Section 43(5) v Explantion to Section 73

Section 43(5) v  Explanation to section 73

 

Consider the following case

1.       Assessee is earning income taxable under the head Profit and gains of business or profession.

2.       Assessee incurred loss in share derivative transactions, being transaction of nature specified in Proviso (d) to section 43(5). As per said proviso, losses from such transactions are not loss from speculative transaction.

3.       Can assessee set off his loss from share derivative transaction with other business income?

 

In recent case in CIT v DLF Commercial Developers Ltd (ITA 94/2013), Hon’ble Delhi High Court denied such set off in view of provisions of explanation to section 73. Section 73 contains the provisions for set-off loss from speculative business and carry-forward of the same.

 

The explanation to section 73 provide as under:-

 

[Explanation.—Where any part of the business of a company [other than a company whose gross total income consists mainly of income which is chargeable under the heads "Interest on securities", "Income from house property", "Capital gains" and "Income from other sources"], or a company the principal business of which is the business of banking or the granting of loans and advances) consists in the purchase and sale of shares of other companies, such company shall, for the purposes of this section, be deemed to be carrying on a speculation business to the extent to which the business consists of the purchase and sale of such shares.]

 

As per said ruling, share derivative transactions carry the character of speculative transactions for section 73 and any loss arising therefrom will be characterised as loss from speculative business and same cannot be set-off against normal business income.

 

As per court section 43(5) defining speculative transaction is only for the purpose defining terms used in section 28 to 41.

Section 43(5) has no application over section 73.

 

This ruling will open Pandora’s box for Share brokers, Share traders and other institution investors, being corporate assesses, if they are showing their share dealings (cash & Derivative transactions) under the head PGBP  i.e they are not falling under exception provided by explanation to section 73 namely, the Gross total income mainly consist of income chargeable under heads “Income from House property”, “Capital Gains” and “Income from other Sources”.

Such assessee will not be able to set off loss in share derivative transactions with other business income.

 

Critical Analysis

The application of above-mentioned ruling will create practical problem in administration of provisions of Income Tax Act, especially relating to set off and carried forward of losses.

It will lead to situation where Nature of Loss will be determined post setting off with other source of Business income and also nature of loss will be dependent upon the quantum of other business income.

 The same is illustrated as under:-

A.      Suppose XYZ Ltd having following source of income:-

1.       Business income

Normal Business Income (Say N) – Rs. 1,00,000

Share Derivative Trading loss (Say S) – Rs. 1,00,000

 

2.       Capital Gain – Rs. 80,000

Computation of Income

1.       Assessee has Income under two heads – PGBP & capital gains

2.       For application of section 73 explanation, one has to determine the components of Gross Total income (GTI)

3.       If  GTI is consist of Income from house property,  Capital gain & Income from other sources, then loss from share transaction is not speculative loss, as per explanation to section 73.

4.       Till section 73 explanation application, loss from share derivative transactions will be treated as non-speculative u/s 43(5), to determine income under the head PFBP

 

Income under PGBP

Source N              – Rs. 1,00,000

Source S               – Rs. 1,00,000

Total                      -- Rs. NIL

 

Income under Capital Gain – Rs. 80,000

 

Gross Total Income – Rs. 80,000

Since GTI is mainly consist of income under the head capital gains, loss from share derivative transaction is not speculative loss

 

Thus nature of loss from share derivative transaction is determined post set-off of the same with other business income

 

B.      Suppose in above example, source N income is Rs. 2,00,000, the GTI will be consist of as under:-

1.       Income under head PGBP    -              Rs. 1,00,000

2.       Capital Gain                                                -              Rs.    80,000

Since GTI is not consist of income under the head capital gains, loss of Rs. 1,00,000 will be treated as speculative loss and GTI will be recomputed.

 

Thus nature of loss from share derivative transaction is based on quantum of other business income

 

C.      Continuing with Example A, suppose in assessment proceedings, income from source N is enhance to Rs. 2,00,000. In that scenario also, the nature of loss from source S will be change to speculative loss from non-speculative loss as claimed by assessee.

 

Thus nature of loss from share derivative transaction will keep on changing as the with the finalisation of normal business income in  appellate proceedings.

 

 

Charitable Trust- Application of Income.

Utilisation of Charitable trust assets for donation to other charitable trust in view of provision of explanation to section 11(2) of Income Tax Act- Whether application of Income in the hands of Donor trust.

