Article by ca. sudha g. bhushan on thin capitalisation

COVER THEME Thin Capitalisation and Arm’s Length Pricing A Sekar Sudha G Bhushan B.Com., Hons, FCA, ACS B.Com., FCMA, ACS, LLB Gen Practising Chartered Accountant, Practising Company Secretary, Mumbai MumbaiCapital Structuring Both own funds and borrowed funds including long-term loans from financial institutions are used byT he most important decision for financial planners in a company is with respect to the most of the large industrial companies. Capital formulation of an ideal capital structure. The structure planning—initially and on continuing basis—capital structure of any company consists of a mix of is of great importance to any company, as it has adebt and equity. How much of the funds should be considerable bearing on its profitability. A wrongthrough equity and how much should be debt is a initial decision in this respect may prove quite costlytypical structuring decision. for the company. While deciding about capital structure, due attention should be paid to objectives Capital structure has to be determined not only at like profitability, solvency and flexibility. The choicethe time a company is promoted, but also later on as it of the amount of debt and other fixed return securitiesrequires funds from time to time. on the one hand and variable income securities, namely The initial capital structure should be designed very equity shares on the other, is made after a comparisoncarefully. The future structure will emerge out of the of the characteristics of each kind of securities andinitial structure. The company will require funds to after careful consideration of internal and externalfinance its activities continuously. Everytime the funds factors related to the companys operations. In realhave to be procured, the pros and cons of various life situations, compromises have to be madesources of finance have to be weighed and the most somewhere on the line between the expectations ofadvantageous source of financing has to be selected companies seeking funds and the expectations of thoseeach time. Thus the capital structure decision is a that supply them. These compromises do not changecontinuous ongoing decision and has to be taken the basic distinctions between debt and equity.whenever a company needs additional finance. Generally, the decision about financing is not of Generally, the factors to be considered whenever a choosing between equity and debt but is of selectingcapital structure decision is taken are : the ideal combination of the two. The decision on debt- equity mix is affected by considerations of suitability, (i) Leverage or Trading on equity risk, income, control and timing. The extent of (ii) Cost of Funds weightage that would be given to these factors will (iii) Cash flow vary from company to company depending on the (iv) Control characteristics of the industry and the particular (v) Flexibility situation of the company. There cannot perhaps be an (vi) Size of the company exact mathematical solution to the decision on capital (vii) Sector to which the company belongs structuring. Human judgement plays an important role (viii) Marketability including efficiency of financial in analysing the various aspects, before a decision on markets appropriate capital structure is reached. (ix) Tax considerations. High Gearing and Low Gearing Capital structure is the composition of various The term ‘‘capital gearing’’ or ‘‘leverage’’ normallysources of long-term finance in the total capitalisation refers to the proportion of relationship between equityof the company. These various sources of long term share capital including reserves and surpluses tofinance can be classified under two broad heads : preference share capital and other fixed interest (a) Own Funds bearing funds or loans. In other words, it is the (b) Borrowed Bunds. proportion between the fixed interest or dividend528 The Management Accountant |May 2012

COVER THEMEbearing funds and non fixed interest or dividend capital is made up of a much greater proportion ofbearing funds. Equity share capital includes equity debt than equity, ie. its gearing or leverage, is too high.share capital and all reserves and surpluses items that This is perceived to create problems for two classes ofbelong to shareholders. Fixed interest bearing funds people :includes debentures, preference share capital and other ● consumers and creditors bear the solvency risklong-term loans. of the company, which has to repay the bulk of Capital Gearing can be defined as : ‘‘The mixture its capital with interest; andof debt and equity in a firms capital structure, which ● revenue authorities, who are concerned aboutinfluences variations in shareholders profits in abuse by excessive interest deductions.response to sales and EBIT variations.’’ An entity (which may be part of a group) may be Formula of capital gearing ratio : said to be thinly capitalized when it has excessive debt [Capital Gearing Ratio = Equity Share Capital/ in relation to its arms length borrowing capacity,Fixed Interest Bearing Funds] leading to the possibility of excessive interest deductions. An important parallel consideration is Capital gearing ratio is important to the company whether the rate of interest is one which would haveand the prospective investors. It must be carefully been obtained at arms length rate while comparingplanned as it affects the company’s capacity to from independent lender as a stand-alone entity.maintain a uniform dividend policy during difficulttrading periods. It reveals the suitability of a company’s In international transactions, the typical method ofcapitalization. But what it is suitable gearing tax avoidance employed is the use of a thinlyin a particular case depends upon the facts and capitalized subsidiary that borrows from the parentcircumstances. or an off-shore vehicle, with the lender being in a low tax jurisdiction. Apart from the financial and ‘‘commercial’’considerations, the decision of capitalization is alsogreatly influenced by tax considerations. There may XYZ B.Vbe situations when a company may not have access to ▲debt based on its financial strength, but because of tax Low tax Jurisdiction Lending of Moneyconsiderations may like to show and treat the finance from XYZ to ABC ▲ ▲received from its associated enterprises or relatedparties as its own debt to claim tax deductions. The Interest payment fromtax authorities globally, however, have been quick to ABC to XYZ ▲pounce upon such tax planning exercises. Differentcountries have made different rules to deal with suchhigh gearing ratio. Over a period of time, the taxmen ABC Private Limitedhave been using the term ‘‘Thin Capitalisation’’ to referto what finance professionals refer to as ‘‘High Capital The main purpose of such an exercise is to shiftGearing.’’ profits from the country where profits are made to a While in strictly arms length transactions with tax haven. Many countries have introducedinstitutional or commercial lenders, no problems are withholding taxes on interest payments made by theexpected. What becomes relevant for financial planners thinly capitalized company to counter this shifting ofand taxmen is the financing by promoters and their profits. Thin capitalization rules usually go beyond justassociated enterprises. The problem of capitalization the levels of debt and equity.however becomes relevant to the taxmen when Thin Capitalization rules can apply in situationssecurities are issued in the nature of debt, (which are where :in fact ‘‘quasi equity’’) and finance raised from ● A security is issued, which would not have been‘‘promoters’’ or ‘‘associated enterprises’’ for claiming issued without a special relationship between theinterest deductions as tax benefits with the object of parties ( tax deductions for interest on loans from groupreducing the taxable income. entities are stopped where the borrower would not Thin Capitalization have been able to sustain the debit on its own). We are discussing the concept of Thin ● A loan is made because of a guarantee given toCapitalisation in the background of financing by way the lender by a party related to the borrower.of ‘‘quasi equity’’ by promoters or associated The expression ‘thin capitalisation’ is commonlyenterprises and the taxmens response to this practice. used to describe a situation where the proportion of A company is said to be thinly capitalized when its debt to equity exceeds certain limits. Thin capitalisationThe Management Accountant |May 2012 529

COVER THEMElegislation is a tool used by tax authorities to prevent on the excess of the loan over the approved proportionthe apparent leakage of tax revenues as a consequence is automatically disallowed and/or treated as aof the way in which a company is financed. Financing dividend. The ratio may be used as a safe-haven rule.a resident company with debt is considerably more It can be seen that these countries which use the fixedtax efficient than financing with equity. The difference ratio approach usually have specific thin capitalisationin tax treatment is an incentive to provide capital to legislation.the company in the form of debt instead of equity. If The basis of the ‘subjective’ approach is to look atthere are no thin capitalisation rules, it is relatively easy the terms and nature of the contribution and thefor a