* IN HIGH COURT OF DELHI AT NEW DELHI + ITA No. 233/2014 Reserved on: 13th February, 2015 % Date of Decision: 27th March, 2015 COMMISSIONER OF INCOME TAX-I Appellant Through Mr. Rohit Madan, Sr. Standing Counsel Versus M/s COTTON NATURALS (I) PVT. LTD. Respondents Through Mr. Ved Jain with Mr. Pranjal Srivastava, Advocates. CORAM: HON BLE MR. JUSTICE SANJIV KHANNA HON'BLE MR. JUSTICE V. KAMESWAR RAO SANJIV KHANNA, J. question raised in present appeal by Revenue under Section 260A of Income Tax Act, 1961 (Act, for short) relates to determination of arm s length rate of interest, paid to assessed, i.e. Cotton Naturals (I) Pvt. Ltd., by their subsidiary M/s JPC Equestrian, company registered in United States of America. appeal emanates from order of Income Tax Appellate Tribunal (Tribunal, for short), dated 30th October, 2013, and pertains to assessment year 2007- 08. 2. On basis of contentions raised by parties, following substantial question of law needs to be answered and decided: ITA No. 233/2014 Page 1 of 34 1. Whether Income-Tax Appellate Tribunal was right in following their earlier order for assessment year 2008-09, dated 8th February, 2013 in ITA No. 5855/Del./2012 and in holding that interest @ 4% p.a. charged by respondent assessee from its subsidiary i.e. Associated Enterprise was arm s length rate of interest and adjustment made in Assessment Order determining arms length rate of interest at 12.20% was unwarranted? 3. With consent of counsel, we had heard them on aforesaid substantial question. 4. respondent assessee, Indian company was engaged during relevant period, in business of manufacture and exports of rider apparels like riding breeches, jodhpurs, socks, riding jackets, horse blankets, fly sheets, riding boots, shirts, saddle pads and riding helmets. Headquarter of assessed was located in Delhi, India with presence in 10 countries through designated channel partners and distributors. However, for purpose of marketing and promoting their exports to USA, respondent assessee had incorporated aforesaid subsidiary, which was wholly owned by them and their two shareholders. 5. As per 3CEB report and Transfer Price documents, following international transactions between respondent assessee and Associated Enterprise i.e. M/s JPC Equestrian (hereinafter referred to as AE), were disclosed: Equestrian Apparel sold to JPC Rs.24,438,153/- Equestrian Inc. Loan provided to JPC Equestrian Inc 10,50,000 $ Interest Received Rs.20,52,101/- ITA No. 233/2014 Page 2 of 34 6. respondent assessee had selected Comparable Uncontrolled Price method (CUP method, for short) to benchmark sale of equestrian apparels and interest received on loan. respondent assessee had declared that interest received at rate of 4% was comparable with export packing credit rate obtained from independent banks in India. 7. Transfer Pricing Officer (TPO, for short) in his report enumerated several reasons, which we are not highlighting at this stage to avoid repetition, to hold that arm s length interest rate should be taken as 14% p.a. He computed arm s length interest on loan at Rs.71, 82, 354/-, in place of interest received of Rs.20,52,101/-. aforesaid upward revision was made as per following table/ chart:- CUP Rate is thus arrived at as under: Basic interest rate for credit LIBOR+400 basis points rating of AE Add: Transaction Cost 300 basis points CUP Rate LIBOR + 700 basis points Add: Adjustment for security Not computed Final CUP Rate > LIBOR + 700 basis points As currency in which loan is exte nded to AE is GBP, 6-month GBP LIBOR (sic) is considered. These rates are given as per Annexure - A. average 6-month GBP LIBOR (sic) is arrived at 5.224% p.a. Thus CUP rate is arrived at as under. CUP Rate > LIBOR + 700 basis points > 5.224%+7% ITA No. 233/2014 Page 3 of 34 > 12.224% Keeping in view that no security is offered by subsidiary and also that taxpayer is not into lending and borrowing money, reasonable interest rate of 14% p.a. can be considered. 8. respondent assessee filed objections before Dispute Resolution Panel (DRP, for short) against adoption of 14% rate of interest as suggested by TPO. DRP while substantially rejecting contentions, granted partial relief in form of reduction of rate of interest to 12.20%, recording that loan was given on fixed rate of interest out of shareholder funds. Funds had flown from one shareholder to another, and reality being that both set of shareholders were same, security aspect was embedded by default in transaction. DRP also noted that Prime Lending Rate (PLR, for short) fixed by Reserve Bank of India, ranged from 10.25% to 10.75% in April, 2006 to 12.25% to 12.50% in March, 2007. In view of above stated, upward revision of interest rate i.e. arm s length interest was computed as Rs.62, 58, 908/-, in place of Rs.20,52,101/-. On basis of directions issued by DRP, assessment order was passed, making addition of Rs.42, 06, 807/- by way of transfer pricing adjustment. 9. respondent assessee succeeded before Tribunal who preferred to follow their earlier order dated 8th February, 2013 in ITA No. 5855/Del/2012 relating to subsequent assessment year 2008- 09. reasoning in this order dated 8th February, 2013 has been reproduced in impugned order and for sake of convenience we would also like to quote same: "11. We have carefully considered submissions and perused records, we find that assessee company in this case is leading manufacturer of ITA No. 233/2014 Page 4 of 34 rider apparel. Assessee entered into international transaction as under:- Equestrian Apparel sold to JPC Equestrian Inc 48191540/- Loan provided to JPC Equestrian Inc 10,50,000 $ 12. As per TP document, CUP method has been chosen to benchmark sale of apparel as well as interest received on loan. TPO accepted assessee's submission qua sale of apparel that same was at arms length. As regards interest assessee mentioned that it has received interest at rate of 4% which was comparable with export packing credit rate obtained from independent banks in India. TPO was not in agreement with above contention of assessee. He observed that it is to be seen that what assessee would have earned by giving loans in Indian market. He noted that lending or borrowing is not one of main businesses of taxpayer. He opined that what is to be