Arm’s length price in case of interest on credit allowed to AE.

Tech Mahindra Limited v. DCIT (ITAT Mumbai ) -ITAT held that the arm’s length price in case of interest on extended credit period allowed to an Associated Enterprise (AE) based in USA shall be determined on the basis of USD London Inter Bank Offer Rate (LIBOR) instead of applying the rate of interest pertaining to EURO denominated loan charged to AE based in Germany since the AE was based in USA.

IN THE INCOME TAX APPELLATE TRIBUNAL

MUMBAI E BENCH, MUMBAI

ITA No. 1176/Mum/2010 Assessment year: 2004-05

Deputy Commissioner of Income Tax Vs. Tech Mahindra Limited

O R D E R

Per Pramod Kumar :

1. This appeal, filed by the Assessing Officer, is directed against the order dated 8th December 2009, passed by the Commissioner (Appeals), in the matter of assessment under section 143 (3) of the Income Tax Act, 1961 (hereinafter referred to as ‘the Act’), for the assessment year 2004- 05.

2. Ground No. 1 is general in nature and does not, as such, call for any specific adjudication by us.

3. In the second ground of appeal, the Assessing Officer has raised the following grievance:

On the facts and in the circumstances of the case and in law, the CIT(A) erred in determining the ALP interest rate of 2% for trade credit chargeable to the AE, without appreciating the fact that the same was required to be charged @ 10% being the rate charged by the assessee to its German AE on an euro denominated loan.

4. The relevant material facts are like this. The assessee, a joint venture between an Indian company by the name of Mahindra & Mahindra Ltd and a UK based company by the name of British Telecommunications, is engaged in the business of software services relating to telecommunication, internet technology and engineering etc. During the assessment proceedings, it was noticed that the assessee had allowed credit to its US based associated enterprises, beyond the stipulated credit period. It was in this backdrop, and pursuant to a reference made by the Assessing Officer to the Transfer Pricing Officer for determination of arms-length price, on account of notional interest relating to excess credit period granted by the assessee to its AEs, that the assessee was required to show cause as to why interest @ 10% not be treated as arms-length interest for such delayed receipts on account of services provided to the AEs. The stand of the assessee was that excess credit period was allowed to the US AE in view of the liquidity problems faced by the AE, and that, in any event, no such interest is charged from even independent enterprises. It was also submitted that interest was not charged because of the business expediency. The Transfer Pricing Officer was, however, not impressed by the stand so taken by the assessee. He was of the view that a cost should have been charged by the assessee for having allowed this excess credit period to the US AE, and the mere fact that the assessee has not charged the independent enterprises, for excess credit period allowed to them, does not help the cause of the assessee was having low level of business with such independent enterprises. The dealings with independent enterprises were thus rejected on the ground that these dealings constitute inappropriate comparables. While the Assessing Officer did observe that “it is not denied that there may be a reason for business expediency and also the genuineness of transaction”, he held that “by not charging interest on such extended period granted to the AE, the assessee has not carried out the transaction at arm’s length”. He also noted that the assessee has charged interest @ 10% from its German AE on the Euro denominated loan granted by the assessee, and, accordingly, adopted the same interest rate as an arms length interest for such excess credit period allowed. The interest on excess credit period thus allowed was computed at Rs 1,87,52,378, and an ALP adjustment was made in respect of the same. Aggrieved, assessee carried the matter in appeal before the CIT(A), who confirmed the ALP adjustment in principle but restricted the same to USD LIBOR rate ( which was 1.2 2% at that point of time) plus a mark up of 80 basis points, which was rounded off to 2%. Aggrieved by the relief so granted by the CIT(A), the Assessing Officer is in appeal before us.

5. Having heard the learned Departmental Representative, and having perused the material on record, we are not inclined to interfere in the matter at the instance of the Assessing Officer. Learned Departmental Representative’s spirited defence of, and vehement reliance on, the stand on the Transfer Pricing Officer does not impress us for more reasons than one. The very selection of comparable by the TPO is contrary to the scheme of the applicable transfer pricing regulations. We have noted that the TPO has proceeded to adopt the interest rate at which the assessee has given a Euro denominated loan to its AE, as an internal comparable under the Comparable Uncontrolled Price (CUP) method, but, in doing so, he apparently overlooked the fact that to be an internal comparable under the CUP method, the transaction has to be with an independent enterprises. Rule 10B(1)(a) specifically provides that, as a first step for determining the Comparable Uncontrolled Price “the price charged or paid for property transferred or services provided in a comparable uncontrolled transaction, or a number of such transactions, is identified (emphasis by underlining supplied by us)”. Rule 10(a), in turn, defines the expression ‘uncontrolled transaction’ as ‘a transaction between enterprises other than associated enterprises, whether resident or non-resident’. It is thus clear that a transaction between the associated enterprises cannot be taken as a comparable for the purpose of application of CUP method. Internal CUP, therefore, can only be a comparable transaction which the assessee enters into with an independent enterprise, while it will be an external CUP when the comparable transaction is between two independent enterprises not involving the assessee. Accordingly, a transaction admittedly with an associated enterprise of the assessee company cannot be taken as an internal comparable for the purpose of ascertaining the ALP. The Transfer Pricing was clearly in error in adopting the interest rate in respect of transactions between the AEs as an internal comparable under the CUP method and observing that “when an internal comparable in the form of rate of interest charged on foreign currency loan is available, the same should be preferable over any other comparable” – particularly when he himself had unambiguously noted that this loan was given by the assessee to its associated enterprises in Germany. In the case of Skoda Auto India Ltd Vs ACIT ( 30 SOT 319), a coordinate bench of this Tribunal also took the same stand. While holding so, the coordinate bench, speaking through one of us ( i.e. the Accountant Member) observed as follows:

We have noted that there are references to the determination of arm’s length price on the basis of CUP (comparable uncontrolled price) method, but, in the course of hearing before us, learned counsel for the assessee admitted that the transactions which were relied upon were transactions that the parent company had with other AEs and the price of Euro 680 thus given is not the price at which transactions have been entered into between independent persons. This is the price that the assessee had adopted as internal CUP. The assessee also submitted that external CUP is not available because the product is unique. To our understanding, this argument is totally devoid of any merits. To be considered as internal CUP also, the transaction has to be an independent transaction i.e., between two entities, which are independent of each other. The sale of car kit has admittedly taken place only between the associated concerns. Therefore, the price at which such transaction has taken place is irrelevant for CUP analysis; what is referred to as CUP (comparable uncontrolled price) is price of a comparable but controlled transaction, since to be termed as an uncontrolled transaction, the transaction has to be between two entities which cannot influence or control each other’s decision. The transactions between AEs obviously do not satisfy such a criterion. There is thus no internal CUP, as claimed by the assessee before the authorities below and as stated in the information filed along with the IT return…….”

