Interest on Continuing Debit Balance Notional or Real Customer Care No. 91-11-45562222 Interest on Continuing Debit Balance Notional or Real www.taxmann.com

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. Customer Care No. 91-11-45562222 www.taxmann.com

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. Customer Care No. 91-11-45562222 www.taxmann.com

(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. Customer Care No. 91-11-45562222 www.taxmann.com

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. Customer Care No. 91-11-45562222 www.taxmann.com

(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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