considered is prevalent interest that could have been earned by advancing loan to unrelated party in India with same financial health as that of tax payer's subsidiary. TPO further observed that taxpayer has not submitted financial of subsidiary, hence . financial healthy of subsidiary cannot be judged. TPO further noted that while deciding interest rate that may be charged on receivables from AE's, Libor rate for calculating interest is not proper. He opined that instead of US rate, Indian rate is to be adopted. He observed that independent person in India would expect maximum return on its investment, and if lending rate is higher in Indian currency then he would not lend in foreign currency where lending rate is not so attractive. TPO further noted that it should not be forgotten that, had AE of assessee company would have got loan from any bank or financial institution in place of residency at Libor rate, then why it did not avail of loan at such rate. Assessing Officer observed that, no company in India would like to invest in form of loan outside India and that also without security as interest returns in India would be higher than those prevailing in developed markets. Finally, Assessing Officer held that interest rate at 17.26% would be fair and reasonable. ITA No. 233/2014 Page 5 of 34 13. Before DRP assessee inter-alia contended that comparison has to be made with respect of advance or loan in USA and not based on Indian conditions. comparison could also be with rate of interest being paid by multinational companies or banks in respect of money borrowed from India. However, DRP agreed with TPO 's point of view. But, it held that further addition on account of security is not needed. It opined that Arm's length interest rate may be taken as PLR of RBI for financial year 2007-08. In accordance with above decision, TPO adopted 13.25% as rate of arms length interest rate. 14. We note that CUP method is most appropriate method in order to ascertain arms length price of international transaction as that of assessee. We agree with assessee's contention that where transaction was of lending money in foreign currency to its foreign subsidiaries comparable transactions, therefore, was of foreign currency Tended by unrelated parties. financial position and credit rating of subsidiaries will be broadly same as holding company. In such situation,- domestic prime lending rate would have no applicability and international Rate Mixed being LIBOR should be taken as benchmark rate for international transactions. 15. above view is duly supported by following case laws relied upon by assessee's counsel. In Siva Industries and Holding Ltd. vs. ACIT Supra it was held by ITAT that assessee had given loan to associate enterprise in U.S. dollars, and in such situation when transaction was in foreign currency, and transaction was international transactions, then transaction would have to be looked upon by applying commercial principles in regard to international transactions. In such situation domestic prime lending would have no applicability and international rate fixed being LIBOR rate would have to be adopted. 16. Similar view as above was expressed by ITAT in case of M/s Four Soft Ltd., Hyderabad vs. DCIT Supra, Dy. C.I.T vs. Tech. Mahindra Supra, Tata Autocomp Systems vs. ACIT Supra. 17. We further note that assessee has arrangement, for loan with Citi Bank, for less than 4%. However, for loan ITA No. 233/2014 Page 6 of 34 provided to its AE's it has charged 4% p.a. interest. Hence, adjustment suggested by TPO is not warranted. 18. We further note that assessee's profits are exempt u/s. 10B. Hence, there is no case that assessee would benefit by shifting profits outside India. This view is supported by Bangalore Tribunal decision in this case Philips Software Centre P Ltd. vs. ACIT Supra and Mumbai Tribunal in case of I.T.O. vs. Zydus Altana Health Care P Ltd. Supra. 19. We further note that in this case loan agreement was for fixed rate of interest. LIBOR has been accepted in decision referred above as most suitable bench mark for judging Arms' length price in case for foreign currency loan. Hence, adjustment as made by TPO is not warranted. 20. In background of aforesaid discussions and precedents, we hold that rate of interest charged by assessee for loans transactions with AE was Arms Length Price. Hence, no transfer pricing adjustment is called for." 10. aforesaid quotation refers to several decisions of Tribunal starting from Siva Industries & Holdings Ltd. vs. ACIT, which is decision by Chennai Bench of Tribunal in ITA No. 2148/Mds/2010. In instant case it has been held: 11. We have considered rival submissions. perusal of order of TPO clearly shows that assessee had raised funds by way of issuance of 0% optional convertible preferential shares. Thus it is noticed that funds raised by assessee company for giving loan to India Telecom Holdings Ltd., Mauritius, which is its Associated Enterprises and which is subsidiary company, is out of funds of assessee company. It is not borrowed funds. assessee has given loan to Associated Enterprises in US dollars. assessee is also receiving interest from Associated Enterprises in Indian rupees. Once transaction between assessee and Associated Enterprises is in foreign currency and transaction is international transaction, then transaction would have to be looked upon by applying commercial principles in regard to international transaction. If this is so, then domestic prime lending rate would ITA No. 233/2014 Page 7 of 34 have no applicability and international rate fixed being LIBOR would come into play. In circumstances, we are of view that it LIBOR rate which has to be considered while determining arm s length interest rate in respect of transaction between assessee and Associated Enterprises. As it is noticed that average of LIBOR rate for 1.4./2005 to 31.3.2006 is 4.42% and assessee has charged interest at 6% which is higher than LIBOR rate, we are of view that no addition on this count is liable to be made in hands of assessee. In circumstances, addition as made by Assessing Officer on this count is deleted. 