non-resident to advance funds to a resident circumstances in which the financing has been madecompany in a way that is christened as debt, so that and to decide, in the light of all facts and circumstances,the ‘‘interest payments’’ are straightaway tax whether the real nature of the contribution is debt ordeductible. If controlling shareholders in particular are equity. Some countries using the subjective approachindifferent to the form in which their investment is have specific legislation. Other countries use morestructured are more likely to be guided by tax general rules if these are available, such as general anti-considerations when structuring the legal form of their avoidance legislation, provisions on ‘abuse of law’,investment. provisions on substance over form. The object of Thin Capitalisation Regulations is to There are also countries that apply ‘hidden profitprevent the use of excessive ‘captive’ or ‘in-house’ or distribution’ rules to reclassify interest as dividends.‘friendly’ loans which would be detrimental to the In some of these countries the hidden profitrevenue of home country (where the borrower is distribution rules are applied along with specific rules which limit the deduction of interest on loans fromresident), as the profits to this extent would effectively shareholders. The general principles of transfer pricingbe shifted to the foreign lender, as the interest payments rules may also play a role in this respect.Thewould be tax deductible in the home country. underlying idea is that if the loan exceeds what would Therefore many countries—through Thin have been lent in an arm’s-length situation, the lenderCapitalisation Regulations—ensure that the deductions must be considered to have an interest in thefor interest on debt owed to connected parties, is profitability of the enterprise and the loan, or anyallowable in the home country as a deduction in the amount in excess of the arm’s-length amount, must behands of the borrower, only if within the permissible seen as being designed to procure share in the profits.limits. While financial leverage has, on its own standing, While some countries, like France, have detailedits own value, this is definitely impaired when interest regulations, others, like the UK, do not specify a debtis not deductible either wholly or partially through these to equity ratio, but merely give the right to the InlandThin Capitalisation Regulations. Revenue to challenge the interest deductions keeping Brief Comparative analysis of Thin Capitalisation in view the arm’s-length principle.Rules by different jurisdictions In the following paragraph, a brief overview of A wide variety of methods are used to deal with the approach to Thin Capitailsation Rules inthin capitalisation in various countries. These countries which provide for safe harbor provisions areapproaches range from complex legislation to no given :specific thin capitalisation legislation at all. Country Limitation Comments Within this range four general approaches may be Australia Debt : Equity 3 : 1 In 2002, Australia’s thin capitalisationdistinguished : regime changed substantially, bringing in lengthy and complex legislation. (1) the fixed ratio approach A ‘safe harbour’ debt amount has been (2) the subjective approach introduced, with an alternative ‘‘arm’s (3) application of rules concerning hidden profit length’’ test which can potentially distributions; and increase the permissible interest (4) the ‘no rules’ approach. Exceptions made for certain financial The emphasis on the above factors or combinations of businesses—authorised deposit takersfactors often varies from country to country. Measures Interest in excess of the prescribed leveltaken by countries to limit excessive debt financing by is denied as a deduction. However, it is fully deductible if the companyshareholders are either based on specific legislation or satisfies the arm’s length test.administrative rules or based on evolving practice. The Australian Tax Office has a well- Under the ‘fixed ratio’ approach, if the debtor organised and accessible website, withcompany’s total debt exceeds a certain proportion of good search facilities.its equity capital, the interest on the loan or the interest (contd.)530 The Management Accountant |May 2012

