Transfer Pricing Alert

BACKGROUND

As per the provisions of section 92B of the Income-tax Act, 1961 (IT Act), an international transaction between/ among associated enterprises is a transaction/ mutual agreement/ arrangement for allocation or apportionment of or contribution to any cost or expense incurred, such that a benefit, service, or facility is provided to one or more of the associated enterprises. Determining whether a particular transaction constitutes an international transaction can be a complicated matter requiring nuanced analysis.
The Mumbai Tax Tribunal (Tax Tribunal) in the matter of Asian Paints Ltd.¹ recently examined whether the issuance of comfort letter can be considered akin to a corporate guarantee and thus an international transaction as per the provisions of Section 92B of the IT Act and Rule 10TA of Income-tax Rules, 1962 (IT Rules). Further, the Tax Tribunal adjudicated on whether charging a consideration for the issuance of comfort letter is warranted, evaluating whether the aforesaid activity casts any financial obligation on the taxpayer. Again, in a matter of a few days, a similar matter came up before the Mumbai Tax Tribunal in the case of Lupin Ltd² wherein it deviated from its earlier judgement.
We, at BDO in India, have summarised the respective ruling of the Tax Tribunal and provided our comments on the impact of these decisions hereunder:

ASIAN PAINTS CASE
FACTS OF THE CASE

• During the fiscal year (FY) 20211-12, the taxpayer issued non-contractual comfort letters on behalf of two Associated Enterprises (AEs) located in Bangladesh and Singapore to third-party banks in the respective jurisdiction, without charging any consideration in this regard.

• The AEs availed borrowings aggregating to approximately INR 1,234.60 million based on the support letters issued to them by the taxpayer.

• The contents of the comfort letters broadly encompassed declarations to the banks that:
  a. The taxpayer is aware of the credit facility being provided to its subsidiaries;
  b. The taxpayer assures the banks that it will continue to be fully supportive of the subsidiaries’ operations by lending management and technical support to them.
  c. The taxpayer confirms that it shall maintain majority ownership and management control of the subsidiaries during the tenure of the facility;
  d. The taxpayer will use its best endeavour to see that obligations of the subsidiaries are met as and when they fall due; and
  e. The taxpayer’s assurance to the banks that it will not take any steps which permit either subsidiary to enter into liquidation or any arrangement with its creditors to prejudice the banks’ rights with respect to the credit facility.

• The Tax Officer (AO) made reference to Transfer Pricing Officer (TPO) pertaining to arm’s length determination of the taxpayer’s international transactions. The TPO observed from Form No. 3CEB that the taxpayer had not reported the issuance of comfort letters therein, and contended that disclosure should have been made as these were international transactions and accordingly, a fee should have been charged.

• The taxpayer rebutted the contentions of the TPO, primarily contending that:
  a. The taxpayer has not undertaken any financial/ legal obligation based on the comfort letters to bear costs of loan repayment in case of any default on the part of the subsidiaries;
  b. The loans granted by the banks are against the security of the respective subsidiary’s debts/ receivables;
  c. Thus, the act of issuing comfort letters cannot be regarded as a transaction and does not attract transfer pricing provisions. Consequently, determination of arm’s length price (ALP) is required and there is no need to charge a consideration; and
  d. Further, a similar issue had already been settled in the taxpayer’s favour for prior AYs 2010-11 and 2011-12, wherein coordinate bench of the Mumbai Tax Tribunal held that the provision of support letter does not create any liability on the taxpayer in the event of default and cannot be considered as an international transaction within the purview of section 92B of the IT Act.

• The TPO did not accept the taxpayer’s contentions and held that the issuance of the support letter is an international transaction (on lines of an intergroup service) and considering the similarity to the issuance of a corporate guarantee, the ALP fee to be charged in this regard was determined at 0.50% (i.e., 50% of 1% fee charged in case of corporate guarantees issued by the taxpayer). Hence, the TPO proposed an adjustment of approximately INR 62 lakh (i.e., 0.50% of INR 123.46 crore).

• The taxpayer challenged this before the First Appellate Authority [CIT(A)]. The CIT(A) followed its predecessor’s order in the taxpayer’s own case of earlier years, and restricted the ALP to 0.04%, thereby reducing the adjustment to roughly INR 5 lakh.

• Aggrieved, the taxpayer as well as the Revenue filed an appeal before the Tax Tribunal.

TAX TRIBUNAL RULING

While holding that the letters of comfort issued by the taxpayer meet the criteria of international transactions as per section 92B of the IT Act, the Tax Tribunal made the following observations:

• In order to constitute an international transaction, at least one of the transacting entities must be a non-resident and the transaction should, inter alia, have an impact on the profits, income, losses, or assets of such enterprises. In this case:
  a. The first condition is self-evident; and
  b. The taxpayer had disclosed the letters of comfort in its financial statements under “contingent liabilities and commitments”. Thus, the taxpayer has not only considered corporate guarantees but also the comfort letters as a contingent liability. This means that the aforesaid letters have a bearing on the taxpayer’s assets and accordingly, the second condition is also satisfied thereby constituting an international transaction under section 92B of the IT Act.

• There are no merits in the taxpayer’s contention that it is not financially obligated to bear the cost of repayment of loans as:
  a. The taxpayer suo-moto considered the credit facility as its contingent liability and no material was brought on record to controvert this disclosure; and
  b. In relation to the credit facility availed by the Singapore-based AE, the same was extended based on the security of the comfort letter issued by the taxpayer.

