The Delhi High Court in its recent judgment has ruled that under Transfer Pricing, for computing arm length interest rate PLR rates are not applicable to loans to be re-paid in foreign currency. According to the Court, the comparison, has to be with comparables and not with what options or choices were available for earning income or maximizing returns

Details of the Case:
Income Tax Appeal No.: 233/2014
Commissioner of Income Tax... Appellant  Versus M/s Cotton Naturals (I) Private Ltd. …..Respondents
Assessment Year: 2007-08
Coram: Hon’ble Mr. Justice Sanjiv Khanna;  Hon'ble Mr. Justice V. Kameswar Rao

Date of Judgment:  27-03-2015

Question of Law:
Whether the Income-Tax Appellate Tribunal was right in following their earlier order for the assessment year 2008-09, dated 8th February, 2013 in ITA No. 5855/Del./2012 and in holding that the interest @ 4% p.a. charged by the respondent assessee from its subsidiary i.e. the Associated Enterprise was arm‘s length rate of interest and the adjustment made in the Assessment Order determining the arms‘ length rate of interest at 12.20% was unwarranted?

Facts of the Case:
The question in the present case was related to the determination of arm‘s length rate of interest, paid to the respondent assessee by their subsidiary M/s JPC Equestrian, a company registered in the United States of America.

The respondent was an Indian company engaged in the business of manufacture and exports of rider apparels. The respondent company had incorporated M/s M/s JPC Equestrian as wholly owned subsidiary for marketing its exports to USA.

Form 3CB and Transfer Pricing Documents revealed the following international transactions between the respondent assessee and M/s JPC Equestrian :

Equestrian Apparel sold to JPC Equestrian Inc.	Rs.24,438,153/-
Loan provided to JPC Equestrian Inc	10,50,000 $
Interest Received	Rs.20,52,101

The respondent company had selected the Comparable Uncontrolled Price (CUP) method to benchmark sale of equestrian apparels and the interest received on the loan. The interest received @ 4% was claimed to be comparable with the export packing credit rate obtained from independent banks in India.

The Transfer Pricing Officer (TPO) took the arm‘s length interest rate as 14% p.a on the basis of CUP rate calculation as LIBOR+700 basis points. The main contention of TPO was hat point to be seen was what the assessee would have earned by giving loans to an unrelated party in the Indian market with the same financial health as that of the respondent’s subsidiary.  Whereas, as per the respondent company, comparison had to be made with respect of advance or loan in USA and not based on Indian conditions.

However, on appeal, ITAT, giving rise to this appeal, set aside the TPO’s order by following its earlier judgment given for AY 2008-09.

Excerpts from the Judgment:

“In our opinion, the reasoning recorded therein suffers from a basic and fundamental fallacy. Transfer pricing determination is not primarily undertaken to re-write the character and nature of the transaction, though this is permissible under two exceptions. Chapter X and Transfer Pricing rules do not permit the Revenue authorities to step into the shoes of the assessee and decide whether or not a transaction should have been entered. It is for the assessed to take commercial decisions and decide how to conduct and carry on its business. Actual business transactions that are legitimate cannot be restructured. It is not uncommon for manufacturers cum exporters to enter into distribution and marketing agreements with third parties or incorporate subsidiaries in different countries for undertaking marketing and distribution of the products.”

“…….. we record that the respondent-assessee had incorporated a subsidiary in United States for undertaking distribution and marketing activities for the products manufactured by them. It is obvious that this was done with the intention to expand and promote exports in the said country and was a legitimate business decision. The transaction of lending of money by the respondent-assessee to the subsidiary, should not be seen in isolation, but also for the purpose of maximising returns, propelling growth and expanding market presence. The reasoning ignores the said objective facet. Transfer pricing rules treat the domestic AE and the foreign AE as two separate entities and profit centres, and the test applied is whether the compensation paid for the products and services is at arm‘s length, but it does not ignore that the two entities have a business and a commercial relationship.”

“…… we cannot accept the reasoning given by the TPO that the transfer pricing adjustment could restructure the transaction to reflect maximum return that a party could have earned and this would be the yardstick or the benchmark for determining the interest payable by the subsidiary AE. This is not what Chapter X of the Act and Rules mandate and stipulate. The aforesaid provisions neither curtail the commercial freedom, nor do they bar or prohibit a legitimate transaction. They permit transfer pricing adjustment so as to bring to tax what would have been paid for the transaction in the same or similar comparable circumstances by an independent third party.”

“The comparison, therefore, has to be with comparables and not with what options or choices which were available to the assessed for earning income or maximizing returns.”

We have no hesitation in holding that the interest rate should be the market determined interest rate applicable to the currency concerned in which the loan has to be repaid. Interest rates should not be computed on the basis of interest payable on the currency or legal tender of the place or the country of residence of either party.

…………. The PLR rate, therefore, would not be applicable and should not be applied for determining the interest rate in the extant case. PLR rates are not applicable to loans to be re-paid in foreign currency. The interest rates vary and are thus dependent on the foreign currency in which the repayment is to be made. The same principle should apply.

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