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TRANSFER PRICING
to guarantee transactions:
I
n recent times, amongst various other things, the applicability
of Indian Transfer Pricing (TP) Regulations to certain pinpointed
transactions has been a subject-matter of noteworthy debate. In
this context, provision of guarantee calls for specific mention. Herein,
the issue not only hovers around applicability of TP Regulations to
guarantee transactions, rather, the benchmarking approach to be so
adopted (post applicability of TP Regulations) has also germinated
a lot of additional controversies. A major factor contributing to this
situation is the lack of adequate guidance within Indian TP Regulations
and international literature vis-à-vis determination of arm’s length
price in such circumstances.
Given the aforesaid background, the endeavour of this article is to
analyse certain interesting and insightful Indian judicial precedents
pronounced in the context of guarantee transactions.
1. TYPES OF GUARANTEE
Multinational companies (MNCs), in the normal course of their
business, provide guarantee on behalf of their subsidiaries and other
related entities. The types of guarantee typically seen in such intra-
group cases include ‘corporate guarantee’, ‘performance guarantee’
and ‘credit guarantee’.
Corporate guarantee is extended to banks on behalf of the borrower.
It enables the borrower to avail funds where it is either not able to
get a loan or is unable to get it at a cheap/competitive interest rate.
Corporate guarantees can either be ‘explicit’ or ‘implicit’. Explicit
guarantees are those where there is an explicit arrangement between
the bank and the guarantor. Implicit guarantees are those where, being
* Shuchi Ray, Director, Deloitte Touche Tohmatsu India Private Limited
** Riddhi Shah, Manager, Deloitte Haskins & Sells LLP.
- Information for the editor for reference purposes only
Shuchi Ray*
Riddhi Shah**

2. 421INTERNATIONAL TAXATION VOL. 10 MAY 2014 69
part of a multi-national group, it becomes possible
to secure a loan or negotiate favourable terms
for the same (which a borrower might not have
been able to obtain as an independent entity).
Performance guarantee is extended on behalf of
the seller to cover costs (if any) incurred by the
buyer where services or goods are not provided
as contractually pre-agreed. Such guarantee
agreements detail the level of commitment and
extent of future responsibility.
Credit guarantee is provided to secure the
interests of a seller in case of non-payment
by a buyer. This type of guarantee affords the
seller a fair degree of protection to the effect
that payment will be received from the buyer.
2. HOW THE INDIAN TP ENVIRONMENT HAS
SHAPED UP SO FAR
The above guarantee transactions (especially
corporate guarantees) have resulted in significant
TP litigation in India so far. Today, contradictory
views exist on whether corporate guarantee
should be treated as an international transaction
or not.
One of the first decisions on corporate guarantee
was pronounced in 2011 by the Hyderabad
Tribunal in the case of Four Soft Limited
pertaining to assessment year (AY) 2006-071
.
In the said case, the Hyderabad Tribunal held
that the corporate guarantee provided by the
taxpayer does not fall within the definition
of the term ‘international transaction’. It also
held that TP legislation does not stipulate
any specific guidelines in respect of such
transactions. Accordingly, in the absence of any
charging provision, it would be incorrect to
bring this transaction within TP ambit. Further,
the Hyderabad Tribunal also observed that the
corporate guarantee is incidental to the taxpayer’s
business, and hence, it cannot be compared with
guarantee transactions undertaken by banks/
financial institutions.
This decision was a temporary breather for
all those Indian taxpayers who had guarantee
transactions with their associated enterprises
(AEs).
Later however, there was a retrospective amendment
(vide Finance Act, 2012) to the definition of the
term ‘international transaction’ as provided in
section 92B of the Income-tax Act, 1961 (the
Act). Pursuant to the same, an explanation was
added to the primary definition of the term
‘international transaction’ to include tangible/
intangible property and services, intragroup
financing (including corporate guarantee) and
business restructuring. Consequentially, this
amendment nullified the judgment of the Hyderabad
Tribunal. Further thereto, a revised format of
Form No. 3CEB was notified, and this required
a specific mention of guarantee transactions in
clause 15 of the said form. Further, in 2013,
the Central Board of Direct Taxes notified Safe
Harbour Rules whereby specific rates were
prescribed for corporate guarantees extended
to subsidiaries outside India. In view of all
of the above, it has been clearly established
that revenue authorities do consider provision
of guarantee as an ‘international transaction’.
