Sunday, July 10, 2011

Patni Computer Systems: Transfer Pricing and "International Transaction"

The Pune Bench of the Income Tax Appellate Tribunal recently clarified several aspects of the law in relation to transfer pricing, as well as some issues in relation to the position in relation to Section 10A of the Income Tax Act, 1961. The elaborate decision, Patni Computer Systems v. DCIT, is available here.

Insofar as the issues in relation to Section 10A are concerned, the principle issue was whether the losses of 10A-eligible units could be set off against the normal business income of the assessee. In the context of Section 10B of the Act, the Bombay High Court has held in Hindustan Unilever v. DCIT, 38 DTR 91 (Bom) that losses of 10B units can be set off against normal business income. The Court had observed:

Prior to the substitution of the provision, the earlier provision stipulated that any profits and gains derived by an assessee from a 100 per cent Export Oriented Undertaking, to which the section applies "shall not be included in the total income of the assessee". The provision, therefore, as it earlier stood was in the nature of an exemption. After the substitution of Section 10B by the Finance Act of 2000, the provision as it now stands provides for a deduction of such profits and gains as are derived by a 100 per cent Export Oriented Undertaking from the export of articles or things or computer software for ten consecutive assessment years beginning with the assessment year relevant to the previous year in which the undertaking begins to manufacture or produce. Consequently, it is evident that the basis on which the assessment has sought to be re-opened is belied by a plain reading of the provision. The Assessing Officer was plainly in error in proceeding on the basis that because the income is exempted, the loss was not allowable. All the four units of the assessee were eligible under Section 10B. Three units had returned a profit during the course of the assessment year, while the Crab Stick unit had returned a loss. The assessee was entitled to a deduction in respect of the profits of the three eligible units while the loss sustained by the fourth unit could be set off against the normal business income. In these circumstances, the basis on which the assessment is sought to be re-opened is contrary to the plain language of Section 10B.

In Patni, following the assessee’s own case for a previous assessment year, the same principle was extended to Section 10A as well. As will be seen from the extract above, the logic behind the decision in Unilever was that Section 10B as it currently stands (post the amendment brought in by the Finance Act 2000 w.e.f. 1/4/2001) is a deduction provision and not an exemption provision. The position in relation to Section 10A is the same. (The decision in the assessee’s own case for the previous year has been affirmed on appeal by the Bombay High Court in CIT v. Patni Computer Systems, ITXA/2177/2010, decided on 1/7/2011: it is thus safe to say that the law on the point is fairly settled, at least so far as that High Court is concerned: losses of 10A/10B units can be set off against normal business income).

Besides the grounds pertaining to Section 10A, the Tribunal in Patni also had to decide two interesting issues related to transfer pricing provisions. We shall discuss the first of these in this post, while the second issue will be discussed in a subsequent post.

The first of these issues pertained to the addition of notional interest under transfer pricing provisions. The assessee had entered into certain transactions with associated enterprises in relation to software development and consultancy services. The Transfer Pricing Officer made adjustments on account of notional interest. The argument of the Department was that “considering the significant cost incurred by the assessee, the extension of the credit to the Associated Enterprises beyond the period of credit contracted for, could not be regarded as an action at arm’s length… a sum of Rs 3.99 Crores was to be construed as the arm’s length compensation receivable by the assessee on account of interest chargeable on the amounts due from the Associated Enterprises, beyond the stipulated period of credit.” The assessee on the other hand placed reliance on the decision of a co-ordinate (Mumbai) Bench in Nimbus Communications v. ACIT, ITA No. 6597/Mum/09, and contended that any “interest” element would be relevant only in the context of indebtedness created out of a loan transaction. It was contended that such an arrangement with associated enterprises did not fall within the scope of “international transaction”, and transfer pricing provisions could not be invoked. In Nimbus, the Mumbai Bench had observed:

“A continuing debit balance, in our humble understanding, is not an international transaction per se, but is a result of international transaction. In plain words, a continuing debit balance only reflects that the payment, even though due, has not been made by the debtor. It is not, however, necessary that a payment is to be made as soon as it becomes due. Many factors, including terms of payment and normal business practices, influence the fact of payment in independent transaction which can be viewed on standalone basis. What can be examined on the touchstone of arm’s length principles is the commercial transaction itself, as a result of which the debit balance has come into existence, and the terms and conditions, including terms of payment, on which the said commercial transaction has been entered into. The payment terms are an integral part of any commercial transaction, and the transaction value takes into account the terms of payment, such as permissible credit period, as well. The residuary clause in the definition of ‘international transaction’ i.e. any other transaction having a bearing on the profits, incomes, losses or assets of such enterprises, does not apply to a continuing debit balance, on the given facts of the case, for the elementary reason that there is nothing on record to show that as a result of not realizing the debts from associated enterprises, there has been any impact on profits, incomes, losses or assets of the assessee. In view of these discussions, in our considered view, a continuing debit balance per se, in the account of the associated enterprises, does not amount to an international transaction under section 92B in respect of which ALP adjustments can be made

Following this, in Patni, the Tribunal held, “the extension of credit to the Associated Enterprises beyond the stipulated credit period cannot be construed as an “international transaction” for the purposes of section 92B(1) of the Act so as to require adjustment for ascertaining the ALP…

The other transfer pricing issue pertained to whether adjustments can be made in a case where associated enterprises had received “specific and identifiable benefits” due to certain actions by the assessee, even though there was no specific “mutual agreement or arrangement” between the assessee and the AEs in this regard. The assessee had paid a certain sum to McKinsey & Co. “for undertaking a study for the purpose of restructuring the assessee’s organizational structure.” As per the Revenue, the proposals/recommendations in the study conducted by McKinsey also gave specific benefits to the AEs; and hence, an arms length allocation of cost of consultancy expenses paid to McKinsey was required to be made. This contention of the Revenue was also rejected. I will look at this issue in detail in a subsequent post.


vswami said...

On the issue against the adjustment /addition made of a sum of notional interest, the whole of the discussion is seen to have been devoted to the one and only aspect- that is, whether in the case on hand there has been any ‘transaction’, more so an ‘international transaction’ within its special meaning under section 92B, so as attract the ‘Transfer Pricing’ provisions.

In order to apply the said provisions, however, as is clearly envisaged by section 92, there are two basic requirements to be satisfied. They are,- (1) there should be ‘income arising’ from a transaction, and (2) such a transaction should be an ‘international transaction’ within its special meaning. Curiously, nay perplexingly, the most essential requirement (1) has not at all been gone into/dealt with.

Anonymous said...

That is for the reason that if the continuing debit balance was part of the international transaction (of sale/supply of services), then income obviously did arise in that transaction.

Anonymous said...

@vswami: If it was an international transaction or part thereof, there would be adjustments as income was resulting from the international transactions. Also, s 92 makes adjustments to the computation of income: it is not correct law to say that "I gave away my services for free to the AE, so do not make any ALP adjustments"

Anonymous said...

I tend to agree with VSwami: On this issue the court has simply followed the principle laid down in Nimbus, without examining it fully.