COVER THEME(contd.) (contd.)Country Limitation Comments Country Limitation CommentsGermany Limit to deducti- The legislation was substantially USA 1.5 : 1 The US ‘‘earnings stripping rules’’ bility of interest revised in 2008 currently include a restriction on (30% of income) Interest deductibility is limited to interest paid by a corporation to related 30% of taxable income before interest, persons, if the corporation has : taxes on income, depreciation and A debt-to-equity ratio exceeding amortisation. 1.5 : 1, and There are exceptions for low interest A net interest expense exceeding 50% expense, and where interest paid to any of the company’s adjusted taxable one shareholder falls within limits. income. This is likely to be tightened, Previously Germany had a widely probably to 25% available safe harbour: a debt:equity ratio of 1.5 : 1 India and Thin CapitalisationFrance Interest limitation A new system was applied from As of now India does not have any specific Thin by ref to third January 2007, applying limitations Capitalisation Rules. In one of the leading case on the party rates between related parties, and bringing subject, in absence of ‘‘thin capitalization rules’’, in the arm’s length measure. interest paid to shareholders for loans cannot be Interest rate limitations : disallowed despite capital-structure tax-planning Arm’s length deduction limited to an average of rates resorted by the tax payer. This was the decision by the measure for charged by lending institutions, or Income Tax Appellate Tribunal (ITAT) in the case of interest rate Besix kher Dabhol SA v DDIT. Debt : equity 1.5 : 1 the interest rate that the debtor The assessee, a Belgium company, was set up to 25% interest : ope- company could have obtained from a execute a project in India and had a PE in India. The rating income ratio third-party lender and assessee’s share capital of Rs. 38 lakhs was owned by Debt-based limitations : two foreign companies (shareholders) in the ratio of overall indebtedness (debt : equity 60 : 40. The said two shareholders also advanced loans ratio), and to the assessee aggregating Rs. 94.10 crores in the same Disallowed interest can be carried ratio in which they held shares in the assessee i.e. forward indefinitely at group level, but 60 : 40. The assessee’s debt-equity ratio was 248 : 1. will be reduced annually by 5% from The assessee paid interest of Rs. 5.73 crores on the loans the second year after the expense was obtained from its shareholders and claimed that as a incurred. There is no differentiation deduction. The AO disallowed the claim on the ground between types of companies. that though the moneys were borrowed from the Companies are considered on a stand shareholders, in view of the abnormal debt-equity alone basis. ratio, they were to be treated as capital/loan taken from Certain financial businesses and the Head Office, and (ii) that as the RBI approval transactions are excluded. did not permit the PE to borrow, the loan was inJapan 3:1 ● Japanese thin capitalisation rules contravention of law. This was upheld by the CIT (A). were revised in 2006. On appeal by the assessee, HELD allowed the appeal : ● A debt:equity safe harbour rule (i) Under Article 7 (1) & 7(3)(b) of the India-Belgium applies to foreign-owned corporations DTAA, the profits of the assessee as are attributable to ● The 2006 rules extend this to third the PE are chargeable to tax in India. In determining parties where foreign corporations such profits, all expenses are allowable subject to guarantee the borrowing limitations specified in the DTAA and the Indian laws.China China introduced thin capitalisation The only limitation is that notional interest paid by a legislation for the first time late in 2008. branch to its HO is not allowable.This limitation does Financial 5 : 1 Two safe harbour ratios have been set, not apply as the assessee borrowed from an outside one for financial industry enterprises, party, i.e. its shareholders; one for non-financial. (ii) The argument of the revenue that the abnormal Non-Financial 2 :1 If these ratios are breached, it appears debt-equity ratio attracts the ‘‘Thin Capitalization that the taxpayer will still have the Rule’’ and that the ‘‘debt’’ should be characterized as opportunity to try to demonstrate that ‘‘equity’’ for purposes of considering whether interest the transaction is still consistent with is deductible is not acceptable. Several countries have the arm’s length principle. detailed ‘‘thin capitalization rules’’ (e.g. Belgium). (contd.) However, there are no such rules in India though theThe Management Accountant |May 2012 531

