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Interest Free Loan In Breach Of Arms Length Principle, Says Indian Tribunal

Monday, February 8, 2010

The Delhi Income Tax Appellate has decided in the case of Perot Systems TSI (India) Ltd. that an interest-free loan to associated enterprises would not be consistent with the arm’s length principle of the transfer pricing provisions and a notional arm’s length interest can be imputed on the loan and taxed.

Perot advanced interest-free loans to its 100% foreign subsidiaries. The subsidiaries used those funds to make investments in other step-down subsidiaries.

Perot argued that the said “loans” were in fact “quasi-equity” and made out of commercial expediency. It was also argued that notional income could not be assessed to tax under the transfer pricing provisions of Chapter X.

ITAT decided that:

  • The argument that the loans were in reality not loans but were quasi-capital cannot be accepted because the agreements show them to be loans and there is no special feature in the contract to treat them otherwise. There was also no reason why the loans were not contributed as capital if they were actually meant to be a capital contribution;
  • The argument that the loans were given on interest-free terms out of commercial expediency is not acceptable because this was not a case of an ordinary business transaction but was an international transaction between associated enterprises. One had to see whether the transaction was at arms length under the transfer pricing provisions;
  • The argument that notional interest income cannot be assessed was not acceptable in the context of transfer pricing. S 92(1) provides that any income arising from an international transaction has to be computed having regard to the arm’s length price. S. 92B (1) defines an “international transaction” to mean “a transaction between two or more associated enterprises … in the nature of … lending or borrowing money …” In considering the “arms length” price of a loan, the rate of interest has to be considered and income on account of interest can be attributed;
  • The result of the transaction was that Perot's income in India would reduce while that of the associate in Bermuda would increase. This was a classic case of violation of transfer pricing norms where profits were shifted to bring down the aggregate tax incidence of a multi-national group; and
  • The Proviso to s. 92C (2) which allows a variation of 5% from the arms length price applied only when “more than one price was determined” and an arithmetic mean adopted. The Tax authority had adopted the LIBOR rate of 2.39% and added the arithmetic mean of ‘average basis point’ charged by other companies which came to 1.64% and worked out the arms length price at LIBOR + 1.64%. As only one LIBOR rate had been applied which was adjusted for some basis points, it could not be said that “more one price” had been used so as to attract the Proviso.