The Hindu Business Line : Interest at arm's length

ONE OF the widely used tax avoidance devices by transnational corporations is transfer pricing. Sister units, known as associated enterprises, are set up in countries that offer tax subsidies and where the taxes are low.

Profits are, thus, shifted to tax havens, though the nature or the scale of activities actually conducted there are of no relevance to the corporations.

Section 92 of the Income-Tax Act empowers the assessing officer (AO) to determine the profits which may reasonably be deemed to have been derived by a resident assessee in India from any business that he carries on with a non-resident, if he finds that, owing to the close connection between them, the business has been so arranged that the transactions between them produced to the resident either no profits or less-than-ordinary profits which may be expected to arise in that business.

MNCs have the ability to control prices in intra-group transactions and this can have an eroding effect on the Indian tax base. India's own transfer price legislation underwent a radical change in 2001 when the old Section 92 was completely substituted by new Sections 92 to 92F governing international transactions of associated enterprises.

The concept of arm's length pricing was interposed in the statute. It was specifically laid down that the cost or expenses allocated or apportioned between two or more associated enterprises under a mutual agreement or arrangement shall be at arm's length price.

However, the arm's length price is not to be used for the computation of income if its adoption results in the reduction of the income chargeable to tax or an increase in the loss. Arm's length price is the price that would have prevailed if the enterprises involved were not controlled, influenced by or associated with another enterprise.

The Finnish case

In this case (Instrumentarium Corporation — 272 ITR 499 AAR), a Finnish company, Instrumentarium Corporation, had a wholly owned Indian subsidiary, Date Ohmeda (India) P Ltd. The holding company was dealing in the manufacture and sale of medical equipment and Datex was the distributor in the Indian market.

In August 2002, the two companies entered into a loan agreement under which Instrumentarium granted a dollar loan equivalent to Rs 36 crore for the general business of Datex. The loan was free of interest. Though it was declared to be an interest-free loan, the agreement also stipulated that delay in repayment would attract default interest of 16 per cent.

The Finnish company approached the Authority for Advance Ruling (AAR) for advice on the question whether the granting of interest-free loan would attract the provisions of the transfer pricing law. According to the Finnish company, it would be taxed at 10 per cent on its Indian profits as per the convention between India and Finland for the avoidance of double taxation concluded in 1983 and notified in 1984 and amended in August 1998. Datex, being an Indian company, was subject to tax at 36.75 per cent. The granting of interest-free loan meant a benefit to the Indian taxman to the extent of 26.75 per cent (36.75 - 10) because of non-levy of interest.

The question was whether the Finnish company should be compelled to adhere to the arm's length price with regard to the interest-free loan even when it is known that such a direction will result in no benefit to the exchequer.

According to CBDT (Central Board of Direct Taxes) Circular No. 14 dated May 11, 2001, Section 92 is not intended to be applied in cases where the adoption of the arm's length price would decrease the overall tax incidence in India in respect of the parties involved in the international transaction.

The Solicitor-General of India appeared before the AAR and argued that it will not be proper to enforce a premature application of Section 92(3) so as to prevent the application of the arm's length rule. This can be done only at the stage of assessment with full facts being placed before the AO. Gain or loss to the Government cannot be a defence against transfer pricing regulations.

The AAR, it was submitted, had no jurisdiction to order "non adherence" to statutory provisions. After all, the Authority is constituted under the Income-Tax Act and no court had powers to prevent the application of Section 92.

The AAR decided that the exact position with regard to the charging of overdue or default interest will be known only at the time of assessment and it will be premature to assume zero interest rate.

The Authority had no option except to reject the application where the question raised involved determination of the fair market value of any property. The case centred on the determination of the fair market rate of interest.

The AAR is prohibited under Proviso (ii) to Section 245 R[2] from going into an exercise to fix fair market value. The Finnish company was directed to comply with the provisions of the Act, including the legislation relating to the transfer pricing. The rate of interest will have to be taken as per the principles of arm's length price.

This is the first case on transfer pricing regulation and it only stresses the need for an advance pricing mechanism so that there is clarity on tax obligations due in international transactions.

(The author is former Chief Commissioner of Income-Tax.)

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Administer it right

Is poverty the best policy?

Needed, a better ideal than Asean rates

Entry tax on earthmoving machinery

Interest at arm's length

Why the taxman didn't join the party at club mandap

On strikes as a weapon

Worth striving for more humane world