• Reliance cannot be placed on the earlier decision of the Tax Tribunal’s coordinate bench in this case, as in the present case, the taxpayer not only undertook to use its best endeavour to see that the obligations of its subsidiaries are met when they fall due, but also treated the liability as a contingent liability in its audited books of accounts. Therefore, the case under consideration is different from the earlier cases referenced by the taxpayer.

• The CIT(A) rightly reduced the ALP for issuance of comfort letters to 0.04% (20% of 0.20%) in conjunction with the reduction of ALP for issuance of corporate guarantees to 0.20% (20% of 1.00%).

LUPIN CASE
FACTS OF THE CASE

• The taxpayer had issued a letter of comfort towards credit facilities sanctioned by a third-party bank to the taxpayer’s AE located in the Philippines. No compensation was charged by the taxpayer for the same.

• The contents of the comfort letter covered confirmations to the bank that:
  a. The taxpayer has approved the facility provided by the bank to its subsidiary and is aware of the relevant terms and conditions;
  b. The taxpayer shall cause the AE to be operated and maintained in such a way so as to be in a financial position to repay the obligations to the bank in a timely manner;
  c. The taxpayer’s policy does not permit it to take any action which shall result in the AE being unable to carry on its business or otherwise being unable to meet its obligations;
  d. The taxpayer’s commitment that it shall not hold and own less than 51% of shareholding in the AE; and
  e. The taxpayer’s assurances will remain valid during the tenure of the facility.

• Upon reference being made to the TPO, the TPO considered the letter of comfort as an international transaction and benchmarked the same, proposing a TP adjustment towards guarantee commission at 1.50%.

• The taxpayer rebutted the contentions of the TPO, primarily contending that:
  a. Guarantee commission is only warranted when the letter of comfort is legally binding on the taxpayer and consequently constituting a financial obligation on the taxpayer;
  b. The comfort letter merely represents the taxpayer’s intent, without creating any liability on the taxpayer to make good any default of the AE;
  c. The passive arrangement due to which there is incidental benefit to the AE does not call for charging a compensation; and
  d. The letter of comfort cannot be considered as a letter of guarantee.

• The TPO went ahead with the TP adjustment, and the taxpayer appealed against the same before the CIT(A). The CIT(A) upheld the TP adjustment, stating that the comfort letter is similar to a guarantee given by the taxpayer which casts a financial obligation on the taxpayer.     

Aggrieved, the taxpayer filed an appeal before the Tax Tribunal.

TAX TRIBUNAL RULING

While holding that the letter of comfort issued by the taxpayer in the present case cannot be treated as a letter of guarantee which would attract any TP adjustment, the Tax Tribunal made the following observations:

• The CIT(A) mentioned in his order that whether a letter of comfort constitutes a guarantee depends upon the nature of the said letter. Thus, to ascertain whether a comfort letter falls within the purview of an international transaction, it is important to examine whether any additional financial obligation is cast on the taxpayer.

• The terms of the letter mandate the borrower/ AE (and not the taxpayer) to prepay the loan in case the shareholding of the taxpayer in the AE falls below 51%. This is different from a guarantee, wherein the party issuing the guarantee is obligated to make payment in case of default by the borrower. Thus, the letter under consideration is only a comfort/ support letter and not a guarantee.

• It was further observed that “Rule 10TA of Safe Harbour Rules for International Transactions defines "corporate guarantee" as explicit corporate guarantee extended by a company to its wholly owned subsidiary being a non-resident in respect of any short-term or long-term borrowing and does not include letter of comfort, implicit corporate guarantee, performance guarantee or any other guarantee of similar nature.”

BDO IN INDIA COMMENTS

As per the generally accepted principles of transfer pricing, the OECD commentary (OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022), and various judicial precedents in this regard, guarantee commission ought to be charged only when an “explicit” guarantee is provided. When the support is “implicit”, which typically is in the case of a “letter of comfort”, no consideration ought to be payable towards such support. Explicit guarantee in this case implies a direct liability on the guarantor in case of a default. 

It appears that in both the above cases, the Tax Tribunal has endorsed the above principle of explicit vs. implicit. While in both the above cases, a comfort letter was issued, in the Asian Paints case, the Tax Tribunal specifically pointed out that a contingent liability was created on account of such a comfort letter. On this basis, the Tax Tribunal stated “… we find no merits in the submission of the assessee that it is not financially obligated to bear the cost of repayment of loans to the banks in case subsidiaries default in repayment ….” The Tax Tribunal appears to have inferred that disclosure as contingent liability essentially imposes an obligation to bear the liability. Mindful of the above, the Tax Tribunal held that the issuance of a comfort letter meets the criteria for international transactions under section 92B of the IT Act.

It is clear from a harmonious reading of these recent rulings as well as the guidance mentioned above that it is critical to evaluate the specific facts and circumstances involved around the issuance of comfort/ support letters. Focus should be drawn on such facts which throw light on the actual conduct and intent of the parties as to whether the guarantee is explicit or implicit.

Mere nomenclature of the instrument, i.e., “corporate guarantee” or “letter of comfort/ support,” etc. ought not to be solely determinative of the nature of the arrangement.  Having said which, wording the instrument accurately could raise fewer questions.

Therefore, whether a compensation is warranted for the issuance of a comfort letter needs to be determined after carefully considering the factual parameters involved in each individual case, and bearing in mind the principle that the provision of explicit support calls for charging a consideration whereas furnishing implicit support does not entail charging a consideration.