ORDER

Vijay Pal Rao, Judicial Member - This appeal by the assessee is directed against the assessment order dated 18.10.2011 passed u/s 143(3) r.w.s 144C(13) in pursuant to the directions of the Dispute Resolution Panel (DRP) dated 25.8.2011 passed u/s 144C(5) of the Act for the Assessment Year 2007-08.

2 The assessee has raised the following grounds in this appeal:

3. Ground no.1 is general in nature and therefore, no specific finding is required.

4. During the course of hearing, the ld AR of the assessee has stated that the assessee does not press ground nos. 3 & 4 and the same may be dismissed as not pressed. The ld DR has no objection, if the ground nos.3 & 4 are dismissed as not pressed.

5. Accordingly, ground nos. 3 & 4 of the appeal of the assessee are dismissed, being not pressed.

6. The only ground left for our consideration and adjudication is ground no.2 which relates to transfer pricing adjustment of Rs. 53,43,272/- being interest on advances given to the Associated Enterprises (AEs).

6.1 The assessee is engaged in the business of software development and web designing services. The Assessing Officer noted that the assessee has given loans of Rs. 15.65 crores to its AEs in USA, Singapore and Bahrain. The assessee claimed the said loans as working capital advances to its 100% subsidiary outside India. Accordingly, the Assessing Officer made a reference u/s 92CA(1) of the I T Act to TPO for computation of Arm's Length Price (ALP) in relation to international transactions.

6.2 The assessee contended before the TPO that the advances were given towards working capital on cost plus zero margin as the AEs were giving the business to the assessee without any cost borne by the company and hence, assessee benchmarked the transactions at the cost plus zero mark-up claiming to use cost plus method.

6.3 The TPO found that as in a third party comparable situation, advances would bear interest and therefore, there is a need to charge a mark up as per CUP method. Accordingly, the TPO proposed to benchmark the loans at dollar denominated LIBO (London Inter Bank Operative) Rate plus mark up of 3%.

6.4 The assessee objected to the proposed benchmark of the loans and contended that no cost has been incurred by the assessee and hence no interest was charged by them. Further, it was claimed that the AEs have given fair margins to the assessee and assessee has full control on its AEs and the loans were in the nature of quasi equity and there is no diversion of interest bearing funds.

6.5 The TPO has not accepted the explanation of the assessee and relied upon the decision of the Tribunal in the case of M/s Perot Systems TSI v. DCIT. Accordingly, the TPO has held that in a comparable uncontrolled situation, funds given as advances would have been liable to interest. The TPO has benchmarked the transaction by taking an interest rate of LIBOR plus 3%. Accordingly, the transfer pricing adjustment has been worked out on account of interest at LIBRO plus 3% for the proposed addition at Rs. 30,80,035/-. Consequently, the Assessing Officer issued a draft assessment order, proposing inter alia transfer pricing addition on account of ALP of interest not charged by the assessee, taking the rate of LIBOR plus 3% amounting to Rs. 30.80,035/-.

6.6 The assessee has filed objections before the DRP and raised the contention as before the TPO. The DRP found that the TPO erred in benchmarking interest rate on outbound loan with LIB0R. The DRP was of the view that only inbound loans i.e;. ECBs (External Commercial Borrowings) taken by the Indian entities from outside India are to be bench marked with LIBOR. In the case of outbound loan, as in the instant case, it is not appropriate to benchmark the interest with LIBOR, as interest applicable would be prevalent in Indian financial system. Thus, the DRP held that while lending money by Indian entity to outside Indian, the interest rate would be benchmarked against those prevailing in India for investing in corporate bonds without security. The DRP has given the reason that since the tested party is taxpayer, the prevalent interest that could have earned by the taxpayer by advancing a loan to an unrelated party in India with the same financial health as that of the taxpayer's AE is to be considered. Hence, the DRP took interest rate prevailing in India on corporate bond for benchmarking the loan transaction in question. The DRP treated the AE of the assessee equal to unrated bonds having very high risk. The yield on BBB rate accordingly was considered by the DRP at 11.40% for the Financial Year 2006-07. Thus, taking the loans to the AE carrying a very high risk, the DRP took the rate of interest at 14% per annum as reasonable and representative of the market. Accordingly, the DRP directed the TPO/Assessing Officer to compute the interest on loans to AE @ 14% per annum on monthly closing balances for the period from 1.4.2006 to 31.3.2007 and consequently, enhanced the transfer pricing adjustment. The Assessing Officer accordingly made the adjustment of Rs. 53,43,272/- on this account while passing the impugned assessment order as per the directions of the DRP.

