2014 (1) TMI 1363 - AT - Income Tax

Arm's Length Pricing on Loan Interest and Guarantee Fees Remanded; Software Cost Not Royalty Under DTAA

The ITAT Hyderabad restored the issue of arm's length pricing on interest charged on loans for fresh adjudication, directing the AO to calculate ... Arm's length price - transfer pricing adjustment - LIBOR plus markup as benchmark for inter-company loans - treatment of corporate guarantees as international transaction / guarantee fee - characterisation of software purchase as royalty or purchase of copyrighted article - obligation to deduct tax at source under section 195 and disallowance under section 40(a)(i) - deeming Explanation to section 9(1) and retrospective operation affecting fees for technical services - application of DTAA and 'make available' criterion for fee for technical services - computation of export turnover under section 10A - exclusion of telecommunication/soft link charges - treatment of foreign exchange gains/losses as business income for section 10A purposesLIBOR plus markup as benchmark for inter-company loans - arm's length price - Appropriate benchmark rate for interest on inter-company loan and period for computation of differential interest - HELD THAT: - The Tribunal considered competing LIBOR rates and coordinate decisions permitting a LIBOR plus mark up approach. On the facts and in view of precedent, a reasonable benchmark is LIBOR + 2%. The Assessing Officer is directed to adopt LIBOR + 2% and to compute the differential interest for the actual period the loan was outstanding rather than for a full year; the matter is set aside to the AO for calculation accordingly. [Paras 8, 9]Adopt LIBOR + 2% as the reasonable rate; remit to Assessing Officer to compute differential interest for the actual loan period.Treatment of corporate guarantees as international transaction / guarantee fee - arm's length price - Whether corporate guarantee given for benefit of foreign subsidiary is an international transaction and quantum of guarantee fee - HELD THAT: - Although the immediate contract was between the assessee and an Indian bank, the Tribunal held that where the benefit of the guarantee accrues to a foreign associated enterprise, the transaction is within the ambit of international transactions and chargeable to transfer pricing scrutiny. Having regard to precedent (including Glenmark), the Tribunal remitted the question of quantification of the appropriate corporate guarantee rate to the TPO to determine the quantum following the methodology adopted in Glenmark. [Paras 11, 13]Corporate guarantee is an international transaction; issue of quantum remitted to the TPO for determination.Characterisation of software purchase as royalty or purchase of copyrighted article - obligation to deduct tax at source under section 195 and disallowance under section 40(a)(i) - application of DTAA - Whether payments to foreign vendor for 'Small World Software' are royalties attracting withholding and disallowance under section 40(a)(i) - HELD THAT: - On the facts the assessee purchased copies of software per transaction for resale and perpetual licence was granted directly to end customers; the assessee did not receive transfer of copyright or licence enabling repeated exploitation. The Tribunal found no basis to treat the payments as 'royalty' under section 9(1)(vi) or Article 12 of India Netherlands DTAA and relied on invoices, manner of sale and contractual arrangements. Consequently, there was no obligation to deduct tax at source and the disallowance under section 40(a)(i) is unsustainable. [Paras 24, 25, 26, 27]Payments are cost of imported trading goods (purchase of software copies), not royalties; disallowance under section 40(a)(i) set aside.Deeming Explanation to section 9(1) and retrospective operation affecting fees for technical services - obligation to deduct tax at source under section 195 and disallowance under section 40(a)(i) - application of DTAA and 'make available' criterion for fee for technical services - Whether payments to foreign subsidiaries constitute income taxable in India as business profits or fees for technical services so as to attract TDS and disallowance under section 40(a)(i) - HELD THAT: - The Tribunal held that the Explanation to section 9(1) (as retrospectively amended) post dates the transactions and that at the relevant time Ishikawajima Harima required rendering and utilisation of services in India. On facts the subsidiaries performed parcelled out contractual work for ultimate clients and did not 'make available' technical knowledge to the assessee; they had no PE or operations in India. The Tribunal therefore found that neither business profits nor FTS could be taxed in India on the material facts, and that it would be unjust to apply a later retrospective deeming amendment to disallow expenses under section 40(a)(i). The decision of the DRP/AO to disallow was set aside. [Paras 35, 36, 41, 42, 45]Payments to foreign subsidiaries are not taxable in India as business profits or FTS on