11. aforesaid view has been subsequently followed by different Benches of Tribunal for almost identical reasons in DCIT vs. Tech Mahindra Ltd. ITA no. 1176/Mum./2010, dated 30th June, 2011; M/s Four Soft Ltd. Hyderabad vs. DCIT- ITA No. 1495/Hyd/2010, dated 9th September, 2011; Tata Autocomp Systems Ltd. vs. ACIT ITA No. 7354/Mum/2011, dated 30th April, 2012; M/s Aurobindo Pharma Ltd. vs. ACIT ITA No. 1866/Hyd/2012 dt. 29th November, 2013; Siva Ventures Ltd. vs. ACIT - ITA No. 2161/Mds/2011, dated 27th June, 2013; Apollo Tyres Ltd. vs. ACIT - ITA No. 616/Coch/2011 dated 20th December, 2013; Hinduja Global Solutions Ltd. vs. Addl. CIT ITA No. 254/Mum/2013, dated 5th June, 2013; M/s PMP Auto components P. Ltd. vs. DCIT ITA No. 1484/Mum/2014 dated 22nd August, 2014; and VIP Industries Ltd. vs. Addl. CIT ITA No. 526/Mum/2014 and its cross appeal titled Dy. CIT vs. VIP Industries Ltd., ITA No. 881/Mum./2014 dated 10th December, 2014. 12. In some of cases, Tribunal has applied mark up on London Interbank Offered Rate (LIBOR for short) and Euro Interbank Offered Rate (EURIBOR, for short). LIBOR is calculated and published by Thomson Reuters, on behalf of British Bankers ITA No. 233/2014 Page 8 of 34 Association. rate is calculated on inter-bank offers for lending rates from banks in reasonable market place. highest 25% and lowest 25% of values offered are eliminated, and rate is determined on remaining 50%. EURIBOR is also calculated and published each day and 15% of lowest and highest interest rates quoted by panel of European banks are eliminated and remaining 70% form basis of calculation. 13. reasoning given in decision relied upon by Revenue for applying PLR, namely Logic Micro Systems Ltd. vs. ACIT, ITA No. 423/Bang/2009, dated 7th October, 2010 records as under: 22. Another important direction given by Commissioner of Income-tax(A) is to adopt LIBOR/US- FED rate for calculating interest. This proposition has been made by Commissioner of Income-tax(A) on premise that ALP factor of interest is to be computed with reference to benefit that would have been earned by AE in USA. On other hand, in calculating cost factors of assessee in India, it is more appropriate to consider potential loss suffered by assessee in India by not bringing receivables within normal period. In fact, said potential loss of assessee in India is ALP factor which contributes to additional income attributable to assessee. Therefore, instead of US rate, TPO is justified in adopting Indian rate. 23. While adopting Indian rate, it is not proper to rely on PLR of State Bank of India. This is because if funds were brought in time and those funds were properly deployed, assessee company may earn income at maximum rate applicable to deposits and not at rate applicable to loans. Therefore, we vacate direction of TPO to adopt PLR rate of 10.25%. Instead we find it appropriate to adopt reasonable rate that would be available to assessee on short-term deposits. 24. We have held that period chargeable to interest has to be recomputed and reasonable deposit rate has to be applied for calculating interest. Taking into consideration all aspects of case like interest-free period and piece-meal remittance of receivables, we fix ITA No. 233/2014 Page 9 of 34 ALP interest rate at 5% and direct Assessing Officer to compute additional income at rate of 5% on Rs.5,52,24,261/- as against 10.25% adopted by Assessing Officer. (emphasis supplied) 14. In another decision, Nimbus Communications Ltd. vs. ACIT ITA No. 6597/Mum/2009, it stands observed that LIBOR is relevant in only cases of lending, borrowing of fund and not in cases of commercial overdues. said decision would however not be relevant to extant case as Nimbus Communications Ltd.(supra) is case of debt balance not paid in commercial transaction. We do not have to answer said question/ aspect. 15. case of appellant-Revenue finds lucid exposition in following table quoted by Transfer Pricing Officer, pointing out difference between lending and borrowing: difference between lending and borrowing when dealing at arm s length is given in below table (Assuming X is in India and Y is outside India). Sl. No. Aspect Lending money Borrowing b X to Y Money b X from Y 1 Primary primary primary Consideration consideration consideration for X is to for X is to maximize its minimize its return in terms rate of interest of interest keeping in view keeping in view risk risk involved. involved. 2 Interest Rate Interest rate Interest rate depends on depends on tenure, credit tenure, credit rating of Y, and rating of X, and ITA No. 233/2014 Page 10 of 34 security offered. security offered. 3 Benchmarking X would see X would see what what maximum return minimum he gets in India interest rate it and spread can borrow required for from Y as taking risk interest rates in of losing money India are higher (depends on when compared credit rating of to interest Y) as well as rates charged in security being ECB loans. offered by Y. Thus bench Independent marking is party would not based on lend outside LIBOR + some India if it can basis points get higher return depending on in India. Thus credit rating of X. benchmarking would be based on interest rate receivable in India for giving loans to parties with similar credit rating as that of Y (like corporate bonds) and also level of security offered by Y. Indian companies go for External Commercial Borrowings as interest rates on ECB loans are generally cheaper than prevailing interest rates in domestic market. Thus as can be seen from above, while borrowing money by X (in India) from Y (outside India), interest rates are benchmarked with LIBOR and interest rate above LIBOR is decided by stand alone credit rating ITA No. 233/2014 Page 11 of 34 of X. On contrary, no company in India would like to investment in form of loan outside India and that also without security as interest returns in India would be higher than those prevailing in developed markets. Thus while lending money by X (in India) to Y (outside India), interest rates would be bench marked against those prevailing in India for investing in corporate bonds (which are without security). 16. We would first like to deal with aforesaid table and reasoning given in case of Logic Micro Systems Ltd. (supra) before we advert to other facets of issue. 