Taxpayer not required to demonstrate that the debt has become bad debt once it is written off in the books of account: SC

Supreme Court Ruling: After 1 April 1989 the Taxpayer is not required to demonstrate that the debt has become bad debt once it is written off in the books of account [TRF Ltd. v. CIT (2010-TIOL-15-SC-IT)]

Supreme Court Ruling:

In order to claim a bad debt as a deduction under section 36(1)(vii) of the Income tax Act (Act) it has been a long drawn controversy between the Taxpayer and the Revenue whether in addition to write-off the debt in the books of account, it is obligatory on the Taxpayer to establish that such debt has become a bad debt, especially after the amendment brought in by the Direct Tax Laws (Amendment) Act, 1987 w.e.f. 1 April 1989.

This controversy has now been put to rest by the Supreme Court in the case of TRF Ltd. v. CIT wherein it has been held that after 1 April 1989 it is not necessary for the Taxpayer to establish that the debt, in fact, has become irrecoverable. It is enough if the bad debt is written off as irrecoverable in the accounts of the Taxpayer.

Our View:

The Direct Tax Laws (Amendment) Act, 1987 substituted the words “any bad debt or part thereof” in place of “any debt, or part thereof, which is established to have become a bad debt in the previous year” in section 36(1)(vii) of the Act w.e.f. 1 April 1989. Subsequent to the above amendment the Central Board of Direct Taxes (CBDT) has issued Circular 551 dated 23 January 1990. The issue pertaining to bad debt is set out in para. 6.6. and the relevant portion reads as under :-

“In order to eliminate the disputes in the matter of determining the year in which a bad debt can be allowed and also to rationalise the provisions, the Amending Act, 1987 has amended clause (vii) of sub-section (1) and clause (i) of sub-section (2) of the section to provide that the claim for bad debt will be allowed in the year in which such a bad debt has been written off as irrecoverable in the accounts of the assessee.”

The Circular of the CBDT clearly spells out that the amendment is to eliminate the disputes in the matter of determining the year in which the bad debt is written off as irrecoverable. If we apply the Rule of interpretation as spelt out in Hyden’s case, it would lead to an irresistible conclusion, that the Legislature by the amendment has sought to exclude the burden on the Taxpayer to prove that the debt is bad debt and leaves it to the commercial wisdom of the Taxpayer to treat the debt as bad, once it is written off as irrecoverable in the accounts of the Taxpayer. Inspite of this clear provision the Taxpayer was again called upon to establish that the debt has become bad debt.

The Supreme Court has now given a ruling in favour of the Taxpayer that it is not obligatory on the Taxpayer to prove whether the debt has become bad debt once such debt has been written off in the books of account. This is a welcome decision and would give a substantial relief to the Taxpayer. It seems that the judgement of the Rajasthan High Court in the case of Kashmir Trading Co. v. DCIT (291 ITR 228) is overruled, while judgements of High Courts in the case of DIT v. Oman International Bank (313 ITR 128)(Bom) and CIT v. Global Capital Ltd. (306 ITR 332) (Del) are approved.

Although the aforesaid judgement of the Supreme Court does not clearly spell out, we believe that after the amendment, though it is neither obligatory nor is there burden on the Taxpayer to prove that the debt written off by him is indeed a bad debt; the write-off needs to be bona fide and should be based on commercial wisdom or expediency.

 

Bad debts written off cannot be a factor to determine the Arms length price under any of the Transfer Pricing methods prescribed in the Income Tax Act, 1961.

This Article summarizes a recent ruling of the Mumbai Income Tax Appellate Tribunal (ITAT) [ITA no. 5420 and 5421/Mum/2006] in the case of CA Computer Associates Pvt. Ltd. (Taxpayer) on the issue of determining arm’s length price (ALP) of royalty paid by the Taxpayer to its associated enterprise for distribution of software products in India. The ITAT held that the disallowance made by the Transfer Pricing Officer (TPO) to the royalty, to the extent of the bad debts written off by the Taxpayer, was not in accordance with the transfer pricing (TP) provisions of the Indian Tax Law (ITL). According to the ITAT, as bad debts written off cannot be a factor to determine the ALP under any of the TP methods prescribed in the ITL, the TPO had exceeded his limitation.

Facts of the case

• The Taxpayer, a company incorporated in India, is engaged in the business of licensing and distributing mainframe, mid¬range and system infrastructure software products in India. The Taxpayer was appointed as the sole distributor in India for the products of a group company in the US (US Co).The Taxpayer had also set up a technical support centre in India to provide support services to end users of the software products on behalf of US Co.

• During the year, the Taxpayer made payments to US Co in the nature of royalty for distribution of US Co’s software products in India. In its return of income, the Taxpayer claimed deduction of such royalty payments. The Taxpayer had also incurred certain bad debts in the course of its business from sale of software products to unrelated customers, which were written off.

• The Tax Authority referred the matter to the TPO for determining the ALP as prescribed in the ITL. The Taxpayer had determined the ALP of the royalty payments, by applying the Comparable Uncontrolled Price (CUP) method. While the TPO accepted the CUP as the most appropriate method, a TP adjustment was made by way of disallowance to the royalty payments, to the extent of the bad debts written off. Hence, the ALP of the royalty for the sale made to the customers, whose receivable was written off, was determined as nil.

• The TPO’s order stated the following reasons for partially disallowing the royalty payments made by the Taxpayer:

• US Co, the licensor, was regularly intimated about the collection position with regard to invoices and, hence, in view of the uncollected invoices, US Co should not have claimed royalty on such amounts.

