Trade Credit — Being at Arm's Length

Have you ever thought that delay in recovering monies from group debtors might trouble the management of your company?

Extending credit is a vital aspect of any business operation. By collecting receivables (debtors) faster, cash is released from the working capital cycle; to the contrary, by collecting receivables (debtors) slower, cash gets locked. Cash resources are managed efficiently by getting better credit terms (in terms of duration or rate) from suppliers.

While a company's management may be concerned with regard to extension of credit to third party customers during a stipulated period, the tax department may disapprove any such benefit being extended to related parties abroad (referred to as Associated Enterprises (AEs) in transfer pricing parlance). Recently, in some cases, the Indian revenue has held that significant costs are incurred by taxpayers by extending interest-free credit to AEs beyond normal credit period.

The tax department may not deny that there may be a reason for business expediency, and may also not deny the genuineness of transaction, but may argue that by not charging interest on the extended credit period granted to the AEs, the taxpayer has not carried out the transaction at arm's length as mandated by the Indian transfer pricing regulations. Accordingly, the tax authorities may compute notional interest on amounts which are past the due date, from the group companies.

During the course of the transfer pricing assessments, the trade credit to AEs beyond a certain period is drawing adverse conclusions, according to tax authorities. They argue that under arm's length behaviour, an entity would charge interest on any outstanding amount beyond a time period of 30-90 days. This is despite the fact that the taxpayer may not be charging any interest on debit balances with independent parties also. Usually, tax authorities quantify notional interest either by applying interest rates at which taxpayer extends loans, or avails loans from its bankers in India or abroad or by applying the Prime Lending Rates of the nationalized banks in India.

RECENT CASE VERDICTS

It is interesting to discuss three recent decisions from the Income Tax Appellate Tribunals (“tax tribunals”). The Mumbai tax tribunal, in the case of Nimbus Communications Limited, had occasion to deliberate if a continuing debit balance constitutes an ‘international transaction' under the transfer pricing regulations in India. The tax tribunal held that a continuing debit balance is not an “international transaction” per se but is a “result” of the international transaction. The tribunal went a step ahead and remarked that even if this is held to be an “international transaction”, no interest can be deemed if a taxpayer gives similar treatment to its group company as well as to third parties. They also remarked that the debit balance of group companies should not be seen in isolation, but along with commercial factors accompanying it.

Recently, based on this decision, in the case of Patni Computer Systems Ltd., the Honourable Pune Tribunal held that the extension of credit to AEs beyond the stipulated credit period cannot be construed as an “international transaction”, so as to require adjustment for ascertaining the ALP.

Another interesting issue was before the Mumbai tax tribunal in the case of Tech Mahindra Limited. Here, two significant conclusions were arrived at by the tax tribunal. First, that transaction with one “group company” cannot be taken as a good comparable while determining an ALP of a transaction with another group company. The comparison should be only between controlled and uncontrolled transactions, i.e. with third parties only. Also, if a company charges interest from a group company located in another geographical location, then that won't constitute a benchmark. In this case, the tax tribunal didn't discuss if an extended credit period was an “international transaction”, as it wasn't a question before them.

In view of these points, it can be fairly said that if a company extends credit to its group companies beyond a period granted to third parties, it should be prepared to justify non-charging of interest with necessary commercial reasons, as tax authorities may doubt this to be an arm's length behaviour. So, one should be watchful on negligence, for the company may be stepping on a landmine.

(The authors are Senior Director and Manager, respectively at Deloitte Haskins & Sells. Views expressed are personal.)

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