6. Grievance of the assessee to the effect that the CIT(A) ought to have upheld the stand of the Transfer Pricing Officer is, therefore, devoid of any legally sustainable merits. As a matter of fact, in case the Transfer Pricing indeed wanted to adopt internal CUP in this case, it would prima facie appear that the correct comparable was the interest that the assessee was charging from independent enterprises – which was admittedly NIL in the present case. It is only elementary that an ALP adjustment can only be made to nullify the impact of interrelationships between the associate enterprises, i.e. for variations in assessee’s dealings vis-à-vis dealings with independent enterprises, and, therefore, when assessee is not charging the interest on delayed payments from independent enterprises, a view is perhaps possible that the assessee cannot be subjected to the ALP adjustment in respect of delayed payments from associated enterprises either. In other words, the TPO need not consider what must happen in ideal circumstances but need to restrict himself to locating the differences in assessee’s dealings with AEs vis-à-vis assessee’s dealings with non AEs, and neutralize the impact of such differences. However, right now we are not concerned with the larger question whether an ALP adjustment could indeed have been made, in respect of the extended credit period allowed to the AE, and therefore these prima facie observations are not really relevant for determining the issue in appeal before us. Even assuming that an ALP adjustment could indeed have been made on the facts of this case, in our considered view, since the AE was based in United States, the right parameter to be applied in US Dollars LIBOR rate, with an appropriate mark up, as against the rate of interest on a Euro denominated loan granted by the assessee to another AE – as adopted by the Transfer Pricing Officer. In the case of Siva Industries & Holdings Ltd Vs ACIT ( ITA2148/Mds/10; order dated 20th May 2011, a coordinate bench of this Tribunal has observed as follows:

“The assessee has given the loan to the Associated Enterprises in US dollars. The assessee is also receiving interest from the Associated Enterprises in Indian rupees. Once the transaction between the assessee and the Associated Enterprises is in foreign currency and the transaction is an international transaction, then the transaction would have to be looked upon by applying the commercial principles in regard to international transaction. If this is so, then the domestic prime lending rate would have no applicability and the international rate fixed being LIBOR would come into play. In the circumstances, we are of the view that it LIBOR rate which has to be considered while determining the arm’s length interest rate in respect of the transaction between the assessee and the Associated Enterprises. As it is noticed that the average of the LIBOR rate for 1.4.2005 to 31.3.2006 is 4.42% and the assessee has charged interest at 6% which is higher than the LIBOR rate, we are of the view that no addition on this count is liable to be made in the hands of the assessee”.

7. The view taken by us also finds support from these observations of the coordinate bench. When there is a choice between the interest rate of a currency other than the currency in which transaction has taken place and the interest rate in respect of the currency in which transaction has taken place, in our considered view, the latter should be adopted. In Siva Industries’ case (supra), coordinate bench was making a choice between the PLR (Prime Lending Rate in India) and the LIBOR (London Inter Bank Offered Rate). The coordinate bench held that “once the transaction between the assessee and the Associated Enterprises is in foreign currency and the transaction is an international transaction, then the transaction would have to be looked upon by applying the commercial principles in regard to international transactions”, and accordingly proceeded to take into account interest rate in terms of LIBOR basis. We have adopted the same approach by taking into account the commercial principles and practices with regard to a US Dollar denominated extended credit for arriving at the benchmark rate, and take LIBOR as the base. Accordingly, the LIBOR (US Dollar) has to be as benchmark for US Dollar transactions – rather than the rate of interest on domestic borrowings, even which is lower than the interest rate of 10% taken as ALP by the TPO, or, for that purpose, rate of interest on any other currency loans. Having said that, we may also reiterate that as we hold so, we are not giving any decision on whether the ALP adjustment can be made, on the basis of LIBOR plus mark up, in respect of extended credit because we are dealing with a very limited issue in this appeal which does not require adjudication on the broader question as to whether an extended credit period can anyway be compared with a loan, much less a loan in some other currency which will have distinct lending rates depending on the peculiarities relating that currency, since it does not involve the lending period commitment as a loan necessarily involves. Be that as it may, the CIT(A) cannot thus be said to be in error in adopting the US Dollars LIBOR rate, with mark-up which is not in dispute for its being too low, as a basis for ALP adjustment – as long as he can be said to be justified in upholding the ALP adjustment. There is thus no justification in grievance raised by the Assessing Officer against the relief granted by the CIT(A). As we uphold the relief given by the CIT(A), we refrain from making any observations on whether or not such an ALP adjustment could have been made in the first place. The mere fact that the relief granted by the CIT(A) is upheld, it does not imply that the CIT(A)’s action of confirming the ALP adjustment on the facts of this case, in principle, is upheld too. That remains an open question and need not be adjudicated in this appeal. With these observations, and to the extent the grievance of the revenue is concerned, we confirm the order of the CIT(A) and decline to interfere in the matter at the instance of the revenue authorities. Ground No. 2 is thus dismissed.

8. In ground no. 3, the Assessing Officer has raised the following grievance:

On the facts and in the circumstances of the case and in law, CIT(A) erred in including the expenses incurred in foreign currency on telecommunication charges and in providing technical services outside India in the total turnover for the purpose of computation of deduction under section 10A, ignoring the fact that in the absence of specific definition of total turnover, whether the same definition can be imported from the other sections for the computation of deduction under section 10 A of the Income Tax Act, 1961.

9. Learned Departmental Representative submits that the issue is covered, in favour of the assessee, by Special Bench decision in the case of ITO Vs Sak Soft Limited ( 121 TTJ 865) and by Tribunal’s decision in assessee’s own case for the assessment year 2002-03. Respectfully following these decisions, we uphold the order of the CIT(A) on this issue as well and decline to interfere in the matter. Ground No. 3 is also thus dismissed.

10.Ground No. 4 is general in nature and does not, therefore, call for any adjudication by us. This ground is also dismissed.

11. In the result, the appeal is dismissed. Pronounced in the open court today on 30th day of June, 2011.

Payments received for leasing of transponder capacity

Delhi bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of Intelsat Corporation (ITA No.5443/D/2010) (Judgment Date: 4 March 2011, Assessment Year: 2007-08) held that income received by the non-resident taxpayer from leasing of transponder capacity and bandwidth cannot be taxed as ‘royalty’ under the provisions of Income-tax Act, 1961 (the Act).

Facts of the Case

The taxpayer, a tax resident of USA, was owner and operator of global network of telecommunication satellites located in outer space. It was engaged in the business of transmitting telecommunication signals to and from the earth stations. The taxpayer entered into contracts with TV Channels, NICNET and Internet Service providers to lease its transponder capacity and bandwidth to various customers in India and outside India, who used the transponders for their business in India.

For the assessment years 1996-97 to 2004-05, the assessment of the taxpayer was completed based on the Mutual Agreement Procedure. However, the taxpayer for the year under consideration filed nil return of income after claiming its income not taxable in India. The Assessing Officer (AO), based on the terms of the MAP, completed the assessment and raised demand of INR 112.34 million.

