PROVISION FOR BAD AND DOUBTFULL DEBT

PROVISION FOR BAD AND DOUBTFULL DEBT WHICH WAS NOT ALLOWED EARLIER IN FULL IN THE ASSESSMENT YEAR CANNOT BE TAXED AS INCOME IN THE YEAR OF WRITE BACK

Each and every business entity working in India is guided by Income Tax Act, 1961. The income which a business entity earns is taxed following the relevant provisions of the Income Tax Act, 1961. There are a lot of section following which tax authority has to decide whether an income is taxable or not. One such section relates to the provisions for bad and doubtful debt. It is covered under section 36(viia)(b) of the Income Tax Act, 1961.

Section 36(viia)(b) is an important section as it allows a bank which though not incorporated India but being a bank under a law of any country outside India is allowed a deduction of five percent of the total income(computed before making such provision and Chapter VI) on account of provision for bad an doubtful debt.

In the banking sector the scope of default by customer is large so there is large provisions created for such default but under the Income Tax Act, 1961 there is a ceiling limit of five percent of the total income beyond which it can create any provision. So there remains some provision which remain unutilized. But in case if it recover some portion of the provision and write backs the amount in the books, whether such income chargeable tax or not is a question.

This can be best understood by a case involving Bank of Tokyo Mitsubishi UFJ Ltd(BTM) and the income tax department.

BTM is bank under the laws of Japan. The bank carries out its operation in India through its branches established in India. The profits earned by its permanent establishment were taxed by the income tax authorities.

Since being a foreign bank it was allowed a deduction under section 36(viia)(b) of the Income Tax Act, 1961 of an amount being not more than five percent of the total income. But since it being a foreign bank maintains its own provision for bad and doubtful debt and therefore because of the ceiling limit, the provisions created over years was not allowed as deduction.

Now during a year BTM made a gross provision and after writing back an amount which was recovered. The resultant figure was then added back to the total income to compute the Net Income.

When the Assessing Officer was assessing the return of income he allowed the deduction under 36(viia)(b) but he also charged the amount recovered on the grounds that no sufficient information was provided regarding the amount recovered and even it was from write back the amount was chargeable to tax assuming it was from a amount already provided as deduction earlier.

BTM was not happy with this assessment and appealed before the Commissioner of Income Tax (Appeal).

BTM won the case. But the income tax authority not happy with decision appealed in the Tribunal.

The Tribunal was of the view that since the department cannot produce any proof that the write off amount taxed was allowed as deduction in any of the earlier previous years. The deduction allowed under section 36(viia)(b) being five percent of the total if recovered can only be taxed as income in the year of recovery. So the decision again went in favor of BTM and the Assessing Officer was ordered to satisfy himself if the amount recovered was from provisions made earlier.

The ultimate conclusion is that an amount which is recovered and written back by a bank can only be subject to tax as an income only if it was allowed as deduction any of the earlier previous years. Until and unless this happens the amount is not subject to tax.

Super-normal profit cos must be excluded from comparables

Adobe Systems India Pvt Ltd vs. ACIT (ITAT Delhi)

Transfer Pricing: Super-normal profit cos must be excluded from comparables. DRP must not pass cursory / laconic orders

The assessee, engaged in providing software development services reported an OP/Cost Margin of 14.96%. The TPO worked out the average of arithmetic mean of ALP (OP/OC) of 42 comparables at 24.91% and directed that an adjustment of Rs. 10.40 crores be made. In its objections to the DRP, the assessee claimed that the comparables included three companies which were “super-normal profit making” and that these should be excluded. It was claimed that if the said companies were excluded, the arithmetic mean of OP/OC of the comparables was 17.15% which was within the +/- 5% range permitted by s.92(C)(2). The TPO rejected the contention on the ground that one company was listed and audited and showing consistent growth at the same level and there was no abnormality and that the other company’s information was not listed in the database. The third “abnormal” company was not dealt with by the TPO. The DRP dismissed the objections of the assessee by a “very cursory and laconic order”. On appeal by the assessee, HELD allowing the appeal:

(i) The TPO rejected the assessee’s contention with regard to inclusion of the three super-normal profit companies without any cogent reason. It is undisputed that the three companies have shown super-normal profits as compared to other comparables. Their exclusion from the list of comparable is quite correct. After excluding the three companies the arithmetic mean of the comparables falls within the +-5% range permitted by s.92(C)(2);

(ii) Despite the voluminous submissions and paper book filed, the DRP passed a very cursory & laconic order without going into the details of the submissions which is quite contrary to the mandate of s. 144C.

Tax on Liason Office

Delhi ITAT rules on taxation of procurement activity undertaken by a foreign company through a liaison office in India

Delhi Income Tax Appellate Tribunal (ITAT) [2011-TII¬05-ITAT-DEL-INTL] in the case of Linmark International (Hong Kong) Ltd. (Taxpayer) on taxation of procurement activity undertaken by the Taxpayer through its liaison offices (LOs) in India held that, as the LOs in India were carrying out real and substantive business operations of the Taxpayer, income could accrue or arise to the Taxpayer in India. The exclusion from taxation for activities of purchasing goods for the purpose of export provided for in the Indian Tax Laws (ITL), could not be relied upon by the Taxpayer. Furthermore, given the extent of functions carried on by the Taxpayer in India, 50% of the commission earned by the Taxpayer’s parent company from third party customers should be attributable to the LOs’ activities.

