Various factors have been developed over the years to step up the scrutiny of transfer pricing arrangements. Overdue outstanding receivables is yet another area that has been in litigation. The tax authorities have alleged that the transfer pricing between companies takes into consideration various factors, including the credit period. Accordingly, in the event the actual receipt is beyond what has been agreed between parties then typically such extended credit period is viewed as an advance of loan that warrants a charge. At the same time, various courts have provided relief by allowing for working capital adjustment and acknowledging the practical and commercial situations. However, recently in the case of Bharti Airtel Services Ltd1, the Delhi Income Tax Appellate Tribunal (ITAT) has provided a contrary view and dismissed the taxpayer's appeal against a transfer pricing adjustment of interest on outstanding receivables.
The taxpayer was engaged in selling hardware for internet and satellite business. The primary transaction entered with its associated enterprise (AE) was the provision of manpower recruitment and related service that was benchmarked using the Cost Plus Method. As per the intercompany service agreement, the credit period allowed to AE was 15 days. However, the Transfer Pricing Officer (TPO) observed a delay in receivables and computed an interest charge for payments received beyond 15 days considering it as a separate transaction (at 11.69% adopting SBI rate + 300 bps). At that juncture, the taxpayer had argued that post applying a working capital adjustment, margins earned by the taxpayer is higher than that of comparables demonstrating that the overall profitability of the taxpayer adequately compensates for outstanding receivable. However, the TPO did not accept the contention on account of unreliable data. The taxpayer filed an appeal before the CIT(A), which confirmed the contentions of the TPO but only allowed the interest rate to be LIBOR based instead of SBI based.
Issue under consideration: Can the outstanding balance of receivable be considered as an international transaction and thereon if the characterization of overdue receivables as loan mandates interest charge.
The taxpayer contended that outstanding receivable could not be regarded as an international transaction as defined under section 92B of the Income Tax Act (the Act). Without prejudice, the taxpayer also submitted that the Airtel group has entered into similar manpower service arrangements with third parties and in which case it has not charged any interest on the outstanding receivable.
The taxpayer placed reliance on various case laws2 to appeal that the imputed interest is not an international transaction. The cases relied on primarily upheld non-charging of interest on account of business decisions considering various factors as well as providing for working capital adjustment to account for the effects of the receivables. Placing reliance on the judgment of Honorable Delhi High Court in the case of Kusum Healthcare Private Limited, the taxpayer argued that as long as the net profit margin of the taxpayer is within the working capital adjusted margins of the comparable companies, the outstanding receivable should be regarded at arm's length.
However, the department representative argued that the facts in the cited cases are not applicable to the instant case as-
- It is not shown that the sale price included the outstanding credit period beyond the agreed credit period. He submitted that had the sale price included the outstanding receivable beyond the specified period for payment and that there was no need to mention 15 days in the agreement;
- Also, in the case of Kusum Healthcare, the taxpayer made the working capital adjustment in its transfer pricing analysis;
- The tax authorities also alleged that the working capital adjustment working submitted by the taxpayer was not reliable.
The ITAT categorically noted that the service agreement mandated payments by the AE to the taxpayer within 15 days. The agreement clause clearly shows that if the payment is beyond 15 days, it does not include the cost of service for withholding the payment beyond 15 days by the AE. This shows that in the service cost, the cost of outstanding which remains overdue is not factored. Further, as the working capital adjustment was denied in the absence of reliable data, the ITAT concluded that the outstanding debtors beyond an agreed period are a separate international transaction of providing funds to its AE, for which the taxpayer must have been compensated in the form of interest at LIBOR + 300 BPS.
There is a plethora of judgments by various courts in India that have decided the issue of overdue receivables in favor of the taxpayer, confirming that the working capital adjustments are the most appropriate barometer to verify the arm's length nature of outstanding receivables. The existing jurisprudence on this issue has been in favor of the taxpayer, broadly on the following grounds:
- Application of working capital adjustment to tested party and comparables margin factors in the effect of receivables;
- The debt-equity structure of the tested party needs to be considered. If it's a debt-free entity, the concept of notional interest cost may not apply;
- The sale price considers the effect of delay in receivables;
- Charging of interest should be considered in comparison with terms of the transaction with an unrelated party. The tax officer cannot be in the shoes of businessman citing commercial reasons.
In the instant case, the court has given due emphasis to the terms of the inter-company agreement. The above referred key aspects from judicial precedents which seem to have settled the issue of overdue receivables were distinguished on the facts that the taxpayer itself had agreed to credit term of 15 days in the instant case.
While the arm's length nature of the interest is stated to be at LIBOR + 300 bps, however, this is something that should also be backed by internal or external benchmarking analysis.
The most important takeaway from this judgment is the importance of documentation (including invoices, agreements, PO's), etc. in defending the arm's length nature of the related party transaction. The judgment once again highlights that the arguments in court could only stand if they are married/consistent with the documentation maintained/submitted by the taxpayer
1. ITA No. 161/Del/2017 (AY 2011-12)
2. Case Laws Relied on:-
- Bechtel India Pvt. Ltd. [Supreme Court Ruling TS 591 SC 2017 TP] r.w. High Court ITA No. 379/Del/2016 r.w. ITA No. 478/Del/2015 (AY 2010-11)
- Kusum Healthcare Pvt. Ltd. [High Court ITA No. 765/Del/2016 r.w. ITA No. 6814/Del/2014 (AY 2010-11)
- AVL India Pvt. Ltd. | ITA No. 4529/Del/2014 & 4275/Del/2016 (AY 2009-10 & 2010-11)
- Motherson Sumi Infotech & Design Ltd. [91 Taxmann.com 443] ITA No. 6331/Del/2016 (AY 2012-13)
- BlackRock Services India Pvt. Ltd. [107 taxmann.com 93] ITA No. 1671/ Del/2015 (AY 2010-11) & 441/Del/2016 (AY 2011-12)
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