The taxpayer relied on the decision of the Delhi High Court in the case of Asia Satellite Communication Co. Ltd. v. DIT (201 1-TII-05-HC-DEL-INTL) (Judgement Date: 31 January 2011) where it was held that the payments made for using capacity in a transponder for uplinking/downlinking data do not constitute ‘royalty’ under the provisions of the Act.

Tribunal’s ruling

The Tribunal relied on the decision of the Delhi High Court in the case of Asia Satellite Communication Co. Ltd. and held that the payments received by the taxpayer cannot be considered as ‘royalty’ under the provisions of Section 9(1)(vi) of the Act. The Tribunal also held that since the receipts are not taxable under the Act, in view of the provisions of Section 90(2) of the Act there is not need to apply the provisions of the India-USA tax treaty.

Hyderabad Tribunal Ruling on the 80IA set off

 

Notional brought forward losses and depreciation should be set off in the current year while calculating the deduction u/s. 80-IA even though they have been set off against other income in earlier years

Hyderabad bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of Hyderabad Chemicals Supplies Limited v. ACIT (ITA No. 352/Hyd/2005) (Judgment date: 21 January 2011) held that as per the provision of Section 80-IA(5) of the Income-tax Act, 1961 (the Act) profit from the eligible undertaking has to be computed after deduction of the notional brought forward losses and depreciation of eligible undertaking even though they have been allowed to set off against other income in earlier years.

Facts of the case

The taxpayer, an eligible undertaking to claim benefits of Section 80-IA of the Act, was engaged in manufacture and trading of agro-chemicals and generation, distribution and sale of power. The taxpayer started its windmill unit on 31 March 1999. For the year under consideration, the taxpayer calculated the benefit under Section 80-IA of the Act without considering the notional brought forward losses or depreciation of the eligible undertaking already set off against the profits of other business income in that year.

The Assessing Officer (AO) accepted the claim of the taxpayer. However, the Commissioner of Income-tax (CIT) invoked the revisionary power under Section 263 of the Act and directed AO to work out the correct amount of depreciation and business losses of the earlier years relating to the eligible undertaking and to carry forward the same and set off against the income of the undertaking in the current year treating the undertaking as if the only business of the taxpayer for the purpose of computing benefits under Section 80-IA of the Act.

Contentions of the taxpayer

The taxpayer contended that real intention behind Section 80-IA(5) of the Act is to ensure that there is no overlapping of any other income of the undertaking or other undertakings and even if there is any reorganisation of that unit subsequent to the claim, the profits of the undertaking should be arrived treating it as a separate unit.

If loss was intended to be set off against the profits in a succeeding year, the law would have certainly provided explicitly as it had provided under earlier Section 80J of the Act which is now deleted. Further, Section 80-IA of the Act nowhere in explicit terms provides that past losses already absorbed needs to be notionally brought back while working out benefit under Section 80-IA of the Act for the current year.

The taxpayer relied on the decision of the Rajasthan High Court in the case of CIT v. Merwer Oil and General Mills Ltd. [2004] 271 ITR 31 1(Raj)

where, while dealing with similar issue, the High Court held that the set off of earlier year’s losses already absorbed is not allowed.

The taxpayer contended that in the case of M.Pallonji & Co. (P) Ltd. v. JCIT [2006] 6 SOT 287 (Mum), notional adjustment was not called for and not contemplated in the claim of deduction provided in Section 80-IA of the Act and therefore the taxpayer’s claim was allowed on the basis of profit of the windmill project, unfettered by any notional amount of unabsorbed depreciation pertaining to the preceding assessment year.

The taxpayer also relied on various other decisions (Mohan Breweries & Distilleries Ltd. [2009] 116 ITD 241 (Chennai) Rangamma Steels & Malleables v. ACIT [2010] 132 TTJ 365 (Chennai) Velayudhaswamy Spinning Mills (P) Ltd. v. ACIT [2010] 38 DTR 57(Mad)) and contended that the taxpayer should be allowed to compute benefit under Section 80-IA of the Act without setting off earlier year’s losses.

Tax department’s contentions

The tax department after relying on the decision of the Ahmadabad Special Bench decision in the case of ACIT v. Gold Mine Shares & Finance (P) Ltd. [2008] 113 ITD 209 (Ahd) (SB) and contended that as per the provisions of Section 80-IA(5) of the Act the income of any eligible undertaking unit shall be computed as if it is the only source of income. Accordingly, earlier year’s losses of the eligible unit should be set off in the current year while calculating benefits under Section 80-IA of the Act even if it was already set off against the profits of the other business units.

Tribunal’s ruling

The Tribunal observed that the Special Bench of the Ahmadabad Tribunal in the case of Gold Mine Share & Finance (P) Limited, after considering similar arguments placed by the taxpayer, held that the losses had to be notionally brought forward and set off against the profits for computing the deduction. The Special Bench observed that the decision of the Rajasthan High Court in the case of Merwar Oil & General Mills Ltd did not consider the non-obstante provisions of Section 80-IA of the Act.

Though the decision of the Rajasthan High Court prevails over an order of the Special Bench, the decision of the High Court has been rendered without having been informed about certain statutory provisions that are directly relevant. Accordingly, the decision of the Rajasthan High Court cannot be followed.

Accordingly, the Tribunal, following the decision of the Special Bench of the Ahmadabad Tribunal in the case of Gold Mine Shares & Finance (P) Ltd, held that the profit from the eligible undertaking for the purpose of determination of the quantum of benefit under Section 80-IA of the Act has to be computed after deduction of the notional brought forward losses and depreciation of eligible undertaking even though they have been allowed to set off against other income in earlier years.

Our Comments

In the present case the Hyderabad Tribunal has held that for the purpose of determination of the quantum of benefit under Section 80-IA of the Act, the notional brought forward losses and depreciation should be set off against the profits of the eligible undertaking even though they have been allowed to set off against other income in earlier years.

The Tribunal has followed the Special Bench decision of the Ahmadabad Tribunal in the case of Gold Mine Shares & Finance (P) Ltd. even though the decision of the Rajasthan High Court was available on similar issue. The Tribunal observed that the decision of the High Court was rendered without having been informed about certain statutory provisions that were directly relevant at the point of time.

Income from onsite software development-Tax View

Income from onsite development exempt only when carried out by offshore liaison office

In a recent case1, the Delhi High Court (“Court”) was faced with a question on the availability of tax exemptions to software companies engaged in exporting software under Section 10A of the Income Tax Act (“Act”), for on-site development activities undertaken by export oriented units (“EOU”) outside India. The Court has agreed with the Revenue’s contention that on-site development should only be carried out by a liaison office in order to be eligible for Section 10A exemption.