COVER THEMEDTC 2010 has proposed this vide S. 123(1)(f). In the GAAR vs. Treaty provisionsabsence of specific ‘‘thin capitalization’’ rules, it is not It has been proposed that the GAAR provisionsopen to the revenue to characterize debt as equity and would apply to a taxpayer irrespective of the fact thatdisallow the interest (principles in Azadi Bachao the treaty provisions are more beneficial. It may be notedAndolan 263 ITR 706 (SC) followed). The domestic law that a unilateral enactment of a new domestic tax lawlimitation of Art. 7(3) refers to the Source Country & which is contrary to an existing treaty, without annot the Residence Country; amendment in treaty could possibly be regarded as (iii) Imposing the ‘‘thin capitalization rules’’ on the violation of international law and is generally knownassessee when domestic companies are not subject to as ‘treaty override’.such rules will violate the ‘‘non-discrimination’’ It may be relevant to note that according to rules ofprovision in Art. 24(5); legislative interpretation, specific legislation overrides (iv) The argument that the finance structure should general legislation. Therefore, an argument may bebe treated as a ‘‘colourable device’’ and disregarded taken that change of a domestic law generally, whichis not acceptable because there is no anti-abuse could be the case with GAAR, may not affect the treaty.provision in the DTAA and in the absence of specific However, in the absence of an anti-avoidancelanguage (such as the proposed s. 129(9) of DTC 2010), provision under the treaty, the reaction of Indias treatythe DTAA cannot be over-ridden by the Act. partner countries needs to be observed. Master Circular issued by RBI under Foreign Salient features/provisions of GAARExchange Management Act, 1999 (FEMA) and The Indian tax law has always had specific anti-Regulations avoidance rules to target known arrangements of tax It would be of interest to note that the latest RBI avoidance, whereas GAAR seeks to completely redefineMaster Circular on External Commercial Borrowings this concept. GAAR as envisaged under the Finance Bill(ECB) stipulates a debt equity ratio of 4 : 1 for 2012 is a broad set of provisions which seek to tax anborrowings by Indian Entity from ‘‘Recognized ‘impermissible avoidance arrangement’ (which may beLenders’’ in excess of US $ 5 Million from ‘‘Foreign a step, a part or whole of an arrangement and hereinafterEquity Holders’’. The Foreign Equity Holders should referred to as ‘Transaction’) whose main purpose is tohold a minimum of 25% of the Equity of the eligible obtain a tax benefit by :borrower. Further the regulations clarify ‘‘ie. a. creating rights or obligation which wouldn’t ariseborrowing the proposed ECB not exceeding four times between persons dealing at arm’s length, orthe direct foreign equity holding’’. This adds a new b. result in the misuse or abuse of the provisionsdimension to the basic question of Debt Equity ratio. of the Act in any way, or General Anti-Avoidance Provisions (GAAR) c. lacks commercial substance either wholly or in part, or Though the Union Budget 2012-13 proposals do not d. entered or carried out in a manner which wouldcontain any direct ‘‘Thin Capitalisation Rules’’, certain not be employed for bona fide purposesnew provisions entitled ‘‘General Anti-AvoidanceRules’’ have been proposed, which, if implemented, While the principal condition for invalidating acan give rise to new dimensions to the issue of Thin transaction might be triggered at the assessment stageCapitalisation concept. itself, the burden to rebut the same shall rest with the tax payer. Further, once the tax benefit test is satisfied, The scope and language of the proposed GAAR the arrangement also has to satisfy at least one out ofprovisions under the Union Budget 2012 are very four additional tests discussed above.similar to the GAAR provisions specified in the DirectTax Code (DTC). It is proposed to empower the tax The tax authorities, upon satisfaction of aforesaidauthorities with widespread powers to disregard and conditions, shall seek to :recast any tax avoiding transaction and income a. disregard, combine or recharacterise any step,accruing therefrom. Further, the Finance Bill 2012 part or whole of a transaction;proposes the introduction of sub-section 2A to Section b. treat the transaction as if it had not been entered into;90 which would enable the provisions of GAAR c. disregard any accommodating party or treating(proposed to be introduced through Chapter X-A in any accommodating party and any other partythe Income-tax Act, 1961) to override the provisions as one and the same person;of the tax treaties signed by India. While the revenue d. deeming connected persons in relation to eachauthorities may be viewing GAAR as a means to other as one;checking tax leakages, one may be tempted to suspect e. reallocating, amongst the parties to thethe intention of the sweeping nature of the provision arrangement —as it provides wide discretion to the tax authorities and ● any accrual, or receipt, of a capital or revenueprovides potential for misuse. nature; or532 The Management Accountant |May 2012