17. In our opinion, reasoning recorded therein suffers from basic and fundamental fallacy. Transfer pricing determination is not primarily undertaken to re-write character and nature of transaction, though this is permissible under two exceptions. Chapter X and Transfer Pricing rules do not permit Revenue authorities to step into shoes of assessee and decide whether or not transaction should have been entered. It is for assessed to take commercial decisions and decide how to conduct and carry on its business. Actual business transactions that are legitimate cannot be restructured. It is not uncommon for manufacturers cum exporters to enter into distribution and marketing agreements with third parties or incorporate subsidiaries in different countries for undertaking marketing and distribution of products. Delhi High Court in Commissioner of Income Tax versus EKL Appliances Limited, (2012) 345 ITR 241 (Delhi) referred to Paragraphs 1.36 to 1.38 of Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2010 published by Organization for Economic Cooperation and Development (OECD, for short) and held as under:- ITA No. 233/2014 Page 12 of 34 17. significance of aforesaid guidelines lies in fact that they recognise that barring exceptional cases, tax administration should not disregard actual transaction or substitute other transactions for them and examination of controlled transaction should ordinarily be based on transaction as it has been actually undertaken and structured by associated enterprises. It is of further significance that guidelines discourage re-structuring of legitimate business transactions. reason for characterisation of such re-structuring as arbitrary exercise, as given in guidelines, is that it has potential to create double taxation if other tax administration does not share same view as to how transaction should be structured. 18. Two exceptions have been allowed to aforesaid principle and they are (i) where economic substance of transaction differs from its form and (ii) where form and substance of transaction are same but arrangements made in relation to transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in commercially rational manner. 18. This judgment was referred to by us in ITA No. 16/2014, Sony Ericsson Mobile Communications India Private Limited (Now known as Sony India Limited) versus Commissioner of Income Tax-III and other connected cases decided on 16th March, 2015 and it was held as under:- 147. Tax authorities examine related and associated parties transaction as actually undertaken and structured by parties. Normally, tax authorities cannot disregard actual transaction or substitute same for another transaction as per their perception. Restructuring of legitimate business transaction would be arbitrary exercise. This legal position stands affirmed ITA No. 233/2014 Page 13 of 34 in EKL Appliances Ltd. (supra). decision accepts two exceptions to said rule. first being where economic substance of transaction differs from its form. In such cases, tax authorities may disregard parties characterisation of transaction and re-characterise same in accordance with its substance. Tribunal has not invoked said exception, but second exception, i.e. when form and substance of transaction are same, but arrangements made in relation to transaction, when viewed in their totality, differ from those which would have been adopted by independent enterprise behaving in commercially rational manner. second exception also mandates that actual structure should practically impede tax authorities from determining appropriate transfer price. majority judgment does not record second condition and holds that in their considered opinion, second exception governs instant situation as per which, form and substance of transaction were same but arrangements made in relation to transaction, when viewed in their totality, differ from those which would have been adopted by independent enterprise behaving in commercially rational manner. aforesaid observations were recorded in light of fact in case of L.G. Electronics (supra). Commenting on factual matrix of L.G. Electronics case (supra) would be beyond our domain; however, we do not find any factual finding to this effect by TPO or Tribunal in any of present cases. However, in L.G. Electronics decision (supra), it is observed that if AMP expenses and when such expenses are beyond bright line, transaction viewed in their totality would differ from one which would have been adopted by independent enterprise behaving in commercially rational manner. No reason or ground for holding or ratio, is indicated or stated. There is no material or justification to hold that no independent party would incur AMP expenses beyond bright line AMP expenses. Free market conditions would indicate and suggest that independent third party would be willing to incur heavy and substantial AMP expenses, if he presumes this is beneficial, and he is adequately compensated. compensation or rate of return would depend upon whether it is case of long-term or short-term association and market conditions, turnover and ironically international or worldwide brand value of intangibles by third party. 19. It would also be appropriate at this stage to reproduce following portion from UN Model Double Taxation Convention Between Developed and Developing Countries, wherein reference ITA No. 233/2014 Page 14 of 34 was made to OECD Model Convention Commentary on Paragraph 6 of Article 11, in following words: 22. This paragraph reproduces Article 11, paragraph 6, of OECD Model Convention, Commentary on which reads as follows: 32. purpose of this paragraph is to restrict operation of provisions concerning taxation of interest in cases where, by reason of special relationship between payer and beneficial owner or between both of them and some other person, amount of interest paid exceeds amount which would have been agreed upon by payer and beneficial owner had they stipulated at arm s length. It provides that in such case provisions of Article apply only to that last-mentioned amount and that excess part of interest shall remain taxable according to laws of two Contracting States, due regard being had to other provisions of Convention. 