate
  adjustment for delay in realization of
  outstanding receivables. This ruling provides the
  much needed clarity for taxpayers on the effect
  of the explanation to section 92B inserted by
  Finance Act, 2012, that is, whether the effect is
  retrospective or prospective and it also provided
  certain guidance post 1 April 2012.
• We have in the ensuing paragraphs discussed the
  ruling and the key outcomes
• Brief of the Ruling
• The Assessee, Rusabh Diamonds was engaged in the
  business of manufacturing, import and export of
  cut and polished diamonds. During the financial
  year (FY) 2009-10, the Assessee had international
  transactions in the nature of sales to its AE,
  which the Assessee benchmarked by applying TNMM.
  During the assessment proceedings the Transfer
  pricing officer (TPO) observed that the AE owed
  approximately 40 of the Assessee's entire
  exports.

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• The TPO further noted that the Assessee has paid
  interest on certain borrowings which could have
  been avoided had the Assessee realized the
  receivables on time. Accordingly, the TPO imputed
  interest plus mark up on the outstanding
  receivables on the ground that it is an
  international transaction pursuant to the
  insertion of the Explanation to section 92B. The
  contention of the Assessee that outstanding
  receivables is not an international transaction
  was disregarded. The Dispute Resolution Panel
  (DRP) upheld the adjustment made by the TPO,
  however with a direction to delete the mark up
  component. The Assessee aggrieved, filed an
  appeal against the interest adjustment in
  relation to the delay in realization of sale
  proceeds from AE. The Revenue alsobeing
  aggrieved, filed an appeal against the deletion
  of the mark up on the arm's length interest rate.
• Key take away from the Ruling
• (a) Imputation of interest on the delay in
  realization of outstanding receivables - Validity
• The Mumbai ITAT has made an important observation
  that on the premise of the Explanation to Section
  92B if it is considered that continuing debit
  balance is an international transaction then
  separate adjustment is not warranted when the
  export sale has been benchmarked on TNMM basis
  and concluded to be at arm's length. The
  justification being that while computing the
  operating profits for the purpose of computing
  the profit level indicator (PLI) all operating
  income (including interest, if any) and expenses
  are considered and if that margin is above the
  margin of the comparable companies then the
  transaction is at arm's length. The exclusion
  from computation being the non-operating items
  such as interest income of the finance and
  banking companies. The rulingindicates that
  continuing debit balance is the outcome of export
  sales and accordingly intrinsically linked and
  cannot be tested for compliance with arm's length
  standard separately. Accordingly, there should
  not be separate interest imputation on delayed
  realization of the outstanding receivables.

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• (b) Effect of the Explanation to section 92B -
  Retrospective or prospective
• The ITAT highlighted that when there are plethora
  of rulings in relation to an issue, it is not an
  uncommon occurrence to nullify the judicial
  interpretation through legislative amendment.
  However, the same has always been prospective in
  effect. The ITAT noted that the insertion of the
  clarificatory Explanation to section 92B being
  retrospective, has been made before the
  understanding of the effects of such
  retrospective taxation.
• The ITAT has placed reliance on the recent case
  of New Skies Satellite wherein the High Court has
  observed that the legislature is competent to
  amend the provisions retrospectively or
  prospectively. However, when the disputes on
  account of such amendments arise before the
  courts then it is the substance of the amendment
  that will determine the operation and not the
  bare language of the amendment. It has been
  emphasized by the ITAT that adjustment in
  relation to continuing debit balance would bring
  the notional income in the tax net, without any
  legal basis and legal jurisdiction.In order to
  mitigate such effect, the ITAT held that the
  clarificatory Explanation to the section 92B
  pertaining to treating the continuing debit
  balance as an international transaction is
  effective from 1 April 2012. Accordingly
  considering that the assessment year of the case
  being discussed is 2009-10, the said Explanation
  to section 92B has no application and the
  adjustment of imputing interest on account of
  delayed realization of outstanding receivables is
  not just.

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