Captive business and knowledge process outsourcing units of multinational groups have recently come under the scanner of the taxman, particularly transfer pricing officers based in our silicon valley, Bangalore.
While Indian tax administrators have in general taken strict interpretation of transfer pricing legislation and the arms-length principle, it appears that the recent development is a concentrated effort to use extraordinary margins as benchmark for comparative purposes and thereby undertake upward adjustment to income. The revenue authorities have justified the action by using the dual principles of protecting Indias tax base and an unrealistic expectation on the level of savings of multinationals outsourcing to India.
Drawn by the vast talent pool available at relatively low cost, foreign multinationals have made a beeline for setting up captives in India. We have been way ahead of other competing jurisdictions in attracting outsourcing. However, our comparative advantage may be lost if the revenue authorities continue to impose excessive and unreasonable tax burden, particularly given the fact that most of them enjoy tax holidays.
The fact is that majority of captives function as low or stripped risk service providers, with market, product, credit, capacity and other associated risks vesting with the parent. Captives are typically insulated from the market, research and development, credit and foreign exchange risks.
Since captives work with limited risks and functions, they logically earn low and steady profit margins. Captives are not expected to earn high profits or incur significant capital expenditure, which would typically be associated with full fledged entrepreneurial companies--third party service providers.
In the recently concluded transfer pricing assessments, for majority of such captives, documentation has been challenged by the revenue department on the basis of chosen comparables, disregarding the fundamental comparability principles.
Transfer pricing arms length analysis requires comparison of return earned by tax-payers undertaking similar functions, taking into account risks assumed functions performed and assets employed. In a glaring disregard to fundamental principles of international tax law and OECD principles, the revenue authorities have compared captive units with independent BPO/software entrepreneurs, who are full fledged risk bearing entities.
Further, they have resorted to the flawed logic of choosing only profitable entrepreneurial companies as comparables, while excluding loss-making companies for benchmarking purposes. Additionally, an arbitrary adjustment of 2 per cent is allowed for working capital and risk differences, ignoring detailed workings submitted by captives.
Applying the above principles, the revenue authorities have arrived at a uniform margin ranging between 25 per cent and 37 per cent for captive IT and ITeS (IT-enabled services) units, respectively. The profit margins are abnormally high by any standards, given the stripped risk business model of the captive units. Though, theoretically speaking, tax-payers have the right to proceed with administrative appeals, there is heightened concern and uncertainty in the minds, given the high-handed approach of administrators.
Indian economys phenomenal growth in recent past has been significantly fuelled by the services sector, which comprises IT and BPO players. Not to forget the FDI and employment generated as a result of such growth.
Economic analysis, empirical data and surveys connected with offshoring of business processes in general have pointed to cost savings of 10-20 per cent after captives are compensated on an arm's-length basis. The Indian competitive arbitrage would no longer accrue if captives are taxed unreasonably. In a tax holiday period, it is like giving in one hand and taking away from the other. Even at the end of the tax holiday period, if margins are not aligned to functions, we shall no longer be a competitive outsourcing destination.
Implications could mean relocation to other competitive jurisdictions, impact on confidence level and a lost opportunity to unleash the countrys potential. Its time that the tax administrators take a serious note of the developments and address the issue. Economic laws like transfer pricing cannot operate effectively unless there are enabling provisions to deal with such complex situations.
The question is, should India look at implementing an Advance Pricing Agreement (APA) regime to avoid such mishaps? An APA mechanism would enable tax payers to obtain upfront binding ruling on their pricing policies and margins.
Suggestions for setting up a central body comprising representatives from the IT ministry, industry groups such as Nasscom and the revenue department to review the current situation have been floated.
Unless the revenue and tax administrators take a positive and pragmatic stand, transparency of our policies will come under question and may prove detrimental to the growth of the industry. Lets demonstrate an element of urgency to address the problem, failing which only advisers will benefit.
S Madhavan (The writer is a partner with BMR & Associates. The views are personal)