33. It is clear from text that for this clause to apply interest held excessive must be due to special relationship between payer and beneficial owner or between both of them and some other person. There may be cited as examples cases where interest is paid to individual or legal person who directly or indirectly controls payer, or who is directly or indirectly controlled by him or is subordinate to group having common interest with him. These examples, moreover, are similar or analogous to cases contemplated by Article 9. 34. On other hand, concept of special relationship also covers relationship by blood or marriage and, in general, any community of interests as distinct from legal relationship giving rise to payment of interest. 35. With regard to taxation treatment to be applied to excess part of interest, exact nature of such excess will need to be ascertained according to circumstances of each case, in order to determine category of income in which it should be classified for purposes of applying provisions of tax laws of States concerned and provisions of Convention. This paragraph permits only adjustment of rate at which interest is charged and not reclassification of loan in ITA No. 233/2014 Page 15 of 34 such way as to give it character of contribution to equity capital. For such adjustment to be possible under paragraph 6 of Article 11 it would be necessary to as minimum to remove limiting phrase having regard to debt-claim for which it is paid . If greater clarity of intent is felt appropriate, phrase such as for whatever reason might be added after exceeds . Either of these alternative versions would apply where some or all of interest payment is excessive because amount of loan or terms relating to it (including rate of interest) are not what would have been agreed upon in absence of special relationship. Nevertheless, this paragraph can affect not only recipient but also payer of excessive interest and if law of State of source permits, excess amount can be disallowed as deduction, due regard being had to other applicable provisions of Convention. If two Contracting States should have difficulty in determining other provisions of Convention applicable, as cases require, to excess part of interest, there would be nothing to prevent them from introducing additional clarifications in last sentence of paragraph 6, as long as they do not alter its general purport. 36. Should principles and rules of their respective laws oblige two Contracting States to apply different Articles of Convention for purpose of taxing excess, it will be necessary to resort to mutual agreement procedure provided by Convention in order to resolve difficulty. 23. When this issue was last considered, some members of former Group of Experts pointed out that there are many artificial devices entered into by persons to take advantage of provisions of Article 11 through, inter alia, creation or assignment of debt claims in respect of which interest is charged. While substance over form rules, abuse of rights principle or any similar doctrine could be used to counter such arrangements, Contracting States which may want to specifically address issue may include clause on following lines in their bilateral tax treaties during negotiations, namely: provisions of this Article shall not apply if it was main purpose or one of main purposes of any person concerned with creation or assignment of debt claim in respect of which interest is paid to take advantage of this Article by means of that creation or assignment. ITA No. 233/2014 Page 16 of 34 20. Reverting to reasoning given, we record that respondent-assessee had incorporated subsidiary in United States for undertaking distribution and marketing activities for products manufactured by them. It is obvious that this was done with intention to expand and promote exports in said country and was legitimate business decision. transaction of lending of money by respondent-assessee to subsidiary, should not be seen in isolation, but also for purpose of maximising returns, propelling growth and expanding market presence. reasoning ignores said objective facet. Transfer pricing rules treat domestic AE and foreign AE as two separate entities and profit centres, and test applied is whether compensation paid for products and services is at arm s length, but it does not ignore that two entities have business and commercial relationship. terms and conditions of commercial business relationship as agreed and undertaken are not to be rewritten or obliterated. Transfer pricing is mechanism to undo attempt to shift profits and correct any under or over payment in controlled transaction by ascertaining fair market price. This is done by computing arm s length price. purpose is to ascertain whether transfer price is same price which would have been agreed and paid for by unrelated enterprises transacting with each other, if price is determined by market forces. first step in this exercise is to ascertain international transaction, which in present case is payment of interest on money lent. next step is to ascertain functions performed under international transaction by respective AEs. Thereafter, comparables have to be selected by undertaking comparability analysis. comparability analysis should ensure that functions ITA No. 233/2014 Page 17 of 34 performed by comparables match with functions being performed by AE to whom payment is made for services rendered. These aspects have been elucidated in detail in Sony India Ltd. (supra) by referring to OECD Guidelines as well as United Nations Practical Manual of Transfer Pricing for Developing Countries. 