India: Inter-company loan(s) and transfer pricing implications

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published on 21 August 2023 | reading time approx. 4 minute


With the liberalization of foreign investment in the Indian markets, the structure of foreign inflow gradually witnessed a shift from traditional capital or private equity funding to a newer and structured debt funding known as External Commercial Borrowing (ECB).
 

 


Background

This growth of ECBs through these years, which also represents the most common form of inter-company financing by Multinational Enterprises (MNE) for their Indian entity operations, can be attributed to the interest rate disparity within the domestic and international market, mixed with the corporate tax benefit of interest expenditure allowance and lower withholding rates being available under the Indian tax regulations, subject to attached conditions.
 

Regulatory framework

To regulate the inflow of ECBs, the apex banking authority in India, the Reserve Bank of India (RBI) was em­pow­ered by Foreign Exchange Management Act, 1999 (FEMA) to regulate such debt arrangements and pass necessary regulations.
 
Accordingly, FEMA regulations were framed which essentially eased the regulatory burden of approvals on the Indian borrowers, with an automatic approval route, wherein no prior approval or consent from the Indian government (GoI) is required, provided that the area of investment made is not sensitive and does not require regular monitoring.
 
In this regard, RBI has been issuing Master Directions since 2016 on all regulatory matters. This Master Direc­tion provides for all-in-cost ceilings i.e. interest rate thresholds, subject to the nature and tenure of the ECBs, and also consolidates and subsumes all instructions, directions, and circulars till date.
 
An indicative summary of the all-in-cost ceilings applicable as per the latest Master Direction, updated as on 9 June 2022, has been provided below for ease of reference:
 
Particulars
All-in-cost ceiling p.a.
Purpose
Maximum limit
Loan through ECB

Existing ECBs in LIBOR – Benchmark rate + 550 bps

 

New ECB in FCY – Benchmark rate + 500 bps

 

ECB in INR – Benchmark rate (prevailing yield of GoI securities with the same maturity) + 450 bps

All purposes except those specifically disallowed in the negative end-use listDifferent for different sectors
 

Transfer pricing regulations and the benchmarking requirements

Thus, as depicted above, these RBI Master Directions do provide for plain vanilla guidance toward the maxi­mum interest rate payable for ECBs, however, any reliance by the Indian entity on these regulations while fixing the interest rate and/or for justification of the interest rate paid/payable to overseas MNE Group entity is increasingly being rejected by the Indian Tax authorities.

This is for the reason that Tax authorities are of the opinion that these RBI regulations and the interest rate thresholds are provided for foreign exchange regulations purposes and cannot be substituted as an arm’s length interest rate adhering to the Transfer Pricing principles.
 
Further, the Organisation for Economic and Co-operation Development (OECD) through its Transfer Pricing Guidance on Financial Transactions, as published in February 2020 and incorporated in the revised OECD Guidelines 2022, also addressed the issues revolving around Intra Group Loans and their pricing meeting the arm’s length principles. The important conditions set forth as per the revised OECD Guidelines, to determine arm's length price for financial transactions, has been summarized below:
 
​Process
​Description
​Determination of the creditworthiness of the borrower​The probability of default of a borrower is commonly conveyed as a credit rating
​Search for comparable debt transactions with similar characteristics of the tested loan​External comparables for benchmarking can be searched on publicly available financial databases, by applying appropriate filters to find comparable loan transactions with the same characteristics:
  • Currency type
  • Tenure
  • Purpose: General/Working Capital/Capital Expansion/Re-financing, etc.
  • Tranche Type: Term Loan/Revolving Credit
  • Covenants: Secured/Unsecured, Guaranteed/Not Guaranteed, Sponsored/Not Sponsored
  • Credit Rating
​Computation of Arm’s Length interest rate ​Arm’s length interest rate (or range) of the selected comparable loan transactions to be determined, which can be further adjusted to meet the economic conditions of the tested loan transaction:
  • Interest Swap Adjustment: Fixed to Floating or vice-versa
  • Tenor Adjustment
  • Country Risk Adjustment: To factor in the geographical difference

Further, as per the approach adopted the Tax authorities, and as supported by judicial precedents, it can be inferred that the Indian Transfer Pricing Regulations also require comprehensive testing of the interest rate in line with arm's length principles, and mere reliance on the RBI regulations for interest rate thresholds cannot be considered as an appropriate benchmarking approach.

A summary of various recent rulings pronounced on the issue of benchmarking of interest related payments along with the principles laid down by various courts is provided below:

​Case citation
​Decision summary
​Winergy Drive Systems India
Private Limited [ITA.No.1720/Mds/2014
​A reference to unadjusted interest rate in respect of India’s External Debt cannot be applied in taxpayer’s case, and a separate arm’s length determination based on comparables is required to be performed.
​LTIMindtree Limited [ITA No.1924/Mum/2014]​The Tax officer was correct in concluding that the interest rate of loan taken by the taxpayer cannot be compared with interest rate of the loan given by the taxpayer to its AE. As it is not in dispute that there is a difference in credit rating of the taxpayer and its AE, and necessary adjustment is required to adjust such difference.
​Broadways Overseas Ltd. [ITA Nos. 477/Asr/2015 and others]​The Tax officer erred in benchmarking the interest rate against the expected return from investment in bonds, as the loan advanced in foreign currency should have been benchmarked by using LIBOR.

Way forward

In light of the above, and in the endeavor to implement the ECB interest rates in line with the available Transfer Pricing related guidance, the following points require due consideration:
  • a benchmarking study is to be conducted from the relevant financial databases, to determine the arm’s length interest rate in line with the underlying loan conditions
  • entering into an ECB arrangement (i.e. agreement) based on the arm’s length interest rate so derived
  • enter into an amendment to the existing ECB agreement, if applicable, based on the revised arm’s length interest rate so derived

Accordingly, it is strongly recommended that in an inter-company loan scenario including ECB loans, a bench­marking exercise for determination of the arm’s length nature of interest payment to be conducted separately, as the onus lies on the taxpayer to justify the arm’s length nature of such interest payments along with main­taining appropriate back-up documentation (i.e. benchmarking study).
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