Background and facts

Linmark Development (BVI) Ltd. (BVI Co), a company incorporated in the British Virgin Islands, is in the business of providing buying and procurement services to unrelated customers located in the USA, Canada, Australia, Europe and other countries located in the Asian region, including India. In this connection, it entered into a service agreement with its group company, Linmark International (Hong Kong) Ltd., a company incorporated in and a resident of Hong Kong i.e., the Taxpayer.

Under the service agreement, the Taxpayer was engaged to provide facilitation services in connection with buying of goods from various countries in Asia. These services were rendered to the buyers which were identified by BVI Co.

The Taxpayer acted as a communication and connecting link between BVI Co, its buyers and vendors in India. For this purpose, the Taxpayer had set up LOs in India. The Taxpayer and its LOs in India acted as a coordinating agency. BVI Co received commission from its buyers, calculated on a fixed percentage of the value of the goods exported to its clients outside India; typically in the range of 5-6%. For its services, the Taxpayer was remunerated at 1% of the value of the goods.

The Taxpayer was of the view that it was not taxable in India in view of a specific exclusion from taxation that was contained in the ITL for activities of a non-resident engaged in purchasing goods for the purpose of export out of India (‘purchase exclusion’).

The Tax Authority was of the view that BVI Co was a non-functional entity and did not play any role in the goods sourced from India as the employees of the Taxpayer directly corresponded with the customers and vendors. Furthermore, the Indian operations performed by the LOs in India had the effect that all business transactions, except formation of contracts, were carried out in India. Hence, the Taxpayer was liable to be taxed in India. The Tax Authority relied upon information gathered during a survey that was conducted on the LOs in India, which included interviews with the Taxpayer’s personnel in India on the activities carried on by the LOs. The Tax Authority attributed 90% of the commission earned by BVI Co to the LOs for the purpose of taxation.

The Taxpayer preferred an appeal to the first appellate authority which held that since the LOs were carrying on substantial business activities, the Taxpayer had a business connection in India. Hence, the Taxpayer was liable to be taxed on the income attributable to the LOs in India. On reviewing the functions, assets and risks (FAR) analysis presented by the Taxpayer, the first appellate authority was of the view that significant functions in the procurement supply chain and related risks should be allocated to the Indian operations. Accordingly, income attributable to India was determined as 72% of the commission earned by BVI Co. Aggrieved by the above, the Taxpayer approached the ITAT.

Taxpayer’s contentions

The Taxpayer was a coordinating agency between the buyer and seller and it acted on the basis of instructions received from the buyers of BVI Co.

The activities carried on in India are confined to operations of purchase of goods in India for the purpose of exports and, hence, the Taxpayer is covered by the ‘purchase exclusion’ contained in the ITL.

No income accrues or arises to the Taxpayer in India. Furthermore, in view of the specific ’purchase exclusion’ that deals with the Taxpayer’s case more specifically, the same should have precedence over the general provisions relating to accrual of income.

Tax Authority’s contentions

The Taxpayer is carrying on several activities in India through its LOs. The original FAR submitted by the Taxpayer itself attributed 33% of the activities to the LOs which provides a clear inference that income accrues to the Taxpayer in India.

Where income accrues or arises in India, one cannot rely on the ‘purchase exclusion’ as that provides exclusion only for incomes that are deemed to accrue or arise and not for incomes that actually accrue or arise in India.

The Taxpayer is not an exporter of goods. Furthermore, the offices in India, though termed as LOs, are functioning offices contributing to the profits of the Taxpayer.

The income attributable to the activities in India cannot be as low as '% which is the remuneration as agreed between the Taxpayer and BVI Co.

ITAT’s Ruling

Taxability in India

The relevant provisions of the ITL relating to charge of income tax on a non-resident has two independent components: (a) Income which accrues or arises in India (b) Income that is deemed to accrue or arise in India. The second component of the provision is further amplified by illustrating the incomes that are regarded as deemed to accrue or arise in India.

The ’purchase exclusion’ only scales down the extent of incomes that are deemed to accrue or arise in India. Such a limitation cannot be read into the provision which deals with income that accrues or arises in India.

Reliance was placed on the Supreme Court decision in the case of Performing Right Society Ltd. & Another v. CIT & Others' where it was held that, where income has actually accrued in India, there is no requirement to further examine whether the income is covered by the provision that deems income to accrue or arise in India. Furthermore, whether income accrues or arises in India is a question of fact which should be looked at and decided in the light of common sense and plain thinking.

It cannot be said that the activities carried on by the LOs in India are not in the normal course of business of the Taxpayer. The LOs carry out all operations of the business of the Taxpayer except the formation of the contract between the vendors and the customers which, in any case, cannot be done by the Taxpayer.

Notwithstanding the nomenclature of a ‘liaison office’, the offices in India are carrying out real and substantive business operations of the Taxpayer and, therefore, income accrues or arises in India.

Attribution of income to Indian LOs: The first appellate authority, while arriving at the attribution of income, had overstated the role of the Indian offices in the overall conduct of business of BVI Co. However, some employees of the Taxpayer were not even aware of the existence of BVI Co and they were dealing directly with the vendors and the customers. Furthermore, the Taxpayer had not pointed out any error in the analysis of the first appellate authority. Based on the above, a partial relief was provided to the Taxpayer and 50% of the commission of BVI Co was attributed to the Indian operations.

This ruling clarifies that the ‘purchase exclusion’ contained in the ITL for export of goods out of India can be relied upon by a non-resident only if income otherwise does not accrue or arise in India. This ruling also states that if a non-resident taxpayer undertakes substantive procurement or buying functions in India, it is likely that income could accrue or arise in India.

This ruling highlights the need for multinational enterprises to review their existing procurement supply chains for India to assess the possible exposure to a taxable presence.