the facts; disallowance under section 40(a)(i) is reversed.Computation of export turnover under section 10A - exclusion of telecommunication/soft link charges - Whether soft link (dedicated internet line) charges qualify as telecommunication charges to be excluded from export turnover for section 10A - HELD THAT: - The Tribunal accepted the distinction between telecommunication (telephonic) charges and soft link/internet charges and relied on precedent (Patni Telecom). The soft link charges incurred by the assessee were not part of consideration received in convertible foreign exchange (not invoiced to customers) and therefore should not be reduced from export turnover while computing deduction under section 10A. [Paras 47, 48, 49, 50]Do not reduce soft link charges from export turnover for section 10A computation; direction to AO accordingly.Treatment of foreign exchange gains/losses as business income for section 10A purposes - Whether foreign exchange fluctuation gain arising on conversion of EEFC balances is to be reduced from export profits for section 10A computation - HELD THAT: - Applying precedent (Sanyo and Supreme Court authorities), the Tribunal concluded the foreign exchange gain was income derived from the export business and taxable as business income; it is eligible for consideration under section 10A and need not be reduced from profits for the purposes of that deduction. [Paras 51, 53, 54]Foreign exchange gain on EEFC conversion is business income and not to be excluded from export profits for section 10A; assessee's ground allowed.Arm's length price - LIBOR plus markup as benchmark for inter-company loans - For assessment year 2007-08, adoption of LIBOR+2% for loan interest adjustment and remand to AO for computation - HELD THAT: - The Tribunal applied the reasoning given for AY 2006-07: coordinate decisions support LIBOR + mark up approach and LIBOR + 2% is reasonable. The AO is directed to adopt this rate and compute differential interest for the actual loan period. [Paras 57]Apply LIBOR + 2% and remit computation to AO for AY 2007-08.Treatment of corporate guarantees as international transaction / guarantee fee - For assessment year 2007-08, guarantee fee quantification to be decided by TPO following Glenmark methodology - HELD THAT: - Following the decision in the earlier year, the Tribunal set aside the corporate guarantee quantum to the TPO to determine the appropriate rate using the approach in Glenmark. [Paras 58]Remit guarantee fee quantum to TPO; follow Glenmark methodology for AY 2007 08.Characterisation of software purchase as royalty or purchase of copyrighted article - obligation to deduct tax at source under section 195 and disallowance under section 40(a)(i) - For assessment year 2007-08, payments to Netherlands vendor are not royalties and disallowance under section 40(a)(i) is erroneous - HELD THAT: - The Tribunal applied its reasoning in the earlier assessment year finding the payments represented purchase of software copies for resale and not royalties; hence no TDS obligation and no disallowance under section 40(a)(i). [Paras 59]Disallowance under section 40(a)(i) reversed for AY 2007 08 with respect to the software purchase.Deeming Explanation to section 9(1) and retrospective operation affecting fees for technical services - obligation to deduct tax at source under section 195 and disallowance under section 40(a)(i) - application of DTAA and 'make available' criterion for fee for technical services - For assessment year 2007-08, payments to foreign subsidiaries cannot be disallowed under section 40(a)(i) as FTS or business profits on the facts - HELD THAT: - Mirroring AY 2006 07 reasoning, the Tribunal held that (i) the retrospective deeming Explanation could not justly be applied to penalise the assessee, (ii) subsidiaries did not make technical knowledge available and had no PE in India, and (iii) payments were not taxable in India as business profits or FTS; therefore the disallowance cannot be sustained. [Paras 60]Ground allowing reversal of disallowance under section 40(a)(i) for payments to foreign subsidiaries allowed for AY 2007 08.Computation of export turnover under section 10A - exclusion of telecommunication/soft link charges - For assessment year 2007-08, soft link charges shall not be reduced from export turnover in computing section 10A deduction - HELD THAT: - Following the Tribunal's decision in the earlier year and Patni Telecom precedent, the AO is directed not to exclude the soft link charges from export turnover for section 10A computation for AY 2007 08. [Paras 61]Do not reduce soft link charges from export turnover; direction to AO for AY 2007 08.Procedural remand for evidentiary verification - Remand to Assessing Officer to adjudicate picnic expenditure on production of vouchers - HELD THAT: - The Tribunal set aside the disallowance of picnic expenses and remitted the matter to the AO to give the assessee another opportunity to produce substantiating vouchers and to decide the claim on the merits if satisfied