Considered following case of Trust A:

The breakup of Trust Corpus upto 4^th year is as under:-

1.      Original Corpus                                   - Rs. 10,00,000

2.      15% income accumulated year each - Rs.      64,500

3.      Accumulation u/s 11(2)                      - Rs.  1,75,000

4.      TOTAL                                                 - Rs. 12,40,000

Facts: Trust A wants to make donation of Rs. 2,00,000 (in excess of current year income of Rs. 1,20,000) in Year 5 (Current years) to other charitable trust.

Explanation to section 11(2) of Income Tax Act

[Explanation.—Any amount credited or paid, out of income referred to in clause (a) or clause (b) of sub-section (1), read with the Explanation to that sub-section, which is not applied, but is accumulated or set apart, to any trust or institution registered under section 12AA or to any fund or institution or trust or any university or other educational institution or any hospital or other medical institution referred to in sub-clause (iv) or sub-clause (v) or sub-clause (vi) or sub-clause (via) of clause (23C) of section 10, shall not be treated as application of income for charitable or religious purposes, either during the period of accumulation or thereafter.]

Question:

Can a Trust make donations in any financial year to another trust registered under 12 A of the Income Tax act in excess of its income of that financial year?  What are income tax implications

Comments

As per explanation to section 11(2), trust cannot utilise the amounts accumulated u/s 11(2) for making donation to other charitable trust. The same view is also endorsed by ICAI in its guidance note issued on Taxation of Charitable trust 

 If trust does so, then such payment to other charitable trust will be treated as income in the hands of Donor Trust (Trust A in this case)

 There appears to be no embargo on utilisation of following amounts for making donation to other charitable trust:-

a)      Income earned in current year

b)      Past year income accumulated to the extent of 15% year each

c)       Out of corpus of trust, not including the corpus accumulated u/s 11(2).

So Trust can make donation of Rs. 2,00,000 to other charitable trust in excess of current year income of Rs.  1,20,000, by utilising the Original corpus (10,00,000) and 15% income accumulated each year (Rs. 64,500)

Foreign AE- Tested party in TP analysis

Foreign Associated Enterprise- Whether it can be tested party in Transfer Pricing Analysis

 

In one of latest judgement, Hon’ble Mumbai Tribunal in the case of Onward Technologies Ltd has held that for Transfer Pricing analysis of Indian assessee, the foreign associated enterprise cannot be taken as Tested party.

 

The facts of the case are as under:-

1.       Assessee is parent company of Onward Technologies Inc., USA and Onward Technologies Gmbh, Germany

2.       Onward group is global provider of Engineering software Development services and solutions to end users.

3.       During the relevant previous year, assessee rendered IT enables services to its AE in USA and Germany for Rs.22 Cr.

4.       Assessee subsidiaries in USA and Germany were responsible for carrying out primarily sales and marketing activity along with sales and site support services to clients in respective countries and remunerate subsidiaries at cost plus 5% mark up. Further sale price received by foreign AE from services ultimately sold to customers  is equal to that charged by the assessee frim its AE

5.       Assessee choose its foreign AE as tested party, adopted TNMM as appropriate method and did TP study by comparing NP profit margin of foreign AE with six foreign companies doing similar activities.

6.       TPO held that price determined by assessee in providing IT enables services is not in accordance with 92C(1) & 92C(2) and rejected assessee TP study.

 

Issue before Tribunal-Can Foreign AE be taken as Tested party for TP study

 

Held

Foreign AE cannot be taken  as tested party by explaining TP law in India as under:-

a)      Section 92(1) provides that Any Income from International transactions shall be determined having regard to the Arm’s length price

b)      Section 92B  defines international transaction to be transaction between two or more associated enterprise

c)       Section 92C read with rule 10B(1)(e) specified TNMM as one of method for determining ALP, which method provides that net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is  computed in relation to cost incurred or sale effected or assets employed or having regard to any other relevant base.

d)      The modus operandi of determining ALP of an international transaction under this method is that firstly, the profit rate earned by the assessee from a transaction with its AE is  determined (say, profit A), which is then compared with the rate of profit of comparable cases (say, profit  B) for ascertaining as to whether profit A is at arm’s length vis-à-vis the profit B.

e)      However, in so far as calculation of profit A is concerned, there cannot be any dispute as the same has to necessarily result only from the transaction between two or more associated enterprises, as is the mandate of sections 92 read with 92B in juxtaposition to rule 10B. The natural corollary which, thus, follows is that under no situation can the calculation of `profit A’ be substituted with anything other than from the international transaction, that is, a transaction between the associated enterprises. So, it is the profit actually realized by the Indian assessee from the transaction with its foreign AE which is compared with that of the comparables. There can be no question of substituting the profit realized by the Indian enterprise from its foreign AE with the profit realized by the foreign AE from the ultimate customers for the purposes of determining the ALP of the international transaction of the Indian enterprise with its foreign AE

