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The Mumbai Tribunal held that non-charging of interest attracts transfer pricing provisions and also affirms the DRP’s order striking the secondary adjustment 24 September 2014

Background

Recently, in the case of PMP Auto Components P. Ltd.1 (the assessee), the Mumbai Tribunal (the Tribunal) held

that interest on loan is an international transaction even in case of moratorium in payment of interest. The Tribunal also struck down the secondary adjustment with regards to notional interest on adjustment on capital infused by the assessee in its subsidiary.

Facts of the case

The assessee is engaged in the business of manufacturing and marketing auto components to original equipment manufacturers.

During the Assessment Year (AY) 2009-10, the assessee had advanced loan to its wholly owned subsdiary PMP Mauritius. It had agreed for a moratorium of one year after which it would charge interest. The assessee had also advanced loan to PMP Bakon, Hungary, another subsidiary, where an interest rate of 8per cent was being charged. The Transfer Pricing Officer (TPO) proposed a Transfer Pricing (TP) adjustment by adopting an interest rate at 15 per cent on the basis of the bank lending rate of 12 per cent plus mark up of 3 per cent on account of the risk in giving the loan without any security, for both the loans. The Dispute Resolution Panel (DRP) upheld the adjustment made by the TPO.

The TPO also made addition on account of notional interest, on the share application money remitted by the assessee towards investment in equity shares of its subsidiary PMP Mauritius, as the shares were allotted almost after a period of one year.

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1 PMP Auto Components P. Ltd. v. DCIT [TS-263-ITAT-2014(Mum)-TP]

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The entire capital of PMP Bakony Hungary, was acquired by the assessee in AY 2006-07 from a third party. Subsequently, further capital was infused in the year under consideration. The TPO treated the arm’s length price (ALP) of the shares at nil and made an adjustment of the entire amount of INR14.15 crore infused by the assessee.

TPO also proposed a secondary adjustment on account of the interest chargeable on the above deemed loan transaction i.e. for the capital investment made in PMP Bakony. However, this adjustment was deleted by the DRP.

Assessee’s contentions before the TPO/DRP

TPO/DRP’s order Tribunal’s Ruling

Issue 1: Addition of notional interest on account of loans given to the Associated Enterprises (AE)

In case of loan advanced to PMP Mauritius, the assessee submitted to the TPO that it had agreed for a moratorium period of one year, and further in terms of Article 11 of Double Taxation Avoidance Agreement (DTAA) with Mauritius, only interest paid is subject to tax and notional interest cannot be taxed.

In case of loan advanced to PMP Bakony, assessee charged interest at the rate of 8per cent on the basis LIBOR

The TPO did not accept the contention of the assessee in both cases.

The TPO concluded an adjustment of 15per cent on both the loans i.e. 12per cent bank lending rate plus mark up of 3per cent on account of risk in giving loan to the AE without any security.

The DRP upheld the order of the TPO and held that Article 11 does not press into service in case of determination of the arm’s length price.

On the issue of prime lending rate or LIBOR rate to be taken as arm’s length interest rate, the Tribunal directed the Assessing Officer/TPO to consider LIBOR plus 2per cent after placing reliance on the Tribunal ruling in Aurionpro Solutions Ltd

2.

The Tribunal dismissed the contention of the assessee due to moratorium of payment of interest, no interest was charged to the Mauritius based AE.

The Tribunal held that it is pertinent to note that when the transaction between the assessee and the AE falls within the ambit of international transaction as per the provisions of section 92B, then the ALP has to be determined by the Comparable Uncontrolled Price (CUP).

On the assessee’s contentions on Article 11, The Tribunal held that the provisions of Article 11 defer the taxability of interest arising but not received, and it is taxable when received. In the present case the assessee did not even admit the arising of interest on the loan and its accrual to the assessee; The Tribunal held that the provisions of Article 11 of Indo-Mauritius treaty cannot be considered in the present case.

__________________ 2 Aurionpro Solutions Ltd. vs. ACIT [TS-75-ITAT-2013(Mum)-TP]

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Issue 2: Re-characterisation of share application money towards investment in subsidiary, PMP Mauritius, as loan and addition on account of notional interest

The assessee contended before the DRP that the Mauritius law does not have a prescribed time period for allotment of shares against the share application money. Therefore, the share application money cannot be treated as advance given to the AE.