21. Appropriate in this regard would be reference also to Rules 10B and 10C of Income Tax Rules, 1962. Rule 10B (2) reads:- 10B. xxx (2) For purposes of sub-rule (1), comparability of international transaction or specified domestic transaction with uncontrolled transaction shall be judged with reference to following, namely: (a) specific characteristics of property transferred or services provided in either transaction; (b) functions performed, taking into account assets employed or to be employed and risks assumed, by respective parties to transactions; (c) contractual terms (whether or not such terms are formal or in writing) of transactions which lay down explicitly or implicitly how responsibilities, risks and benefits are to be divided between respective parties to transactions; (d) conditions prevailing in markets in which respective parties to transactions operate, including geographical location and size of markets, laws and Government orders in force, costs of labour and capital in markets, overall economic development and level of competition and whether markets are wholesale or retail. Equally important is sub-rule (3) to Rule 10B, which reads:- ITA No. 233/2014 Page 18 of 34 10B. (3) uncontrolled transaction shall be comparable to international transaction or specified domestic transaction if (i) none of differences, if any, between transactions being compared, or between enterprises entering into such transactions are likely to materially affect price or cost charged or paid in, or profit arising from, such transactions in open market; or (ii) reasonably accurate adjustments can be made to eliminate material effects of such differences. Similarly, Rule 10C (1) reads:- 10C. (1) For purposes of sub-section (1) of section 92C, most appropriate method shall be method which is best suited to facts and circumstances of each particular international transaction or specified domestic transaction, and which provides most reliable measure of arm's length price in relation to international transaction or specified domestic transaction, as case may be. (2) In selecting most appropriate method as specified in sub-rule (1), following factors shall be taken into account, namely: (a) nature and class of international transaction or specified domestic transaction; (b) class or classes of associated enterprises entering into transaction and functions performed by them taking into account assets employed or to be employed and risks assumed by such enterprises; (c) availability, coverage and reliability of data necessary for application of method; (d) degree of comparability existing between international transaction or specified domestic transaction and uncontrolled transaction and between enterprises entering into such transactions; (e) extent to which reliable and accurate adjustments can be made to account for differences, if any, between international transaction or specified domestic transaction and comparable uncontrolled transaction or between enterprises entering into such transactions; (f) nature, extent and reliability of assumptions required ITA No. 233/2014 Page 19 of 34 to be made in application of method. 22. aforesaid Rules indicate factors that ought to be taken into account for selection of comparables, which necessarily include contractual terms of transaction and how risks, benefits and responsibilities are to be divided. conditions prevailing in market in which respective parties to transactions operate, including geographical location and size of markets, laws and Government orders in force, costs of labour and capital in markets, overall economic development and level of competition, are all material and relevant aspects. If we keep aforesaid aspects in mind, it would be delusive not to accept and agree that as per prevalent practice, subsidiary AEs are often incorporated to carry on distribution and marking function. This is not unusual but common. Once this is accepted, then we cannot accept reasoning given by TPO that transfer pricing adjustment could restructure transaction to reflect maximum return that party could have earned and this would be yardstick or benchmark for determining interest payable by subsidiary AE. This is not what Chapter X of Act and Rules mandate and stipulate. aforesaid provisions neither curtail commercial freedom, nor do they bar or prohibit legitimate transaction. They permit transfer pricing adjustment so as to bring to tax what would have been paid for transaction in same or similar comparable circumstances by independent third party. 23. This ratio and rationale, when applied to facts of present case, would mean that transfer pricing determination would decide what independent distributor and marketer, on same ITA No. 233/2014 Page 20 of 34 contractual terms and having same relationship, would have earned/paid as interest on loan in question. What independent party would have paid under same or identical circumstances would be arm s length price or rate of interest. What assessed would have earned in case he would have entered into or gone ahead with different transaction, say with party in India, is not criteria. What is permitted and made subject matter of arm s length determination is question of rate of interest and not re- classification or substitution of transaction. position would have been different, if two exceptions carved out in case of EKL Appliances (supra) were applicable. 24. This is clear and lucid when we examine methodology prescribed in Rule 10B (1) (a), which prescribes manner of computing arm s length price under CUP method. Rule 10B (1) (a) reads:- 10B. (1) For purposes of sub-section (2) of section 92C, arm's length price in relation to international transaction 55a[or specified domestic transaction] shall be determined by any of following methods, being most appropriate method, in following manner, namely : (a) comparable uncontrolled price method, by which, (i) price charged or paid for property transferred or services provided in comparable uncontrolled transaction, or number of such transactions, is identified; (ii) such price is adjusted to account for differences, if any, between international transaction or specified domestic transaction and comparable uncontrolled transactions or between enterprises entering into such transactions, which could materially affect price in open market; (iii) adjusted price arrived at under sub-clause (ii) is taken to be arm's length price in respect of property transferred or services provided in international transaction or specified domestic transaction ITA No. 233/2014 Page 21 of 34 xxx 25. comparison, therefore, has to be with comparables and not with what options or choices which were available to assessed for earning income or maximizing returns. Importantly, TPO, DRP and Assessing Officer have all accepted that respondent assessee had adopted and applied CUP Method for computing arm s length interest payable by subsidiary AE. To this extent, there is no lis or dispute. 