Background

Interra Software India Pvt. Ltd. (“Taxpayer”) is a company engaged in the business of development and export of computer software and is registered as an EOU with Noida Export Processing Zone (NEPZ), India. The Taxpayer is entitled to benefit of tax exemption provided under Section 10A of the Act, in the relevant year. Pursuant to an agreement with a company in Japan, the Taxpayer, with the approval of the Reserve Bank of India (“RBI”), set up a non-trading branch in Tokyo, Japan (“Japan Branch”) to facilitate communication between the NEPZ unit and the company in Japan, assist in marketing efforts, help procure orders, render assistance to professionals deputed there on off-shore assignments, attend to validation and testing of the products, if required and providing other requisite comforts to customers. The Taxpayer sought to avail Section 10A benefits over profits of the Japan branch.

The Revenue rejected the Taxpayer’s claim and contended that the Taxpayer had step-up a trading branch in Tokyo which was undertaking ‘full-fledged marketing activities’ and incurring expenses which were borne by the Taxpayer in India. The Revenue further argued that Section 10A benefits could be extended to onsite development when undertaken by a liaison office and not a branch office working independently and carrying out ‘full-fledged marketing operations’ as such activities could not fall within the ambit of ‘onsite development’, as in the present case.

Section 10A of the Act

Section 10A provided a ten-year tax holiday to companies engaged in inter alia software development and export and registered as an EOU. Explanation 3 to Section 10A also extended this exemption to profits derived from on site development of computer software (including services for development of software) outside India. These exemptions are no longer available from April 1, 2011.

Ruling

The Court agreed with the Revenue’s contention that for profits from onsite development of software outside India to be eligible for Section 10A benefits, such onsite software development should be undertaken only by a liaison office set up by the Indian company, and acting as an intermediary between the enterprise and the customers. Where, on the other hand, such office operates as an independent unit meeting all commercial requirements, profits arising therefrom are not eligible for Section 10A benefits.

While the Court agreed with the above interpretation, it was of the view that the documents submitted by the Taxpayer were not examined properly by the lower authorities and thus, remanded back to the lower authorities to re-examine the said documents and to determine whether the Japan Branch constituted an independent branch office or a liaison office.

Analysis

As mentioned above, in the ruling, the Court agrees with the Revenue that a liaison office would be eligible and not a full-fledged branch office. A liaison office by definition acts as a communication channel and marketing office for the parent and undertakes no commercial activity with the object of earning income. A branch office, on the other hand, is an extension of the parent entity in another jurisdiction which undertakes commercial activities for or on behalf of the parent; a branch office is thus engaged in commercial activity with an objective to generate income. This gives rise to an unreasonable situation whereby tax exemption under Section 10A is available for a liaison office which would not typically undertake onsite development and generate no profits, and disallowed for branch office which would undertake such activity and generate income. Based on the aforesaid, it appears that reliance on the generic definition of liaison office or branch office would not prove very useful in understanding the scope of services that the office should or should not carry out in order to be eligible for the exemption.

Moreover, onsite development with respect to computer software contemplates creation, customization and integration of software on the client site as opposed to being a mere communication link or intermediary, as suggested in the ruling. Having said that, inclusion of marketing activities in on-site development may be stretching the concept too far.

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.

Fastest Growing Economies of the World

If you think that China is the world's fastest growing economy, think again.

However, among the major (or large) economies, China does remain the fastest growing economy. But if you take smaller nations too in the list, China slips down the list.

Similarly, India too has been for a while considered to be the second fastest growing economy after China. The reality however is different.

Asia and Africa account for the world's fastest growing economies, says Economy Watch.

Many of the nations in this list have a smaller base and even a small amount of robust economic activity impacts overall growth figures. However, it is significant to note that some of these nations which showed hardly any growth in the past are now speeding along merrily on the path to economic development and well being.

The most recent quarterly Global Economic Outlook from Fitch Ratings says that the economic recovery rate across the world is encouraging despite significant financial market volatility.

The global ratings agency says that the global economy will grow at 3.4 per cent this year, up from its previous projection of 3.2 per cent, at 3 per cent in 2011 and at 3.3 per cent in 2012.

1. Ghana: 20.146%

Many economists believe that Africa is the next boomtown. Several African nations are now growing at a rapid pace, trying to make lives better for their people. None more so than Ghana.

For quite a long time, Ghana received many an unflattering adjectives to describe its economy: 'worst managed', 'disastrous', etc. However, the small African nation has since then come a long way and is the world's fastest growing economy today.

Ghana's economy is growing at a blistering 20.15 per cent, says Economy Watch. It's a $23.4-billion economy.

Blessed with rich reserves of natural resources, Ghana has suddenly turned around and is now speeding along the growth path.

Ghana suffered the most due to the ineffective economic policies of past military governments, says Wikipedia, but the new government has managed to bring the country out of economic doldrums.

Economic reforms, political stability, low crime rate, and an overhaul of earlier policies have made the nation very attractive to foreign investors.

2. Qatar: 14.337%

With a GDP growth rate of 12.337 per cent, Qatar is the world's second fastest growing economy, says Economy Watch. It's a $132-billion economy.

The economy of Qatar, one of the world's largest exporters of petroleum, is primarily oil-based. High oil and gas prices have boosted the economy of this Gulf state over the last few years.

The per capita income of Qataris is $66,100, the sixth highest in the world.

The nation's economy mainly depends on its huge oil and natural gas reserves. There is no income tax in Qatar.

Qatar is an oil- and gas-rich nation with world's third largest gas reserves.

The country has excellent infrastructure which was further boosted as it hosted the 2006 Asian Games too. Within the other Gulf region, the nation is a role model for its economic and social transformation, says Wikipedia

3. Turkmenistan: 12.178%

Turkmenistan is blessed with the world's fourth-largest reserves of natural gas. The country is also the world's 10th largest producer of cotton.

It is the world's third fastest growing nation with a GDP growth rate of 12.18 per cent, according to Economy Watch. It is a $41-billion economy.

Although oil and gas is the biggest revenue generator for Turkmenistan, agriculture too accounts for a healthy percentage of its GDP.

Citizens in Turkmenistan get 120 litres of petrol free every month for car drivers, while truck/bus drivers get 200 litres of petrol free. Apart from this, electricity too is subsidised for the citizens

4. China: 9.908%

China is the world's fourth fastest growing economy at 9.908% GDP growth rate, and in monetary terms it is of the order of a whopping $6 trillion, says Economy Watch.

China, which most economists believe could soon upstage the United States as the world's largest economy, showed some signs of slowing down.

However, the rising inflation rates in China are posing a new challenge to the country.

China's gross domestic product grew 9.6 per cent in the third quarter as compared to the same period last year. The growth rate slowed down from 11.9 per cent in the first quarter and 10.3 per cent in the second quarter.

Analysts said that the Chinese government's steps to 'cool the housing market and bank lending' and the shutting down of outdated industrial capacity' led to the slowdown in its economy in the third quarter of 2010.

5. Liberia: 9.003%

Even though Liberia remains one of the poorest countries on earth, it has shown robust economic activity in the last few years.

This African nation is the world's fifth fastest growing economy with a GDP growth rate of 9.003 per cent, says Economy Watch. It is a $1.05 billion economy.

