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

Finance Bill 2016- Penal Provisions – 270A & 270AA – Demystified

Finance Bill 2016- Penal Provisions – Sections 270A & 270AA – Demystified

Finance bill ushered in new regime whereby Penalty for concealment and furnishing of inaccurate particulars of income has given way to Under-reporting and Misreporting of income.

Due to subjective nature of the concept, the litigations are bound to arise as to whether there is an under-reporting or misreporting of income

I have tried to analyze the other critical aspects in the implementation of  section 270A & 270AA.

1.       Applicability of Section 270A

A)     Section 270A as proposed by Finance Bill 2016 is effected from 1.4.2017

B)      The sunset clause for section 271 read as “The provisions of this section shall not apply to and in relation to any assessment for the assessment year commencing on or after the 1st day of April, 2017”

C)      The Supreme court in Brij Mohan v CIT 120 ITR 1 (1979)(SC) & in CIT v. Onkar Saran and Sons (1992) 195 ITR 1 (SC) held that law applicable regarding penalty for concealment is the law in force as on the date of filing Return of Income.

D)     The penalty provision for concealment of income is deterrent provision and meant to prevent the assessee from indulging in reporting of income contrary to law of land. What shall be considered concealment of income/ reporting inaccurate particulars of income/under-reporting of income (hereinafter referred to as Incorrect reporting of Income) shall be known to assessee at the time when he is reporting his income i.e filing return of income and he cannot be punished for incorrect reporting of income, which was not incorrect reporting at the time of reporting of income.

E)      Accordingly, following position emerges as regard applicability of section 271(1)(c) & section 270A :-

a)      Section 270(1)(c) will continue to rule the penalty proceedings for Incorrect reporting of  Income for assessment years up to  2016-17 . In other words for assessment to be done for Assessment year 2014-15, 2015-16 & 2016-17, penalty proceedings, if any, will be driven by section 271(1)(c) This view is based on following reasoning:-

i)                    Section 271(1)(c) was in force when Return of income was filled for assessment year prior to assessment year 2016-17 or will be filed for assessment year 2016-17 before 31.3.2017.

ii)                   Sunset provision in section 271 also provides the applicability of section 271 for assessment done for assessment year 2016-17 or prior to that year.

b)      Accordingly, if pursuant to re-assessment/revision/appellate proceedings for any assessment year prior to assessment year 2017-18, penalty for incorrect reporting of income is to be levied, the same shall be administered under provision of section 271(1)(c).

c)       As a result thereof, provision of section 270A will regulate the penalty proceedings for incorrect reporting of income for assessment year 2017-18 and onwards.

d)      Further if return of income for assessment year 2016-17 is belatedly filed after 1.4.2017, then section 270A will govern the penalty proceedings for incorrect reporting of income, if any.

2.       Time Limit for Initiation of Penalty Proceedings U/s 270A

a)      Under Section 271, Assessing officer  is required to record his satisfaction for initiation of penalty proceedings u/s 271(1)(c ) in assessment order and thereupon in assessment order itself, AO give direction for initiation of Penalty Proceedings.

b)      U/s 275, where assessee has not appealed against assessment order, Assessing officer is required to pass penalty order within the financial year in which Assessment proceedings, in the course of which action for imposition of penalty has been initiated, are completed or 6 months from the end of month in which action for imposition of penalty is initiated, whichever period expires later. Suppose assessment proceedings are concluded in March 2016, then penalty proceedings are expected to be finalized by Sept 2016.

c)       Due to correlation (initiation of penalty proceedings in assessment order) between section 275 and 271(1)( c),  under existing penalty proceedings, Assessee is sure of time period within which penalty proceedings will be culminated.

d)      I feel that TIME FRAME FOR CONCLUSION of penalty proceedings are completely missing in section 270A on account of absence of explicit timeliness for initiation of penalty proceedings , explained as under:-

i)                    Section 270A read as “The Assessing Officer or the Commissioner (Appeals) or the Principal Commissioner or Commissioner may direct that any person who has under-reported his income shall be liable to pay a penalty in addition to tax, if any, on the under-reported income”.