7. Before us, the ld AR of the assessee has submitted that the advance was given to 100% subsidiary outside India as working capital loan. Since the assessee is getting business from the AEs; therefore, the transaction has to be seen on commercial consideration as no motive to evade tax by shifting the income to tax heaven. He has further contended that all the AEs are wholly subsidiaries of the assessee and there is no relationship as lender and borrower. One cannot earn the interest by borrowing to itself. He has further submitted that the objection of the transfer pricing provisions are intended to ensure that profits taxable in India are not understated by declaring lower receipts or higher outgoings in relation to the transaction with related parties. Thus, the basic intention underlying the transfer pricing regulations is to prevent shifting out of profits by manipulating prices charged or paid in international transactions. The advances were given to the AEs in the ordinary course of its business and it cannot be presumed that if the assessee has not financed the AEs, the AEs would have borrowed from other parties. The ld AR has contended that it is not a case of financing AE in the nature of loan without any business transaction. The entire transaction has to be looked into in the context of commercial consideration; therefore, no addition on account of transfer pricing adjustment is called for.

7.1 The ld AR has further contended that the authorities have held that the loans given to the AEs bearing high risk, which is not correct because the AEs is 100% subsidiary of the assessee; therefore, there is no risk of credit. He has further submitted that when the assessee has not incurred any cost for giving advances to the AEs; therefore, benchmarking of the transactions would be cost plus zero. The AEs of the assessee are not in any tax heaven country and therefore, the decision of the Delhi Benches of the Tribunal in the case of M/s Perot Systems TSI, relied upon by the TPO is not applicable in the facts of the assessee's case.

7.2 Alternatively, the ld AR of the assessee has submitted that while applying the transfer pricing principles and determining the ALP interest rate prevailing in the country, the borrower should be taken and used for benchmarking. He has further submitted that the interest rate to be used for benchmarking shall be the rate of interest in respect of the currency in which underlining transaction has taken place in consideration of economic and commercial factors around the specific currency. In support of his contention, he has relied upon the following decisions:

7.3 Thus, the ld AR of the assessee has submitted that the Tribunal in these decisions has held that in the case of transfer pricing, the rate of interest to be applied should be LIBOR and accordingly pleaded that in the case of the assessee also the LIBOR should be applied without any higher estimate of 3% considered by the TPO or the rate applied by the DRP.

7.4 On the other hand, the ld DR has referred the provisions of section 92B and submitted that the term 'international transaction' as per sec. 92B includes lending or borrowing of money to AEs. Thus, the ld DR has submitted that advancing loan to AEs is undoubtedly an international transaction. Even the Tribunal, in the decision relied upon by the ld AR has held that the advance to AEs is an international transaction. He has further contended that under the transfer pricing provisions and regulations, there is no requirement of shifting the income to tax heaven for treating a transaction as an international transaction. In the absence of any such condition, if the transaction falls within the meaning of international transaction, then ALP has to be determined as per the provisions provided under the statute.

8. We have considered the rival submissions as well as relevant material on record. The first contention of the ld AR of the assessee is that the advance was given to the AEs towards working capital and the assessee is getting good business from the AEs; therefore, having commercial consideration, no adjustment of transfer price is justified. We do not agree with the contention of the ld AR because, though it may be an objective behind the Transfer Pricing Regulation that the profits taxable in India are not shifted out of India by manipulating the price charged between the AEs; however, as per the Transfer Pricing Regulations, there is no such condition of existence or non-existence of commercial consideration between the assessee and the AEs.

8.1 Further, in the case in hand, the advance does not represent the credit period extended to the AEs in respect of the business transaction; but it is a transaction of advancing loans to the AEs. The transaction of advancing loans to the AEs falls under the ambit of international transactions as per the terms of Sec 92B whereby the "international transaction" means a transaction between two or more associated enterprises, inter alia lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises………………………..

