The dividend distributed by CFC to CAHPL was exempt in the hands of CAHPL under Australian tax laws and the dividend earned by CAHPL was redistributed to CVX, the ultimate holding company. CAHPL also claimed deduction for the interest paid to CFC.
The transfer pricing addition was made by the ATO in respect of interest paid by CAHPL to CFC. The ATO made TP additions by reducing the amount of interest claimed by CAHPL under division 13 (Section 136 AD read with Section 136AA of the Australian Income Tax Assessment Act 1936 (ITAA 1936) and sub-division 815-A of the ITAA 1997 for the tax year 2004 to 2008)
ARGUMENTS BY BOTH SIDES
CAHPL’s case was that the arm’s length principle, as mandated under division 13 of the ITAA 1936, requires a comparison of arm’s length consideration with actual consideration. In other words what had to be priced was a loan taken by CAHPL without security and financial and operational covenants from a commercial lender. CAHPL emphasized that the case required pricing the loan it obtained on those terms and upon the hypothesis of CAHPL’s stand-alone credit worthiness.
The ATO’s arguments centered around the interpretation of “arm’s length consideration” and “arm’s length conditions” in Division 13 and Sub-division 815-A of the ITAA 1936 and ITAA 1997 respectively. The crux of ATO’s argument was that terms and contract of the Credit Facility arrangement between CFC and CAHPL was such that an enterprise in the circumstances similar to CAHPL entering into contract with another entity, independent of each other but not necessarily independent of similar affiliation as CAHPL, would not have entered into same type of loan arrangement and, therefore, the rate of interest paid to CFC was not at arm’s length. Arm’s length consideration as defined in Section 136 AA read with operative section 136 AD did not necessarily require the tax payer (CAHPL in the case) to be one of the transacting entity. Instead the law permitted considering a hypothetical borrower under the similar situation as CAHPL (which may not necessarily be CAHPL) from a hypothetical lender.
While building its arguments on unrealistic loan arrangement, the ATO focused on the lack of operational and financial covenant and the lack of parental guarantee. The ATO believed that the definition of “arm’s length considerations” in section 136AD(3)(d) of the ITAA1936 is broad enough to consider the absence or otherwise of such financial and operational covenants and parental guarantee. In terms of the ATO, the interest rate charged from CAHPL by CFC would have been substantially lower had the loan arrangement been on an arm’s length.
INITIAL FEDERAL COURT OF AUSTRALIA (FCA) RULING - OCTOBER 2015
The FCA held that the expression “arm’s length consideration”, in the context of loan, is not limited to the interest rate paid but it also takes into consideration the presence or otherwise of the financial and operational covenants, parental guarantee etc.
As CAHPL did not give the security and operational and financial covenants which independent parties dealing at arm’s length would have provided, the absence of which contributed to the higher interest rate actually charged.
The FCA also clarified that hypothesizing the agreement akin to one entered into between CAHPL and CFC along with adding/deleting the real-life attributes, does tantamount to re-characterization. Instead it facilitates in determining what the arm’s length consideration between independent parties would have been for the loan acquired.
The FCA seemed to have agreed, in principle, that the implicit support of the group parent should be considered as one of the comparability factors and may not be excluded on the premise that arm’s length principle requires the parties to be independent. The FCA’s position on parental affiliation or implicit support was generally consistent with the findings in the General Electric Capital case in Canada where the concept of implicit support was also confirmed. It clarified that being independent does not require commercial circumstances to be ignored. Any improvement in credit worthiness due to parental support, even implicit, is a factor that should not be ignored. The reasoning for this is that commercial lender, in real world, do take into account these factors while determining the rate of interest. However, the Court also accepted, based on the evidence and cross examination of expert witness on record, that in the absence of a legally binding parental guarantee, implicit credit support had very little impact on pricing by a commercial lender in the real world.
The revenue had also argued that even if division 13 fails for procedural reasons (there was technical defect in TP assessment in terms of level of authority required for assessment) Article 9 of the treaty between Australia and USA would still reach the same conclusion as division 13. FCA held against the revenue that article 9 of the treaty cannot operate on its own unless there is a domestic charging section. However, this conclusion did not rescue CAHPL for the reason that FCA did not strike down the assessment on procedural ground.
