Global Tax Alert (News from Transfer Pricing) | 19 August 2013

Indian Tax Administration announces draft rules on transfer pricing safe harbors

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Executive summary

India’s Finance (No 2) Act (FA), 2009 introduced provisions in the Income-tax Law (ITL) that empowered the Central Board of Direct Taxes (CBDT), the apex Indian Tax Administration, to issue transfer pricing “safe harbor” rules. A “safe harbor” is defined in the ITL as circumstances in which the Tax Authority shall accept the transfer price declared by the taxpayer. On 14 August 2013, the CBDT released draft safe harbor rules for public comments. The draft rules propose to provide minimum operating profit margins in relation to operating expenses1 that a taxpayer is expected to earn for certain categories of international transactions, such as provision of software development services, contract research and development (R&D) services, and the manufacture and export of automotive components that will be acceptable to the Tax Authority. The draft rules also provide acceptable norms for certain categories of financial transactions such as intra-group loans made or guarantees provided to nonresident affiliates of an Indian taxpayer. The draft rules, which are optional for a taxpayer, contain the conditions and circumstances under which the norms/margins would be accepted by the Tax Authority and the related compliance obligations. The safe harbor provisions at present shall be applicable for the financial year (FY) 2012-13 and 2013-14. Taxpayers opting to use the safe harbor provisions would nevertheless be required to maintain transfer pricing documentation and file Accountant’s report in Form 3CEB. A taxpayer electing the safe harbor will not be entitled to make any other comparability adjustment nor seek the benefit of the range prescribed in the ITL. Comments to the draft rules need to be submitted to the CBDT by 26 August 2013. The Indian tax administration is thereafter expected to finalize and issue the final rules.

Background

The FA 2009 introduced provisions in the ITL that empowered the CBDT, to issue transfer pricing “safe harbor” rules. A “safe harbor” is defined in the ITL as circumstances in which the Tax Authority shall accept the transfer price declared by the taxpayer. A number of representations were received from stakeholders to prescribe safe harbor rules. On 30 July 2012, the Indian Prime Minister established a Committee to Review Taxation of Development Centres and the Information Technology (IT) sector under the chairmanship of Mr. N. Rangachary, a former Chairman of the CBDT (Rangachary Committee). Among others, the Rangachary Committee also submitted its report on safe harbor rules for Software and Information Technology Enabled Services (ITeS) sectors. Subsequently, the Government of India (GoI) office memo dated 12 September 2012 approved the considered suggestion of the Rangachary Committee in order to finalize the safe harbor rules for five sectors, including IT and ITES, contract R&D in IT and pharma, financial transactions related to outbound loans and corporate guarantees and original equipment manufacturers (OEM) sales for auto parts. The GoI has accepted the majority of the recommendations of the Rangachary Committee with some modifications. Accordingly, the CBDT prepared the draft safe harbor rules and released the same for public comments on 14 August 2013. The draft notification introduces new Rules 10TA-10TG codifying safe harbor rules.

International transactions and applicable safe harbor transfer price

The transfer price declared by an eligible taxpayer shall be accepted by the tax authorities for the international transactions (eligible international transactions) listed below subject to the circumstances/ceilings:

Sl. No

Eligible international transaction

Circumstances/ceilings

1

Provision of software development services with insignificant risk other than contract R&D where the total value of the international transaction does not exceed INR 1 billion

The operating profit margin declared in relation to operating expense incurred is 20% or more.

2

Provision of information technology enabled services with insignificant risk other than contract R&D where the total value of the international transaction does not exceed INR 1 billion

The operating profit margin declared in relation to operating expense is 20% or more.

3

Provision of information technology enabled services being knowledge processes outsourcing services with insignificant risk other than contract R&D where the total value of the international transaction does not exceed INR 1 billion

The operating profit margin declared in relation to operating expense is 30% or more.

4

Advancing of intra-group loan to a nonresident wholly owned subsidiary where the amount of the loan does not exceed INR 500 million.

The interest rate declared in relation to the international transaction, is equal to or greater than the base rate of State Bank of India (SBI) on 30 June of the relevant previous year plus 150 basis points.

5

Advancing of intra-group loan to a nonresident wholly owned subsidiary where the amount of the loan exceeds INR 500 million.

The interest rate declared in relation to the international transaction is equal to or greater than the base rate of SBI on 30 June of the relevant previous year plus 300 basis points.

6

Providing explicit corporate guarantee to a wholly owned subsidiary where the amount guaranteed does not exceed INR 1 billion.

The commission or fee declared in relation to the international transaction is at the rate of 2% or more per annum on the amount guaranteed.

7

Provision of specified contract R&D services wholly or partly relating to software development with insignificant risk.

The operating profit margin declared in relation to operating expense incurred is 30% or more.

8

Provision of contract R&D services wholly or partly relating to generic pharmaceutical drugs with insignificant risk.

The operating profit margin declared in relation to operating expense incurred is 29% or more.

9

Manufacture and export of core auto components

The operating profit margin declared in relation to operating expense is 12% or more.

10

Manufacture and export of noncore auto components.

The operating profit margin declared in relation to operating expense is 8.5% or more.