8.2 Thus, the transaction of advancing loans to the AEs undoubtedly falls within the meaning of international transaction as per section 92B. Even otherwise, the Tribunal in the case of Tata Autocomp Systems Ltd (supra) as relied upon by the assessee held in paras 16 & 17 as under:

16. Interest free loan extended to the associated concerns as at arm's length lending or borrowing money between two associated enterprises comes within the ambit of international transaction and whether the same is at arms length price has to be considered. The question of rate of interest on the borrowing loan is an integral part of arms length price re-determination in this context. The fact that the loan has the RBI's approval does not put a seal of approval on the true character of the transaction from the perspective of transfer pricing regulation as the substance of the transaction has to be judged as to whether the transaction is at arms length or not. The Delhi Bench of ITAT in the case of Perot Systems TSI (India) Ltd. v. DCIT (supra) had considered identical argument and held as follows:

"9. Before us, the ld. Counsel of the assessee contended that income means real income and not fictitious income and since the assessee has not earned any income, the same cannot be taxed. Reliance in this regard has been placed upon in the case of CIT v. KRMTT Thiagaraja Chetty & Co. reported in 24 ITR 525 (SC) & in the case of Morvi Industries Ltd. v. Commissioner Of Income Tax (Central) Calcutta reported in 82 ITR 835 (SC) for the proposition that liability to tax can arise only when there is income. No tax can be charged as notional income on accrual. Further reliance has been placed upon the ruling of Authority for Advance Rulings delivered in the case of Veneburg Group B.V. v. CIT 727 of 2006 for the proposition that in the absence of any income, Transfer Pricing provisions being machinery provision shall not apply. It has further been argued that Transfer Pricing document maintained by the assessee clearly mentioned that these loans/advances are in the nature of quasi-equity and hence the transaction of granting interest free loan is at arm's length. The loan agreements mentioned that these are interest free loans. Reliance in this regard is placed upon the decision of Delhi Tribunal in the case of Sony India Ltd. 114 ITD 448 Para 100 that "under fiscal loans actual transaction as entered between the parties is to be considered. Authorities have no right to re-write the transaction unless it is held that it sham or bogus or entered into by the parties to avoid and evade taxes." Further reference has been made to para 1.37 of 1995 of OECD guidelines for the proposition that it is legitimate to consider that economic substance of the transactions. The transactions has been said to be commercially expedient and loan granted to support the subsidiary and obtain returns in future. The assessee had full control over its subsidiary which reduce the credit risk. The loan had been duly granted by the approval of the RBI. The Income Tax Act, 1961 and OECD guidelines support the contention that the effect of government control/ intervention should be considered while determining the arm's length price. Under the thin capitalization rules, no deduction was allowable to the Hungary entity for payment of interest therefore, there existed impossibility of performance with regard to payment of Hungary entity. Economic circumstances of the subsidiaries did not warrant the charging of interest from subsidiaries. The ld. Counsel for the assessee further relied upon the Apex Court decision in the case of M/s S.A. Builders Ltd. v. CIT(Appeals) and others 288 ITR 1 (SC) .

9.1 The ld. DR for the revenue on the other hand relied upon the orders of the ld. CIT(A), he claimed that the ld. CIT(A)'s order was a speaking order and it has rebutted all the arguments of the assessee.

10. We have carefully considered the submissions and perused the records. The primary contention before us, as submitted by the ld. Counsel of the assessee is that it was commercially expedient for assessee to advance interest free loans to the AEs and that since no interest has actually been charged, there is no real income exigible to tax. As observed by the ld. CIT(A) the agreements show that these are loan amount given by the assessee to Associated Enterprises (AEs). This in fact is an admitted position. There is no case that any special feature in the contract make the transaction as capital in nature. It is also an admitted proposition that the assessee has extended the loan to its AE's who are 100% subsidiaries. The Assessee's case is that it has actually not earned any interest and it was commercially expedient to extend these interest free loans. Now it is noted that this is not a case of ordinary business transaction. The question relates to scrutiny of international transaction to determine whether or not the same it as arm's length. The principle of transfer pricing aims at determining the pricing in the situations of cross-border international transactions, where two enterprises which are subject to the same centre or direction or control (associated enterprise) maintain commercially or financially relation with other. In such a situation, the possibility exist that by way of intervention from the centre or otherwise, business conditions must be accepted by the acting units which differs from those which in the same circumstances would have agreed upon between unrelated parties. The aim is to examine whether there is anomaly in the transaction which arise out of special relationship between the creditor and the debtor. Hence the contention of having actually not earned any income cannot come to the rescue of the assessee in this scenario. The case laws from the Apex Court cited by the ld. Counsel of the assessee are in the context of the proposition that only the real income has to be taxed and interest free advances can be given by companies (domestic) to their subsidiaries on the ground of commercial expediency. But these decisions are not in the context of Chapter-X of the IT Act which relates to special provision relating to computation of income from international having regard to arm's length price. Other case laws cited by the assessee are not germane to the facts of this case. Hence in our considered opinion they do not help the case of the assessee."