3. BHARTI AIRTEL’s CASE
However recently, the Delhi Tribunal, in the
case of Bharti Airtel Ltd. v. Addl. CIT [2014]
43 taxmann.com 150, has held that issuance
of corporate guarantee is not an ‘international
transaction’ under section 92B of the Act since
the transaction does not have any bearing on
profits, income, losses or assets of the enterprise.
While passing this judgment, the Tribunal
analysed the definition of the term ‘international
transaction’, amended retrospectively vide Finance
Act, 2012. The below paragraphs capture the
basis of the said judgment.
Bharti Airtel, an Indian taxpayer, had issued
a corporate guarantee to an Indian bank on
behalf of its foreign subsidiary (i.e. its AE).
Further, it did not charge any guarantee fee
from its AE on the premise that firstly it was a
shareholder’s activity, and secondly, it did not
incur any cost or expense for providing the said
guarantee. However, in its TP documentation
study, Bharti Airtel determined 0.65 per cent
as the arm’s length guarantee fee (based on a
market quote for such corporate guarantee), and
offered such notional income to tax.
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During the TP audit, the Transfer Pricing
officer (TPO), relying on the Organization
for Economic Cooperation and Development
(OECD) guidelines, held that the taxpayer had
provided an intra-group service to its AE by
issuing the corporate guarantee. This in turn
led to enhancement of the credit rating of the
AE. The TPO then benchmarked the transaction
by applying the Comparable Uncontrolled Price
(CUP) method and determined the arm’s length
price of the guarantee fee income at the rate
of 2.68 per cent plus a mark-up of 200 basis
points. The TPO also relied on the landmark
ruling of the Tax Court of Canada in the case
of GE Capital Canada Inc. v. Queen 2009 TCC
563. Accordingly, a TP adjustment was made
with respect to the differential guarantee fee.
The Tribunal analyzed the definition of the
term ‘international transaction’ provided in
the Indian TP Regulations. It observed that
under the scheme of the Act, any transaction
(including capital financing, guarantees and
business restructuring/reorganization) can be
regarded as an ‘international transaction’ only if
such a transaction has a bearing on the profits,
income, losses or assets of an enterprise (either
immediately or in future). The Tribunal further
noted that the corporate guarantees issued by
the taxpayer to the bank on behalf of its AE
do not have any impact on the profits, income,
losses or assets of the taxpayer. It also observed
that the AE had not taken any borrowing from
the bank based on the taxpayer’s guarantee.
Further, the Tribunal distinguished between
certainty and contingency of the impact. It noted
that when a taxpayer extends any assistance to
its AE without incurring any expenditure for
which the taxpayer otherwise also would not
have realized any income by rendering it to
any third party, such assistance cannot be said
to have any bearing on profits, income, losses
or assets of the taxpayer. Hence, as a corollary,
it cannot be regarded as an ‘international
transaction’.
4. FOUR SOFT’s CASE
After Bharti Airtel’s case, there has been a
recent pronouncement again by the Hyderabad
Tribunal in the case of Four Soft (P.) Ltd. (AY
2007-08)2
wherein it has been held that the arm’s
length price of the corporate guarantee under
consideration has to be specifically determined
since the transaction falls within the scope and
ambit of the term ‘international transaction’
(post the retrospective amendment to section
92B of the Act).
Four Soft, an Indian taxpayer, had provided a
corporate guarantee to a third party bank on
behalf of its foreign subsidiary. Four Soft did
not charge any guarantee fee for provision of
the same. During the audit proceedings, the
TPO imputed a TP adjustment of 3.75 per
cent, this being determined as the arm’s length
guarantee fee. The TPO determined this rate
based on the commission charged by the third
party bank for providing a bank guarantee
to its customers. The taxpayer relied on the
Tribunal’s ruling in its own case for an earlier
year contending that the provision of guarantee
is not an ‘international transaction’ pursuant to
Indian TP provisions.
The Tribunal held that the corporate guarantee
provided by the taxpayer to its foreign subsidiary
does fall within the ambit of the term ‘international
transaction’ post the retrospective amendment
brought about (to the definition) vide Finance
Act, 2012. However, as regards pricing the
guarantee, the Tribunal observed that a bank
guarantee cannot be used as a comparable
benchmark for a corporate guarantee provided by
a group company. Accordingly, the matter was
remanded back to the TPO for determination of
arm’s length price of the corporate guarantee.