COVER THEME ● any expenditure, deduction, relief or rebate; (c) the means by, or manner in, which round or tripped amounts are transferred or received; f. relocating place of residence of a party or location ii. an accommodating or tax indifferent party; of a transaction or situs of an asset to a place other iii. any elements that have the effect of offsetting than provided in the arrangement; and each other; or g. considering or looking through an arrangement iv. a transaction which is conducted through one by disregarding any corporate structure. or more persons and disguises the nature, location, For the above purposes, following re-charac- source, ownership, or control, of the fund.terization may be done — 7. ‘‘Round trip financing’’ includes financing in ● any equity into debt, or vice versa; which — ● any accrual, or receipt, of a capital or revenue Funds are transferred among the parties to the nature; or arrangement in a manner which would : ● any expenditure, deduction, relief or rebate. ● result, directly or indirectly, in a tax benefit; or Meaning of some of the terms used in GAAR ● significantly reduce, offset or eliminate any 1. Accommodating Party business risk incurred by any party to the arrangement. Accommodating party means a party to anarrangement whose main purpose for direct or indirect Some Concerns about GAAR and recommendationsparticipation in an arrangement (in whole or in part) to overcome themis to secure benefits whether directly or indirectly to a The description and definition as proposed rendersperson to whom it may be connected or not. GAAR subjective and open to interpretation. Perhaps, 2. ‘‘An arrangement’’ means introduction of guiding principles should be evolved ● any step in or a part or whole of so as to make the same objective, more definite, fair, ● any transaction, operation, scheme, agreement equitable, meaningful and relevant. or understanding, Specifically if one were to refer to the explanation/ ● whether enforceable or not, and meaning of ‘‘lacking of commercial substance’’, this one ● includes any of the above involving the phrase can typically lead to a series of litigations. With alienation of property. the shifting of the onus of proof to the taxpayer, it has to 3. ‘‘Tax benefit’’ means be only hoped that the final outcome of the interpretation ● a reduction, avoidance or deferral of, or an does not result in ‘Commercial Nonsense’ increase in a refund of tax under the Income Tax Though the provisions relating to GAAR are broadly Act (‘‘ITA’’ or ‘‘the Act’’). in line with the internationally accepted standards of ● a reduction, avoidance or deferral of, or an anti-avoidance measures, it may be noted that some of increase in a refund of tax for a Tax Treaty. the important recommendations of the Standard ● a reduction in tax bases including increase in loss. Committee on Finance have not been taken into account 4. ‘‘Arm’s length price’’ means while introducing the GAAR provisions, such as : ● a price applied or proposed to be applied in a ● Suitable provisions may be made to protect thetransaction between persons or enterprises other than interest of the tax-payers who have entered intoassociated enterprises in uncontrolled, unrelated or structures/arrangements under the existing law inindependent conditions. good faith and without intent to evade tax; 5. ‘‘Associated Enterprises’’ means as defined in ● Uncertainties with regard to applicability of taxSection 92A of the Act. treaty provisions to be removed so that India’s 6. ‘‘Lacks commercial substance’’ credibility as a reliable treaty partner is not affected; ● The proposals should not lead to any fiscal A step in, or a part or whole of, an arrangement shallbe deemed to be lacking commercial substance, if — uncertainty or ambiguity; ● It should be ensured that any of the proposals do ● The substance or effect of the arrangement as a not pave the way for increased and avoidable litigation.whole, is inconsistent with, or differs significantly from,the form of its individual steps or a part; or With respect to thin capitalization, an entirely new concept of re-characterization of debt into equity or ● it includes, or involves — vice versa. The emphasis is on the term ‘‘vice versa’’ i. round trip financing without regard to, — which means that debt can also be classified into equity. (a) whether or not the round tripped amounts can Such reclassification including the circumstances in be traced to funds transferred or received; which this could result will be a completely new (b) the time, or sequence, in which round tripped concept to which this complex financial world may not amounts are transferred or received; or have a ready answer.The Management Accountant |May 2012 533

