6 April 2022
Extending Trade Credit to an associated enterprise can not be equated to the loan facility; Mumbai Tax Tribunal
  1. Facts of the case

    Tech Mahindra Limited (taxpayer) is an Indian multinational information technology services and consulting company1. Part of the Mahindra Group, the company is headquartered in India.

    During the years under consideration (AY 2004-05 and AY 2005-06), the company had entered into certain international transactions with its Associated Enterprise (AE) in the USA. The said AE was not performing well and had incurred losses in the years under consideration. Based on submissions made by the taxpayer, the trade credit was provided to enable AE to tide over the temporary liquidity situation. The taxpayer did not charge any interest on such trade credit facility provided to AE.

    The taxpayer justified the non-charging of interest as follows:

    • The AE was not able to borrow funds from any third-party bank/financial institutions at competitive rates due to operating losses.
    • If the liquidity position of AE further worsens, then its growth would be hampered.
    • The taxpayer also contended that the profits that are now coming (in the subsequent year, that is) would not have arisen if AE was not supported in the year when it had liquidity challenges.
  2. TPO's Approach

    The Transfer Pricing Officer (TPO) rejected the above reasoning provided by the taxpayer for non-charging of interest. The TPO imputed interest at 10% on such a trade credit facility. The TPO stated that the 10% rate is taken from the taxpayer's own case, wherein the taxpayer has given a loan to its other AE in Germany. The loan to German AE was Euro denominated loan.

  3. Proceedings before the First Appellate Authority

    The taxpayer challenged the above TP adjustment before the Commissioner of Income-tax (Appeals) [CIT(A)/First Appellate Authority].

    The taxpayer submitted that the trade credit facility provided to its AE in the USA cannot be equated/compared with the loan facility provided to its German AE.

    The taxpayer highlighted below distinguishing factors:

    Parameter Trade credit facility Loan facility
    Tenor Short term Long term
    Purpose Working capital Capital expenditures
    Funding channel Intra-group arrangement Banking channels
    Security Unsecured Secured (generally by asset or other collateral)
    Geography USA Europe

    The First Appellate Authority accepted the above contentions of the taxpayer that trade credit can not be compared/equated to a loan. However, the CIT(A) proceeded to determine the Arm's Length Price (ALP) of the trade credit facility by adopting a USD LIBOR rate of 1.22% and a mark-up of 80 basis points (i.e., an effective interest rate of 2%) for AY 2004-05 and interest rate of 4.20% for AY 2005-06.

  4. Proceedings before the Income-Tax Appellate Tribunal (ITAT) / Second Appellate Authority
    • The taxpayer reiterated its grounds to justify the non-charging of interest on a trade credit facility. On the other hand, the Revenue argued that the ALP of interest should be re-instated to 2% and 4.20% for AY 2004-05 and AY 2005-06, respectively.
    • The ITAT observed that the average debtor days in respect of the trade credit granted by the taxpayer to its AE was 124 days, and for unrelated third-party transactions, it was 150 days. It was the taxpayer's submission that in relation to the excess credit period granted to independent third parties, the taxpayer did not levy any interest with respect to delayed payments.
    • The ITAT was in agreement with the findings of the CIT(A) with respect to not equating normal trade credit granted by the taxpayer to its AE with a loan. Furthermore, in the taxpayer's own case for AY 2002-03 and AY 2003-04, no adjustment was made on account of interest for extended credit.
    • However, the ITAT held that the interest rate as determined by the CIT(A) was vague and no quantification of the period was verified by the CIT(A). In lieu of the above, the ITAT remanded the matter to the Assessing Officer (AO)/TPO to verify the period as well as the interest rate which was available at that particular point in the open market.
1. Tech Mahindra Limited (ITA Nos. 1034 & 1035/Mum/2010) for Assessment Year 2004-05 and 2005-06
Our Comments

Funding as a function itself is very dynamic, especially when you add cross-border and related party elements, it becomes complex to analyze and measure. The TP implications on intra-group financing have been a matter of significant dispute in almost all jurisdictions where the TP regime or ALP exists. The Organisation for Economic Co-operation and Development (OECD)'s response to this issue was also largely applauded by all when it released a comprehensive paper titled "TP guidance on Financial Transactions" in February 2020.

In the given case, the appellate authorities (first as well as second) rightly distinguished the trade credit facility from a typical loan. At the same time, the arguments such as – the AE's inability to borrow from third parties and similar credit period offered to third parties have not been appreciated by the appellate authorities.

In our view, business situations (loss-making/liquidity crunch) are an important factor to be kept in mind while one assesses or identifies the tax base erosion potential in an intra-group transaction. If the taxpayer provides adequate evidence and reasoning in support of a genuine business situation and if it is documented in the TP documentation, the tax authorities ought to appreciate/accept that. In fact, there are a plethora of court judgments that have held that the tax authority can not step in the taxpayer's shoes while challenging the taxpayer's transactions.
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