While the interpretation of the Tribunal vis-à-vis
definition of the term ‘international transaction’
in the case of Bharti Airtel has triggered a
debate as regards applicability of TP provisions
to such transactions, one needs to bear in mind
that the Tribunal has held that the guarantee
transaction under consideration is not covered
under the definition based on the specific facts
of the case. A notable fact in the said case
was that the AE had not taken any loans from
the third party bank based on the taxpayer’s
guarantee.
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5. INTERNATIONAL GUIDANCE
Amidst all the controversies specific to interpretation
of the term ‘international transaction’ and
coverage of guarantees, the applicability of
Indian TP to guarantee transactions based on
internationally acceptable TP principles also
needs to be duly analysed.
The two most important aspects that need to
be considered in guarantee transactions are–
(1) Benefits received by the borrower; and
(2) Risks undertaken by the guarantor.
These two aspects vary depending upon the
arrangement between the parties, viz. -
5.1 Explicit guarantee arrangement
Under a corporate guarantee, the guarantor
actually ‘lends’ its higher credit rating to
the borrower which enables the borrower to
borrow funds at cheaper rate. Accordingly, if
the borrower receives any benefit, it should pay
an arm’s length commission to the guarantor
to the extent of the benefit enjoyed by it. The
OECD guidelines mention that an intra-group
service is rendered when a service provided
by one group member to another endows the
beneficiary of the service with economic or
commercial value to enhance its position.
5.2 Passive association
If merely due to an entity’ affiliation to an
MNC group, the credit quality of the entity
is perceived to be higher than what it would
have been for this entity on a standalone basis
(i.e. without considering the group support),
then such group support could be perceived as
‘passive association’. This view finds place in
OECD guidelines as well. Issuance of comfort
letter may be considered as an example -
where the guarantor would never be under an
obligation to pay. Such a situation may not be
considered as a service provided by the MNC
group to its group entity. In this case, even
the benefit of a lower interest rate enjoyed by
the group entity owing to its perceived higher
credit quality may not be considered as a direct
benefit, and therefore, no guarantee commission
may be required.
5.3 Shareholder’s activity
In certain situations, provision of guarantee
could also be perceived as shareholder’s activity.
In such a case, the activity is not one where
a charge can be justified. The following two
elements (as mentioned in the OECD guidelines)
may be kept in perspective while determining
as to whether rendition of such a service may
be considered as shareholder’s activity or not:
From the perspective of the beneficiary, a
shareholder’s service is one for which it
would not have been willing to pay an
independent party; and
From the perspective of the provider of
the service, it is an activity performed
solely because of ownership interest.
While analyzing the above, one needs to examine
the purpose for which the guarantee has
been provided, purpose for which funds have
been utilized (in case of corporate guarantee),
circumstances of the beneficiary company at the
time of availing the guarantee, future benefits
to the service provider, future conduct of both
the companies, etc.
The ATO3
guidance paper on intra-group finance
guarantees and loans provides that when a
guarantee substitutes for the investment of
equity needed to allow a subsidiary to be self-
sufficient and raise the debt funding it needs,
the costs of the guarantee (and the associated
risk) should remain with the parent company
providing the guarantee.
6. BENCHMARKING OF GUARANTEE TRANSACTIONS
Keeping all of the above in hindsight, in case
where a company provides an explicit guarantee
on behalf of its related entity, it is exposed to the
risk of default. Under transfer pricing principles,
there should be an appropriate remuneration
compensating an entity for the risks arising
from business activities which are borne by
it. Therefore, an arm’s length commission is
required to compensate the guarantor for the
risks assumed by it.
The literature/guidance that prescribes or defines
methods/approaches for benchmarking guarantee
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fees is limited. TPOs in India have been using
guarantee commission charged by banks as a
benchmark for corporate guarantees without
considering germane factors such as risk profile
and financial position of the borrower, terms
of the guarantee, securities involved and the
underlying loan amount.
There have been various Tribunal rulings like
Four Soft Ltd. (supra), Glenmark Pharmaceuticals
Ltd. v. Addl. CIT [2014] 43 taxmann.com 191
(Mum.), Asian Paints Ltd. v. CIT [IT Appeal No.
408 (Mum.) of 2010, dated 31-10-2011], Everest
Kanto Cylinders Ltd. v. Dy. CIT (LTU) [2013] 34
taxmann.com 19 (Mum.) and Reliance Industries
Ltd. v. Addl. CIT [IT Appeal No. 4475 (Mum.) of
2011, dated 13-9-2013] where the use of naked
bank quotes as external comparables was rejected.