RECENT FULL FEDERAL COURT OF AUSTRALIA RULING - APRIL 2017
Aggrieved by the order of FCA, CAHPL appealed to the full bench of federal court. The Full Court agreed with the conclusions reached by the FCA.
The Full Court specifically held, relying on full federal court decision in SNF Australian case, that determination of “arm’s length consideration”, as defined in Section 136AA, does not necessarily require that one party necessarily has to be taxpayer (CAHPL in the case). The implication of this is that this offers flexibility to hypothesise the agreement, as closely as possible to the real-world situation. This obviously facilitates the determination of arm’s length consideration in terms of definition provided in Section 136AA of the ITAA 1936. In respect of the meaning of “independence”, FCA held that being independent does not require CAHPL to be considered as “orphan”. Doing this would mean undermining the reality and actual situation of taxpayer.
CRTICAL ANALYSIS & KEY ASPECTS OF FULL FEDERAL COURT RULING
While the ruling has explained the meaning of “arm’s length consideration” and “arm’s length conditions” and discusses several connected concepts such as role of implicit support, re-characterization, dependence of Article 9 of the treaty on domestic legislation, few issues need further critical analysis:
Section D of the Chapter 1 of the OECD TP guidelines, dealing with arm’s length principle has been completely revised by BEPS Action 8-10. In respect of re-characterization it mentions at Para 1.123 that “mere fact that transactions may not be seen between independent parties does not mean that the arrangement lacks the arm’s length characteristics.” As can be seen in the present ruling that none of the third-party loan agreement presented by both the respondent and the appellant were considered as comparable and thus were rejected. Adding/deleting the terms of contract from the actual contract, even partially, may be classified as re-characterization. Further, Section 815-A of ITAA1997 was revised in 2012 retrospectively from 2004 to include the reference of OECD TP guideline 2010 as source for interpreting the domestic TP provisions. The reason for not classifying the imputation of arm’s length conditions in the category of recharacterization may be due to the nuanced interpretation of arm’s length consideration. Even otherwise, the OECD TP guidelines, 2010 also recommended re-characterization in situation when the arrangement, as a whole, impedes the arm’s length computation. The fact that OECD guidelines 2010 as well as revised chapter 1 of the OECD TP guidelines under BEPS Action plan 8-10 emphasizes that re-characterisation route may be resorted only under exceptional circumstances, the facts in the present case reveals that terms of the interest for CAHPL was unsustainable. Had the facts in the present case did not reveal so, the conclusion of this decision might have been totally different.
Under the facts of the present case (CVX having parental relation with both CAHPL and CFC), the Court came to the conclusion that parental affiliation is an important comparability factors. The conclusion was that while arm’s length principle required the relationship between CAHPL and CFC as independent of each other but the inescapable fact that CAHPL was a part of group having CVX as parent needed to be considered as comparability factor. Arm’s length principle did not require that CAHPL be considered as “orphan”. However, whether the same conclusion can be drawn if the loan providing and loan recipient were to be the only entities in the group and had holding and subsidiary relation. The answer seems no as in that scenario the relationship between the two entities needed to haven been hypothesized as independent and this exclusion of relationship would have excluded the parental support as comparability factor.
RELEVANCE AND INDIAN CONTEXT
Let us now evaluate as to how the idea of “arm’s length consideration” takes shape under the Indian TP regime. Section 92 of the Income-Tax Act,1961 (the Act) provides that income arising from international transactions shall be computed having regard to arm’s length price.
Further, arm’s length price is defined in Section 92F(ii) of the Act as the price which is applied or proposed to be applied in a transaction between unrelated entities in uncontrolled conditions. As against this, Section 136AA(3)(c)/(d) of the ITAA 1936 defines arm’s length consideration to include even hypothetical consideration between unrelated parties dealing at arm’s length. The concept of arm’s length principle under ITAA 1936 involves a suppressed premise or assumption that, in the real world, commercial parties could enter into transaction such that an arm’s length consideration can be hypothesized. Based on the judgement of the Full Court, it can be said that in the Hon’ble Judges’ view the definition of “ arm’s length consideration”, as mandated in the ITAA 1936, provides the flexibility to tweak/change the terms of the actual agreement, of course only under compelling facts to do so, to facilitate the arm’s length consideration.