The nation has rich reserves of iron ore, and also exports rubber exports. In the last few years, it has been receiving a lot of foreign direct investment which has resulted in higher employment, better infrastructure and increased economic activity.

6. India: 8.43%

Economy Watch says that the India, at 8.43 per cent GDP growth rate, is the world's sixth fastest growing economy. India is a $1.5-trillion economy.

However, Finance Minister Pranab Mukherjee has exuded confidence that the Indian economy would shortly revert to 9 per cent growth rate but identified rising prices as a major concern, although inflation has declined to 8.6 per cent from double digits in June.

The India growth story is enviable. Despite plaguing problems, India has emerged stronger and resilient to the global crisis so far.

India is expected to be the world's fastest growing economy by 2018, according to Economist Intelligence Unit (EIU), the research arm of the Economist magazine.

Driven by good performance of agriculture and manufacturing, the Indian economy grew by 8.9 per cent in the second quarter of the current fiscal, up from 8.7 per cent in the corresponding period a year ago.

The growth rate for the first quarter was revised upwards to 8.9 per cent from 8.8 per cent.

This took the overall economic expansion during the first half (April-September) to 8.9 per cent, up from 7.5 per cent in the corresponding period a year ago.

India, the second largest growing economy will overtake China as the fastest growing major economy with an average of 8 per cent in the next five years, the report stated earlier this year. China witnessed 11.9 per cent growth in the same quarter.

For India, the ideal inflation rate would be 4-5 per cent although it may be difficult to attain.

Attributing inflation mainly to rising food prices, Mukherjee said, "in terms of consumer price indices (retail prices), inflation in the three major groups -- industrial workers, agricultural labour and rural labour -- have come down to single digit level."

Regarding economic growth, Mukherjee said he hoped it would be 8.5 per cent (plus/minus 0.25 per cent) during 2009-10, rising further to 9 per cent in short term.

Having achieved over 9 per cent rate for the three consecutive years, the economic growth dipped to 6.7 per cent during 2008-09, mainly on account of the global financial meltdown.

However, it picked up to 7.4 per cent in 2009-10 and recorded 8.8 per cent in first quarter of the current fiscal

7. Angola: 8.251%

Angola is the world's seventh fastest growing economy at a GDP growth rate of 8.251 per cent, as per the Economy Watch report. It is a $ 99-billion economy.

Battered by a civil war for close to 25 years, Angola has since then come a long way.

Fresh pro-people and pro-reform policies have seen funding from the International Monetary Fund and other global lenders rising. These funds are being utilised to create infrastructure in the nation, thus generating employment and healthy economic activity.

Angola is an oil-rich state and most of its economy is based on the oil and gas industry, but agriculture too plays a significant role. Wikipedia says that Luanda, the capital of Angola, is the nation's economic and commercial hub.

Political and economic stability have resulted in Angola's growth rate rising at a blistering pace. However, the nation remains mired in poverty.

8. Iraq: 7.873%

Iraq is growing at 7.873 per cent, making it the world's eighth fastest growing economy, according to Economy Watch. It is a $93-billion economy.

The war ravaged nation of Iraq is slowly trying to come out of the devastation it suffered through wars over the last two decades.

The oil and gas industry is the mainstay of the Iraqi economy. Close to 90 per cent of its foreign exchange revenues comes from the export of oil. With some amount of stability coming to the nation, infrastructure-building/replacement is the priority for Iraq.

These reconstruction measures have led to a churn in the economic activity in the country, leading to generation of jobs.

9. Ethiopia: 7.663%

Economy Watch says that with an annual GDP growth rate of 7.663 per cent, Ethiopia is the world's ninth fastest growing economy. It is a $31.7-billion economy.

Over the last two decades, Ethiopia has been noticing the fruits of focussed efforts at propelling its economy. Some reforms were undertaken in spite of opposition from various political quarters in the country.

However, a constant tug of war between the political parties and the severe drought that hit the nation some years ago have had a hugely debilitating effect on the nation's economic health.

Agricultural activity, says Wikipedia, accounts for more than 40 per cent of Ethiopia's GDP. Coffee beans are Ethiopia's largest export commodity

10. Mozambique: 7.548%

Mozambique, a member of the Southern African Development Community, is the world's 10th fastest growing economy with a GDP growth rate of 7.548 per cent. It is a $10.5-billion economy.

The SADC free trade plan aims at eliminating tariffs and trade barriers, thus making it more competitive, says Wikipedia.

Despite having been described as a 'success story' by the World Bank and the IMF, Mozambique continues to languish in poverty. But its economic reforms have begun to bear some fruit as more and more of the nation's population gets access to better facilities, albeit slowly.

Big foreign institutional investments in large projects across various industry sectors have revived the nation's economy.

Like in India, a majority of the population in Mozambique too is engaged in the agriculture sector.

11. Timor Leste (East Timor): 7.4%

Timor Leste (or East Timor) is the world's eleventh fastest growing economy with an annual GDP growth rate of 7.4 per cent. It's a tiny, $732-million economy.

East Timor's economy is mainly driven by the sectors of agriculture and oil and gas.

An invasion by Indonesia in 1999 led to more than 70 per cent of East Timor's economic infrastructure being destroyed, says Wikipedia. Later, intervention by the United Nations, UN-appointed peacekeepers, and foreign funding helped rebuild the nation's infrastructure.

Some large projects too revived the nation's economic activity. Today, it is one of the rising economic stars in Asia.

12. Laos: 7.395%

The GDP growth rate of Laos is 7.395 per cent, making it the world's 12th fastest growing economy. It is a $6.9-billion economy.

Agriculture is the most important part of the Laotian economy. Over 80 per cent of the country's working people are engaged in the agri sector. The sector also accounts for about 50 per cent of the nation's GDP, says Wikipedia.

Laos's economy is dependent on trade with Thailand, Vietnam, China and other South East Asian nations. Foreign investment has recently been pouring into the country, giving a much-needed boost to the economy. Its tourism industry has been growing rapidly in the last few years.

Captive service provider cannot be compared with Infosys

Court : Delhi bench of the Income-tax Appellate Tribunal

Brief : ITAT Delhi held that a captive service provider assuming minimal risks, cannot be compared to a large company like Infosys Technologies Limited which assumes all risks leading to greater rewards.

Citation : Agnity India Technologies Private Limited Vs. ITO (ITA No. 3856(Del)/ 2010)

Facts of the case

The taxpayer is a wholly owned subsidiary of BayPackets Inc., USA and is engaged in the business of software development in the field of telecommunication for its parent company. The taxpayer also enjoys a tax holiday.

The taxpayer operating at a net profit margin of 17 percent over costs, identified 23 comparables in the TP documentation resulting in arm’s length net profit margin of 10 percent over costs.

The Transfer Pricing Officer (TPO) rejected few comparables identified by the taxpayer on the basis of functional dissimilarity and wages/ sales ratio. The TPO also included Infosys Technologies Limited (Infosys) and Satyam Computers Services Ltd. (Satyam) as comparables and thereby determined the arms length net profit margin at 27.08 percent over costs.