In order to identify an eligible taxpayer with insignificant risk, the factors outlined in the draft rules are similar to the conditions stated under Circular 6 of 2013 for identifying contract R&D centres bearing insignificant risks. These conditions broadly require the foreign principal or its associated enterprises (AEs) to perform economically significant functions and provide capital and other economically significant assets.2 The Indian entity is expected to work under the supervision of the foreign principal or its AEs who have capability to control or supervise the work of the Indian entity. The Indian entity should not assume any economically significant risk. The terms software development services, ITES, knowledge processes outsourcing services, intra-group loan, corporate guarantee, contract R&D services wholly or partly relating to software development, core auto components, noncore auto components, operating expense, operating revenue, operating profit margin in relation to operating expense have been defined in the draft Rules.

Filing of Form 3CEG

Any taxpayer who has entered into an eligible international transaction and who wishes to exercise the option to be governed by the safe harbor rules is required to file a specified form (Form 3CEG) and furnish it before the due date for filing the income tax return. The form is in the nature of a self declaration and needs to be signed by the person who is authorized to sign the tax return under section 140 of the ITL. Among others, Form 3CEG requires the taxpayer to declare the following:

  • Transaction entered with an AE is an eligible international transaction;
  • Whether the AEs country or territory is a no tax or low tax country or territory; and
  • Operating profit margin/transfer price.

Assessment procedure

The Rules empower the Assessing Officer (AO)/Transfer Pricing Officer (TPO) to verify whether the taxpayer exercising the safe harbor option is an eligible taxpayer and whether the transaction for which the option is exercised is an eligible international transaction or not. The AO/TPO is also empowered to call for any information/documents/explanation for verifying any of the above. Where the AO/TPO is of the opinion that the option exercised by the taxpayer is valid, he shall indicate acceptance of the transfer price declared by the taxpayer within the specified timelines and after following the specified procedure. However, if the AO/TPO is not satisfied that the option exercised by the taxpayer is valid, then he shall proceed to determine the transfer price in accordance with the other ITL provisions and without having regard to the safe harbor price/margin.

Ineligible taxpayers

The safe harbor provisions shall not be applicable to taxpayers who have entered into an eligible international transaction with an AE located in a country or territory listed under section 94A of the ITL, or in a no tax or low tax country/territory. No tax or low tax country/territory has been defined as a country or territory in which the maximum marginal rate of income tax is zero or less than 15% with respect to the AE. However, no country or territory has been listed for the purposes of section 94A of the ITL yet.

Other key aspects

  • The safe harbor norms mentioned above shall be applicable for the FY 2012-13 and 2013-14.
  • Taxpayers electing the safe harbor will not be able to claim any further adjustment to the price, either on account of comparability differences or the benefit of the range as prescribed under the second proviso to Section 92C(2) of the ITL.
  • Taxpayers opting for the safe harbor shall be required to maintain the mandatory prescribed transfer pricing documentation and also file the Accountant’s report in Form 3CEB.
  • Where a taxpayer’s transfer price is accepted by the tax authority under the safe harbor rules, the taxpayer shall not be entitled to invoke mutual agreement procedure (MAP) under an applicable tax treaty.

Implications

Applying the arm’s length principle can be a resource-intensive process. It may impose a heavy administrative burden on taxpayers and tax administrations that can be exacerbated by both complex rules and resulting compliance demands. These facts may lead to consideration of whether and when safe harbor rules would be appropriate in the transfer pricing area. Some of the difficulties that arise in applying the arm’s length principle may be avoided by providing circumstances in which eligible taxpayers may elect to follow a simple set of prescribed transfer pricing rules in connection with clearly and carefully defined transactions.

In the Indian context, where a number of taxpayers find themselves in the challenging position of documenting and defending their transfer pricing issues as controversy is on the rise due to increasingly well-staffed tax authorities applying more sophisticated and sweeping transfer pricing tools, specifically targeted safe harbor rules can provide certainty that the taxpayer’s transfer prices will be accepted, provided they have met the eligibility conditions of, and complied with, the safe harbor provisions. However, some of the provisions contained in the draft rules do seem to raise questions on whether the norms correspond in all cases to an outcome that may arise if a taxpayer properly applied the arm’s length principle using the most appropriate method applicable to the facts and circumstances under the general transfer pricing provisions. One major concern in such cases is that it may increase the risk of double taxation if the country where the AE is resident does not accept the safe harbor norms as arm’s length.

Properly designed safe harbors may also significantly ease compliance burdens by eliminating data collection and associated documentation requirements in exchange for the taxpayer pricing qualifying transactions within the parameters set by the safe harbor. However, the draft rules still seem to require taxpayers who elect for the safe harbors to maintain prescribed documentation.

Stakeholders should consider providing their comments so that the safe harbor rules can help provide taxpayers with greater certainty. Taxpayers should also evaluate the impact of the draft rules on their inter-company pricing arrangements and consider options for transfer pricing risk management.

Endnotes

1. The draft rules have provided operating profit (OP) to operating costs (OC) (OP/OC) as the profit level indicator for the services provided and the expected margins to be earned by the taxpayer. OP and OC have been defined under the rules.

2. For more details on Circular 6 please refer to EY Transfer Pricing Tax Alert, Indian tax administration issues revised circulars on transfer pricing issues relating to development centers, dated 2 July 2013.

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP (India), Bangalore
  • Rajendra Nayak
    +91 80 4027 5454
    rajendra.nayak@in.ey.com
Ernst & Young LLP (India), New Delhi
  • Vijay Iyer
    +91 11 6623 324
    vijay.iyer@in.ey.com

EYG no. CM3739