Bank's 1% rate for Stand-by Letter of Credit to foreign associate deemed arm's length price under CUP method

ITAT Delhi held that for determining arm's length price of Stand-by Letter of Credit issued to foreign associated enterprise, the rate of 1% charged by assessee's bank should be considered as comparable under CUP method, rather than bank guarantee rates used by TPO/DRP. The tribunal directed AO/TPO to apply 1% as ALP for the international transaction. Regarding disallowance under section 35(2AB), ITAT ruled that expenditure exceeding DSIR quantified amount should be allowed as revenue expenditure under section 37(1), as tax authorities failed to examine whether differential amount was for business purposes. Both grounds were allowed in favor of assessee.

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1. ISSUES PRESENTED and CONSIDERED

The core legal questions considered in this judgment include:

• Whether the Transfer Pricing Officer (TPO) and Dispute Resolution Panel (DRP) erred in using bank guarantee rates as comparables under the Comparable Uncontrolled Price (CUP) method for determining the Arm's Length Price (ALP) of the Standby Letter of Credit (SBLC) issued to a foreign Associate Enterprise (AE).
• Whether the Assessing Officer (AO) and DRP erred in disallowing revenue expenditure under Section 35(2AB) of the Income Tax Act, which was in excess of the amount quantified by the Department of Scientific and Industrial Research (DSIR), and further disallowing the same under Section 37(1) of the Act.

2. ISSUE-WISE DETAILED ANALYSIS

Issue 1: Determination of ALP for SBLC

• Relevant legal framework and precedents: The issue revolves around the determination of ALP for international transactions under the Income Tax Act, specifically using the CUP method. Relevant precedents include decisions from various tribunals and courts, such as Everest Kanto Cylinder Ltd. v. DCIT, Micromax Informatics Ltd. v. DCIT, and Havells India Ltd. v. ACIT.
• Court's interpretation and reasoning: The court noted that while a bank guarantee and an SBLC serve similar purposes, they are governed by different rules. It emphasized that the commercial rationale behind issuing a corporate guarantee or SBLC differs from that of a bank guarantee.
• Key evidence and findings: The appellant had paid a 0.5% commission fee per annum to HDFC Bank for the SBLC, which was argued to be an internal CUP. The TPO had incorrectly used a higher rate based on bank guarantees.
• Application of law to facts: The court found that the commission charged by commercial banks for bank guarantees should not benchmark the ALP for corporate guarantees or SBLCs. The appellant's payment of 1% during the relevant period was deemed appropriate.
• Treatment of competing arguments: The court considered the appellant's argument regarding the internal CUP and the TPO's reliance on bank guarantee rates. It favored the appellant's position, citing relevant precedents.
• Conclusions: The court concluded that the ALP for the SBLC should be set at 1%, and the TPO should apply the correct foreign exchange conversion rate.

Issue 2: Disallowance of Revenue Expenditure

• Relevant legal framework and precedents: The issue involves the interpretation of Sections 35(2AB) and 37(1) of the Income Tax Act. Relevant precedents include Auto Ignition Ltd. v. ACIT and M/s. BEML Limited v. DCIT.
• Court's interpretation and reasoning: The court emphasized that Section 37 is the primary basis for considering an expense before disallowance under Section 35(2AB). The fact that part of the expenditure was allowed as capital expenditure supports its nature as business expenditure.
• Key evidence and findings: The appellant incurred revenue expenditure for scientific research, which was partially disallowed by the AO/DRP. The appellant argued that the excess should be allowed under Section 37(1).
• Application of law to facts: The court found that the AO/DRP erred in not considering the excess expenditure as revenue expenditure, given its business purpose.
• Treatment of competing arguments: The court considered the appellant's argument regarding the business nature of the expenditure and the DR's contention that the AO did not examine this aspect.
• Conclusions: The court allowed the appellant's claim for the excess revenue expenditure under Section 37(1).

3. SIGNIFICANT HOLDINGS

• Preserve verbatim quotes of crucial legal reasoning: "The considerations which applied for issuance of a Corporate guarantee are distinct and separate from that of bank guarantee and accordingly we are of the view that commission charged cannot be called in question, in the manner TPO has done."
• Core principles established: The court established that corporate guarantees and SBLCs should not be benchmarked against bank guarantees due to differing commercial considerations. It also reinforced the principle that business expenditure should be recognized under Section 37(1) when incurred for business purposes.
• Final determinations on each issue: The court determined the ALP for the SBLC at 1% and allowed the excess revenue expenditure under Section 37(1).

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