The question is does the definition of “arm’s length price”, as mandated under Indian TP legislation provides such a flexibility? Alternatively, the moot question is can the expression “uncontrolled conditions” be considered as same as “dealing at arm’s length”. In order to answer this moot question, let us analyse Rule 10B of the Income-Tax Rules, 1962 (the Rule) which explains the very process of determining the arm’s length price. Rule 10B(1) explains the methods of determining arm’s length price. The central theme of the methods under Rule 10B(1) is “comparability” of the uncontrolled transactions. Further, Rule 10B(2) of the Rule, mentions the factors of comparability and Rule 10B(3) of the Rule mentions that in order for the uncontrolled transaction to be comparable, none of the differences, if any, between the transactions being compared or between the entities entering into such transactions are likely to materially affect the price, cost or profit as the case may be.
A harmonious and wholesome reading of Section 92 read with 92F(ii) and Rule 10B(1) through Rule 10B(3) requires that one of the entities for comparability necessarily has to be taxpayer preventing the scope of hypothesizing the actual transaction. The above TP provision provides that arm’s length price will be the price fetched by an uncontrolled entity having FAR, terms and condition, product and service characteristic, market condition etc. same/similar to taxpayer. It does not offer the liberty to modify the terms and conditions in the actual agreements entered into by the taxpayer even on deserving cases as explained in the Full Court ruling. Therefore, it may be concluded that Indian TP legislation as it stands today is defines “arm’s length consideration” narrowly as compared to its erstwhile Australian counterpart defined in Section 136AA(3)(d)/(c) of the ITAA 1936.
Article 9 of the tax treaty which India has entered into with several counties is similar to OECD Model convention. The authoritative statement on arm’s length principle contained in Article 9 provides a much wider and flexible definition of arm’s length consideration. However, unless there is specific provision mandated in the Act, interpretation which is more beneficial to the taxpayer will have to be applied as is a settled principle that, in general, treaty provision cannot be used as creating a tax lability.
It is more than a decade now since the first transfer pricing case was decided by Tribunal in Aztec Software. Since then there have been more than 1500 cases decided by Tribunals as well as Courts now. However, the interpretation on arm’s length principle has never been the core issue in any transfer pricing rulings in India. Besides a passing reference in Nimbus communication case the issue passive benefit, and few other connected and crucial issues in respect of arm’s length principle have not found its ways in Indian jurisprudence.
Comparability, which is at the heart of arm’s length principle, has been the subject of consideration in several cases but the level of analysis has been restricted to broad product/service and functional comparability and to some extent FAR comparability. Although the number of transfer pricing cases in USA, UK, Canada, Australia and other western nations have been very few, interpretation of “arm’s length principle” almost always, at least in landmark and big ticket cases, becomes the corner stone of the judgement. Given the level of focus and nuanced interpretation of arm’s length principle in the developed jurisdiction including Australia, the Indian jurisprudence, barring a few cases, may sometime look vague and superficial. Interpretation of arm’s length principle and related issues like implicit/passive association, options realistically available, price setting vs. price testing have yet not arrived at the Indian Courts. In fact the notion of implicit support may favour the revenue authorities of net capital importing country like India and the Indian authority may pick up these arguments sooner or later.
A point worth mentioning is that the loan arrangement between CFC and CAHPL could have come under scrutiny under Australian GAAR provision (Part IV A of the Australian ITAA 1936) as the sole purpose of the arrangement was to take tax benefit and would possibly have failed commercial purpose test as well .While Indian GAAR covers cases where the arrangement creates rights or obligations which are not ordinarily created between persons dealing at arm’s length, its practical implementation is yet to be experienced and there is nothing in the GAAR which touches aspect like implicit support.
Given the Government of India’s stand on most of the aspects of BEPS Action 8-10 and GAAR provisions covering transaction lacking commercial rational, taxpayers in India should evaluate its international transactions and structures which meets substance and commercial rational test and not leave the matters exposed to uncertainty in the interpretation of arm’s length principle.