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Govt should review the audit procedures for transfer pricing
May, 01st 2007

Let this be a test case for the courts to decide, is a phrase that we hear from the Indian tax authorities when they propose an aggressive view during a transfer pricing assessment. It essentially reflects the approach of the tax authorities of taking aggressive positions on transfer pricing issues and has landed scores of multinational names in India with substantial transfer pricing adjustments.

Much has been said about the wide spread discontentment amongst the industry and the professionals over the aggressive outlook of tax administrators towards transfer pricing issues. The Organisation for Economic Cooperation and Development (OECD) recognises that applying the arm's length principle can be a fact-intensive process and uncertainty associated with it may impose a heavy administrative burden on tax payers and tax administrations that can be aggravated by both legislative and compliance complexity.

The situation can be exacerbated where there is a lack of adequate guidance and jurisprudence. While there have been three cycles of transfer pricing audits that have been completed so far, the number of cases disposed by the first appellate level (commissioner -appeals) remains abysmally low. The large number of cases pending for disposal is not helping the case of the taxpayers as they face the ever-increasing pressure of recovery of demands by the tax authorities.

While it is time that the Indian tax administrators issued clarifications to reduce the ambiguity in the law, it might be a good time for the government to also review the audit procedures for transfer pricing. It is a well-known fact that transfer pricing is based on economic principles. Automatic selection of cases for scrutiny based on the mere volume of related party transactions has led to the selection of a large number of taxpayers for a detailed audit, which has had an adverse impact on the quality of the examination. In the current budget, tax administrators have tried to address this issue by increasing the time limit for the completion of transfer pricing-related assessments by ten months.

However, while assessments for the financial year 2004-05 can be completed by October 2008, thereafter the TPOs will again have one year left to complete assessments for subsequent years. Instead, tax administrators could consider carrying out assessments for a block of years, say three years. This would optimise the effort of the tax authorities and the taxpayers, since the duplication that arises in case of a year-on-year assessment is avoided. Tax administrations of some of the advanced economies follow this approach. The number of cases pending for disposal at the appellate level would be reduced vastly.

A lot of taxpayers undergo a detailed audit and assessment by both the customs authorities and income tax authorities.

There should be a mechanism in place whereby if one of the reviewing authorities has adjudicated that the value of transaction as disclosed by the taxpayer is appropriate, the other authority should not burden the tax payer with another detailed scrutiny. Alignment of valuation rules under the two departments could also help the taxpayers in determining appropriate pricing policies and preparing common documentation for both authorities. There should be some synergies within the two authorities especially given that they both fall under the purview of ministry of finance, department of revenue.

Having safe harbours such as no scrutiny for taxpayers in certain industries in case they earn a certain level of mark-up, interest charged or paid between certain range, etc can go a long way to reduce compliance efforts and litigation costs. Countries like Australia and the US have such provisions in their transfer pricing legislation.

While the spate of adverse orders relating to transfer pricing issues has caused ripples in India and internationally, it is assisting in making transfer pricing a board room issue. The aggressive view of the tax authorities on transfer pricing issues is becoming a decision variable for companies for their expansion plans in India. Perhaps its time for the government to try out some of the administrative reforms and simple measures discussed above even as a test case and let the taxpayers and tax administrators decide on whether it is having the desired effect of improving the quality of transfer pricing audit and less litigation and compliance costs.

The authors are senior tax professionals with Ernst & Young

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