Sunday, 10 April 2016

International Transaction -Receivable in the course of Business-Analysis


International Transaction -Receivable in the course of Business-Analysis

Finance Act 2012 added new wings to the definition of word “international transaction” u/s 92B of Income Tax Act, 1961 by adding an explanation to said section.
Among the various clauses of said explanation, under clause (i) (c ) “ debt arising during the course of business “  (Receivable)is given a recognition of being International Transaction.

·        Does it mean that Receivable was earlier not an International transaction but now made it or it was so previously, but now made it more explicit?

a)      In normal course Receivable arising in the course of business is not a transaction; it is a consequence/cause of transaction of sale of good on credit.
b)      A transaction of sale of goods inter-alia includes arrangement/understanding on the part of seller as regard execution of accompanied functions/risk like transportation of goods, credit terms, after sale services etc.
c)       As per clause (v) of section 92F, transaction includes arrangement, understanding, and action in concert.
d)      It seems that by virtue of afore-said provision u/s 92F, legislature must have assigned to arrangement/understanding on credit terms, the status of international transaction, which was hitherto not an international transaction but rather one of the facet of transaction of sale of good.
e)      The function of Explanation in a statute is to explain the meaning of certain phrases and expressions contained in the statutory provisions.
f)       The “Sale transaction”, already an international transaction by virtue of Substantive provision of section 92B, does not require aid of explanation to explain its meaning, which is an unambiguous in itself.
g)      Can an explanation deem a function/risk associated with Sale transaction as an international transaction without corresponding amendment in the substantive provision of section 92B or do an explanation have power to render anything as international transaction, when the same is not mandated by fundamental provision to which explanation is appended?
h)      Can said explanation be understood in the context of one limb of section 92B , “any other transaction having a bearing on the profit, income, losses or assets of enterprise”  , so as to include within its ambit the transaction of capital financing characterized in the Form of debt arising in the course of business i.e one entity financing its associated enterprise through credit sale of good and not collecting the corresponding Receivable over long period of time.
i)        It seems that true to Interpretation principles, Receivable shall be treated as an international transaction in the latter case only i.e where it is intended as mean of capital financing and not when same originate and collected in normal course of business.

·         If one ignores the afore-said enunciation, treat every Sale transaction and its associated Receivable, as separate International transactions in each and every case, the point of consideration is how to determine the ALP of Receivable:-
a)      Whether to determine ALP of Receivable independently of main transaction (sale of goods) to which it is sub-set or
b)      Whether ALP of Receivable is to be determined in juxtaposition with principal transaction from which it originate?

Ø  Do Receivable merit independent ALP benchmarking

a)      Separate analysis of Receivable dehors the primary sale transaction, do not stand the test of Transfer pricing principles.
b)      For transfer pricing analysis, following are pre-requisites:-
ü  An International Transaction
ü  Income or expenses associated with an International Transaction or expected to arise from an International transaction in Arm’s Length Scenario.
ü  Existence of Comparable transaction.

Now evaluate how Receivable falls into afore-said criterion

1.       Receivable is an international transaction by virtue of Explanation to section 92B.

2.        In ordinary course of business, no separate compensation is intended from Receivable but rather only profit from principal sale transaction is contemplated. However if Receivable extends beyond a threshold level, interest is considered as separate compensation for such Receivable. The threshold level would be dependent upon business exigencies and market trend. Thus in normal course, compensation for Receivable is embedded in Profit from sale transaction.

3.       Comparability
§  Receivable cannot be compared solely with the unsecured loan to determine appropriate rate of interest as compensation for Receivable, as both the transactions are not comparable. In loan transaction, the entire compensation is in the form of Interest and in Receivable, the compensation is incorporated in separate international transaction, being sale of goods.
§  There may be the case, where one person is charging interest on Receivable. Does this transaction (Charging Interest on Receivable) become a comparable case, so that tested party should also charge interest on Receivable? Consider a situation  of following two persons in same line of business, where normal credit period is business is 2 months
i)                    Mr. A Charging Sale price of 1020/unit
ii)                   Mr. B is charging sale Price of Rs. 1000/unit + Rs. 20 as Interest for credit period extended
Can anybody said, on the basis of transaction of Mr. B, that Mr. A should also charge Rs. 20 as Interest on his Receivable, without comparing the Sale price of both the parties.
The obvious answer seems to be NO. On account of cost involved in extending credit period, one person has compensated himself through enhanced sale price, while other person has explicitly charged separate consideration for the same, through Interest

§  Since the compensation for Receivable is inextricably linked with sale price, the appropriate comparable would always be comparable sale transaction but not an unsecured loan transaction.

