Navigating International Tax Compliance – APA | Secondary Adjustments | Thin Capitalisation | Case Laws

Table of Contents

1. Advance Pricing Agreement (APA) [Secs. 92CC and 92CD]
2. Secondary Adjustment in Certain International Transactions [Sec. 92CE]
3. Provisions Pertaining to Thin Capitalisation
4. Important Judicial Rulings

Check out Taxmann's Direct Taxes Law & Practice with Special Reference to Tax Planning, by Vinod K. Singhania & Kapil Singhania for A.Y. 2023-24 and has been the 'go-to-guide' for Students & Professional Practitioners for over 40 years. It aims to make the reader understand the Law and develop the ability to apply it. It will be helpful for students appearing in CA, CS, ICWA, M.Com., LL.B., and MBA examinations. It will also be helpful for those appearing in the income-tax departmental examination.

1. Advance Pricing Agreement (APA) [Secs. 92CC and 92CD]

Advance Pricing Agreement is an agreement between a taxpayer and a taxing authority on an appropriate transfer pricing methodology for a set of transactions over a fixed period of time in future. The APA offers better assurance on transfer pricing methods and are conducive in providing certainty and unanimity of approach.

Sections 92CC and 92CD provide a framework for advance pricing agreement under the Act. These provisions provide the following—

• Board may enter into APA – Section 92CC empowers the Board (with the approval of the Central Government) to enter into an advance pricing agreement with any person to determine the –

a. arm’s length price (or specifying the manner in which arm’s length price is to be determined) in relation to an international transaction;

b. (with effect from April 1, 2020) income referred to in section 9(1)(i) (or specifying the manner in which said income is to be determined) as is reasonably attributable to the operations carried out in India by (or on behalf of) a non-resident.

• Purpose of APA – Such APA shall include determination of the arm’s length price or specify the manner in which arm’s length price shall be determined, in relation to an international transaction to be entered into, by that person.
• How to compute ALP – The manner of determination of arm’s length price in such cases shall be any method including those already provided in section 92C(1), with necessary adjustments or variations.
• APA to supersede provisions of section 92C or 92CA – The arm’s length price of any international transaction, which is covered under such APA, shall be determined in accordance with the APA so entered into. The provisions of section 92C or 92CA which normally apply for determination of arm’s length price will be modified to this extent. As a consequence, arm’s length price shall be determined in accordance with APA.
• Validity of APA – The APA shall be valid for such previous years as are specified in the agreement which in no case shall exceed five consecutive previous years.
• Roll back provisions – APA scheme is in operation in many countries. In many countries, the APA scheme provides for “roll back” mechanism for dealing with ALP issues relating to transactions entered into during the period prior to APA. The “roll back” provisions refer to the applicability of the methodology of determination of ALP, or the ALP, to be applied to the international transactions which had already been entered into in a period prior to the period covered under an APA. However, the “roll back” relief is provided on case to case basis subject to certain conditions. In the original scheme of APA as inserted by the Finance Act, 2012, there was no provision of “roll back”. The Finance (No. 2) Act, 2014, however, amended the provisions of section 92CC (with effect from October 1, 2014) to provide roll back mechanism. The APA may, subject to such prescribed conditions‡, procedure and manner, provide for determining the arm’s length price or for specifying the manner in which arm’s length price is to be determined in relation to an international transaction entered into by a person during any period not exceeding 4 previous years preceding the first of the previous years for which the advance pricing agreement applies in respect of the international transaction to be undertaken in future.
• Effectiveness of APA – The APA shall be binding only on the person and the Commissioner (including income-tax authorities subordinate to him) in respect of the transaction in relation to which the agreement has been entered into. The APA shall not be binding if there is any change, in law, or facts having bearing on such APA.
• APA obtained by fraud – The Board is empowered to declare, with the approval of Central Government, any such agreement to be void ab initio, if it finds that the agreement has been obtained by the person by fraud or misrepresentation of facts. Once an agreement is declared void ab initio, all the provisions of the Act shall apply to the person as if such APA had never been entered into.

For the purpose of computing any period of limitation under the Act, the period beginning with the date of such APA and ending on the date of order declaring the agreement void ab initio shall be excluded. However, if after the exclusion of the aforesaid period, the period of limitation referred to in any provision of the Act is less than 60 days, such remaining period shall be extended to 60 days.

