Two important developments last week in the transfer pricing domain have the potential of completely transforming the way this critical and controversial tax area has been handled by the income-tax department.

One is the Delhi High Court judgment on tackling the AMP (advertisement, marketing and sales promotion) expenses involving a number of MNCs—to keep it simple, the Court has rejected the taxman’s methods for calculating the arm’s length price, and the other is the announcement of norms for rollback of Advance Pricing Agreements (APAs).

The problem, however, is that these two positive developments can help curb litigation or the huge, and in most cases high-handed, transfer pricing adjustments in the future, which total R2.64 lakh crore between FY06 and FY15, only if the government comes out with suitable supporting measures.

The Delhi High Court concluded in its judgment delivered on March 16: “Lastly, a word of caution is necessary that our findings or ratio should not be construed as an attempt to impart a talismanic precision to this complex issue which would to a large extent depend on the factual matrix of a given case. Disputes of such nature highlight importance of ‘safe harbour rules’, for they instil certainty and curtail litigation.”

But the fact of the matter is that not many companies have evinced interest in the ‘safe harbour’ window provided by the Central Board of Direct Taxes (CBDT), with only about 30 applications getting filed in the first year of its coming into force in FY14.

While the high ‘profit margin’ of 20-25% fixed by the CBDT has been one of the reasons for this, it is the characterisation of activities which has been a major dampener. Tax experts feel that the characterisation at present is more theoretical than practical and this needs to change.

The safe harbour rules notified in September 2013 provide 20% margin for IT & ITeS transactions up to R500 crore and 22% for transactions above R500 crore; for knowledge process outsourcing services, the operating margin is 25%; for outbound loans, the safe harbour interest rate is SBI base rate plus 150 basis points for loans advanced up to R50 crore, and for loans above R50 crore, it is the SBI base rate plus 300 basis points.

The safe harbour commission or fee for corporate guarantees up to R100 crore is 2%, and for transactions of corporate guarantee above R100 crore, safe harbour is available only if the wholly-owned subsidiary is rated to be adequate for highest safety and the safe harbour commission or fee is 1.75%. Then, the operating margin for contract R&D in software development is 30%, for contract R&D in generic pharmaceutical drugs it is 29%, and for the auto components manufacturer and exporter it is 12% for core auto components manufacturer and exporter and 8.5% for non-core auto components manufacturer and exporter.

These rules are applicable for five assessment years beginning FY14, but considering poor response, the CBDT would do well by quickly reviewing the safe harbour norms and coming out with a workable framework.

While this will help the small- and medium-sized companies get over their transfer pricing woes as they don’t mind paying higher margins to avoid compliance hassles, for large companies the APAs are the preferred route as they can negotiate lower profit margins for a longer period (five years) with the revenue department and also deal with tax authorities in other countries effectively.

But the record of the income-tax department in handling the APAs, too, has been poor. In the first year of the APA regime in FY13, the department received 117 unilateral and 29 bilateral APA applications; in FY14, another 206 unilateral and 26 bilateral APA applications were submitted; and the total number of APA applications pending with the transfer pricing office is expected to be about 500 now.

Of these, only five unilateral and one bilateral applications have been turned into APAs.

One of the reasons for slow progress on the APA front was a delay in the announcement of the APA rollback norms. With the CBDT coming out with the rollback provisions now, it is likely that the APA activity will pick up from here.

The bigger issue, though, in getting the APAs reach the final stage is the position papers (the APA proposals) prepared by the transfer pricing officials being stuck at the CBDT level. Those in the know of the situation say about 80 position papers are awaiting approvals from the top level, and once this is expedited, not less than 50 APAs could be signed quickly.

With the rollback norms in place, which will make APAs applicable for the previous four years—the CBDT is likely to extend the current deadline of March 31 to file an application for availing this opportunity—the government must ensure that all the 500 APA applications that have been filed are handled in a time-bound manner.

Once a strong APA system and a workable safe harbour regime is put in place, transfer pricing disputes and litigation will come down substantially.

The government, in the last few months, has shown that it is not wary of taking steps that help avoid fruitless litigation—not appealing the Bombay High Court’s ruling in the Vodafone and Shell transfer pricing cases in the Supreme Court has been a good example—and it is high time the taxman also moves faster on measures to take this to the next level.