On objections raised by the taxpayer before the Dispute Resolution Panel (DRP), Satyam was excluded by the DRP since the data available was not reliable. However, Infosys was retained, leading to an arm’s length net profit margin of 25.6 percent over costs.

Against the order of the assessing officer, an appeal was filed by the taxpayer to the Income Tax Appellate Tribunal (the Tribunal).

Tribunal’s Ruling

The Tribunal ruled in favor of the taxpayer. The key aspects of Tribunal’s order are summarised below:

The Tribunal held that the taxpayer was not comparable to Infosys Technologies Limited since Infosys is a giant in the area of development of software and assumes all risks, leading to higher profit as compared to the taxpayer which is a captive unit and assumes only limited currency risks.

The Tribunal also referred to other reasons given by the taxpayer for establishing that Infosys was not comparable to the taxpayer, including:

Infosys renders diversified services as compared to the taxpayer which is only rendering software development services

Vast difference in turnover/capital of Infosys and of the taxpayer

Infosys owns proprietary products as compared to none owned by the taxpayer

Infosys renders onshore and offshore services equally as

compared to taxpayer which only renders offshore services

Infosys incurs a substantial expenditure on advertising/ sales promotion and research & development which are not incurred by the taxpayer

After exclusion of Infosys, the arms length net profit margin based on rest of the comparable companies was found to be consistent with the net profit margin of the taxpayer.

The Ruling emphasises that a pigmy enterprise cannot be compared with a giant company and that functions, assets and risks analysis is critical to comparability.

Losses on un-matured forward contracts cannot be considered as notional or contingent in nature

Losses on un-matured forward contracts cannot be considered as notional or contingent in nature

Court : Mumbai Bench of the Income-tax Appellate Tribunal

Brief : In this case Special Bench of the Income-tax Appellate Tribunal dealt with the issue of allowability of losses on account of unmatured forward contracts in foreign exchange entered into by the taxpayer. The Special Bench while dismissing the contentions of the tax department held that the loss on unmatured forward contracts is in the nature of anticipated losses and not a contingent loss. The Special Bench observed that a binding obligation (although not fully ascertainable) arose against the taxpayer the moment it entered into forward foreign exchange contract. The Special Bench has relied on the recent decision of the Supreme Court in the case of CIT v. Woodward Governor of India [2009] 312 ITR 254 (SC) wherein the Supreme Court had held that exchange fluctuation loss arising on mark- to-market restatement of liability which is revenue in nature is an allowable loss. The Special Bench further observed that where profits were being taxed by the tax department in respect of such unmatured foreign exchange contracts then there was no reason to disallow the loss on such contracts.

Citation : DCIT v. Bank of Bahrain & Kuwait [2010-TIOL-447-ITAT-MUM-SB]

Judgment :

Facts of the case

• The taxpayer, a non-resident company carrying on banking business in India, entered into forward contracts with its clients to buy or sell foreign exchange at an agreed price on a future date. In cases where the date of maturity of the contract falls beyond the end of the accounting period, the taxpayer evaluates the unmatured forward contracts on the last day of the accounting period on the basis of rate of foreign exchange prevailing on that date and books the loss or profit accordingly. Accordingly the taxpayer booked losses of INR 1.2 million.

• However, the Assessing Officer (AO) observed that the principles of taxation require that actual profit or loss was to be brought to tax and not contingent losses. And since in a forward contracts, liability arises only on the date on which the contracts mature such losses should not be allowed as a deduction..

• The AO also referred to the Madras High Court’s decision in the case of Indian Overseas Bank v. CIT [1990] 246 ITR 206 (Mad) wherein it was held that before settlement of contracts in foreign currency, no actual profit could accrue and the amount in question represented notional profits only. Accordingly, the AO disallowed the loss of INR 1.2 million treating the same as notional loss.

Taxpayer’s contentions

• The taxpayer contended that as per the Reserve Bank of India guidelines, it was required to revalue its outstanding foreign exchange forward contract as per the rates notified by the Foreign Exchange Dealers Association of India (FEDAI) on 31 March every year. Therefore it had to re-assess the anticipated loss at the end of the year in accordance with the method of accounting consistently followed by it.

• The taxpayer relied on the Supreme Court’s decision in the case of Investment Ltd v. CIT [1970] 77 ITR 533 (SC) wherein, it has been held that the method of accounting consistently and regularly followed by the taxpayer cannot be discarded by the tax department merely on the ground that a better method of accounting could be the alternate one.

• In the case of Woodward Governor India (P) Ltd, the Supreme Court has held that the additional liability on account of fluctuation in foreign currency as on 31 March 1991 in respect of foreign currency working capital loans outstanding on that date was an allowable revenue loss and was not notional or contingent.

• A forward exchange creates a binding obligation arises which is required to be discharged. Therefore, the physical delivery of foreign currency on the date of maturity does not wipe out the present liability incurred by the taxpayer.

• The loss on the revaluation of the outstanding forward exchange contracts is to be allowed on the well recognised principle that taxpayer’s stock/circulating capital has to be valued at cost or market price, wherever is lower.

Tax department’s contentions

• The taxpayer was carrying on banking business in India and it is not the taxpayer’s business to deal in forward contracts. It entered into forward contracts with its clients to buy or sell foreign currency at an agreed price on a future date in order to in order to avoid wide fluctuation in foreign currency.

• The Tribunal’s decision in the case of Deutsche Bank A.G v. DCIT [2003] 86 ITD 431 (Mum) and the decision of the Bombay High Court in the case of CIT v. Bank of India [1996] 218 ITR 371 (Bom) proceeded on the footing that the securities were stock-in-trade. However, in the present case there is no material to prove that forward contract to buy or sell foreign currency itself constitutes the stock-in-trade and therefore these cases are not applicable to the case under consideration.

• The Supreme Court in the case of Woodward Governor of India observed that as per Accounting Standard (AS) -11 on “Effect of Changes in Foreign Exchange Rates”, effect of changes in exchange rate vis-à-vis monetary items denominated in a foreign currency has to be taken into account for giving accounting treatment on the balance sheet date. The tax department contended that in the present case, since no transaction has been entered into in the books of account, there was no monetary item requiring adjustment of exchange rate difference.

• The tax department relied on the Bombay High Court’s decision in the case of CIT v. Kamani Metals and Alloys Ltd [1994] 208 ITR 1017(Bom) wherein, the taxpayer had entered into a contract with MMTC for purchase of copper cathodes at a particular rate. The High Court observed that the material was received in the next accounting period and therefore there was no closing stock of the material in the hands of the taxpayer. Accordingly, the High Court held that the material contracted to be purchased could not be regarded as taxpayer’s stock-in-trade and hence, could not be valued in the accounts as such.

• The liability accrues or arises only on the date of maturity of the contract and estimated liability as per FEDAI guidelines cannot be allowed under the Act.