• Procedures – The Board is empowered to prescribe* a scheme providing for the manner, form, procedure and any other matter generally in respect of the advance pricing agreement.
• Pending proceedings – Where an application is made by a person for entering into such an APA, proceedings shall be deemed to be pending in the case of the person for the purposes of the Act like for making enquiries under section 133.
• Modified return within 3 months† – The person entering into such APA shall necessarily have to furnish a modified return within a period of 3 months from the end of the month in which the said APA was entered into in respect of the return of income already filed for a previous year to which the APA applies. The modified return has to reflect modification to the income only in respect of the issues arising from the APA and in accordance with it.
• Pending assessments – Where the assessment or reassessment proceedings for an assessment year relevant to the previous year to which the agreement applies are pending on the date of filing of a modified return, the Assessing Officer shall proceed to complete the assessment or reassessment proceedings in accordance with the agreement, taking into consideration the modified return so filed and the normal period of limitation of completion of proceedings shall be extended by 1 year.
• Modification of completed assessment – If the assessment or reassessment proceedings for an assessment year relevant to a previous year to which the agreement applies has been completed before the expiry of period allowed for furnishing of modified return, the Assessing Officer shall, in a case where modified return is filed, pass an order modifying the total income of the relevant assessment year determined in such assessment or reassessment, having regard to and in accordance with the APA. To such order, all the provisions relating to assessment shall apply as if the modified return is a return furnished under section 139. The period of limitation for such order is 1 year from the end of the financial year in which the modified return is furnished.
• Case study – For the assessment year 2015-16, X Ltd. submits return of income on November 10, 2015. On November 18, 2015, it enters into an advance pricing agreement (APA) with the Board pertaining to determination of arm’s length price in connection with import of semi-finished goods from its holding company situated in the Netherlands. The agreement provides ALP for the transactions pertaining to the assessment years 2014-15 and 2015-16. The assessment of 2014-15 has already been completed but the assessment for 2015-16 is pending on the date of entering into APA.

In this case, X Ltd. will have to submit a modified return for the assessment year 2014-15 (and also for the assessment year 2015-16) on or before February 28, 2016 (i.e., within 3 months from the end of the month in which APA is made).

On February 28, 2016, the assessment for the assessment year 2014-15 has already been completed. For the assessment year 2014-15, the Assessing Officer will reassess or modify the income keeping in view the provisions of APA. This order can be completed on or before March 31, 2017 (i.e., within 1 year from the end of the financial year in which modified return is submitted).

On February 28, 2016, the assessment for the assessment year 2015-16 is pending. Normally, the assessment for the assessment year 2015-16 should be completed before April 1, 2018. In this case, the Assessing Officer can complete the assessment for the assessment year 2015-16 (keeping in view the provisions of APA) at any time before April 1, 2019.

2. Secondary Adjustment in Certain International Transactions [Sec. 92CE]

Section 92CE was inserted with effect from the assessment year 2018-19.

2.1 Secondary adjustment in common parlance

“Secondary adjustment” means an adjustment in the books of account of the assessee and its associated enterprise to reflect that the actual allocation of profits between the assessee and its associated enterprise are consistent with the transfer price determined as a result of primary adjustment, thereby removing the imbalance between cash account and actual profit of the assessee. As per the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD transfer pricing guidelines), secondary adjustment may take the form of constructive dividends, constructive equity contributions, or constructive loans.

The provisions of secondary adjustment are internationally recognised and are already part of the transfer pricing rules of many leading economies in the World (countries like Canada, France, Korea, South Africa, USA have adopted this kind of adjustment in their transfer pricing legislations). While mode of secondary adjustments in different countries is different, yet there can be no case of secondary adjustment in the absence of primary adjustment. Deemed dividend, deemed equity contribution or deemed loan are different approaches adopted by different countries. However, the object of different approaches is to align the economic benefit of the transaction with the arm’s length position.

2.2 When section 92CE is applicable

Under section 92CE, the assessee is required to carry out secondary adjustment where the primary adjustment to transfer price has been made.

• What is primary adjustments – “Primary adjustment” to a transfer price means the determination of transfer price in accordance with the arm’s length principle resulting in an increase in the total income or reduction in the loss, as the case may be, of the assessee.
• What is secondary adjustment – “Secondary adjustment” means an adjustment in the books of account of the assessee and its associated enterprise to reflect that the actual allocation of profits between the assessee and its associated enterprise is consistent with the transfer price determined as a result of primary adjustment, thereby removing the imbalance between cash account and actual profit of the assessee.
• When secondary adjustment will be applicable – Secondary adjustment will be applicable in the following situations –

1. 1. Where a primary adjustment to transfer price has been made suo motu by the assessee in his return of income.
   2. Where a primary adjustment to transfer price made by the Assessing Officer has been accepted by the assessee.
   3. Where a primary adjustment to transfer price is determined by an advance pricing agreement entered into by the assessee under section 92CC on or after April 1, 2017.
   4. Where a primary adjustment to transfer price is made as per the safe harbour rules framed under section 92CB.
   5. Where a primary adjustment to transfer price is arising as a result of resolution of an assessment by way of the mutual agreement procedure under DTAA entered into under section 90/90A.