ii)                   Under section 270A, there is no requirement for Assessing offer to record his satisfaction for initiation of penalty proceedings in Assessment order Thus post conclusion of assessment proceedings, AO will separately assess, whether there is under-reporting of Income and if feels so, he will issue separate notice for initiation of penalty proceedings u/s 270A read with section 274.

iii)                 One will appreciate that initiation of penalty proceedings will be stage posterior to conclusion of Assessment proceedings and there is no limit prescribed in section 270A or elsewhere for initiation of penalty proceedings.

iv)                 Suppose AO feels that there is no under-reporting of Income but one year later, his successor, on review of earlier assessment order feels that there was under-reporting of Income and he may initiate penalty proceeding after one/two years from conclusion of assessment proceedings

e)      At present section 275 only control the time limit for conclusion of penalty proceedings upon initiation of the same. Unless specific time frame for initiation of penalty proceedings is incarnated post incorporation of section 270A on statue, assessee will always be under threat for initiation of penalty proceedings for past assessments.

3.       Appeal against penalty order u/s 270A

a)      Section 246A, which provides the list of orders appealable before Commissioner Appeal, has not been amended to incorporate the penalty order section 270A passed by assessing officer.

b)      However section 253, providing the list of order appealable before Tribunal has been amended to include penalty order passed by Commissioner (Appeal) or Principal Commissioner or Commissioner u/s 270A.

c)       It seems that there is an inadvertent error by not making penalty order u/s 270A appealable before CIT(A), which I hope, will be taken care at time of passage of Finance Act, 2016.

4.       Inconsistency in computing under-reporting income u/s 270A, where income is computed 115JB .

a)      The itinerary of section 270A is as under:-

i)                    Section 270A (1) empower Assessing Authority to levy penalty, where there is an under-reporting of income.

ii)                   Section 270A(2) lay down the exhaustive criterion to determine the case of under-reporting of Income.

iii)                 Section 270A(3) determines the quantum of under-reported income.

iv)                 Section 270A (7) levy penalty @ 50% on tax on under-reported income.

b)      The significance of afore-said is that if at stage ii (section 270A(2)), it is concluded that there is no under-reporting of Income, there is no need to go to section 270A(3), as  sub-section (3) contains detailed modes-operandi for computing quantum of under-reporting income, where section 115JB is applicable to assessee company.

c)       Under section 270A(2), if section 115JB is applicable and Return of Income is filed by company, then there is under-reporting when deemed total income assessed u/s 115JB is greater than deemed total income determined in intimation issued u/s 143(1)(a).

d)      Consider the following case:-

i)                    Income as per Normal Provision-                      Rs. 10,000

ii)                   Book Profit u/s 115JB                                             Rs. 1,00,000

iii)                 Tax on Income as per Normal provision         Rs. 3,000

iv)                 Tax on books profit u/s 115JB                             Rs. 18,500

v)                  Deemed Total income                                           Rs. 1,00,000

vi)                 Assessment u/s 143(3) on normal income    Rs. 25,000

vii)               Deemed Total Income u/s 143(3)                      Rs. 1,00,000

·         It is assumed that Returned Income is accepted in intimation issued u/s 143(1)(a)

·         Even after taking into account addition of Rs. 15,000 u/s 143(3) on normal income, tax on books profit is more than tax on normal income and hence book profit is taken as deemed total income.

e)      Thus one will appreciate that there is no under-reporting of income in above case as per measure stated in section 270A(2), as deemed total income on assessment is same as computed in Intimation u/s 143(1)(a).

f)       Thus when it is established that there is no under-reporting of Income u/s 270A(2), there is no need to visit section 270A(3) and detailed steps for computing amount of under reported income in the instance case will be of no use to AO for levying penalty.

