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The authors are Purava Rathi and Disha Kothawade, third year students at National Law Institute University, Bhopal.
INTRODUCTION
The Mumbai Bench of the Income Tax Appellate Tribunal (ITAT) in the case of Crayon Group AS v. ACIT has held that “bank guarantee rates cannot be considered for benchmarking corporate guarantee fees.”
A corporate guarantee is a contract of guarantee in which a corporate entity agrees to compensate for the default on the part of the debtor, usually a subsidiary company of the guarantor. This transaction facilitates the process of receiving credit from banks and ensures that the debt is recoverable from either party– the principal debtor or the corporate guarantor.
While extending a guarantee, it is common practice to charge a certain fee or commission. However, in a corporate guarantee transaction, the holding company may not charge a commission for it may choose to be a guarantor for its own subsidiary company or an associated enterprise (AE). An AE for the purposes of transfer pricing regulations, is an enterprise that has an interdependent relationship with the guarantor company in matters of ownership, economic interests, or control. Such a relationship can extensively influence the pricing of transactions between them for tax purposes.
In transactions involving AEs, if the guarantee commission is charged by the guarantor company, it will have a bearing on the profit, income, losses, or assets of the business thereby bringing it within the ambit of an international transaction for purposes of calculating the arm’s length price (ALP). The term ‘arm's length price’ refers to the price at which transactions between AEs should be conducted, ensuring that they are consistent with prices that would be agreed upon between unrelated parties in similar transactions. To determine the arm's length price, the Income Tax Act prescribes the use of various methods. Hence, the choice of the method of computing ALP becomes paramount for the assessee as accordingly an adjustment, on account of the corporate guarantee issued to its AE, would have to be made.
In India, a corporate guarantee provided by a holding company to its associated enterprise without a fee and with no direct impact on profits, income, or costs should not be considered an international transaction for the purpose of determining the ALP under the transfer pricing regulations. This is because such guarantees often serve strategic, business-driven purposes and may not have immediate financial implications. As such, they might not qualify as international transactions, as they do not substantially impact profits, income, losses, or assets.
However, the issue is that the courts and tribunals have not been able to provide for a settled principle to decide if corporate guarantee dealings which do not have any bearing on profits, income, losses, or assets are international transactions per se. The ambiguity continues to persist.
Therefore, the article aims to discuss whether the extension of corporate guarantee to an associated enterprise is essentially an international transaction or not. Further, the article also delves into why in an international transaction, bank guarantee rates cannot be used to benchmark corporate guarantee fees for the computation of the arm’s length price. The article discusses these pertinent questions in the context of the aforementioned order.
FACTS AND BACKGROUND
The Crayon Group (the assessee company), is a foreign company, incorporated in Norway. The assessee company had extended a corporate guarantee to its associated enterprise (AE), Crayon Software Exports India Private Limited. This guarantee was extended without charging any corporate guarantee fee or commission. The AE in the present case is a wholly owned subsidiary of the assessee company. The Hon'ble Dispute Resolution Panel (“DRP”), the Learned Assessing Officer, and the Learned Transfer Pricing Officer (“TPO”) considered this transaction to be an international transaction. Accordingly, they used an ad-hoc rate of 1% which was the arithmetic mean of bank guarantee quotes of three banks, for the determination of Arm’s Length Price (ALP). The arm’s-length price of the international transaction entered into by the assessee company was determined by the TPO. Accordingly, an adjustment of ₹ 950,000 was made, on account of the issuance of corporate guarantee. Although, pertinently, no guarantee commission was charged. The assessee submitted that this transaction was merely a shareholder’s activity and it did not require to be remunerated by the AE.
Therefore, in this regard, a pertinent question arises. Even though the guarantee commission was not charged, the Tribunal considered the particular transaction to be international in nature. By not charging the guarantee fees, there is absolutely no bearing on the profits, income, losses, or assets.
ANALYSIS
Whether the extension of corporate guarantee to an associated enterprise is essentially an international transaction or not?
According to 92B of the Finance Act, 2012, “international transaction includes any transaction between two or more AEs…having a bearing on profits, income, losses or assets of such enterprises.”
The condition precedent before categorizing a transaction as an international transaction is that it should have a bearing on profits, income, losses, or assets of the enterprises—either the guarantor company or the AE. When the parent company extends its assistance to its associated enterprise for which no fee is charged, there is no bearing on profits, incomes, losses, or assets of the business. Such a transaction, in reality, is not an international transaction. As a result, it should not be considered for transfer pricing and the question of benchmarking corporate guarantee fees will not arise in the first place. It is therefore of prime importance to take into consideration the purpose for which the guarantee is given.
