Recharacterizing Intercompany Loans Based on Substance Over Form for Interest Benchmarking

“3. INTEREST

3.1 The Borrower shall pay to the Lender interest at the rate of 3 month’s LABOR and it shall be computed on the basis of 360 days year.

3.2 Interest for the period commencing from the disbursement date till 31st December of each calendar year shall be payable every year on 31 December.

3.3 The Lender shall also have full right and discretion to charge penal interest at the rate of one (J) per cent per annum for the period for which any installment of repayment of loan thereof remains in arrears.

4. REPAYMENT

4.1 the Borrower shall repay the principal amount of loan along with the outstanding interest, if any at the end of three (3) years from, the date of disbursement of each tranche of the Loan.

4.2 In the event of any default in payment of principal amount of Loan and/or any interest, postponement, if any, allowed by the Lender shall be at the rate of interest as may be stipulated by the Lender at the time of postponement.”

“2.9.2 The assessee explained that non residents who wished nonresidents to invest in South Africa by means of loan capital needs approval from South African Reserve Bank particularly with reference to intended repayment dates and interest rates. The agree to interest rates in excess of prime Reserve Bank will not agree rate being charged by non resident shareholders on loans to non-resident the South African subsidiaries but loans from non non-residents residents other than shareholder may be allowed to carry interest at prime +2%. The relevant extracts of the regulations were provided to Learned TPO. It was submitted that intra-group intra loan advanced to Mauritius Entity was ultimately utilized in South Africa since JSWEMML further advanced the said loan to JSW Energy South Africa Ltd. [JSWENRSAL] and in view of o the South African Reserve Bank regulation, the Mauritius entity would not be able to charge any interest more than LIBOR from South African Entity. In the aforesaid background, it was submitted that the intra group transaction was to acquire the asset is South Africa and therefore, transaction was at Arm’s Length Price as prescribed in the Indian Regulations. In nutshell, it was submitted that due to regulatory restraints of South Africa, the interest rate could not borrowings from any group be more than LIBOR rate for any borrowings companies outside South Africa.

2.9.3 Without prejudice to the above submissions, the assessee benchmarked the loan transaction on the basis of External Comparable Uncontrolled Price [CUP] Method by comparing the interest rates at which the independent parties with similar credit ratings would be able to obtain intra-group intra loans. The AE was selected as the tested party and its credit rating was determined to be Baa1 (Moody; equivalent to S&P BBB+) which fall in the lower medium investment grade. Selecting the borrower country to be Mauritius/South Africa/USA, the assessee arrived at mean ALP margin of 243.83 basis points over LIBOR. Applying the spread of 243.83 basis point to LIBOR, the ALP interest was computed to be US Dollars 367598 (INR (INR Equivalent Rs.164.13 Lacs) as against Rs.13.82 Lacs charged by the assessee from its AE. The assessee, in support of LIBOR, also submitted that the loans were advanced from internal accruals and it did not have any foreign borrowings. The weighted average of domestic borrowings was computed as 10.14% as per the workings submitted by the assessee.

2.9.4 However, upon due consideration, the Ld. TPO opined that the regulatory restriction imposed under South African Regulations would not be determinative since the loan was since advanced to Mauritius entity and not to South African entity. Further, the regulatory authority of any country would not take into account the transfer pricing provisions to determine the appropriate rates which could be considered as Arm’ Length Price for interest payment. Drawing analogy from the decision rendered in Coca Coca-Cola India Inc. v. Asstt. CIT  (Punj & Har.) that the royalty rates represent ALP of any international permitted by RBI would not represent transactions, Ld. TPO opined that determination of ALP was to be examined from the point of view of Transfer Pricing Provisions under the Income Tax Act.

2.9.5 Proceeding further, finding defects in the assessee’s methodology to benchmark the same by External CUP in view of the fact that comparable entities were based in USA whereas the loans was advanced to Mauritius entity and further, the credit rating of Mauritius AE would be much lower than BBB+ as adopted by the assessee for benchmarking, Ld. TPO concluded that the search process was not proper and was required to be rejected. The argument that the loans were advanced from internal accruals was also rejected since the assessee, in the opinion of Ld. TPO, failed to prove nexus between interest free funds available with the assessee vis-a- vis loans advanced to its AE.