In the case of Glenmark Pharmaceuticals Ltd.,
the Mumbai Tribunal has differentiated between
bank guarantees and corporate guarantees. The
Tribunal observed that bank guarantees are
issued by banks in the general course of their
business while a corporate guarantee is provided
in order to support the financial health of an AE
from a long term perspective. The commercial
considerations in the two cases differ, and hence,
the Tribunal ruled that they are not comparable
unless appropriate adjustments are made.
Although there have been quite a few judicial
precedents which have rejected naked bank
quotes as a comparable for guarantee transactions,
they have refrained from having any discussion
whatsoever on internationally applied approaches
for benchmarking guarantee transactions. The
ruling by the Tax Court of Canada in the
case of GE Capital Canada has subscribed to
the interest saved approach for benchmarking
such transactions. This approach has been
duly recognized in the Rangachary Committee
report on Safe Harbour. Another approach for
benchmarking guarantee transactions is the risk
of loss approach. These scientific approaches are
certainly more apt and better justified when
compared with naked bank quotes. Further, they
are also internationally accepted benchmarking
methodologies.
7. CONCLUSION
Due to the abovementioned uncertainties,
the coverage of guarantee transactions under
the Indian TP regulations would depend on
the facts and circumstances of each case. Of
course, given the penal and other consequences
relating to disclosure requirements, it would be
imperative to ensure that robust documentation
is maintained (qua guarantee transactions)
capturing all the facts and positions so adopted.
While one unambiguously understands that
there are more acceptable ways and means
of benchmarking guarantee transactions in
line with robust international guidance, very
little has been done so far to put them into
due practice vis-à-vis Indian TP Regulations.
Further, the benchmarking should be carried
out judiciously post a detailed analysis and
duly backed by substantive facts.
Goes without saying, one would earnestly
hope that Tribunals, High Courts and the
Apex Court of India dive deeper and take into
consideration internationally accepted principles
and guidance available while adjudicating on
cases involving determination of arm’s length
price of guarantee transactions. This should
help the Indian TP interpretation on the concept
of corporate guarantee mature in line with
international standards.
฀
1. ITA No.1495/Hyd/2010(The Tribunal is a second level appellate authority, as also the final fact finding authority in the appellate chain.)
2. ITA No.1903/Hyd/2011
3. Australian Taxation Office
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TRANSFER PRICING
Benchmarking - Some Relief in Sight
T
he Indian Transfer Pricing Regime was introduced with the
intention of curbing the practice of avoidance of tax by the
foreign companies in India. However, in the recent times it
can be viewed that the instant economic exercise has lead to tedious
and prolonged tax litigations.
The very recent judgment by the Hon’ble Gujarat High Court in
the case of Adani Wilmar Ltd.1
(‘The company’) has gone into the
intricacies of the aspect of use of some third party quotations for
benchmarking transactions with associated enterprises (‘AE’)/inter-
company transactions.
As stated in the reported judgment the company is engaged in the
business of manufacturing, refining and trading of edible oils. In financial
year 2002-03, the company entered into an international transaction
for purchase of edible oil with one of its AE. For benchmarking
the transaction and determination of Arm’s Length Price (‘ALP’) the
company adopted Comparable Uncontrollable Price (‘CUP’) as the
most appropriate method and considered the mean of quotations
from Malaysia Palm Oil Board (‘MPOB’) and Oil World as the CUP.
During the Transfer Pricing Assessment, the Transfer Pricing Officer
(‘TPO’) rejected the quotation from Oil World on the grounds that the
same, not being a statutory authority and an independent organization
registered in Germany has no connection with the oil prices prevailing
in Malaysia and thereby made an addition of ` 58,48,771.
The company approached the CIT(Appeals) (‘CIT (A)’) wherein in the
first appellate proceedings, the Ld. CIT(A) held that the Ld. TPO has
erred in rejecting oil world’s quotation, as the same was an authentic
independent trade organisation providing primary information and
quotations of different countries relating to the oil industry and is
duly covered under the various documents which have been listed
in Rule 10D(3)(b)2
and (c) of the Income Tax Rules, 1962 (‘Rules’).
The CIT(A) also suggested that since the international transaction
with its AE was less than 5% of the arithmetical mean in terms
of proviso to section 92C the company was justified in taking the
international transaction at arm’s length and that it is also pertinent