26. TPO has noticed contractual terms and referred to following facets: advance given by parent company i.e. assessed to M/s JPC Equestrian Inc. was to meet working capital requirements of subsidiary AE. He noted that when independent enterprises transact with each other, their business relations are determined by market forces operating, i.e. what is amount of interest that would have been earned had such advance been given to unrelated party placed in similar position as that of subsidiary AE. TPO had asked for audited financial accounts of subsidiary. Credit rating would be relevant. He accepted that there was sense of commercial expediency and related benefits in loan transaction but assessed had not been able to demonstrate that interest charged satisfied arm s length standard. He observed that business prudence or necessity of advancing loan to subsidiary was not relevant for computing arm s length price (i.e. rate of interest in this case) in unrelated party transactions. This aspect, he held, would not take precedence over arm s length nature of interest. ITA No. 233/2014 Page 22 of 34 27. Several aspects enunciated above, reflect correct legal position. We, however, express our inability to accept that commercial expediency and related benefits have no connection or relationship with rate of interest. In terms of Clause (c) and (d) to Rule 10B (2), contractual relations or terms, and other material facts should be recognized. Having said so, we do accept force of alternative argument advanced that this fact could be of marginal significance and effect. It would be for assessed to show and prove that transaction separately benchmarked, included consideration for lower interest rate being paid. 28. We do not agree with finding recorded in paragraph 5 of TPO s order that comparable test to be applied is to ascertain what interest would have been earned by assessed by advancing loan to unrelated party in India with similar financial health as taxpayer s subsidiary. aforesaid reasoning is unacceptable and illogical as loan to subsidiary AE in instant case is not granted in India and is not to be repaid in Indian Rupee. It is not comparable transaction. finding of TPO that for this reason interest rate should be computed at 14% per annum i.e. average yield on unrated bonds for Financial Years (FY, for short) 2006-07, has to be rejected. 29. TPO has referred to decision of Tribunal in case of Perot Systems TSI (India) Limited versus DCIT and VVF Limited versus DCIT, 2010-TIOL-55-ITAT-MUM wherein LIBOR plus 1.64% i.e. 4.03% and LIBOR plus 3% respectively, were accepted as arm s length rate of interest. But these decisions, he held, were unacceptable for reasons set out in paragraph 6.1 of TPO s ITA No. 233/2014 Page 23 of 34 order (the table has been quoted above). We have rejected reasoning given in table. 30. However, TPO was right in rejecting computation of arm s length interest on basis of Reserve Bank of India Master Circular dated 1st July, 2006 and 2nd July, 2007, fixing ceiling on interest rate on export credit at LIBOR plus 100 basis points etc. reasoning given is correct and befitting. These were special schemes floated by Reserve Bank of India for encouraging and facilitating exports with said object and purpose. Export credit interest was available only for limited number of days and for specific purposes. rates fixed did not reflect comparable market rates. 31. On question of adjustment, TPO referred to FCNR loan advanced by Power Finance Corporation to Indian company i.e. Jindal Thermal Power Company Ltd. of US$ 44.50 million. Interest charged in said case was US LIBOR plus 350 basis points for company which had been given BB+ credit rating. However, full facts like nature of transaction; risk factors etc. are not elucidated. He has also referred to Bank of Baroda website that rate of interest on FCNR loan were between 350-650 basis points over LIBOR for FY 2006-07. TPO held that in view of financial health of subsidiary AE, interest rate could be taken as average of six months LIBOR plus 400 basis points. On question of transaction cost, it was stated that it was mandatory for bank to insist that borrower must book forward contracts to hedge their position. TPO referred to premium payable for undertaking said hedging transactions and added cost of 3% per annum as premium, which should have been paid. At same time, ITA No. 233/2014 Page 24 of 34 TPO acknowledged that taxpayer was not in business of lending or borrowing money and observed that taxpayer s risk was higher in advancing loan to single customer, vis bank which spreads its risk among various customers. Banks spread their risk when loans are/were advanced to various consumers, but this does not happen when loan is given to single customer. 32. On question of adjustment made on account of transaction cost, we do not appreciate reasoning given by TPO and find it difficult to accept. transaction or hedging cost is borne and paid by borrower. These are undertaken when they take loans in US Dollars or other foreign currencies because borrower wants to cover any loss on account of depreciation of Indian Rupee vis- a- vis foreign currency. assessee in present case is not borrower, but lender. Transaction cost is not, therefore, applicable in case in question, as loan had to be repaid in US Dollars. Mark up towards transaction cost is exorbitant and even comparison with banks is unsound and unintelligible. Risk factor adjustment is also stretched, for it ignores close relationship between two AEs and funds were shareholder funds, and not borrowed money. 33. DRP accepted addition of 700 basis points on account of credit rating and transaction costs, but suggested third adjustment of 1.776 basis points was not accepted as loan was given out of shareholder funds, which flowed from one set of shareholders to another set of shareholders. security aspect it was held was embedded by default in transaction. Thus, there was no requirement to make further addition on account of security. ITA No. 233/2014 Page 25 of 34 34. In present case, loan was granted in year 2002-2003 and not during period relevant to assessment year in question. agreements in respect of loan was entered into on 13th April, 2002, 7th May, 2003 and then on 8th September, 2003. agreements fixed rate of interest at 4% per annum on principal sum. said rate has been accepted in earlier assessment years and, as noticed above, even in subsequent assessment year 2008- 09. 