g)      Thus there is urgent need to clear the ambiguity expected to surface again on computation of penalty where assessee total income is determined u/s 115jB

5.       Provisions of section 270AA.

a)      Section 270AA label as “Immunity from imposition of penalty etc.”  propose to be inserted from 1^st April 2017 provides as under:-

i)                     An Assessee may make an application to Assessing officer for non-imposition of penalty u/s 270A and non-initiation of proceedings u/s 276C (Prosecution Proceedings), upon satisfaction of following conditions (required conditions)

·         Tax and Interest payable as per assessment order has been paid within the time allowed under notice of demand.

·         No appeal has been filed against assessment order.

ii)                   Assessing officer will accept the application of Assessee, where he is satisfied that required conditions have been met and also the addition to income is not on account of misreporting as per section 270A(9).

b)      As stated at point no. 2, under section 270A, initiation of penalty proceedings are separated from assessment proceedings. Thus at the time of making application u/s 270AA for non-imposition of penalty , assessee is not sure how AO will treat  addition to income i.e whether it is under-reporting of Income or misreporting of income. If AO treats the addition, as misreporting, assessee right to have non-imposition of penalty will be lost forever , explained as under:-

i)                    There is an addition to returned income and assessee bona-fide accepts the same.

ii)                   Assessee pays tax & interest on addition carried out in assessment.

iii)                 Assessee files an application for immunity from penalty under section 270AA.

iv)                 AO reject the assessee application by holding that there is misreporting of income and levies penalty u/s 270A.

v)                  Assessee files an appeal against the penalty order and it was finally held that there was under-reporting of income and not misreporting.

vi)                 Now assessee cannot filed an application u/s 270AA again, as the required time limit has been expired and he will forced to pay penalty @ 50% on tax on under-reported income.

vii)               If assessee application u/s 270AA has been accepted in beginning, he would have been saved from 50% penalty.

c)       Thus there should be provision in section 270AA for revival of application, which was rejected on account of misreporting of income, on being held that it was under-reporting to maintain its benevolent spirit.

d)      Further on making application u/s 270AA, before disposal of application u/s 270AA(1) AO will wait till the expiry of time for filing the appeal as per section 249(2)(b) expires i.e 30 days from the date of service of notice of demand relating to assessment. In case assessment order is passed in pursuance of directions of Dispute Resolution panel, the time limit for filing the appeal to Tribunal is 60 days. Thus it seems to be an error, which I hope will be taken care.

Transfer Pricing Rules- Amendment – Disguise conditional Benefit

Transfer Pricing Rules- Amendment – Disguise conditional Benefit

In October 15, CBDT amended the Income Tax Rules relating to Transfer Price regulations, to tone down the rigour associated with computation of Arm’s length price/Margin, based on average price of multiple comparables

Post Amendment in rules, In case assessee is following either Comparable Uncontrolled Price (CUP) or Resale Price Method (RSM) or Cost Plus Method (CPM) or Transactional Net Margin Method (TNMM) as Most Appropriate Method (MAM) and number of comparables are 6 or more, then International Transaction or Specified Domestic Transaction will be at ALP, if the price of such transactions is falling in the bandwidth of comparable prices ranging from 35^th Percentile to 65^th Percentile.

Apart from above- said benevolent amendment, the said amendments also contains another conditional benign provision, deliberated as under:-

Rule 10CA – Computation of ALP in certain cases.

1.       Proviso to Rule 10CA(2) seems to resolve the practical problem faced by assessee in establishing the Arm’s length Margin (i.e. for application of RSM, CPM & TNMM) in dealing with AE for Current year (Previous Year for which Transfer Pricing study is to be carried out)

2.       Assessee does not have comparable data for current year, but it must have details of comparable margin for years preceding the current year (preceding year/years). On that basis, assessee could plan for Arm’s length Margin for current year. However in erstwhile provisions, assessee was forced to use comparable data of current year only, without weightage and consideration of data relating to preceding year/s.