Special Bench’s ruling

• The Forward exchange contract creates a continuing binding obligation on the date of contract against the taxpayer to fulfill the same on the date of maturity.

• As observed by Supreme Court in the case of Woodward Governor, AS -11 which is mandatory requires that when the transaction is not settled in the same accounting period as that in which it occurred, the exchange differences arises in more than one period. The principle laid down by Supreme Court that in case of a working capital loan, loss on account of fluctuation in foreign currency as on the date of foreign exchange is an item of expenditure under Section 28 of the Income-tax Act, 1961 (the Act) would be applicable in this case too.

• Contingent liability is not allowed as a deduction. However, if an anticipated liability is coupled with present obligation and only quantification can vary depending upon the terms of contract, then a liability is said to have crystallised on the date of balance sheet date. Hence anticipated losses on account of existing obligation, determinable with reasonable accuracy have to be taken into account. Reliance was placed on the decision of the Supreme Court in the case of Bharat Earth Movers v. CIT [2000] 245 ITR 428 (SC).

• It is a settled law that a method of accounting regularly employed by the taxpayer cannot be disregarded by the AO unless he is of the opinion that profits are not correctly deductible from such method of accounting as per the provisions of section 145(3) of Act. However, the AO cannot reject the method of accounting followed by the taxpayer merely on the ground that a better method of accounting could be the alternate one. However, in the present case, though observations have been made by the AO to this effect but actual disallowance has been made by treating the impugned amount as contingent liability.

• The Special Bench observed that there was no dispute that the foreign exchange currency held by the taxpayer bank was its stock-in-trade and the taxpayer had entered into forward foreign exchange contracts in order to protect its interest against the wide fluctuation in the foreign currency itself. Therefore, this contract was incidental to taxpayer’s holding of the foreign currency as current asset. Towards this, the Special Bench relied on the Calcutta Special Bench decision in the case of Shree Capital Services Ltd. v. ACIT [2009] 121 ITD 498 (Kol) (SB)

• The Special Bench also observed that tax department had for the Assessment Year 2002-03 and 2003-04 assessed the taxpayer in respect of the profit shown by the Bank on restatement of outstanding forward foreign exchange. Accordingly, there was no reason to disallow the loss as claimed by taxpayer in respect of same contracts on the same footing.

Our Comments

This is welcome decision of the Mumbai Special Bench where it is held that losses arising on account of unmatured forward contracts are not notional in nature. This decision holds importance since prior to this decision there were no clear judicial precedents directly on the point. Before this decision reliance was generally placed on RBI guidelines, Accounting Standards and the Supreme Court decision in the case of Woodward Governor of India.

It is interesting to note that the Central Board of Direct Taxes had issued Instruction no. 03/20 10 dated 23 March 2010 to the effect that losses arising on account of year-end valuation of forex-derivatives are to be disallowed on the ground that these are contingent and notional in nature.

Pan for Non Residents

Non-resident individuals and organisations need to have a Permanent Account Number (PAN) number if they receive an income and need to file returns in India. PAN is issued by the Income Tax (IT) Department to all assessees and quoting of PAN is compulsory in all returns filed with the IT department.

The PAN number comprises of ten alphanumeric characters and is issued in the form of a laminated card. A PAN card is required for both resident as well as non-resident assessees. In case of non-resident assessees, there are a few minor changes in the requirements for an application.

A non-resident assessee is:

A citizen of India residing outside India at the time of making application

Not a citizen of India i.e. foreign citizen

Other than individual (a company, trust, firm, etc) - not a citizen of India - having no office of its own in India.

The following points should be noted while applying for the PAN:

AO Code : AO code pertaining to International Taxation Directorate should be used.

Address: A foreign address can be provided as residential (only for individuals) and office address by such applicants, if they do not have any Indian address of their own. Individual applicants may indicate any address (residential or office -whether Indian or abroad) as the address for communication.

Additional courier charges for PAN card dispatch shall be payable by applicant at the time of making application if the address for communication is a foreign address. Complete address including name of state, province (if applicable) and name of country should be clearly mentioned in the application as part of the address.

A proper zip or pin code, if applicable, should be provided by the applicant. Further, a valid email address must be provided by such applicants. It is to be noted that providing details of Residential Address (RA) is not mandatory in the PAN application for such applicants. However, if RA details are provided, proof of identity and address in respect of RA shall be required in addition to those of the applicant.

Photograph and signature: Individual applicants should provide their own recent colour photograph of prescribed size. This is not applicable for other applicants. Application should always be signed by the applicant himself / herself in all cases (for individuals). In case of applicants other than individuals, application should be signed by an authorized signatory on behalf of the applicant (eg director of the company or partner of the firm or trustee of the trust, etc).

Even if the RA details are provided, the application should be signed by the applicant (in case of individual applicants) or by the authorized signatory (for non-individual applicants).

Payment received for sale of copyright article does not amount to royalty under the India – USA tax treaty

Payment received for sale of copyright article does not amount to royalty under the India – USA tax treaty

Court : Mumbai bench of the Income-tax Appellate Tribunal

Brief : Recently, the Mumbai bench of the Income-tax Appellate Tribunal held that the payment received by the taxpayer company towards the sale of copyright article does not amount to royalty within the provisions of Article 12(3) of the India-USA tax treaty (tax treaty).

Citation : DDIT v. Alcatel USA International Marketing Inc [2010-TII-123-ITAT-MUM-INTL]

Facts of the case

The taxpayer, a tax resident of USA, was marketing and selling Alcatel products to customers outside USA. The taxpayer supplied software under the Subscriber Data Note (SDN) network software agreement to Reliance Infocomm Ltd (RIL) for the purpose of telecommunication network of RIL.

• The Agreements clearly mentioned that

The taxpayer grants a perpetual, irrevocable, non-exclusive, unrestricted right to Reliance for the use of Software within Reliance’s network. However, title to the copyright in software remains with the taxpayer.

Reliance shall not transfer, assign, sublicense or outsource the license without the written permission of the taxpayer except where it is required for its own network.

Reliance shall not use the software for commercial time sharing with non-affiliate third parties, rental, lease and sub-licensing to non affiliate third parties and service-bureau purposes.

• The taxpayer company received consideration of INR 167.26 million for the supply of the said software. The software supplied by the taxpayer company to RIL creates a database to store subscriber profiles and other information, e.g. customer phone number, calling plan, etc and make this information available to different network element requesting it.

• The AO treated the consideration received by the taxpayer as royalty taxable in India.

Taxpayer’s contentions

• The taxpayer contended that the consideration received for the supply of software was not taxable in India as the same was in the nature of business profit and not royalty and in the absence of PE of taxpayer in India the consideration received was not taxable in India.

Tribunal’s ruling

• The Tribunal observed that identical issue has been dealt by Delhi Tribunal in taxpayer’s own case for assessment year 2003-04. The Delhi Tribunal after relying on the decision of the Delhi Special Bench in the case of Motorola Inc. Ericsson Radio Systems AB and Nokia Corporation v. DCIT [2005] 96 TTJ 1 (Del) (SB) held that the transaction under consideration cannot be considered as royalty under the provisions of Act or under the tax treaty.

