4 May 2023
Economic Principles are relevant while performing Transfer Pricing Analysis of Corporate Guarantee Transactions
Facts and Background

Macrotech Developers Limited 1 (Known by the brand name 'Lodha' and hereafter referred to as the 'taxpayer') is an Indian company engaged in the business of building and developing residential and commercial properties.

During the years under consideration (AY 2017-18 and AY 2018-19), the taxpayer had entered into international transactions with its Associated Enterprise (AE) based in Mauritius. During AY 2013-14, the AE raised funds by issuing bonds for its business purpose. The taxpayer along with a few other group companies provided corporate guarantees to the AE towards issuing such bonds. However, no guarantee commission was charged from the AE in lieu of such a guarantee. The Assessing Officer (AO) referred the matter to the Transfer Pricing Officer (TPO) for the determination of Arm's Length Price (ALP).
Submissions of the Taxpayer on why Guarantee Commission is Not Charged

The taxpayer justified the non-charging of commission as follows:  
  • Provision of guarantee did not have any bearing on profits, income, losses, or assets of the enterprise. It would be outside the ambit of an international transaction.
  • The provision of a guarantee is essentially similar to a shareholder activity and cannot be regarded as an international transaction.
  • The taxpayer and AE had a common parent company and the guarantee was given on behalf of the parent company, which was fully indemnified by the latter.
Without prejudice to the above justifications, the taxpayer computed the guarantee fee by adopting an interest saving approach wherein the taxpayer analyzed the transaction by determining the synthetic credit rating of the AE using an external tool. The taxpayer further conducted an external search on the database to identify comparable transactions. Based on the benchmarking search, the taxpayer determined the savings in interest cost due to the guarantee and distributed the interest saving equally between the taxpayer and the AE, thereby determining the Arm's Length Commission at 0.35%.
Approach of the TPO

The TPO stated that the guarantee provided by the taxpayer is an international transaction, and the taxpayer should have charged the guarantee commission fee from the AE. Furthermore, the TPO rejected the benchmarking search conducted by the taxpayer. The TPO noted that the AE had also borrowed a loan from the taxpayer. Accordingly, the TPO suggested that the interest rate under the circumstance when there is no corporate guarantee should be considered at 14%. At the same time, the interest paid by the AE on bonds (which were guaranteed) is 12%. Accordingly, the TPO calculated an interest saving of 2% because of the guarantee support. Further, the TPO made certain economic adjustments to factor in the differences in the Tenor and Currency, and arrived at the adjusted interest savings of 1.27%.

The TPO submitted that the creditworthiness of the taxpayer is much higher than that of the AE, and therefore, interest savings should not be shared equally as done by the taxpayer but rather should be shared in the ratio of 80:20. Accordingly, the TPO proposed a guarantee commission at the rate of 1% as opposed to 0.35% determined by the taxpayer.

The ALP determination by the taxpayer and the TPO has been summarized in the below comparative chart:
Sr No. Particulars Taxpayer TPO
1 Methodology Adopted Interest Saving Approach Interest Saving Approach
2 Comparable Data Used External Database to identify comparable Loan Transactions with/without guarantee Internal Data
Interest on Loan without Guarantee @14%
Bonds (Backed by Guarantee) @12%
3 Economic Adjustments Performed Tenor Adjustment and Currency Adjustment Tenor Adjustment and Currency Adjustment
4 Interest Rate with Guarantee 3.99% 12.73%
5 Interest Rate without Guarantee 4.70% 14.00%
6 Savings in Interest due to Guarantee Support 0.70% 1.27%
7 Split in the Interest Savings Ratio between Taxpayer and AE 50:50 80:20
8 Arm's Length Corporate Guarantee Fee to be Charged 0.35% 1.00%
Objections before Dispute Resolution Panel (DRP)

The taxpayer objected against the draft order before DRP who rejected the benchmarking approach adopted by the TPO and decided the ALP for corporate guarantee to be 0.5% by placing reliance on the decision of the Hon'ble Bombay High Court in the case of Everest Kanto Cylinder Ltd2. Based on the DRP's directions, the AO passed the final assessment order.
Proceedings before the Appellate Authority

Aggrieved by the DRP's directions, the taxpayer preferred to appeal before the Income Tax Appellate Tribunal (ITAT) at the Mumbai bench.

The taxpayer submitted that 0.5% ALP of the guarantee commission is not sacrosanct. The approaches adopted by the taxpayer based on the credit rating of the AE coupled with a robust benchmarking search is the most credible and scientific approach. The taxpayer also relied on several judicial precedents wherein the Hon'ble High Court upheld the guarantee commission rate at less than 0.5%.
Held by the ITAT

The Hon'ble Tribunal explained and commented on the following grounds raised by the taxpayer as follows:

Regarding Corporate Guarantee is not an International Transaction
The ITAT, following the ruling of the Hon'ble Madras High Court in the case of Redington (India) Limited3, rejected this ground of the taxpayer.

Regarding Issuance of the Corporate Guarantee is a Shareholders' Activity
The ITAT highlighted that the relationship between the taxpayer and AE is of a fellow subsidiary, and the taxpayer has not issued the guarantee in favor of its subsidiary.

The tribunal further noted that the taxpayer could not demonstrate that the guarantee was issued to ensure continuous cash flows to the AE. It is neither provided for the control of the capital structure nor due to ownership purposes to be characterized as a shareholder activity. The ITAT stated, that since the taxpayer could not provide any compelling factors to call the transaction as a shareholder activity, the ground of the taxpayer is dismissed.

Regarding Quantum of Guarantee Commission
The ITAT observed that the case cited by the DRP was in relation to a bank guarantee. Thus, the approach of the DRP lacked considering the economic aspect of Transfer Pricing and clearly violates the provisions of Section 92CA (3) of the Income-tax Act. The ITAT stated that the emphasis should be more on 'economic concept' over 'judicial concept' by drawing the comparison on the same footing such as economic conditions, similar assessment years, benchmarking methodology, geographical location, etc.

The Hon'ble Tribunal specified that the corporate guarantee commission could be benchmarked by using the Yield Method/Interest Saving Method.

Accordingly, the Hon'ble ITAT upheld the taxpayer's computation of corporate guarantee commission at 0.35% derived using the Interest Saving Approach/Yield Approach.
  1. ITA No. 2266 & 2239/Mum/2022
  2. CIT Vs Everest Kanto Cylinders Ltd. (2015) 378 ITR 57 (Bom)
  3. PCIT Vs Redington [ India] Limited [2021] 430 ITR 298 (Mad)
Our Comments
In the given case, the Hon'ble ITAT emphasized on the principle that every transaction with a subsidiary cannot be called a shareholder's activity unless compelling reasons are demonstrated with credible facts. The judgment again highlights that arguments based on such litigative matters can only withstand if they are backed with valid documentation.

Another key takeaway from this judgement is the validation by the Hon'ble ITAT of the economic principles used to justify the Arm's Length Price (ALP).

Intra-group Financial Arrangements are increasingly subjected to tax scrutiny by tax authorities not only in India but also in other countries. It is important that the taxpayers adopt and adhere to the relevant economic principles and Transfer Pricing guidelines to determine the ALP in Intra-group Financial Arrangements.
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