• Any independent entity, acting as sole distributor of US Co, would have sought waiver of royalty payable, considering the huge amount of non-receivables in the year. Further, existence of bad debts risk would be considered by independent parties while entering into distributor agreements in the initial years of business.

• If US Co had licensed the products directly to the clients, it would have suffered the bad debts.

• Royalty payments should be considered on the basis of actual collections and not just on the basis of invoicing.

• The invoices were raised and written off in the same year and hence, no royalty was payable annually.

• The Tax Authority followed the above order of the TPO. Against this, the Taxpayer appealed before the first appellate authority which upheld the Tax Authority’s order. Aggrieved by the first appellate authority’s order, the Taxpayer preferred an appeal before the ITAT.

Contentions of the Taxpayer

• Jurisdiction of the TPO is restricted to determine the ALP of any international transaction in view of the power vested in him under the provisions of the ITL.

• Specific methods have been prescribed in the ITL and the TPO is bound to determine the ALP of any international transaction within the framework of the methods prescribed by the statute.

• Writing off the bad debts cannot be the subject matter for determining the ALP under the powers of the TPO.

• Merely because the royalty payments were relating to the products sold by the Taxpayer to its clients, which payments could not be recovered, it cannot be a consideration before the TPO for deterring ALP of any international transaction.

Ruling of the ITAT

• The manner in which the ALP is to be determined by any of the methods is prescribed in the ITL and bad debts written off cannot be a factor to determine the ALP of any international transaction.

• The TPO has exceeded his limitation by following the method which is not authorized under the ITL.

• The ALP determined by the TPO and adopted by the Tax Authority is not as per the procedure prescribed and, hence, the same cannot be sustained.

Comments

For the purposes of the CUP method, an uncontrolled transaction is comparable to a controlled transaction, if none of the differences (if any) between the transactions being compared materially affects the price or some reasonably accurate adjustments can be made to eliminate the material effects of these differences. In considering whether controlled and uncontrolled transactions are comparable, regard should be had to the effect on price of broader business functions and allocation of risks arising from these functions.

The present ITAT ruling does not throw much light on the allocation of risks (specifically bad debts risk) between US Co and the Taxpayer or on whether the adjustment proposed by the TPO was to account for the difference in pricing likely to arise from the allocation of bad debt risk. Nevertheless, this ITAT ruling recognizes the principle that, in determining the ALP the TP methods should be applied strictly in accordance with the manner in which the same have been prescribed in the TP rules.

ITAT: No Tax on Foreign Cos if arm’s length basis followed

ITAT: No Tax on Foreign Cos if arm’s length basis followed

The Income Tax Appellate Tribunal (ITAT) has held that a foreign company is not liable to pay tax to Indian authorities if its domestic agent is paid on an arm’s length basis. ITAT given the order in an appeal filed by UK-based BBC Worldwide.

An arm’s length price is at which two related parties trade as if they are not associated, so that there is no conflict of interest.

BBC Worldwide had appointed its Indian subsidiary BBC India to solicit orders for the sale of advertising airtime on its channel. BBC Worldwide had received the payment from advertisers while BBC India got a 15% commission.

BBC Worldwide claimed that as the revenue was its “business profit” and it had no permanent establishment in India, the income was not taxable in the country under the India-UK Double Taxation Avoidance Agreement (DTAA).

However, the I-T assessing officer (AO) in New Delhi submitted that BBC Worldwide’s income from the advertisement accrued in India should attract 20% tax as per the DTAA as its Indian subsidiary was a permanent establishment in India.

But the ITAT held that BBC India’s commission was fixed at an arm’s length and the quantum of the commission was a fair transfer price. ITAT also found that commission paid to advertising agents of foreign telecasting companies in India is usually 15% of revenues.

The ITAT also considered a circular issued by the Central Board of Direct Taxes, which said if the sales of the non-resident company were secured through its agent in India, the taxable income was limited to the profits of the agent.

The CBDT circular also stated that the business activities should be channelled wholly through the agent and the contract to sell should be signed outside India.

Notional interest on interest-free loans is assessable under transfer pricing law

The assessee, an Indian company, advanced interest-free loans to its 100% foreign subsidiaries. The subsidiaries used those funds to make investments in other step-down subsidiaries. On the question whether notional interest on the said loans could be assessed in the hands of the assessee under the transfer pricing provisions of Chapter X, the assessee 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. HELD rejecting both arguments:


(i) 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 is also no reason why the loans were not contributed as capital if they were actually meant to be a capital contribution;

(ii) 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;

(iii) The argument that notional interest income cannot be assessed is 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;

(iv) The result of the transaction was that the income of the assessee in India would reduce while that of the assessee in Bermuda, a tax haven, would increase. This was a classic case of violation of transfer pricing norms where profits were shifted to tax havens to bring down the aggregate tax incidence of a multi national group;

(v) The Proviso to s. 92C (2) which allows a variation of 5% from the arms length price applies only when “more than one price is determined” and an arithmetic mean is adopted. The TPO 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 has been applied which has been adjusted for some basis points, it cannot be said that “more one price” has been used so as to attract the Proviso.

Note: In In Re Dana Corporation (AAR) it was held that transfer pricing provisions, not being in the nature of a charging provision but being mere computation provisions, could not apply when there was no income.

Source:

In the Case Of : Perot Systems TSI vs. DCIT, Decided BY:(ITAT Delhi, Appeal No. I.T.A 2320, 2321 ,2322/Del/2008, Assessment year: 2002-03, 2003-04, 2004-2005