Justifying arm's length for cost reimbursements - A two pronged test

September 08,2015
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Ashutosh Mohan Rastogi (Partner, Amicus Advocates & Solicitors)

Divya Ahuja (Senior Associate, Amicus – Advocates & Solicitors)

The complexity of modern business inevitably gives rise to reimbursement transactions undertaken due to administrative convenience or practical exigency. Recent Court decisions have highlighted that even cost to cost reimbursements and allocations can pose a challenge and should not be taken lightly by tax management. In the backdrop of recent Court decisions, this article examines issues surrounding deductibility of reimbursement/allocation expenditure.

For reimbursement expenditure to be deductible, it must satisfy the two pronged test of arm's length justification [(quantitative test under Transfer Pricing Regulations
(Section 92 of Indian Tax Code)] and 'benefit' test[(qualitative test under General Corporate Tax (Section 37 of Indian Tax Code)].

Quantitative Test- Arm's Length justification For Reimbursements (Section 92)

A reimbursement transaction typically entails a back-to-back arrangement between the taxpayer and its related party for the procurement of goods and services from a third party on a cost to cost basis. The associated enterprise first procures the good or service from the third party on (behalf of the taxpayer) and is subsequently reimbursed at cost by the taxpayer. The level of value addition by the associated enterprise is so insignificant that a mere cost to cost reimbursement without any mark-up suffices for arm's length compliance. However, proving that the transaction is at cost-to-cost is only the first limb of the two pronged test that such a transaction must satisfy. The taxpayer must additionally demonstrate that reimbursement expenditure has arisen out of a business need and is therefore an allowable expense.

Qualitative Test- Benefit Test (Section 37)

In order for any expense to be deductible, the taxpayer must demonstrate that it is 'wholly and exclusively' connected with taxpayer's business.

In Commissioner of Income Tax- I vs. M/s Cushman & Wakefield (India) Pvt. Ltd (ITA 475/2012), the Delhi High Court held that the jurisdiction of Assessing officer under
Section 37, and that of the Transfer Pricing Officer under Section 92CA of the Act, are distinct and separate.The Court ruled that the authority of Transfer Pricing Officer is to conduct a Transfer Pricing analysis to determine the ALP, and not to determine whether this is a service or not from which the taxpayer benefits. That aspect of the exercise is left to the Assessing officer under Section 37.

The High court held that it was not sufficient to merely state that a reimbursement expenditure to AE was at cost. The taxpayer must furnish evidence on following aspects:

1. Where the expenditure reimbursed is derived by allocating a part of total cost pool(incurred overseas), the taxpayer must be able to substantiate the overseas cost base;

2. The portion of total cost allocated to the taxpayer must be derived on a reasonable and scientific basis say,by using a reasonable allocation key; and

3. Last but not the least, it must also be demonstrated what services or benefit has been received by the assessee by the incurring of such costs by AE.


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