by the evidence. [Paras 62]Issue remitted to AO to verify vouchers and decide the picnic expenses claim afresh.Final Conclusion: Appeal for assessment year 2006-2007 (ITA No.115/Hyd/2011) is partly allowed: loan interest adjustment remitted with direction to use LIBOR + 2% and compute for actual loan period; corporate guarantee quantum remitted to TPO; software purchase payment held not to be royalty and disallowance under section 40(a)(i) set aside; payments to foreign subsidiaries held not taxable in India on the facts and disallowance under section 40(a)(i) set aside; soft link charges not to be excluded from export turnover; foreign exchange gain treated as business income eligible for section 10A. Appeal for assessment year 2007-2008 (ITA No.2184/Hyd/2011) is allowed for statistical purposes following the same conclusions and remands for that year; one issue (picnic expenses) remitted to AO for fresh adjudication on production of vouchers. Issues Involved:1. Adjustment of Arms Length Price (ALP) for loan interest.2. Corporate guarantees as international transactions.3. Characterization of software purchase as royalty.4. Disallowance of technical consultancy charges.5. Exclusion of communication expenses from export turnover.6. Treatment of foreign exchange fluctuation gain.7. Disallowance of picnic expenses.Issue-Wise Detailed Analysis:1. Adjustment of Arms Length Price (ALP) for loan interest:The assessee contested the Dispute Resolution Panel's (DRP) decision to grant relief of only Rs.9,03,674/- from the ALP determined by the Transfer Pricing Officer (TPO) at Rs.27,68,740/- for interest on a loan to its subsidiary. The TPO adopted the Indian rate of interest under the Comparable Uncontrolled Price (CUP) Method, determining the ALP at 14% p.a. The DRP partially adjusted this to 7.247%. The Tribunal directed the Assessing Officer (AO) to adopt a reasonable rate of LIBOR + 2% and calculate differential interest for the relevant period, not the entire year.2. Corporate guarantees as international transactions:The assessee argued against the addition of Rs.12,78,695/- for corporate guarantees issued to City Bank India for its US subsidiary. The DRP and TPO considered it an international transaction under section 92B. The Tribunal noted that the benefit of the guarantee was for the US subsidiary, thus rendering a service for which fees must be charged at arm's length. The Tribunal set aside the issue to the TPO to decide the quantum of corporate guarantee rates as per the method in Glenmark Pharmaceuticals vs. ACIT.3. Characterization of software purchase as royalty:The assessee objected to the disallowance of Rs.52,55,881/- under section 40(a)(i), arguing that the payment to GE Network Solutions for 'Small World Software' was not royalty but a purchase of a copyrighted article. The Tribunal agreed, noting that the software was bundled with the assessee's own software and sold to customers without obtaining any license. The Tribunal concluded that the payment was for trading goods, not royalty, and hence, no tax withholding was required.4. Disallowance of technical consultancy charges:The AO disallowed Rs.19,48,02,907/- paid to foreign subsidiaries under section 40(a)(i), citing business connection and technical services. The Tribunal found that the assessee had not habitually secured orders for its subsidiaries but had only parcelled out work. The Tribunal held that section 9(1)(i) was inapplicable and that the retrospective amendment to section 9(1)(vii) could not justify disallowance under section 40(a)(i). The Tribunal also noted that under the India-USA and India-UK treaties, the payments did not fall under Fees for Technical Services (FTS) due to the 'make available' clause.5. Exclusion of communication expenses from export turnover:The AO excluded Rs.1,16,67,429/- of communication expenses from the export turnover. The Tribunal directed the AO not to reduce this amount from the export turnover, referencing the decision in Patni Telecom Pvt. Ltd. vs. ITO, which distinguished between technical services and software development services.6. Treatment of foreign exchange fluctuation gain:The DRP held that the foreign exchange fluctuation gain of Rs.8,52,831/- should be reduced from both the 'profit of the business' and the 'total turnover.' The Tribunal disagreed, citing the decision in Sanyo LSI Technology India Private Ltd. vs. DCIT, which treated such gains as part of business profits eligible for deduction under section 10A.7. Disallowance of picnic expenses:The AO disallowed Rs.8,40,444/- for picnic expenses due to the non-production of vouchers. The Tribunal set aside this issue to the AO, directing to give the assessee another opportunity to substantiate its claim.Conclusion:The appeal in ITA No. 115/Hyd/2011 was partly allowed for statistical purposes, and ITA No. 2184/Hyd/2011 was allowed for statistical purposes. The Tribunal provided detailed directions for each issue, ensuring a thorough examination and appropriate relief based on the merits of each case.