Tribunal Limits Scope Of ‘Associated Enterprises’: Influencing Price Without De Facto Control Not Enough for Applying Transfer Pricing Regulations
Recently, the Chennai Bench of the Income Tax Appellate Tribunal (“ITAT”) in the case of Orchid Pharma Ltd. v. Deputy Commissioner of Income Tax clarified the scope of the concept of associated enterprises under the Income Tax Act, 1961 (“ITA”) and held that mere influence over price by one enterprise is not sufficient to constitute participation in ‘control’ of that enterprise over the other as mandated under Section 92A(1). The ITAT discussed the interplay between the basic definition of AE under Section 92A(1) and situations listed in Section 92A(2), holding that the two should be read conjointly to determine whether two enterprises qualify as AEs.
Orchid Pharma Ltd. (“OPL”/ “Taxpayer”) is a global pharmaceutical company which produces and sells active pharmaceutical ingredients (APIs) and finished dosage forms (FDFs) around the world. In furtherance of its business, OPL has entered into distribution channel arrangements with various overseas entities for marketing and distributing the Taxpayer’s products in their respective markets. During the relevant financial year, transfer pricing scrutiny was initiated against OPL with respect to its arrangement with Northstar Healthcare Limited (“Northstar”), an Irish company, who acted as a distribution partner of the Taxpayer. The profit sharing arrangement between Northstar and the Taxpayer was as follows –
Additionally, there was also a tripartite agreement along similar lines where the Taxpayer was the manufacturer, Northstar was the distributor, while an entity named Actavis Elizabeth LLC, USA (“Actavis”) undertook the necessary research and development. In this arrangement, the Distribution Profit was shared as – Northstar 50%, OPL 25% and Actavis 25%.
The Transfer Pricing Officer (“TPO”) squarely relied on an order of the Settlement Commission in the same case for an earlier assessment year where the Commission was of the view that the Taxpayer and Northstar were ‘associated enterprises’ (“AEs”) under Section 92A(2)(i) of the ITA, and therefore the distribution arrangements between the two were subject to transfer pricing adjustments. Basis the TPO’s adjustments, the Assessing Officer (“AO”) passed a draft assessment order, which was subsequently confirmed by the Dispute Resolution Panel. On appeal, the Taxpayer approached the ITAT.
Section 92A(1) defines AE for the purpose of transfer pricing provisions as an enterprise which –
a. directly or indirectly participates “in the management or control or capital of the other enterprise”; or
b. If the same persons participate in the management, control or capital of both the enterprises.
Section 92A(2) states that for the purposes of Section 92A(1), two enterprises shall be deemed to be AEs if, inter alia –
“(i) the goods or articles manufactured or processed by one enterprise, are sold to the other enterprise or to persons specified by the other enterprise, and the prices and other conditions relating thereto are influenced by such other enterprise”
Whether the OPL and Northstar qualify as AEs under Section 92A(1) read with Section 92(A)(2)(i) of the ITA.
The ITAT at the outset held that decisions of the Settlement Commission do not constitute binding legal precedent and the TPO ought not to have squarely relied on that. However, the ITAT examined the line of reasoning followed by the Settlement Commission (which the TPO relied on) and held that merely because Northstar may influence prices and other conditions relating to sale, it would not constitute as an AE of OPL under Section 92A(2)(i) since the sales channeled through Northstar are only 5% of the total sales of OPL, and the ‘influence’ of Northstar over prices does not qualify as ‘dominant influence”. Hence, there is no “control” of Northstar over OPL as mandated under Section 92A(1).
a. Enterprise should have de facto control: Section 92A(1) sets out the basic rule for qualification of an enterprise as an AE in relation to the other, i.e., participation “in the management or control or capital of the other enterprise”, or common participation thereof in both. Further, Section 92A(2) specifically provides illustrations of the situations, as stated in clauses (a) to (m) therein, in which one enterprise would be deemed to be an AE of the other. The ITAT relied on the Memorandum explaining the Finance Bill, 2002 which while inserting the phrase “for the purposes of sub-section (1)” in Section 92A(2) explained that merely satisfying Section 92A(1) in terms of participation in the management, capital or control would not qualify the AE test unless the criteria laid down in Section 92A(2) was also fulfilled.
The ITAT classified the illustrations under 92A(2) into three distinct segment –
ITAT observed that unlike the other clauses of the Third Segment, Clause (i) does not have a quantitative threshold of activity such as a percentage or otherwise. Hence a literal interpretation of clause (i) could result in absurd conclusions as even sales to the other enterprise constituting less than one percent would be sufficient to qualify the AE test if the other enterprise can influence the price of the goods sold. Therefore the ITAT held that in addition to the words of Section 92A(2)(i), the mandate under Section 92A(1) should also be satisfied and the level of commercial relationship under Section 92A(2)(i) should necessarily constitute participation of one enterprise over ‘control’ of the other. The ITAT in principle relied on a decision by the co-ordinate bench of the Bangalore ITAT in Page Industries Limited v. DCIT1 which held that in order to constitute relationship of an AE, the parameters laid down in both Section 92A(1) and Section 92A(2) should be satisfied.