17. The aforesaid decision of the Tribunal is an answer to the argument of the Assessee before us that the impugned addition could not have been made by the AO at all. Respectfully following the said decision, we hold that the AO was well within his powers in making the impugned addition. The justification for the quantum of notional income considered as taxable in the hands of the Assessee is a matter which we will examine in the subsequent paragraphs."

8.3 Accordingly, we do not have any doubt in mind that the transaction in question is an international transaction and subjected to the ALP as per the Transfer Pricing Regulations.

8.4 Having treated the transaction as international transaction, the only question remains to be considered and adjudicated is Arm's Length rate of interest.

8.5 So far as the question of most appropriate method for determining the ALP is concerned, the same is also settled by the various decisions as relied upon by the assessee wherein it has been held that in case of benchmarking of interest on the loans to the AEs, CUP is the most appropriate method for determining the ALP. Even, the assessee has not challenged the method adopted by the authorities below for determination of the ALP in the case of the assessee.

8.6 Now, the question arises whether LIBOR rate or prevailing market rate in India could be considered for determining the Arm's Length interest rate in respect of the loans advanced by the assessee to the AEs. The TPO had adopted LIBOR plus 3% as ALP for the rate of interest on the loan transaction in this case; whereas the DRP took the bond rate prevailing in Indian market and treated the AE as below BBB rating bond and accordingly, determined the rate at 14% as ALP in para 3.8 to 3.11 as under:

3.8 Since the taxpayer has extended loans to its AE without charging interest, similar uncontrolled transaction would have provided for interest and in view of this fact the international transaction representing loans without charging interest are not at arm's length price, within the meaning of section 92C(3) of the Income Tax Act read with Rule 10B (1)(a) of the Income Tax Act, the arm's length interest is to be determined by following CUP method wherein the interest rate is determined under the circumstances in which the taxpayer and its AE are operating i.e. what is the interest that would have been earned if such loans given from the funds of Indian entity to unrelated parties in similar situation as that of the AE. Since the tested party is taxpayer, the prevalent interest that could have earned by the taxpayer by advancing a loan to an unrelated party in India with the same weak financial health as that of the taxpayer's AE is to be considered.

3.9 Corporate bonds issued by companies in India also give an indication of interest that could be earned if, the amount is lent to the companies. Government bonds are subject only to interest rate risk. However, corporate bonds are subject to credit risk in addition to interest rate risk. Interest rate risk refers to the risk of a bond changing in value due to changes in the structure or level of interest rates. It is seen from the information available in the public domain that the yield rate on corporate debt papers (with AAA rating) for five year maturity ranged between 7.24 percent and 8.43 per cent in 2005-06, 8.43 per cent and 9.44 per cent in 2006-07. Thus the average yield on 5 year AAA rated corporate bonds can be reasonably considered at 8.9% (arithmetical mean of 8.43% and 9.44%) for the FY 2006-07. Further, it is seen that the yield spread between BBB grade corporate bond (investment bonds and AAA rated corporate bond reduced from 300 basis points from the beginning to 200 basis points till the end of FY 2006-07. It can be inferred from this fact that for the FY 2006-07, the average yield on five year BBB grade corporate bond is around 250 basis points more than that of AAA rated corporate bond, Thus the yield on BBB rated corporate bond may be considered at 11.40% p.a for the FY 2006-07 The higher the risk, the higher is the interest rate or the yield. Further, it is seen that the yield on unrated bonds can be taken as 20% more than the lowest graded bond BBB.

3.10 It is not considered fit that the AE of the taxpayer can be rated even as BBB (investment grade). Thus, as the risk is very high, a rate of interest of 14% p.a could be considered reasonable and representative of the market after considering the corporate bond market and the financial health of the AE.