• Threshold limit – When secondary adjustment is not applicable – If the following two conditions are not satisfied, secondary adjustment is not required –

1. 1. the amount of primary adjustment made in the case of an assessee in any previous year does not exceed Rs. 1 crore; or
   2. the primary adjustment is made in respect of the assessment year 2016-17 (or any earlier assessment year).

• Quantification of secondary adjustment – The relevant provisions are as follows –

1. 1. As a result of primary adjustment to the transfer price, there is an increase in the total income or reduction in the loss, as the case may be, of the assessee.
   2. The difference between the arm’s length price determined in primary adjustment and the price at which the international transaction has actually been undertaken, is “excess money”.
   3. The excess money is not repatriated to India by the associated enterprise within the prescribed time (given by rule 10CB) (in general terms, repatriation means effectively reversing the funds so that the accounts of the parties involved are in line with the economic intend of the primary adjustment). The excess money (or part thereof, which is not repatriated to India) shall be deemed to be an advance made by the assessee to such associated enterprise and the interest on such advance shall be computed as the income of the assessee in the manner as is prescribed by rule 10CB.

• Prescribed time-limit as per rule 10CB – CBDT has notified rule 10CB which prescribes computation of interest income pursuant to secondary adjustment. Rule 10CB also provides that repatriation of excess money shall be made on or before 90 days from –
  1. Due date of filing of return, if primary adjustment to TP has been made suo motu by the assessee.
  2. Date of order of Assessing Officer or appellate authority, if primary adjustment determined in the order has been accepted by assessee.
  3. Due date of filing of return in case assessee had entered into advance pricing agreement (if the advance pricing agreement has been entered into on or before the due date of filing of return for the relevant previous year).
  4. The end of the month in which the advance pricing agreement has been entered into (if the said agreement has been entered into after the due date of filing of return for the relevant previous year).
  5. Due date of filing of return in case assessee opted for safe harbour rules.
  6. The date of giving effect by the Assessing Officer under rule 44H to the resolution arrived at under mutual agreement procedure (MAP), where the primary adjustment to transfer price is determined by such resolution.

The following points should be noted –

1. If the repatriation of excess money is not made within 90 days from the dates given above, interest would be chargeable from the dates given above (without excluding 90 days).
2. The time-limit of 90 days for repatriation of excess money shall begin only when the primary adjustments exceeding Rs. 1 crore made in respect of assessment year 2017-18 (or later), attains finality. Where the transfer pricing order is appealed against by the taxpayer, the time-limit for repatriation shall commence only after the appeal is finalized by the appellate authority

• Prescribed rate of interest as per rule 10CB – With regard to the rate of interest to be computed in the case of failure to repatriate the excess money within the prescribed time given above, rule 10CB provides for separate interest rates for international transactions denominated in Indian rupee and those denominated in foreign currency. The rate of interest is on annual basis and shall be computed as follows –
  1. At one year marginal cost of fund lending rate of SBI as on April 1 of previous year plus 325 basis points in case international transaction is denominated in Indian rupees.
  2. At six-month LIBOR as on September 30 of previous year plus 300 basis points in the case international transaction is denominated in foreign currency.

The rate of exchange for the calculation of the value in rupees of the international transaction denominated in foreign currency shall be the telegraphic transfer SBI buying rate of such currency on the last day of the previous year in which such international transaction was undertaken.

• Additional income tax – In a case, where the excess money (or part thereof) has not been repatriated in time, the assessee has an option (with effect from September 1, 2019) to pay additional income-tax at the rate of 18 per cent on such excess money (or part thereof). It is subject to surcharge of 12 per cent and health and education cess of 4 per cent (effective tax rate: 20.9664 per cent). The following points should be noted –
  1. If the assessee pays the additional income-tax, he is not required to make secondary adjustment or compute interest from the date of payment of such tax. However, he is required to make secondary adjustment pertaining to interest till the date of payment of additional tax.
  2. The tax so paid shall be the final payment of tax and no credit shall be allowed in respect of the amount of tax so paid.
  3. The deduction in respect of the amount on which such tax has been paid, shall not be allowed under any other provision.