The assessee contended that the transaction did not fall under the definition of ‘international transaction’.

The TPO/DRP contended that there was an abnormal delay in the allotment of shares, and hence share application money was to be considered as loan given to AE without charging interest.

The TPO/DRP held that the transaction was an international transaction covered under clause (c) of explanation to section 92B of the Act.

The DRP upheld the charging of notional interest.

The Tribunal placed reliance on the Tribunal ruling in Bharti Airtel Limited where it was held that, capital contribution could be treated as interest free loan for the period of inordinate delay and not the entire period till actual allotment of shares.

The Tribunal held that as the assessee was the 100per cent shareholder of the AE, the assessee had control over the allotment of shares. Any abnormal delay in allotment of shares, cannot be held to be reasonable or beyond the control of the assessee.

The assessee had failed to bring on record any reasons for delay in allotment of shares.

The addition if any, on account of share application money and delay in allotment of shares should be done on the basis of what would have been interest payable to an unrelated share applicant.

The issue was referred back to the AO/TPO to determine the actual period of delay and arm’s length interest that would have been received had the transaction been with an unrelated party.

Issue 3: Treatment of equity investment at par in overseas subsidiary as international transaction and addition of full amount as income of the assessee. Further, secondary TP adjustment on account of notional interest on the income receivable from the AE - PMP Bankony

The assessee claimed that additional capital contribution was not an ‘international transaction’ and could not be treated as its income.

The assessee had made investment at par, though the discounted cash flow valuation was much higher.

The assesee was the only shareholder of the subsidiary, and infusion of additional capital will have no effect on the value of shares.

The TPO applying the networth method noted that the book value of the shares on 31 August 2008 was negative and treated the ALP of shares at ‘NIL’ and proposed a TP adjustment treating the infusion as income of the assessee.

The TPO also made a secondary TP adjustment on account of interest chargeable on additional capital infused, as no amount of interest was realised by the assessee on additional capital infused.

The Tribunal accepted the assessee’s reliance placed on the valuation report of KPMG based on the Discounted Cashflow (DCF) method, and held that the valuation in case of a 100per cent subsidiary should be based on future prospective earnings rather than present net worth of the subsidiary.

The Tribunal observed that that the investment is for long-term and not restricted to capital gains, and accepted the contention of the assessee to use the DCF method.

© 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

The DRP deleted the adjustment by holding that Indian TP provisions in the Act do not envisage the concept of ‘secondary transfer pricing adjustment’.

The Tribunal remanded the case back to the AO/TPO to decide after taking into account the valuation report based on the DCF method.

In respect of the secondary adjustment, which was over and above the entire amount of capital investment, it was held that it was not permissible as per the provisions of the Income-tax Act, 1961.

The Tribunal upheld the DRP’s order and ruled in favour of the assessee.

Our comments

The Tribunal held that computation of notional interest on loan advanced to AEs is within the ambit of transfer pricing provisions. The provisions of Article 11 of the DTAA between India and Mauritius, which state that interest is taxable only on payments, does not press into service for determination of arm’s length price. On the issue related to notional interest on share application money, the Tribunal held that capital contribution could be treated as interest free loan for the period of inordinate delay, and not the entire period till the actual allotment of shares. The Tribunal also held that the addition, if any, on account of share application money and delay in allotment of shares, should be done on the basis of what would have been interest payable to an unrelated share applicant. The Tribunal importantly placed reliance on future earnings rather than the present net worth in case of a 100per cent subsidiary, and accepted DCF valuation for treatment of equity investment, which can be considered a rational view. Moreover, the Tribunal provided clarity, in respect of secondary adjustment on account of notional interest, on the income receivable from the AE, in respect of the capital infused by the assessee, by holding that the same is not permitted under the TP provisions under the Income-Tax Act, 1961.

All in all, this ruling re-emphasises certain important principles laid down in other rulings like LIBOR plus being acceptable for foreign lending, secondary adjustment on capital infusion not permissible as per law, and interest on inordinate delay in share allotment justifiable.

© 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we

endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue

to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

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