3.11 So keeping all the above issues in consideration, it is considered view of the Panel that a reasonable interest rate of 14% appears appropriate in the facts and circumstances of the taxpayer. Hence, the interest on the loans facility extended by the taxpayers to its AE should be computed at the rate of 14% p a on the monthly closing balance for the period from 1.4.2006 to 31.3.2007. The Assessing Officer is directed to re-compute the arm's length interest, TP adjustment and addition on account of TP adjustment in view of the above direction, which may result in enhancement of TP adjustment and addition of Rs. 30,80,035/- as made by the TP/TPO."

8.7 Under the Transfer Pricing Regulations, an international transaction has to be compared with an uncontrolled transactions between unrelated parties which means that an international transaction is tested with the transaction, if the assessee could have entered into a similar transaction with unrelated third party and thereby the income of the assessee would have earned from a similar transaction with an uncontrolled party. Thus, the same income is expected or deemed to have been earned from the transaction with the AEs. The underlining principle of determining the ALP is based on the transaction between the unrelated parties. The income of the assessee should not be effected as reduced and therefore, the same is compared with the income or expenditure as the case may be earned or incurred by the assessee, if it would have been between the assessee and the unrelated parties. Therefore, tested party for the purpose of determination of ALP is the assessee and not the AEs.

8.8 In the case in hand, the assessee has advanced loans to the AEs without charging any interest; therefore, the transaction has to be tested with a situation, had the assessee invested or advanced or deposited the said amount with an unrelated third party and thereby the income, which would have been earned by the assessee is expected to have been earned from the transaction of advancing loans to the AEs.

8.9 Thus, on principle, we do agree with the DRP on the point of the tested party for determining the Arm's Length interest rate that would have been earned by the assessee by advancing loans to the unrelated third party.

8.10 The Transfer Pricing Regulation are based on the deeming principle by taking into account a hypothecal situation that instead of having transaction with AE had the assessee transacted with unrelated party what would have been the financial/commercial result of that transaction. Thus, the effect of transaction on the income of the assessee is to be seen and considered and not effect on the cost or income of the AE. Therefore, the tested party is always the taxpayer and not the AE. None of the factors under the Transfer Pricing Regulations require to consider whether the AEs would have incurred or earned more or less; but it is always considered whether the assessee had earned more or less by doing a similar transaction with an unrelated parties.

8.11 Even under Rule 10B of the IT Rules, the factors prescribed for inclusion or exclusion of comparables to determine the ALP are also based on the comparison of the assessee with the chosen entities and the AE has no rule in the exercise of selecting the comparables. Thus, in our view, the interest that would have been earned by the assessee by advancing or placing the said amount with unrelated parties would be the Arm's Length interest in relation to the interest free loans/advances to the AE. The safest comparables, which can be taken as Arm's Length interest rate in such a case would be the interest on FD with the bank for a term equivalent to the term for which the loans given to the AEs.

8.12 It is pertinent to note that in case of FD with the Bank, the investment is safe as it is free from risk of credit and interest. On the other hand, if the loan/advance is given to the unrelated party, then always there is some risk of credit and interest involved in such transaction. There is one more reason for taking the FD as an appropriate and good comparable because the lending rate by financial institutions/bank varies depending upon the credit rating of the borrower and further on the guarantee and security provided to secure the loans.

8.13 Though in principle we do concur with the view of DRP on this issue, however, since the issue of LIBOR has been considered and decided by the Tribunal in various cases as relied upon by the assessee (supra); therefore, to maintain the rule of consistency, we follow the decision of the coordinate Benches of this Tribunal, and accept LIBOR for benchmarking interest on interest free loans to AEs. Since the LIBOR is a rate applicable in the transactions between the banks and further the loans advanced by the bank to clients are secure by security and guarantee; therefore, a loan which has been advanced without any security or guarantee as in the case of the assessee has to be benchmark by taking the Arm's Length interest rate as LIBOR plus. Though the TPO took ALP as LIBOR + 3%; however, in our view, the appropriate rate would be LIBOR plus 2%. We accordingly, direct the AO/TPO to determine the Arm's Length interest by considering the LIBOR plus 2% on the monthly closing balance of advances during the financial year relevant to the AY under consideration.

In the result, the appeal of the assesses is partly allowed.

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