Accordingly, the ITAT held that in the instant case, even though the wordings of Section 92A(2)(i) are admittedly satisfied, Northstar cannot be considered as an AE of OPL since the mandate of Section 92A(1) with regards to “control” is not satisfied. This is because the scale of commercial relationship between the two is too insignificant vis-à-vis the total business operations of the Taxpayer for there to be any “control” of Northstar over the Taxpayer.
b. “influence” should be “dominant influence”: The ITAT held that the ‘influence’ over prices and other related conditions contemplated under Section 92A(2)(i) is something more than influence in the ordinary course of business and in the process of negotiation. It should be read as ‘dominant influence’ which leads to a de facto control over the enterprise rather than an influence simplicitor. Any other interpretation would lead to incongruous results as all enterprises dealing with each other on negotiated prices would be considered as AEs. ITAT relied on a principle of interpretation explained by the Supreme Court in CIT v. Hindustan Bulk Carriers2 which states that a construction which renders the statute futile should be avoided. Explaining further, the ITAT held that acceptance of terms of the buyer on commercial considerations cannot be treated as an ‘influence’ of the buyer. It becomes ‘influence’ for the purpose of Section 92A(2)(i) when the seller is placed in such a situation that he has no choice but to accept the price (or other related conditions) dictated by the buyer due to the buyer’s dominant influence.
Applying this to the instant case, the ITAT held that the influence of Northstar, given the scale of business through Nortstar as a distribution partner is too modest to make it a dominant influence in the nature of control. Hence, the Taxpayer and Northstar cannot be considered AEs under Section 92A.
Globally, countries follow either of the two approaches to the concept of AEs – wider approach and a narrow approach. A narrow approach only considers formal or de jure relationships such as formal participation in the management or capital through shareholding, advancement of loan or guarantee, right to appoint board members etc. A wider approach to the concept of AE additionally also takes into account de facto control in the absence of formal participation in capital or management. Such de facto control could be through commercial relationships in which one has dominant influence over the other. Unlike countries such as Netherlands, India follows the wider approach which is reflected in Section 92A(1) of the ITA requiring participation in “control” in addition to management and capital, and further illustrated in cases under the Third Segment (explained above) of Section 92A(2) which reflect de facto control where enterprises are deemed to be AEs despite having no formal association. The wider concept of AEs is also contemplated in the OECD Model Tax Convention, and in India’s Double Taxation Treaties.
This is a welcome judgment which sincerely attempts to clear the vagueness associated with the concept of AEs under the ITA. While it is recognized that Section 92A(1) which lays down the basic rule for qualification of AE is restricted in its scope only to illustrations laid down in Section 92A(2), the ITAT reverses the rule as it is faced with a situation where the requirements under Section 92A(2)(i) are satisfied but those under Section 92A(1) are not. To that extent, the ITAT has limited the application of cases falling under clause (i) of Section 92A(2) only to the extent that the commercial relationship should be significant enough to qualify as “control”, and the influence on prices and other related conditions should be “dominant influence” and not merely influence “simplicitor”. This conjoint reading of Section 92A(1) and (2) with both sub-sections mutually limiting each other’s scope goes a long way in reducing the existing subjectivity in the AE test.
This judgment is especially relevant now considering that the significance of the AE test goes beyond the transfer pricing provisions. The recent Budget 2017 proposes to introduce thin capitalization rules as an anti-avoidance measure under Section 94B of the ITA (please see our hotline on the Budget which also discusses thin capitalization http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/article/india-budget-analysis-2017-18.html?no_cache=1&cHash=220b45800a7409f2a176d3f5bae6f155). The proposed thin capitalization rules limit permissible deductions on interest payments by an Indian company to its overseas AE only up to 30 per cent of the Indian company’s earnings before interest, taxes, depreciation and amortization (“EBITDA”), and any deduction in excess is disallowed for that year. AEs being defined so widely under the ITA, often independent third parties are also deemed to be AEs as illustrated in this case. Resultantly, the thin capitalization could target transactions beyond just intra-group transactions which may not have been the intention in the first place. The streamlined interpretation of AEs attempted by the ITAT in this case, especially in the context of deemed AEs, could spill over to other provisions of the ITA such as thin capitalization.
Additionally, the judgment is also relevant considering the fact that the definition of connected persons under the General Anti Avoidance Rules (“GAAR”) provisions, slated to become operative from April 1st 2017 includes AEs. Reading Section 92A(2) as a deeming provision coupled with the literal interpretation of Section 92A(2)(i) and GAAR would leave a lot of room for ambiguity and cumbersome litigation. As recommended by the ITAT, an amendment in Section 92(2)(i) providing for a threshold would help reduce this potential wastage of resources in endless litigation.
As the legislation is amended to cast a wider net and plug loopholes, at times, due to poor drafting or unforeseen consequences, some provisions intended to help taxpayers can have an unintended negative impact. The judiciary must step in at such times by giving a purposive rather than literal interpretation to such provisions in order to give effect to the intention of the Parliament. Taxation is not merely an exercise of revenue generation and collection. If that were the case, a simple flat rate with no exemptions and deductions would suffice. It is, instead, a tool in the hands of policy makers to help guide investment and the economy by providing incentives in particular sectors and disincetivising certain practices such as the recent initiatives to disincentivise cash transactions. Accordingly, a provision when interpreted literally, which tends to abuse the Act as a whole or negates the intention of the Legislature must be read down in order to give effect to the clear intentions of Parliament.
1 (2016) 159 ITD 680 (Bang.)
2 (2003) 259 ITR 449 SC