15 July 2011

Transfer pricing adjustments on interest free loans

An interesting matter on transfer pricing came before the Income Tax Appellate Tribunal (Tribunal) in New Delhi, India, some time ago.

An Indian company (A) in the technology business solutions industry extended two interest free foreign currency loans to two of its off-shore subsidiaries (B and C) to the value of US$1.5 million and US$4.6 million respectively.

When the Indian revenue authorities scrutinised the transactions in terms of transfer pricing, they concluded that the loans extended to B and C were not at arm's length, and A's income for the relevant years of assessment was adjusted upward.

A's argument was that the loans extended to B and C were not in the nature of debt, but rather quasi-equity. B and C were start-up companies and were not conducting significant business activities. Lenders would not lend money to start-up companies. The funds were used to make long term step down investments in subsidiaries and the intention was to earn dividends and not interest. The loans were also approved by the Reserve Bank of India.

A also argued that in terms of the loan to C, a company incorporated in Hungary, that country in terms of its thin capitalisation rules regarded any debt exceeding three times a company's capital to be capital. Accordingly the argument that the funds were actually equity is reinforced.

The revenue authorities argued that no person would give an interest free loan to another if the relationship between the parties is strictly a business relationship because the lender forgoes income which he could have earned from the funds. The lender also risks losing the funds advanced if the debtor defaults.

There is a big difference between debt and equity. In the case of a loan, one's return is limited. In the case of equity one is entitled to share in the profits and exercise a voting right. A shareholder also has the benefit of any appreciation in the value of the share.

The revenue authorities further argued that B was a company incorporated in Bermuda, a tax haven. If profit is shifted to B, then A's income will be reduced in India, and overall less tax will be payable by the group. The transaction was a classic example of a breach of transfer pricing norms. Also, B is not obliged to pay dividends and may retain profits and thus A's income in India would remain lower. The revenue authorities could see no other reason for the transactions other than the reduction of the tax burden of the group.

The Tribunal dismissed A's argument that the loans were actually quasi-equity in that the agreements clearly provided for debt and not equity and there was no reason why A could not have subscribed for equity if it wanted to. The reliance on any thin capitalisation provisions was similarly dismissed. The Tribunal also dismissed the argument that nobody would lend start-up companies money because if A comes to the rescue of B and C by lending them money, it does not follow that the loan should necessarily be interest free. The Tribunal instead found the revenue authorities' arguments to be cogent and that it was clear that the loans fell within the ambit of India's transfer pricing regime.

The only remaining issue was whether the revenue authorities had calculated the arm's length interest rate correctly for purposes of the adjustment. They had used the London International Bank Official Rate (LIBOR) for the relevant period in respect of a US dollar loan. They added to the LIBOR the average basis points charged by other companies. The arithmetic mean of the basis points charged by five other companies was computed, being 1.64%. The rate used for purposes of the adjustment was thus LIBOR + 1.64%, using the Comparable Uncontrolled Price method.

The Tribunal found that the interest rate had been calculated correctly.

Companies should be aware of the fact that they may became subject to transfer pricing adjustments when making interest free loans to subsiduries situated in other jurisdictions.

Heinrich Louw

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