SEPTEMBER 05, 2015

By Subhashree R & Tapas Mishra

P.G.WODEHOUSE uses the words 'act of disinterested kindness' to denote a favour done with no expectation of returns by an unknown (non AE) person. If by such act the third party is part of an arrangement - without this being a concerted action - which may result in a benefit to AE, will such third party become an AE?

Transfer pricing (TP) provisions apply to 'international transactions'. The two requirements of international transaction are that there must be a transaction between associated enterprises and either or both parties should be non-residents. Section 92B(2) was amended by Finance (No 2) Act, 2014 w.e.f 1.4.2015 to deem even a transaction between an enterprise and a non-associated enterprise (third party) as an 'international transaction' if the terms of that transaction were determined by a prior agreement between that third party and an associated enterprise. What would be the position under Section 92B(2) as it stood prior to this amendment?

This question was examined and answered by ITAT Bangalore Bench vide Order dated 08.05.2015 in Novo Nordisk India v. DCIT - 2015-TII-233-ITAT-BANG-TP, in a matter involving two resident non-related entities and one (related) non-resident entity. In that case, pertaining to AY 2009-10, the ITAT opined that a transaction with third party, which is in substance a transaction between AEs, will be subject to transfer pricing regulations. The amendatory words, as inserted by Finance Act 2014, were held to have been added only by way of abundant caution.

The transaction and the dispute

The resident unrelated enterprise (third party) purchased raw material, namely insulin in crystal form, from the overseas entity (Novo Nordisk Denmark) related to the assessee (Novo Nordisk India) and after manufacturing insulin formulations as per specification of, and using know how supplied by the overseas entity, sold them to the assessee at rates fixed by the overseas entity. There were thus two limbs to the transactions; (i) sale of raw material by Novo Nordisk Denmark to the third party, and (ii) sale of manufactured products by the third party to the assesse.

The department emphasised on reading the agreements between the third party manufacturer and the overseas entity, those between the assessee and the manufacturer and those between the AEs, together. It argued that since one non-resident entity was involved, the ingredients for international transactions were satisfied. Further it pointed out that transaction included arrangement or action in concert. Interestingly, even the assessee's TP Study Report recognized the arrangements between the three parties as international transactions.

Interposing a third party

An arrangement whereby a foreign investor gets a third party to manufacture goods as per specification /standards for which he supplies raw material, knowhow, etc., is quite a common arrangement. It need not flow from a prior agreement between parties. It would not be unusual for the investor to have an entity taking care of distribution/sale etc. The decision suggests that even though the non-related party may have negotiated the price of material it imports and sells the manufactured product at a pre-determined margin to the resident AE, the revenue authorities would be quite within their power to question the same. The foreign investor could of course argue that the business model is decided by ease of operations, necessity for quality control etc, rather than Chapter X of Income Tax Act, 1961.

The ITAT observed that the arrangement was a concerted action with an intention to escape the provisions of Section 92B of the Income-tax Act, 1961. The ITAT's reading of the relevant provisions proceeded from the effect of the transactions namely escapement of income when the overseas AE sells the raw material to the Indian manufacturer and it held that that the resident intermediary was interposed only to avoid TP regulations. Of course in the instant case, the agreements referred to each other. However, even assuming that one or more of them did not refer to each other, if the concept of control over the third party's action can be used to gauge substance of the transactions, when the agreements are read together, it would appear that rigours of TP was the foremost concern of the parties.

Deemed international transaction

'Amendment to Section 92B(2) by Finance Act, 2014 was inserted only by way of abundant caution' -ITAT, Bangalore

Prior to its amendment, Section 92B(2) provided that where there was a transaction between an enterprise and a third party which as per terms influenced by a prior agreement between the third party and an associated enterprise, that transaction would be deemed to be one between associated enterprises. Once it was a deemed transaction between associated enterprises, and one of them was a non-resident, Section 92B(1) got attracted and that transaction could be an international transaction. But this interpretation (which found favour with the Tribunal in Novo Nordisk case), was questioned by some assesses who argued that once a transaction was out of section 92B(1), a deeming fiction of section 92B(2) would not bring it back to sub-section (1). That prompted the amendment to sub-section (2).

In Novo Nordisk , the Tribunal observed that there was no need to look into the provisions relating to deemed transaction between AEs [Section 92 B (2)] or the definition of AE under Section 92A(2). The ITAT's test of substance of a transaction means that it would be open for the revenue authorities to question transactions which have the effect of conferring a benefit on an AE though by itself the transaction may be at arm's length or not within the ambit of 'international transaction'.

The deeming provision, treating a transaction between non-associated enterprises as a transaction between AE if there existed a prior agreement, will not apply to a transaction concluded between (resident) subsidiaries of two different entities though the sale within India is in pursuance of a global agreement, since the domestic transaction was concluded by the resident entities on their own terms and as such there was no prior agreement having any bearing on profits.. This was the opinion of ITAT, Mumbai in Kodak India P ltd v. ACIT - 2013-TII-87-ITAT-MUM-TP.

The ITAT in the instant case has opined that even without the amendment to Section 92B (effective 1-4-2015) transactions between non-AEs where third party is a resident can be brought within the ambit of TP provisions. While this may not invite a TP adjustment, it does involve additional compliance burden and is to be factored into cost and pricing arrangements.

'Action in concert'

Another interesting aspect of the Novo Nordisk decision is the definition of transaction - as per Section 92F(v) which the revenue authorities relied upon to state that when viewed together, various agreements pertaining to the chain of transactions from import of raw material till it is sold by the resident AE would be 'action in concert'.

International transaction between residents

In the instant case, the set of transactions whereby the resident manufacturer sold the goods manufactured to the resident AE, was held to be a domestic transaction. The Tribunal held that since each entity was assessed to tax in India on the income earned by it, there was no erosion of tax base and there was no need to examine the ALP of the transaction. However, in the earlier paragraphs the Tribunal seems to have accepted the Revenue's argument that the non-related resident is a captive contract manufacturer who is controlled by the resident AE. If the entire transaction chain is to be seen together and the third party is merely a controlled intermediary, transaction between the third party and the resident AE may not be at arm's length. Post amendment by Finance (No.2) Act, 2014, this limb of the transaction will be regarded as an international transaction.

The Tribunal has held that the requirement of Section 92B (1) on international transaction has been satisfied since there is one non-resident who is transacting with an AE though there is a non-related intermediary. It also observed that ' the concept of transaction between two residents who are associated enterprises being regarded as an international transaction was implicit in the scheme of Transfer Pricing provisions in India, if it impacted or eroded tax base '.

While agreeing with the decision of the Tribunal, in our view this observation appears to be not correct. Prior to amendment, section 92B (2) stipulated that a transaction between two unrelated parties could be regarded as one between two AEs if one of the parties had a prior agreement with an AE of the other party and if that agreement had an effect on this transaction. Once this transaction got deemed to be one between AEs, section 92B(1) came into force and if one of these two unrelated parties was a non resident, the transaction became an international transaction.

Post amendment, in the transaction contemplated above, if either or both AEs are non residents, then irrespective of whether the non related party is a non-resident or not, the transaction will be deemed to be an international transaction. As a result, in the facts of Novo Nordisk case, the transaction between Novo Nordisk India and the Indian manufacturer, which was correctly held by the Tribunal as not being an international transaction in that year, will become a deemed international transaction with effect from 1.4.2015. The amendment, while seeking to clarify the legislative intent, has expanded the scope of 'international transaction'.

[The authors are associated with Lakshmikumaran & Sridharan, New Delhi. The views expressed in this article are personal]