The corporate guarantor usually extends a corporate guarantee in favour of its AE because the AE is essentially the subsidiary of the holding company. The assessee in some way will have a deep interest in the well-being of the subsidiary company. This transaction does not involve any cash flow or transfer of assets from AEs to the guarantor. It is merely a guarantee that will be executed on default. Such a transaction only ensures a certain level of comfort for the AE. It is quite possible that the AE may not even be able to obtain a guarantee or could get the guarantee at a high-interest rate if it had not been for the credit rating of the holding company. Therefore, these transactions are domestic transactions.
Further, a corporate guarantee provided by the parent company without charging any commission is a shareholder activity and cannot be brought under the TP provisions. Pertinently, these dealings fall under the ambit of commercially expedient transactions, the purpose of which is to promote the business interest of the associate enterprise. These transactions do not attract arm’s length adjustment.
It is also important to consider that the precondition of an impact on profits, income, losses, or assets has to be on a real basis and this bearing cannot be contingent on the happening of an event. Corporate guarantee or any guarantee for that matter can be executed only in case of default by the AE. Since the execution of the corporate guarantee is dependent on a contingent event, the precondition cannot be considered here.
The TPO and the DRP have not considered the above arguments while computing the guarantee commission percentage. The Hon’ble Tribunal has also disregarded this fact and held the transaction as international. In the present case, no costs were incurred while extending the guarantee. Therefore, the taxpayer contended that the aforementioned transaction was a domestic transaction, precisely a shareholder’s activity. As a result, it did not require to be compensated. Further, the assessee contended that in arguendo, if the said transaction were an international transaction, then such a rate cannot exceed 0.5% placing reliance on various judicial precedents.
In an international transaction, can bank guarantee rates be used to benchmark corporate guarantee fees for the computation of arm’s length price?
In the case at hand, the TPO submitted that no comparable price was available and therefore the average of the available banking rates at 1% was taken. The same was upheld by the Dispute Resolution Panel (DRP) stating that bank guarantee rates generally vary between 1% to 3%. Therefore, it was held that it would be appropriate to charge a corporate guarantee fee of 1% from the associated enterprise. However, the Tribunal held that the bank guarantee rates differ on the basis of creditworthiness and the subsequent benefits arising out of the transaction in question. Thus, the Tribunal suggested using better methods for computing the arm’s length price instead of using bank guarantee rates to benchmark corporate guarantee fees.
Bank guarantee rates cannot be used for benchmarking corporate guarantee fees because a corporate guarantee and a bank guarantee are not alike. The considerations for both are distinct. A guarantee is issued by a commercial bank while a corporate guarantee is issued by a holding company for its AE. The guarantees differ on the basis of their distinct risk profiles and creditworthiness of the two issuing institutions. A bank guarantee can easily be encashed in the event of default. A corporate guarantee ensures that the guarantor would repay the creditor in case of default. Further, bank guarantees are commonly associated with financial transactions, while corporate guarantees serve a broader range of functions, including securing loans, facilitating business relationships, and supporting subsidiary operations. Even the market dynamics and regulatory frameworks that impact guarantee fees may differ between different markets. Due to the obvious differences between the two, it is not appropriate to use bank guarantee rates to benchmark corporate guarantee fees. The same was explained in the case of CIT v. Everest Kento Cylinders Ltd.
Given the unique economic factors and legal requirements of India's corporate landscape, reliance solely on bank guarantees as benchmarks could result in an inaccurate assessment of arm's length prices. Therefore, a more prudent approach for transfer pricing purposes lies in analysing comparable transactions involving corporate guarantees among unrelated entities, as set forth in Section 92C of the Income Tax Act and supported by the Organization for Economic Cooperation and Development's (OECD) guidelines on transfer pricing. These approaches ensure compliance with Indian tax regulations and a more accurate determination of arm's length prices, reducing the risk of potential tax disputes.
The Tribunal also clarified that the determination of the arm’s length price of an international transaction cannot be decided on the basis of judicial precedents as the decision in each case is subjective, taking various factors into account. Further, the Tribunal also noted that S. 92CA (3) of the Act provides for a mandate that needs to be considered for benchmarking. Notably, the mandate was not followed by the assessee or the TPO. The approaches adopted by the assessing company and the TPO/DRP were incorrect and unsatisfactory.
CONCLUSION
The case of Crayon Group AS v. A.C.I.T. highlights the complexities involved in categorizing corporate guarantees as international transactions under the Indian transfer pricing regulations. The Tribunal's ruling that “Bank guarantee rates cannot be considered for benchmarking corporate guarantee fees” underscores the importance of using reliable alternate methods such as the interest-saving approach, comparable corporate guarantee fee rates, the cost of providing the guarantee, or any other approach, for determining the arm's length price in such scenarios.
In the broader context of transfer pricing regulations, this case emphasizes the necessity for a case-by-case analysis, considering the specific circumstances and economic realities surrounding each transaction. Ultimately, as the landscape of international business evolves, maintaining a fair and accurate transfer pricing framework remains crucial for preventing profit shifting and ensuring tax compliance.