With a fast changing tax environment and India tightening its transfer pricing/BEPS belt, investors in India would do well to identify any such challenges and adopt measures to mitigate the same
In recent times, there have been major changes in tax regimes across the world, primarily on account of OECD’s initiatives for tackling Base Erosion and Profit Shifting (BEPS). India, being a major participant and contributor to the initiative, formally endorsed the 15-point action laid down by OECD in November 2015.
BEPS norms were adopted to align transfer pricing outcomes with value creation, thereby preventing multinational companies from shifting their profits to low-tax jurisdictions to evade taxes.
They made it mandatory for such entities to disclose information about the entire group’s operations—even those of subsidiaries that are based in India—to check if the company is shifting its profits to a low-tax jurisdiction to evade taxes where they are due.
BEPS Action 6 lays down pointers that would impact the ability of fund holding structures to benefit from double tax treaties. BEPS Action 2 would impact cross-border arrangements that carry different characterizations in different jurisdictions for tax purposes. Actions 8 to 10 focus on aligning transfer pricing outcomes with value creation, which impacts the allocation of profits of a particular multinational group in line with value creation. Accordingly, this also has a bearing on tax advantages/arbitrages under the current holding structures.
Transfer pricing is the practice of arm’s-length pricing for transactions between a group’s companies based in different countries to ensure that a fair price—one that would have been charged to an unrelated party—is levied.
While BEPS has been creating a storm in the world, including India, India’s domestic transfer pricing regulations also call for some attention.
Indian transfer pricing regulations prescribe general conditions for triggering an “associated enterprise” association i.e. relation through direct or indirect participation in management, control or capital, and also prescribes specific criteria such as one entity directly or indirectly having a shareholding greater than 26% of the other enterprise, or advanced loans above a threshold, or procured raw material above a threshold, etc., as the yardstick for identification of “association”.
However, in a few recent rulings by the tax tribunal in India, the tax administration has taken a pragmatic view and concluded that though the specific criteria prescribed are not being met, any presence of influence in the management/control/capital of an enterprise by another enterprise/individual (which can be demonstrated) would be sufficient to deem that there is an association between the parties, and they should be treated as related parties for the purposes of transfer pricing compliances.
1: Promoter Mr X of company ‘A’ transfers shareholding of ‘A’ to Mr Y, who is managing director of company ‘B’ in an overseas jurisdiction. Mr Y participates in the management of ‘B’ as well as capital of ‘A’. ‘A’ and ‘B’ potentially become associated enterprises. Company ‘A’ receives service charges from company ‘B’, which become subject to transfer pricing.
2. Mr X overseas invests in Fund A. Fund A invests in company B in India. Mr X’s brother is a director in company B, in his individual capacity, with a management role. A potential “associated enterprise” relation could be triggered for any transaction between the fund/Mr X and company B.
Such an interpretation of existing legal provisions opens the door for tax authorities to question investment structures (involving confidential agreements) used by individuals/investors for direct or indirect investment (by way of private equity/venture funding or trust) into an Indian business/start-up, if there is any semblance of “association” between the investor and investee.
It would be important that investors be extremely careful to identify such potential associated enterprise relationships. Not doing so could open them up to non-compliance penalties (India requires annual transfer pricing compliance for even a rupee of related party transaction) and increased scrutiny by tax authorities. Given that tax authorities are fairly aggressive, a foreign investor could be unwittingly caught in unending transfer pricing litigation, posing a significant tax risk.
With the convergence of the Indian law with requirements under BEPS, both areas become important viz. ensuring flow of control and capital in manner of transactions (in contract and conduct) as well as matching of value creation with rewards across geographies. Hence, erstwhile typical structures used by multinationals and other investor vehicles (such as investment by high net worth individuals through various entities low on substance, control and management by relatives of investors, etc.,) would no longer be appropriate.
The attractive business valuations of Indian businesses could also likely be impacted in cases where there is a lack of clarity on account of huge potential tax risks of such unidentified relationships or lack of substance in conduct. For any investor looking to invest in India, a thorough analysis of the structure used to invest as well as funding flow/management, etc., need to be looked into, preferably at the time of making the investment. Investors looking to cash out or businesses hoping to raise future funding are also susceptible to valuations being impacted at time of exit/funding, on account of potential tax risks due to unidentified relationships or BEPS challenges.
With a fast changing tax environment and India tightening its transfer pricing/BEPS belt, investors in India would do well to identify any such challenges at the earliest and adopt measures to mitigate the same.