Published Editorial

Marginally safe harbor

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The Hindu Business Line

by

Vijay Iyer
Partner and National Leader – Transfer Pricing
EY

Transfer pricing is one of the most controversial areas of international tax and the number of related disputes has increased steadily in recent times. The quantum of tax stuck in dispute has grown exponentially. As the concept of ‘arm’s length’ is subjective, tax authorities and taxpayers often differ on it. The enormity of the disputes is attracting the attention of boardrooms in multinationals. Investment and expansion decisions now have a TP angle, with companies evaluating jurisdictions on factors including TP certainty. Recognizing the far-reaching implications of the TP controversy, the Government has taken steps to provide greater clarity to taxpayers. The safe harbor rules are a key initiative. The Prime Minister’s Office had set up the Rangachary Committee on TP issues, with mandate to suggest safe harbor norms for some industries/ transactions. The committee’s report forms the basis for the draft safe harbor rules published by the Central Board of Direct Taxes.

The draft rules provide for a safe harbor 20 per cent margin for IT and IT-enabled services, which may be higher than what the industry expected. In any cross-border transfer pricing transaction, two tax jurisdictions are involved. The safe harbor is a margin/ price acceptable to one jurisdiction (in this case, India). However, the other jurisdiction is not bound by it and usually analyses the transaction independently. By adopting a safe harbor in India, the taxpayer may mitigate the TP risk here but perhaps not in the other jurisdiction. If the safe harbor margin/ price is higher than acceptable, the other jurisdiction may seek a TP adjustment. Therefore, the safe harbor margin should be within an acceptable band to attract taxpayers. The rates proposed currently may not have many takers unless CBDT reconsiders the margins. Apart from the high margins, the draft rules throw up a few other significant issues.

Artificial segregation of contract R&D for software development

In terms of skill sets, processes and methodologies, there is no difference in writing software codes for software products, operating systems, application software, communication software and others. If the contract R&D includes writing algorithms and designing software, that would be different. But a software programming shop that writes codes for operating software cannot be any different in profitability than one that writes for an application software and so on. The artificial segregation should end and a common safe harbor used for contract R&D and software development units.

Separate safe harbors for BPOs and KPOs

Contrary to the Rangachary Committee finding that there need be no segregation between BPOs (business process outsourcing) and KPOs (knowledge process outsourcing), the CBDT has separate safe harbor margins for them. The committee rightly pointed out that there is no correlation between complexity of work and profitability. Complex work may have a higher value/ price but also higher costs and, therefore, the profitability may not be different for KPOs vs. BPOs. This differentiation may result in more disputes.

Threshold for safe harbor

A turnover threshold has been fixed for most activities, which may limit the number of takers. Also, it is widely accepted and vehemently argued by tax authorities in several tribunal cases that turnover should not have a bearing on the profitability and, hence, high-turnover and low-turnover companies can be compared. If this is the revenue’s position then there is no need for a revenue threshold for safe harbors.

Safe harbor for outbound loans not appropriate

The safe harbor for outbound loans imposes a rupee interest rate on foreign currency loans too. This is contrary to arm’s length principle. Foreign currency loans from rupee sources are still fraught with currency risks and the interest rates in foreign currency factor in these risks. Therefore, the safe harbor must provide for a Libor- or Euribor-based interest for the specified currency of loan, plus a required spread for TP.

Outbound guarantee

The draft safe harbor rules have glossed over the methodology for deriving the guarantee fee for an outbound guarantee transaction, prescribing 2 per cent. The fee is not chargeable where the guarantee is given by a parent to a subsidiary in lieu of contributing capital. To conserve foreign exchange, the Government should have encouraged the use of corporate guarantees to raise capital in foreign jurisdictions. Rather than limit overseas direct investment to conserve foreign exchange, an easier option is to permit corporate guarantees without the guarantee fee to enable foreign subsidiaries to raise capital. An explicit waiver of guarantee fee if the shareholder function is performed by the parent is, therefore, warranted.

The task is cut out for industry representatives and associations to highlight the challenges inherent in the proposed safe harbor rules and convince CBDT to revise the safe harbor norms. A moderated safe harbor norm with wider coverage would go a long way in reducing TP litigation.