3. Provisions Pertaining to Thin Capitalisation

A company is typically financed or capitalized through a mixture of debt and equity. The way a company is capitalized often has a significant impact on the amount of profit it reports for tax purposes as the tax legislations of countries typically allow a deduction for interest paid or payable in arriving at the profit for tax purposes while the dividend paid on equity contribution is not deductible (in some countries, dividend distribution attracts additional tax). Therefore, higher the level of debt in a company (and thus the amount of interest it pays), the lower will be its taxable profit and tax liability. For this reason, debt is often a more tax efficient method of finance than equity. Multinational groups are often able to structure their financing arrangements to maximize these benefits. For this reason, country’s tax administrations often introduce rules that place a limit on the amount of interest that can be deducted in computing a company’s profit for tax purposes. Such rules are designed to counter cross-border shifting of profit through excessive interest payments, and, thus, aim to protect a country’s tax base.

3.1 Limitation on interest deductible [Sec. 94B]

Section 94B was inserted with effect from the assessment year 2018-19.

• Conditions – Section 94B is applicable if the following conditions are satisfied –

1. 1. The assessee (i.e., borrower) is an Indian company or a permanent establishment of a foreign company in India.
   2. It incurs any expenditure by way of interest (or of similar nature) in respect of any debt (or deemed debt). The debt is issued by a non-resident (being an associated enterprise of the borrower). Where the debt is issued by a lender (which is not associated with the borrower) and an associated enterprise either provides an implicit or explicit guarantee to such lender (or deposits a corresponding and matching amount of funds with the lender), such debt shall be “deemed” to have been issued by an associated enterprise. “Debt” means any loan, financial instrument, finance lease, financial derivative, or any arrangement that gives rise to interest, discounts or other finance charges that are deductible.
   3. Interest is deductible while computing income chargeable under the head “Profits and gains of business or profession”.
   4. For the aforesaid debt, interest (which is otherwise deductible for computing business/professional income of the borrower for the previous year) is more than Rs. 1 crore.
   5. The borrower is not engaged in the business of banking or insurance or (with effect from the assessment year 2024-25) such class of non-banking financial companies as may be notified by the Central Government.
   6. With effect from the assessment year 2021-22, interest is not paid in respect of a debt issued by a lender which is a PE of a non-resident (being a person engaged in the business of banking) in India.

• Limitation on deduction of interest under section 94B – If the above conditions are satisfied, interest shall not be deductible while computing income under the head “Profit and gains of business or profession” to the extent it arises from “excess interest”. “Excess interest”, as per section 94B(2), is –

1. 1. interest paid or payable in excess of 30 per cent of earnings (before interest, taxes, depreciation and amortization) (EBITDA) of borrower in the previous year; or
   2. interest paid or payable to associated enterprises for that previous year, whichever is less.

• Carry forward of the excess interest – The excess interest of the current year (which is not allowed as deduction) shall be carried forward to the following assessment year. In the next assessment year, it shall be allowed as a deduction against business/profession income of the borrower to the extent of maximum allowable interest expenditure in accordance with section 94B(2). This carry forward is allowed for 8 assessment years (immediately succeeding the assessment year for which the excess interest was first computed).

4. Important Judicial Rulings

One should also keep in view the following judicial rulings –

• When same persons participate, directly or indirectly or through an intermediary, in management or control or capital of two or more enterprises, such enterprises are required to be treated as ‘associated enterprise’. Thus, the true test of associated enterprise is control by one enterprise over other, or control of two or more associated enterprises by common interests—Diageo India (P.) Ltd. v. CIT [2011] 47 SOT 252 (Mum.).
• Rule 10B(4) clearly states that the data to be used in analyzing the comparability of uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into. Proviso to rule 10B(4) provides an exception to the effect that the data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer price in relation to transactions being compared. Thus, according to the law, the data relating to relevant financial year is only the contemporaneous data and the proviso is applicable only in some specified cases—Geodis Overseas (P.) Ltd. v. CIT [2011] 45 SOT 375 (Delhi).
• In case of transaction of lending money in foreign currency to foreign subsidiary, London Inter Bank Offered Rate (LIBOR) should be taken as benchmark rate for computing ALP of interest— Cotton Naturals (I) (P.) Ltd. v. CIT [2013] 32 taxmann.com 219 (Delhi).

‡ See rule 10MA.

*Rules 10F to 10T inserted by Notification No. 36/2012, dated August 30, 2012.

† If the time-limit expires during March 20, 2020 and December 31, 2020, it has been extended to March 31, 2021 by virtue of the Taxation and Other Laws (Relaxation and Amendment of Certain Provisions) Act, 2020.