Interest on Continuing Debit Balance– Notional or Real!

Introduction

Over the years since the introduction of the Indian Transfer pricing regulations, the transfer pricing audits based on the experience and learnings gained have seen numerous interpretations of the provisions, thereby leading to transfer pricing adjustments. The Indian transfer pricing litigation scenario has seen the trend of adjustments shifting from mere dispute on comparable companies to larger issues such as location savings, management cross charges, intangibles, share valuations, business restructuring, etc.

One such issue being the continuing debit balance in the financials of multinational companies(MNC). Globally due to the financial exigencies, the MNCs often commercially require to defer the payables / receivables. The continuing debit balance / receivables have been treated by the tax authorities as an international transaction and thereby sought to impute arm's length interest on receivables outstanding from the associated enterprise (AE) that were not realized within the credit period.

The Section 92B of the Indian transfer pricing regulations provides the coverage of the transactions that could be treated as international transaction. Vide Finance Act 2012, a clarificatory Explanation was inserted with retrospective effect from 1 April 2002. By virtue of the said Explanation, inter alia the expression 'international transaction' included capital financing such as any type of long-term or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type o

f advance, payments or deferred payment or receivable or any other debt arising during the course of business.

In spite of the clarification being provided, the question whether the continuing debit balance is an international transaction or not has been contested by both the Assessee and the Revenue. In this relation, various judicial rulings have held in favour of the Assesseethat the continuing debit balance is not an international transaction and that there is no legal justification for imputing notional interest when there is no real income arising in the hands of the Assessee. Though, the clarificatory Explanation has as such over-ruled the said rulings which held that outstanding receivables is not an international transaction, there are some of the following instances of favorable rulings which were pronounced after April 2012 (even though pertaining to assessment year prior to April 2012):

(a)		Indo American Jewellery Ltd - The Bombay HC held that if there is complete uniformity in the act of the taxpayer in not charging interest from both the AE and the non AE and the delay in realization of the export proceeds in both the scenarios is the same, then no notional interest should be charged on delayed receipts of the export proceeds.
(b)		Evonik Degussa India P. Ltd. - The Mumbai ITAT held that the TP adjustment cannot be made on hypothetical and notional basis until and unless there is some material on record that there has been under charging of real income.
(c)		Gold Star - The Mumbai ITAT held that allowing credit period to the AE for realization of the sale proceeds is not a separate international transaction but is intrinsically linked to the sale transaction to the AE.
(d)		Kusum Healthcare (P) Ltd v ACIT - The Delhi ITAT held that where the transaction with the AEs earns higher margins as compared to the comparable companies, then such high margins compensates for credit period extended to the AEs and accordingly no adjustment is required.

Yet again, in the recently adjudicated ruling by the Mumbai Tribunal in the case of Rusabh Diamonds, it has been held that outstanding receivables is not an international transaction and also as long as the sales are benchmarked on Transaction Net Margin Method ('TNMM'), there cannot be any occasion to make a separate adjustment for delay in realization of outstanding receivables. This ruling provides the much needed clarity for taxpayers on the effect of the explanation to section 92B inserted by Finance Act, 2012, that is, whether the effect is retrospective or prospective and it also provided certain guidance post 1 April 2012.