COVER THEME Applicability of Thin Capitalisation Norms for to be facing finance problems and are struggling todomestic companies obtain debt financing at competitive rates. In such The budget proposals have introduced a new cases, it is usual for the companies to arrange financesection by which specified domestic transactions have from related parties (including group companies) inbeen brought under the purview of Transfer Pricing the form of unsecured loans carrying structuredregulations. The computation of value of Specified interest rates rather than equity to meet the promotersDomestic Transactions should, therefore, be as per contribution requirements for obtaining maximumArms Length provisions under Transfer Pricing possible bank finance. The lending banks treat thisregulations. The provision would be applicable if the ‘‘structured debt’’ as ‘‘Quasi-Equity’’ and fit it asvalue of Specified Domestic transactions in aggregate ‘‘Equity’’ in their assessment for ‘‘Debt-Equity Ratio’’.exceeds 5 Crores. If this structure is viewed by the tax authorities under the lens of GAAR and read with the proposed domestic The Specific Domestic Transactions for the transfer pricing regulations and the interest chargedpurposes of application of Transfer Pricing provisions is below the bank rate, the tax authorities can, underwould be : this situation, impose tax on the differential interest or (a) Expenses/payment transactions between even treat this ‘‘structured debt’’ as equity, andrelated persons as covered under the provisions of disallow the interest deduction claimed by theSection 40 A (2) (b); borrowing company. All these could lead to (b) Transfer of goods/services/business from one uncertainties and unpredictable litigations.unit/undertaking of the Assessee to another unit/ There will be widespread ambiguity on what is theundertaking of the assessee, claiming benefit under ideal or safe debt-equity ratio which would beSection 80 IA, under Chapter VI A or 10 AA where the acceptable to the tax authorities. We have seen theprovisions of 80IA are applicable; confusion created by the RBI Master circular while The assessees in such cases would be required to stipulating the debt-equity ratio with respect to ECBmaintain/furnish documentation and obtain from foreign equity holders. When we have multiplecertification of Specified Domestic Transactions. regulators giving different interpretations and The other Transfer Pricing provisions pertaining to meanings to otherwise established definitions, theinternational transactions would also be applicable for problem becomes more complex. Further complicatingSpecified Domestic Transactions. this would be the GAAR driven as it would be by revenue collecting considerations, the emerging Section 40A (2)(b) would even cover transactions confusion is going to be more and more difficult toof interest payments to related parties and comprehend—particularly to the domestic SME sectorconsequently the provisions contained in the other which is in dire need of greater flexibility and openness.transfer pricing regulations including the GAAR andthe thin capitalization rules/test could apply to quasi- There will be a great role for Management Accountantsequity financing by related parties christened as debt. and other financial consultants in evolving a proper groupThis is going to be a new challenge for domestic structure and also capital structure for individual entities,companies, most of whom are not even exposed to the apprising them of the regulations and consequences ofconcept of Thin Capitalisation and the prevalent rules. default simultaneously so that there emerges Challenge before Indian Companies (a) good commercial sense not only at the group Indian companies having international transac- level, but also at the entity level; andtions are exposed to international financing pattern and (b) there is better understanding on the part of thesethe global taxation trends. For these companies, the groups and entities of the complex level of challengesconcept of thin capitalization is going to add a new to be faced in balancing commercial, regulatory andvariable to the financial and tax structuring. tax considerations; and The greater challenge is, however, going to be faced (c) the potential for commercial nonsense—whichby pure domestic companies in the SME sector, where disastrous short term opportunistic planning willthere is a reasonable amount of related party anyway entail—is reduced. ❐transactions much beyond the stipulated the threshold Referenceslevels of Rs. 5 crores which appears to be fairly low. 1. Moneyterms.co.uk When there are many SME companies/organi- 2. www.transferpricing-india.comzations in a group, a great deal of planning would have 3. bcasonline.org ‘‘Worldwide Tax Trends—Thin Capitalisa-to be done to plan and implement the capital structure tion’’ by Rajendra Nayak and Lubna Kably" CAin such a way that the group goals are achieved without 4. www.taxmann.comfalling into the erring side of the tax net. 5. www.itatonline.org Quite a few companies in the SME sector are known 6. http://www.hmrc.gov.uk534 The Management Accountant |May 2012

