Transfer pricing rules still fuzzy
The Hindu Business Line
Partner & National Leader – Transfer Pricing
Senior Tax Professional
Transfer pricing is an extremely contentious tax issue in India. Its vexatious nature is evidenced by the fact that adjustments of approximately Rs 70,000 crore were proposed in the recently concluded audit by the tax authorities for the assessment year 2009-10 alone.
A spiral of litigation has vexed taxpayers across industries. The last 18 months has seen the Government of India take steps to address the consequent uncertainty --- and the introduction of ‘safe harbor’ rules is one important measure.
Indian tax laws define safe harbor as the circumstances in which the tax authority may accept the transfer price declared by a taxpayer.
Hence, if an operating margin of, say, at least 20 per cent is to be declared upfront for the tax authorities to accept the transfer price declared by the tax payer, 20 per cent is the ‘safe harbour’.
The point of contention here is whether the criterion is too stiff in some cases. It is in this respect that consultations with the government have made some difference. But there is still scope for improvement.
In August 2013, draft rules were released for public comments. The Government’s consultative attitude was welcomed and stakeholders submitted their recommendations. This has culminated in the final rules.
These rules will be applicable for five years, beginning 2012-13, thereby granting certainty over a longer horizon. The rules have relaxed the circumstances (or eligibility threshold) under which the tax authority will accept the transfer price spelt out by the taxpayer.
For software services and IT-enabled services other than contract R&D services with insignificant risk, the safe harbor margin has been pegged at 20 per cent or more on cost for transaction value up to Rs 500 crore and at 22 per cent or more on cost for transaction value in excess of Rs 500 crore.
While retaining the distinction between business process outsourcing services (BPO) and knowledge process outsourcing services (KPO), the safe harbor margin has been rationalized from 30 per cent on cost to 25 per cent on cost for KPO services.
Furthermore, no eligibility threshold has been prescribed for these services.
The margin for contract R&D relating to software development has been set at 30 per cent or more on cost, while contract R&D services relating to generic pharmaceutical drugs is at 29 per cent or more on cost.
Taxpayers manufacturing core and non-core auto components would have to achieve a margin of 12 per cent or more and 8.5 per cent or more on total costs respectively to opt for the safe harbour. Financial transactions such as India outbound loans and guarantees have also been covered through the safe harbor rules.
The safe harbor margins appear to be high and do not reflect the economic environment. Continued insistence on such high margins would erode competitiveness of the Indian contract service provider, and shift work away to other jurisdictions.
This is further complicated by prescribing higher margins for companies with higher turnover — a relationship not empirically proven. These margins are likely to be challenged in the other country which is party to the transaction and can lead to double taxation.
Introducing an artificial segregation within the software services industry and IT-enabled services industry is expected to intensify legal disputes.
The definition of terms like BPO and KPO or software services and contract R&D in the rules are not supported by any expert analysis.
Arguably, there could exist significant overlap between these activities. Financial transactions are fact-sensitive -- and it may not be conducive for taxpayers to apply the safe harbour rules.
The interest rates and guarantee commissions seem excessive. The rules do not phase out transactions which have taken place in earlier years. This may deter taxpayers from adopting these rates, for fear that they may be used against them for the past.
The Government could have used this as an opportunity to simplify the compliance rules for taxpayers.
Safe harbor rules continue to impose the burden of maintaining transfer pricing documentation on taxpayers opting for it. Excluding taxpayers transacting with low tax or no tax countries from the ambit of safe harbor rules creates a further exception.
The safe harbor rules were intended to bring in a more definite transfer pricing regime and reduce heightening controversy. Announcing the rules is itself laudable.
However concerns still remain. The possibility of the tax authorities disputing the safe harbour option on various grounds cannot be ruled out.
The definition of some terms such as BPO, KPO and software development require more clarity to mitigate subjectivity in the audit process.
The rules still do not carry a safeguard that it effectively exempts a taxpayer who opts not to go for it and has an arm’s length price below the safe harbor.
Restricting the operation of ‘mutual agreement procedure’ (MAP) for a taxpayer opting for the safe harbor could act as a serious hurdle.
Taxpayers would do well to carefully evaluate the impact of the safe harbor rules on their inter-company arrangements and compare it with the option of pursuing an Advance Pricing Agreement (APA) to determine comparative benefits.