2.9.6 The Ld. TPO also came to a conclusion that interest on outbound loan was not to be benchmarked with LIBOR since no company would like to advance loans outside e India without security as the interest rate in India would be higher than those prevailing in the developed country. Therefore, the rates prevailing in India would be an appropriate benchmark to determine the ALP of loans advanced by Indian entities. Although the assessee placed reliance on certain judicial pronouncements for the submission that LIBOR would be appropriate benchmark rate, however Ld. TPO opined that certain vital aspects remained to be considered in the cited decisions. Rather reliance was placed on the decision of Tribunal rendered in Aurionpro Solutions Ltd. v. Addl. CI (Mum. – Trib.) for the conclusion that lending should not be below the cost of the borrowings of the assessee and the assessee should earn income which it would have earned by advancing loans to third parties.

2.9.7 Finally, Ld. TPO proceeded to work out the mean ALP rate on the basis of above factors. The assessee was taken as the tested party and External CUP method was used for benchmarking the aforesaid transaction. External CUP, as per Ld. TPO, could be the Bank Prime Lending Rate [PLR], Corporate Bond Rates or the cost of borrowings in the domestic market. Applying the average spread of 2.89% to assessee’s cost of borrowing i.e. 10.14%, cost of domestic borrowings was worked out to be 13.03%. Relying upon safe harbor rules, Prime Lending Rate was worked out to be 10.50%, which was nothing but 3% spread over State Bank of India base rate of 7.5%. The ALP based on Corporate Bond Rates was worked out to be 15%. Finally, the most conservative rate i.e. 10.5%, out of three rates, was adopted to benchmark the stated transactions. The ALP interest, thus, worked out to be Rs.441.61 Lacs as per computations made in para 5.8 of learned TPO’s order. Adjusting the interest of Rs.13.82 Lacs as charged by the assessee from its AE, the net TP adjustment, thus proposed, worked out to be Rs.427.78 Lacs.

2.9.8. The aforesaid TP adjustment was incorporated in assessment order dated 17/04/2014. The assessee submitted that it did not want to pursue the matter before Ld. Dispute Resolution Panel and expressed its intention to contest the same through normal appellate channel of Ld. CIT(A). Accordingly, the assessment order was passed by Ld. AO on 17/04/2014 which was subjected to further appeal before Ld. first appellate authority.

2.10 Before Ld. first appellate authority, the assessee, inter inter alia, drew attention to the fact that similar benchmarking, in immediately succeeding year i.e. AY assessee’s own case for immediately 2012-13, 13, has been done by Ld. TPO himself in its subsequent order dated 29/01/2016 adopting LIBOR rates as the base rates and ruled out the application of Corporate Bond Rate, SBI PLR Rate or Cost of Borrowing rate etc. RelianReliance was placed, inter-alia, alia, on the decision of Hon’ble Delhi High Court rendered in CIT v. Cotton Naturals (I) (P.) Ltd. to support the benchmarking submissions that LIBOR would be appropriate benchmarking rate on such outbound loan transactions. The list of other decisions which has also affirmed the said view, as relied upon by assessee during appellate proceedings, has also been tabulated on page nos. 18 19 of the appellate order.

18-19 with assessee’s submissions, Ld. CIT(A) allowed Concurring with assessee’s ground by observing as under: –

I have considered the submissions of the assessee, the views of the AO in the assessment order and the material on record.

use of intra-group It is apparent from the above that the end use intra loan was to acquire the asset company in South Africa and it is clearly evident that the JSWEMML was not able to charge the interest more than LIBOR from JSW South Africa Ltd. (JSWENRSAL), which had a direct impact on the interest repayment nt capability of JSWEMML to JSWEL of not more than LIBOR.

Further, the assessee submitted that with respect to cross border transactions, the interest rate is determined by using foreign currency rate (LIBOR/EURIBOR) and the same has JSW Energy Ltd 26 ITA Nos. 3714 & 3713/MUM/2024 been upheld as an appropriate benchmarking rate in various judicial decisions which have been mentioned above.

Thus, considering the above view taken by the appellant and the view taken by the TPO in appellant’s own case for later years i.e. AY 12-13 12 & AY 13-14, the transaction on of interest on loan has been benchmarked using the LIBOR Rate and also it is a well settled law that with respect to the cross border transactions, LIBOR has been considered as an appropriate benchmarking and thus, this ground of appeal raised by the assessee is allowed.

Aggrieved as aforesaid, the revenue is in further appeal before us.”