 

COMMENTS:

The law as explained by Hon’ble Mumbai Tribunal in afore-said case can be further illustrated as under:-

A Ltd – Domestic Company- Purchase Goods worth Rs. 10 Cr

B Ltd – AE of A Ltd. in Foreign Country

A Ltd Sold goods to B Ltd for Rs. 12 Cr

B Ltd sold all goods in foreign company to independent buyers for Rs. 13 Cr

 

In these transactions A Ltd earned profit of Rs. 2 Cr and B Ltd earned a profit of Rs. 1 Cr.

The international transaction is sale of goods by A Ltd to B Ltd worth Rs. 12 Cr.

In order to earn profit, an entity has to purchase and sold goods.

In above example, A has earned profit of Rs. 2 Cr purchasing goods from non-associated enterprise and selling goods to Foreign AE in International Transaction.

B Ltd has earned profit of Rs. 1 Cr by purchasing goods from foreign AE in international transaction and selling goods to non-associate enterprise.

This both A & B has earned profit in series of transactions, where International Transaction is common thread.

In above-said case, Hon’ble Tribunal has assumed that only India AE has earned profit from International Transaction and Profitability of Foreign AE is not linked to International Transaction, which is not the case.

 

The extracts of relevant provisions under Transfer pricing chapter are once again reiterated to substantiate the fact that foreign AE can be tested party.

 

Section 92C read with rule 10B(1)(e) specified TNMM as one of method for determining ALP, which method provides that net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is  computed in relation to cost incurred or sale effected or assets employed or having regard to any other relevant base

 

Section 92B  defines international transaction to be transaction between two or more associated enterprise

 

Associated Enterprise is defined u/s 92A in relative manner by providing that two enterprise shall be deemed to be associate if prescribed conditions are fulfilled.

 

Enterprise is defined u/s 92F(iii) to means person who is or has been or proposed to be engaged in prescribed activity.

 

Thus position of law can be summarise as under:-

1.       Under TNMM, we are required to calculate net profit realised by enterprise from an International Transaction.

2.       Section 92C read with rule 10B does not prescribed that for application of TNMM, enterprise should be either resident enterprise or domestic enterprise or enterprise based out of India.

3.       Thus for application of TNMM, net profit margin of any one of the associated enterprise involved in international transaction could be evaluated or any one of associated enterprise could be TESTED PARTY.

 

 

Alternatively

Considered the above example again from Resale Price Method perspective

Suppose in above example A Ltd is assuming all major risk and owning intangible. B Ltd is assuming the function of low risk distributor.

In view of above-said hypothesis, Resale price Method will be most appropriate method with B Ltd will be taken as Tested party for which Gross margin will be evaluated and compared with uncontrolled comparables.

If ruling of Hon’ble Tribunal is followed, then it would not have been possible to follow resale price method in the instant case.

 

Another Tribunal Decision

In AIA Engineering Ltd, Hon’ble Ahmedabad upheld the use of foreign associated enterprise as tested party for transfer pricing analysis of Indian AE.

 

OECE View on Tested Party

OECD Transfer Pricing Guidelines, 2012 also advocate the use of either associate enterprise as tested party in application of TNMM. The relevant extracts as :-

Para 2.59

However, a one-sided method (traditional transaction method or transactional net margin method) may be applicable in cases where one of the parties makes all the unique contributions involved in the controlled transaction, while the other party does not make any unique contribution. In such a case, the tested party should be the less complex one.

Para 3.18

When applying a cost plus, resale price or transactional net margin method as described in Chapter II, it is necessary to choose the party to the transaction for which a financial indicator (mark-up on costs, gross margin, or net profit indicator) is tested. The choice of the tested party should be consistent with the functional analysis of the transaction. As a general rule,  the tested party is the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found, i.e. it will most often be the one that has the less complex functional analysis.

 

UN View

UN Practice Manual – Developing countries also echoes the views of OECD with respect of selection of tested party.

The relevant extract are as under:-

Para 6.3.2.1

The TNMM looks at the profits of one of the related parties involved in a transaction, as do the cost plus and resale price methods. The party examined is referred to as the tested party

 

Thus from the afore-said analysis, conclusion can be drawn that selection foreign AE as tested party is not prohibited under Indian taxation law.