• The Tribunal, after examining the relevant clauses of the agreement between the taxpayer and RIL and the provisions of the Act and the tax treaty, held that payment received by the taxpayer company towards the sale of copyright article does not amount to royalty within the meaning of Article 12(3) of the DTAA between India and USA

Arm's length price should be based on the functional and asset profile of the company

Arm's length price should be based on the functional and asset profile of the company

Court : Mumbai Bench of the Income Tax Appellate Tribunal

Brief : The Mumbai Bench of the Income Tax Appellate Tribunal ('the Tribunal'), in the case of ITO v. Zydus Altana Healthcare Pvt. Ltd. [2010-TI I-29-ITAT–MUM-TP], while deciding the case in favour of the assessee, ruled that the determination of arm's length price should be based on the functional and asset profile of a company and profit margins earned by comparable companies should be adjusted for functional differences between the tested party and the comparables. The Tribunal also ruled that in case an assessee's income is exempt from tax (and taxable in the overseas jurisdiction), this factor should be considered by the revenue authorities while undertaking a tax assessment since in such a situation, there is no benefit to the assessee in charging its associated enterprise a lower mark-up.

Citation : ITO v. Zydus Altana Healthcare Pvt. Ltd. [2010-TI I-29-ITAT–MUM-TP]

Judgement :

Facts- The assessee is a Joint Venture between Cadila Healthcare Ltd., and Byk Gulden Lomberg GmbH Germany ("BGL"). The assessee, a 100% export oriented unit is engaged in the manufacture and export of pharmaceutical intermediates exclusively for BGL. The assessee also provides clinical trial services with respect to molecules developed from the research undertaken by BGL for which it is remunerated on a cost plus 5% basis. In addition, the assessee receives reimbursement from BGL of certain clinical trial expenses.

During the course of transfer pricing ("TP") assessment proceedings, the Transfer Pricing Officer ("TPO") accepted the assessee's export prices of pharmaceutical products to be at arm's length. The TPO, however, proposed an adjustment to the transfer price for the transaction involving clinical trial services provided by the assessee to its Associated Enterprise ("AE"). For this purpose, the TPO identified a set of companies providing clinical trial services to third parties and determined the arm's length cost plus mark up at 17.14%.

The Assessing Officer ("AO") passed an order, incorporating the transfer pricing adjustment proposed by the TPO, against which the assessee filed an appeal before the Commissioner of Income-Tax, Appeals ("CIT (A)"). The CIT(A), based on the facts of the case, deleted the adjustment proposed by the TPO, aggrieved by which the Indian Revenue authorities brought an appeal before the Tribunal.

Revenue Contentions

Key contentions of the Revenue were as follows:

•           The assessee as per the recitals of the research and development ("R&D") services agreement was entrusted to perform certain R&D service work on contract research basis on behalf of BGL. However, the CIT(A) did not examine the relevant articles of the R&D services agreement and wrongly held that the assessee is merely engaged in providing support services in the nature of facilitation/coordination services between BGL and the hospitals.

•           The nature of expense reimbursements made by the AE to the assessee for the clinical trial services clearly indicated that the assessee had full-fledged infrastructure facilities for conducting R&D activities.

•           Though the CIT(A) rightly referred to the guidelines provided by the Special Bench of Bangalore ITAT in the case Aztec Software Technology Services Ltd. v. ACIT [2007 - TII – 01 - ITAT – BANG – SB - TP] for selecting comparable companies based on functional analysis, the CIT(A) had not applied such guidelines to the facts of the present case thereby wrongly rejecting the search conducted by the TPO for comparable transactions with respect to the clinical R&D work undertaken by the assessee on behalf of the AE.

 Assessee Contentions

Key contentions of the assessee were as follows:

•           The assessee did not undertake clinical trials on its own. It only acted as a facilitator / co-ordinator between BGL and the hospitals which performed the clinical trials. This was evidenced by the fact that the reimbursement received by the assessee primarily related to expenses incurred towards hospitals for clinical tests undertaken by them on the molecules that were developed by BGL. Therefore, the functions performed by the assessee with respect to the clinical trials service transaction were limited and were essentially in the nature of administrative services, including data collation and compilation, maintenance of documentation, liaising with doctors, etc.

•           The assessee did not have the necessary infrastructure to undertake R&D activities. The TPO, during the course of the assessment proceedings, agreed to the fact that the assessee could not be characterised as a contract research organisation.

•           Comparables selected by the TPO were in a different line of business to that of the assessee.

Tribunal Ruling

The Tribunal held as follows:

•           The entire research activity relating to molecules was carried out in three phases. Under Phase I, the main molecules were generated by BGL and its effectiveness over Indian patients was to be examined by carrying out clinical trials in Phase II and Phase III. Thus, the major part of the research activity was Phase I in which molecules per se were generated, and not Phase II and Phase III, which involved only clinical trials being conducted by third parties i.e. hospitals, which the assessee only paid for. Further, the assessee's infrastructure was limited to furniture, vehicle, office equipments and computers, which were not sufficient for carrying out an entire research activity.

Therefore, the assessee's activity was more in the nature of coordinating / facilitating such clinical trials carried out at various hospitals rather than performing the R&D function itself, for which a return of 5 per mark-up on costs was suitable.

•           Referring to Rule 10B(1)(a)(ii) of the Indian Income-tax Rules, 1962 ("the Rules"), the Tribunal held that the TPO when selecting comparables should have made necessary adjustments for functional differences.

•           In case an assessee's income is exempt from tax (and taxable in the overseas jurisdiction), this factor should be considered by the revenue authorities while undertaking a tax assessment since in such a situation, there is no benefit to the assessee in charging its associated enterprise a lower mark-up.

Based on the above, the Tribunal upheld the order of the CIT(A) and rejected the transfer pricing adjustment made by the AO thereby deciding the case in favour of the assessee.

Conclusion

In establishing the functional profile of the assessee and evaluating its return, the Tribunal had correctly examined the nature of activities and contribution of the assessee in the value chain. It had also given due consideration to the tangible asset profile of the assessee. However, the Tribunal, in its ruling, did not provide its views on certain determinative aspects relating to who exercises control over the R&D function, who has the risk bearing capacity, who contributes to intangible creation, etc.

Further, with respect to comparability adjustments, although no guidance was provided, the Tribunal reiterated the need to make appropriate adjustments to comparables while applying a transfer pricing method and determining the arm's length price.

The Tribunal also ruled that in case an assessee's income is exempt from tax (and taxable in the overseas jurisdiction), this factor should be considered by the revenue authorities while undertaking a tax assessment.

Tags : Cadila Healthcare, Byk Gulden Lomberg GmbH Germany,  Zydus Altana Healthcare , transfer pricing , Arm's length price .