3.       In recognition of genuine hardship, proviso to newly inserted rule 10CA(2), provides for use of weighted average margin based on comparable uncontrolled transactions undertaken by comparable enterprise in current year and preceding year or current year and preceding two years for ALP determination.

4.       The First Proviso to Rule 10CA(2) read as under:-

Provided that in a case referred to in clause (i) of sub-rule (5) of rule 10B, where the comparable uncontrolled transaction has been identified on the basis of data relating to the current year and the enterprise undertaking the said uncontrolled transaction, [not being the enterprise undertaking the international transaction or the specified domestic transaction referred to in sub-rule (1)], has in either or both of the two financial years immediately preceding the current year undertaken the same or similar comparable uncontrolled transaction then,-

(i) the most appropriate method used to determine the price of the comparable uncontrolled transaction undertaken in the current year shall be applied in similar manner to the comparable uncontrolled transaction or transactions undertaken in the aforesaid period and the price in respect of such uncontrolled transactions shall be determined; and

(ii) the weighted average of the prices, computed in accordance with the manner provided in sub-rule (3) , of the comparable uncontrolled transactions undertaken in the current year and in the aforesaid period preceding it shall be included in the dataset instead of the price referred to in sub-rule (1)

5.       The illustration, based on RSM, below will highlight the obvious benefit to assessee under proviso to rule 10CA(2):-

Particulars		Preceding Years(PDY)
		PDY-2	PDY-1	CY
Comparable	Sale	1000	1100	1200
	COGS	900	968	1008
	GP	100	132	192
	GP Margin %	10%	12%	16%
Tested Party	Sale			2000
	GP Margin			13%
	COGS -International Transaction			1740
TP Analysis- Based on Current Year Data u/r 10B(4)	Comparable GP%			16%
	Arm length Price (2000 * 84% (100-16))			1680
	International Transaction			1740
	Difference			60
	% Difference			3.45%
	Addition to Income (Since variation is more than 3%)			60
TP Analysis- Based on weighted Average u/r 10CA(2)	Weighted Average GP% (Weights being yearly sales)			12.85%
	Arm length Price			1743
	International Transaction			1740
	Difference			-3
	% Difference			-0.17%
	Arm length Price			1740
	Addition to Income			NIL

6.       One will appreciate that, TP analysis based on current year GP margin of comparable resulted in addition of Rs. 60 in the hands of assessee, whereas corresponding examination based on weighted average GP catapult that international Transaction is at ALP.

7.       However, the afore-said benefit, benefit to take yearly weighted  average  Margin, is subject to the satisfaction following conditions cumulatively :-

a)      The MAM is either RSM, CPM or TNMM and

b)      Comparable uncontrolled transaction has been identified on basis of data relating to current year  undertaken by an comparable Enterprise and

c)       There is same or similar comparable uncontrolled transaction in preceding year  or previous two preceding years undertaken by comparable enterprise and

d)      Comparable enterprise has not undertaken any International Transaction or Specified Domestic Transaction (related party Transaction)

8.       The condition stated at (d) above may curtail the desired benefits of beneficial provision to assessee, in cases where comparable enterprise has undertaken  related party transaction of even miniscule level , say 5%. In such scenario, assessee will not able to use weighted average margin of such comparable and will be required to use current year margin for TP analysis.

9.       In a present day scenario, where backward and forward integration is call of the day to remain ahead of competition, assessee may find it difficult to discover comparable, which has not taken ANY related party Transaction.

10.   During tenure of 14 years, since the incorporation of TP regulations under Income Tax Statue, it has been fairly established by Judiciary, that enterprise which has undertaken related party transaction to the tune of 15-20% can be taken as comparable enterprise.

11.   Now when the amendment is carrying the munificent flavor, it should facilitate the execution of same in pragmatic manner and should not be stifled down by trying conditions embedded therein and I hope that same will be taken care in ensuing months.