“2.14 Now the only question that survives for our determination of ALP rate keeping in view consideration is the determination the facts and circumstances of the case. The Ld. first appellate authority has confirmed the determination of ALP on the basis of LIBOR only without any spread-over. However, the said rate, in our opinion, represent inter-bank in bank rates which are applicable in case of entities having highest credit rating. The same is also fortified by the fact that the assessee, itself, has assigned a rating of Baa1/BBB+ to its AE while benchmarking the transactions. The said rating represents ‘lower medium investment grade rating. Therefore, the determination of ALP merely on the basis of LIBOR, in our considered opinion, would not be justified. During the course of proceedings before Ld. TPO, the assessee had arrived at mean spread of 243.83 243 basis points over LIBOR which is evident from page nos. 5-65 of Ld. TPO’s order. The computation of the same has nowhere been disputed by the revenue. Applying LIBOR + spread-over, spread ALP interest has been worked out to be Rs.1,64,13,241/-. We considered opinion that this spread over as are of the considered computed by the assessee was undisputed, quite fair and reasonable and the same was to be accepted. Accordingly, we confirm the ALP rate of LIBOR + 2.4383% as computed by the assessee in the alternative submissions made before Ld. TPO.

The impugned order stand modified to that extent. The Ld. TPO/Ld. AO is directed to recompute the income of the assessee in terms of our direction. Accordingly, Ground Nos. 1 & 2 stands dismissed. Ground No.3 stand allowed. Ground No. 4 stands partly allowed.”

“3.7.4 Upon careful consideration, we find that the facts of this year are pari-materia with the facts of AY 2011-12.12. The loan transactions arise out of same contractual terms and conditions. We also find force in the submissions that learned TPO proceeded on the basis of wrong parameters as pointed out by the assessee before lower authorities, completely disregarding the contractual terms. It is settled position that the contractual terms agreed to between the parties could not be rewritten or obliterated and reclassification or substitution of the transaction was not permitted. Nothing on record rebut the facts that as per the terms of the contract, the borrower had agreed to pay the lender interest at rates equal to 3 months’ LIBOR prevailing on the date of each interest payment up to 31/03/2012. The said fact has also been noted by Ld. DRP at para 2.29 of its directions. The only allegation is that the original agreement dated 26/07/2010 was not produced before Ld. DRP. However, the same would not make much difference since we have already confirmed the application of 2011 12. Since in AY 2011-12, floating rates of interest for AY 2011-12. 2011 we have upheld the working made by assessee, taking the same view, we upheld the workings made by the assessee during proceedings before learned TPO. Accordingly, we direct lower authorities to accept alternative TP adjustment of Rs.491.07 Lacs as worked out by the assessee during proceedings before Ld. TPO based on LIBOR + spread of 243.88 bps/163.8 bps for AYs 2011-12 2011 12 & 2012-13 respectively. The interest already charged by the assessee would be adjusted from the same and the net amount shall be the amount of TP adjustment for the impugned AY. Ground No.1 stand partly allowed.”

“23. This brings to the fore as to what do we mean by the expression “open market” which is expression not defined.

24. Black’s Law Dictionary, 10th Edition, defines the expression “open market” to mean a market in which any buyer or seller may trade and in which prices and product availability are determined by free competition. P Ramanatha Aiyer’s Advanced Law Lexicon has also defined the expression “open market” to mean a market in which goods are available to be bought and sold by anyone who cares to. Prices in an open market are determined by the laws of supply and demand.

25. Therefore, the expression “market value” in relation to any goods as defined by the explanation below the proviso to sub-section (8) of Section 80-1A would mean the price of such goods determined in an environment of free trade or competition. “Market value” is an expression which denotes the price of a good arrived at between a buyer and a seller in the open market ie where the transaction takes place in the normal course of trading. Such pricing is unfettered by any control or regulation, rather, it is determined by the economics of demand and supply.”

“3.4.11 We have carefully heard the rival submissions and perused relevant material on record. Upon due consideration, we find that the facts enumerated by is in the preceding paragraphs are undisputed facts. The erstwhile entity i.e. JSWEVL got merged with assesse company under a merger scheme as approved by Hon’ble Bombay High Court w.e.f. 01/04/2008. It is also undisputed fact that the assessee was major shareholder (to the extent of 74%) in the merged entity and the said entity was assessee’s subsidiary. Further, out of total estimated cost of Rs.1,860 Crores, the assessee had expanded more than 35% of the total cost, which is evident from the fact that, on the date of merger, Capital WIP stood at Rs.1129.16 Crores which would strengthen the fact that the assessee not only made major investment but also undertook entrepreneurial risk.