Conclusion

a)      Though Receivable have been grouped under the category of capital financing in explanation to section 92B, it does not mandate that every Receivable should earn interest to satisfy benchmark of being at ALP.
b)      Enterprise envisages consolidated profit from sale transaction, which is meant to remunerate various associated functions like transportation, extending credit, after sale service etc.  If law deems any of such function as separate international transaction, it does not mean that assessee should charge separate compensation for the same, unless statue overtly provides for reducing the sale price because the recompense for such function (deemed transaction) is already included in principal sale transaction.
c)       The Transfer Provisions are part of anti-abusive measures which seeks to solicit rational behavior on the part of assessee; it cannot force assessee to do business in particular manner.
d)      Since income determination and comparability analysis of Receivable cannot be done in isolation with sale transaction, Arm length benchmarking of Receivable has to be in done in collocation with Primary Sale transaction Discrete Transfer Pricing analysis of Receivable in sequestration and derogation of primary sale transaction, of which it is sub-set, is not true comparability/benchmarking from Transfer pricing perspective in current scenario.

Ø  ALP determination of Receivable in association with Sale Transaction

o   Legal Position
a)      Section 92 requires that income arising from International Transaction should be determined on Arm’s length basis, advocating transaction by transaction approach in application of Arm’s Length Principles.
b)      Rule 10A(d) provides that transaction includes closely linked Transactions, empowering to treat closely linked transactions as single transaction for ALP benchmarking.
c)       The words closely linked transaction has not been defined in the Act or rule.
d)      Para 3.9 OECD Transfer Pricing guidelines provides that where pricing of two transactions are so closely linked that it is impractical to determine price of individual transactions, these transactions should be evaluated on combined basis.
e)       ICAI guidance note on Transfer pricing provides that two or more transactions can be said to be linked when these transactions emanate from a common source being an order or a contract or an agreement or an arrangement and the nature, characteristics and terms of these transactions are substantially flowing from the said common source.
f)       Receivable and Sale transaction not only originate from common contract but also their pricing cannot be determined on individual basis.
g)      Thus literature behind statutory provisions allows the evaluation of Sale Transaction and Receivable on aggregate basis.

o   Modus-operandi
Since the compensation for Receivable is part and parcel of sale transaction, ALP benchmarking of sale transaction in conjunction with the credit terms, will be due compliance of Transfer Pricing study of Sale Transaction and Receivable on aggregate/combined basis, as currently in practice.
a)      In case of CUP method, the adjustment in sale price of comparable to account for different credit terms shall be considered as due benchmarking and evaluation of Sale transaction & Receivable of Tested party
b)      In case of Margin Methods (CPM & TNMM), the margin of tested party duly adjusted for working capital difference shall be deemed as due ALP determination of Sale Transaction & Receivable.


·         Take another case: Suppose as per terms of Contract in international transaction, the credit period is two months, but in actual transaction, credit period is between 2-4 months. Can AO take a stand that compensation associated with 2 months credit period is incorporated in sale price and for balance terms of Receivable, Interest should be charged.

The stand of AO may be counter as under:-

a)      Evaluating credit term in sale transaction is a part of functional analysis establishing the credit risk taken by seller.
b)      In OECD guidelines, it is emphasized that we need to evaluate whether purported allocation of risk is consistent with economic substance of transaction and in this regard the parties’ conduct should generally be taken as best evidence of concerning the true allocation of risk.
c)       So if contract provides for credit period of 2 months, but actual conduct of parties convey credit period of 2-4 months, then seller shall be assumed to taking credit risk of 2-4 months based on actual conduct.
d)      Thus arrangement or understanding in transaction must be gathered from actual conduct of parties, rather than professed by parties.
e)      Thus if cumulative ALP determination of sale transaction in concurrence with actual credit terms is in consonance with Comparable sale transaction, then no separate Interest adjustment is required.


Summary

1.       It is not that compensation associated with Receivable was untaxed before deeming the Receivable as International Transaction. The ALP determination of Sale transaction duly takes into consideration the credit terms, thus compensation for cost associated with Receivable is duly factored into while evaluating the sale transaction. Thus said amendment has not plugged any existing loophole.
2.       On the principle of valuing each and every word of statue and principle of Harmonious Construction, it seem that deeming credit arrangement between associated enterprises, as discrete International Transaction warranting separate charge of interest on the same, should be taken in the sense of Capital financing only, in current setting of statue   
3.       Treating Receivable as international Transaction should not empower assessing authorities to take Interest as appropriate ALP of Receivable in normal course, without statute explicitly providing of reducing the sale price/Margin for compensation for Receivable already rooted therein, because if one goes by literal interpretation and treat every Receivable as International Transaction,  Sale Transaction and Receivable are already evaluated on combined basis


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