35. LIBOR rate plus markup or interest rate prevailing in United States at that time, i.e. 2003 have not been examined and are not basis on which TPO made adjustment and compute interest rate for transaction under consideration. It claimed that LIBOR rates in year 2002 varied between 1.447 % to 3.006 % and in year 2003 between 1.201% to 1.487%. Rates in year 2004 were again marginal, with highest at 3.100% and lowest at 1.340%. LIBOR rate of 5.224% quoted in TPO s order, it is pointed out, was rate received on investment made during assessment year in question by assessed. Thus, it was argued that present case is of long-term loan granted to AE and rate of interest charged was much higher than then prevailing LIBOR interest rate. There is no finding of TPO, DRP or Assessing Officer questioning long-term transaction as such. 36. Under sub-rule (4) to Rule 10B, data used for comparability of uncontrolled transaction should be data relating to financial year in which international transaction has been entered into. proviso permits consideration of data, not more than two years prior to financial year, if such data reveals ITA No. 233/2014 Page 26 of 34 facts which would have influenced determination of transfer price in relation to transaction being compared. transaction in question was entered into in year 2002-03 when loans were granted to AE. This was financial year of international transaction. Payment of interest is also international transaction but would have reference to year in which loan was granted in case of long term loan. However, in such situations, question may arise whether case would fall under second exception mentioned in case of E.K.L. Appliances (supra), when AE has right to recall and ask for repayment of loan. These aspects have not been considered and applied by TPO, DRP and Assessing Officer. Neither has this ground been argued before us on behalf Revenue. We, therefore, would not proceed to examine said aspect and leave question open. Similarly, we have not expressed any opinion on issue or question of thin capitalization which does not arise for consideration in present case. 37. We observe that whatever Revenue argues and submits in case of outbound loans or for that matter what we have observed would be equally applicable to inbound loans given to Indian subsidiaries of foreign AEs. parameters cannot be different for outbound and inbound loans. similar reasoning applies to both inbound and outbound loans. Revenue has erroneously argued that different parameters would apply for inbound and outbound loans, which is not acceptable . 38. DRP referred to PLR rates fixed in India. It is evident that PLR rates were not basis for fixing arm s length price. Both TPO and DRP have referred to PLR rates only by way of ITA No. 233/2014 Page 27 of 34 analogy so as to state prevailing interest rates in India, but while applying CUP method for comparability, they had applied LIBOR rates prevailing and had applied mark-up of 700 points on account of low credit rating of subsidiary AE and cost of transaction. 39. question whether interest rate prevailing in India should be applied, for lender was Indian company/assessee, or lending rate prevalent in United States should be applied, for borrower was resident and assessee of said country, in our considered opinion, must be answered by adopting and applying commonsensical and pragmatic reasoning. We have no hesitation in holding that interest rate should be market determined interest rate applicable to currency concerned in which loan has to be repaid. Interest rates should not be computed on basis of interest payable on currency or legal tender of place or country of residence of either party. Interest rates applicable to loans and deposits in national currency of borrower or lender would vary and are dependent upon fiscal policy of Central bank, mandate of Government and several other parameters. Interest rates payable on currency specific loans/ deposits are significantly universal and globally applicable. currency in which loan is to be re-paid normally determines rate of return on money lent, i.e. rate of interest. Klaus Vogel on Double Taxation Conventions (Third Edition) under Article 11 in paragraph 115 states as under:- existing differences in levels of interest rates do not depend on any place but rather on currency concerned. rate of interest on US $ loan is same in New York as in Frankfurt-at least within framework of free capital markets (subject to arbitrage). In regard to question as to whether ITA No. 233/2014 Page 28 of 34 level of interest rates in lender s State or that in borrower s is decisive, therefore, primarily depends on currency agreed upon (BFH BSt.B1. II 725 (1994), re. 1 AStG). differentiation between debt-claims or debts in national currency and those in foreign currency is normally no use, because, for instance, US $ loan advanced by US lender is to him debt-claim in national currency whereas to German borrower it is foreign currency debt (the situation being different, however, when agreement in third currency is involved). Moreover, difference in interest levels frequently reflects no more than different expectations in regard to rates of exchange, rates of inflation and other aspects. Hence, choice of one particular currency can be just as reasonable as that of another, despite different levels of interest rates. economic criterion for one party may be that it wants, if possible, to avoid exchange risks (for example, by matching currency of loan with that of funds anticipated to be available for debt service), such as taking out US $ loan if proceeds in US $ are expected to become available (say from exports). If exchange risk were to prove incapable of being avoided (say, by forward rate fixing), appropriate course would be to attribute it to economically more powerful party. But, exactly where there is no special relationship , this will frequently not be possible in dealings with such party. Consequently, it will normally not be possible to review and adjust interest rate to extent that such rate depends on currency involved. Moreover, it is questionable whether such adjustment could be based on Art. Commissioner Of Income-tax-I v. M/s Cotton Naturals (I) Pvt. Ltd