3.4.12 Undisputedly, the units under consideration were at the construction stage only when the merger took place which is evident from fact that the approval to both the units was granted by Government of Karnataka (CEIG) only during the month of July, 2009 and September, 2009. This is further fortified by the fact that, upon completion of plant, the assessee started claiming deduction against the same, for the first time, starting from AY 2010- 11. This is also supported by the fact that substantial investments were made by the assessee post-merger. The aforesaid facts would lead us to conclude that, at the time of merger, neither assessee nor the merged entity was an eligible undertaking within the meaning of Section 80-IA and hence, the circular as relied upon by lower authorities would have no application under the given circumstances and reliance upon the same by revenue, would be misplaced. The circular No. 3/2008, in our considered opinion, postulates existence of an undertaking which has already started claiming deduction u/s 80-IA, which is not the case here since neither the assessee nor the merged entity, on the date of merger, was an eligible undertaking entitled to claim the deduction with respect to unit SBU-II. Rather, it was the assessee, who upon commissioning of the plant, became eligible to claim the stated deduction for the first time starting from AY 2010-11. Accordingly, we find substantial force in the arguments advanced before us by Ld. AR, in this regard.

3.4.13 Another aspect of issue would be that the impugned year is the third year of claiming aforesaid deduction by the assessee u/s 80-IA against SBU-II. The deduction was claimed for the first time during AY 2010-11 which was allowed after thorough examination of the claim after considering various details, documents, explanations furnished by the assessee. From assessment order for AY 2011-12, it is quite evident that the said claim was initially allowed to the assessee in that year also. Accepting the objections raised by Comptroller & Auditor General (CAG), learned CIT, invoked revisional jurisdiction u/s 263 for AY 2011-12, the validity of which came up under challenge before the coordinate bench of this Tribunal vide ITA No. 3659/Mum/2017 order dated 15/12/2017. One of the issues to trigger jurisdiction u/s 263 was irregular allowance of deduction u/s 80IA with respect to Power Plant Unit SBU-II. The coordinate bench, after considering detailed submissions, on similar lines and after relying upon the decision of Hon’ble Delhi High Court rendered in CIT V/s Tata Communications internet Services Ltd. , finally held as under: –

51. Therefore, as could be seen from the above decision the eligibility of a claim for deduction u/s. 80IA and the bar if any is to be considered only in the first year of claim for deduction made under u/s. 80IA of the Act. It was held that since the assessee had been granted claim of deduction right from the Assessment Year 2004-05 u/s. 80IA of the Act consequently it cannot be denied deduction for the subsequent years. In as much as restraint of section 80IA(3) cannot be considered for every year of claim of deduction but can be considered only in the year of formation of business. In the case on hand since the Assessing Officer examined the issue thoroughly, called for various details in the initial Assessment Year being Assessment Year 2010-11 and allowed the claim of the assessee even during the current Assessment Year i.e. subsequent to 2010-11, the same cannot be revised unless there is change in facts or change in law.

3.4.14 Keeping in view the aforesaid facts and circumstances and following the ratio laid down by coordinate bench of the Tribunal in cited decision in assessee’s own case, we hold that the assessee was entitled to claim deduction u/s 80-IA with respect to unit SBU-II. Accordingly, we direct lower authorities to grant the same to the assessee and recomputed its income, as per law. Ground Nos. 3 to 5 stands allowed.”

“On hearing the learned Counsel for the Department and on a perusal of the impugned orders, it appears that both the Authorities have recorded a clear finding of fact that there was no exempt income earned by the assessee. While holding so, the Authorities relied on the judgment of the Delhi High Court in Income Tax Appeal No. 749/2014, which holds that the expression “does not form part of the total income” in Section 14A of the Income Tax Act 961 envisages that there should be an actual receipt of the income, which is not includible in the total income, during the relevant previous year for the purpose of disallowing any expenditure incurred in relation to the said income. The Income Tax Appellate Tribunal held that the provisions of Section 14A of the Income Tax Act, 1961 would not apply to the facts of this case as no exempt income was received or receivable during the relevant previous year. It is not the case of the Assessing Officer that any actual income was received by the assessee and the same was includible in the total income. In the facts of the case, the Authorities held that since the investments made by the assessee in the sister concerns were not the actual income received by the assessee, they could not have been included in the total income.”