COVER THEME Arm’s Length Pricing in India Dr. Sukamal Datta Principal Naba Ballygunge Mahavidyalaya (C.U.) KolkataIntroduction financial position of the seller company; and (ii) helps to prevent the question of taxes arising from suchT he Arm’s Length Principle is the condition that both the parties to a transaction are independent transaction. Many countries including India have their and are on equal footing. This type of transaction laws for determining inter-company or arms lengthis known as an ‘Arm’s Length Transaction’. It is price structures. With the extension of arms lengthgenerally use in contract law for the arrangement of price, there is no question about conflict of interest ofan equitable agreement though either the parties may buyer and seller. Here the revenue is completelyhave shared interests or they are closely related to each transparent and there is no hidden motive in theother to be seen as completely independent. In the transaction. According to the internationally acceptedpresent global business environment it is observed that principles, any income from international transactionlarge multinational companies have subsidiary or an outgoing—like expenses or interest from thecompanies and those companies conduct business international transaction between associatedtransactions with one another as if they are not at all companies—shall be computed extending an arm’s-part of the same corporate family. When two length price that would be charged in the transactioncompanies, any way, are connected with each other, if it had been entered into by unrelated parties inthe type of business they transact is often referred to similar conditions. Some companies occasionally tryas an ‘arm’s length transaction’. It is a deal between to manipulate inter-company prices to reduce overalltwo interested associates parties. They show the tax burden. On the other hand, tax authorities want tobehaviour as if they were not related, so that there is ensure that the inter-company price is equivalent tono query of a disagreement of attention. The concept an arms length price to prevent the loss of tax revenue.of arms length deal concerns with the transaction in Computation of Arm’s length Price u/s 92C ofwhich both the parties behave in their self-attention Income Tax Actand are not issue any force from the other associate. The arm’s length price in relation to an internationalThe basic principle behind the arm’s length price is transaction shall be determined by any of the followingthat though the both the buyer and seller are related methods, being the most appropriate method :to a parent concern, the prices extended will still (a) Comparable Uncontrolled Price Method,remain at fair market value. This means that the sellercompany will offer no special in-house discount to the (b) Resale Price Method,buyer company though both of them are subsidiaries (c) Cost Plus Method,of a parent company i.e. the subsidiary company will (d) Profit Split Method,enjoy the same volume of discount that may be (e) Transactional Net Margin Method, andextended to any customer with a similar pattern of (f) Such other Method as may be prescribed by thevolume purchasing. So, the arms length price is the Board.price in which a sister company never expects any From the above six methods the most appropriatediscount or reduced price that would be extended to method shall be applied for determination of arm’sother customers. The comparability between the length price provided that, where more than one pricecontrolled and uncontrolled transaction is the key is determined as the most appropriate method, thefactor for determining the arms length price an arm’s-length price shall be taken to be the arithmeticinternational transaction. mean of such prices or at the option of the assessee, a Arm’s length price essentially conducts two things price which may vary form such arithmetic mean notat a time : (i) this form of pricing structure protects the exceeding five per cent. To make it clear we mayThe Management Accountant |May 2012 535

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