Revised Transfer Pricing Safe Harbour Rules Bring Cheer
June, 19th 2017
India has, for long, been always regarded as the one of the most aggressive transfer pricing jurisdictions. To mend this image and reduce litigation, the government introduced various measures like Advance Pricing Agreements (APA), the safe harbour regime, risk-based selection of transfer pricing audit cases etc. While most of these initiatives were highly applauded, the safe harbour provisions, introduced in September 2013, attracted the interest of only a handful of taxpayers. That’s because the safe harbour margins were not in consonance with industry realities and arm’s-length expectations. Generally, ‘safe harbour’ means circumstances in which income tax authorities shall accept the transfer price declared by the taxpayer.
In order to meet the expectations of taxpayers, after three years of its introduction, the Safe Harbour Rules have been amended by way of a notification issued by the Central Board of Direct Taxes on June 7 this year. The revised rules would be applicable for three years starting from the financial year 2016-17, and there’s an option for eligible taxpayers to apply old or new safe harbor rules for FY17. This article highlights the key changes in the revised rules.
Lower Safe Harbour Margins For Contract/Captive Service Providers
The Indian captive service providers of foreign multinational companies (MNC) had seen a lot of litigation and were the very first target of the tax authorities when the transfer pricing regime was introduced. Significant transfer pricing adjustments were made, considering cost plus mark-ups ranging from 25 percent to 35-40 percent in some cases. The 2013 Safe Harbour Rules provided a 20 percent mark-up (for a transaction value of less than Rs 500 crore) and 22 percent mark-up (for Rs 500 crore and above) for captive software development, information technology enabled services, and business process outsourcing companies (BPO); whereas knowledge process outsourcing (KPO) companies were subject to a 25 percent mark-up. These margins were seen as very high compared to industry realities and there was a risk of double taxation with foreign tax authorities from an associated enterprise’s jurisdiction rejecting such a high mark-up for Indian captive service providers.
Hence, there was hardly any response to the earlier rules. Larger MNCs opted for APAs and were successfully able to negotiate mark-up between 16 percent and 18 percent. Smaller companies bore the brunt of litigation to achieve the same result. Not surprisingly, a large number of 800+ APAs applications pertained to captive service providers.
In this backdrop, there was an urgent need to revise the safe harbour margins to really make it effective and encourage participation. Several taxpayers as well as trade bodies like NASSCOM had made representations to the government on this aspect time and again.
The revised margin now prescribed under the new safe harbour rules are much more realistic and aligned with outcomes achieved in the negotiated APAs. The revised margins are tabulated below.
The revised safe harbor rules provide a definitive advantage to small and medium enterprises (SME) since there is now a cap on the value of transactions, keeping out larger companies. While these margins may not yet reflect arm’s length mark-ups, paying taxes at a rate that's higher by a few percentage points would still be a good idea to avoid litigation.
This reduction in the mark-up, coupled with the reduction in the tax rate announced in Budget 2017 would significantly reduce the tax outflow for SMEs.
Larger companies anyway would not want to opt for safe harbor since even a single percentage point's difference in mark-up is significant enough justify the cost and effort of opting for litigation or APA. It has been witnessed that tax authorities at the higher levels (tribunal and above), and APA authorities, agree to margins which are closer to business realities and lower than the safe harbour margins. We can now expect the APAs margin go below than the ones currently negotiated and seeing sub-15 percent mark-up under APAs is possible as well.
There was a lot of controversy on the classification of entities into software development, BPO or KPOs. While the revised regulations have tried to clarify these aspects, especially the different mark-ups for different types of KPOs, based on their employee costs, an ideal approach would be to do away with the classification - to avoid litigation in that area.
The definition of operating expenses, on which the mark-up is to be levied, is also elaborated in the new rules to include cost relating to an employee stock ownership plan (ESOP). This means that the contract service providers would have to consider the ESOP cost in the cost base for the purpose of mark-up.
Outbound Financial Transactions
Financial transactions, especially by Indian MNCs in their quest to expand overseas, have had their share of litigation and controversy. Indian MNCs expanding overseas were always in a dilemma about funding foreign expansion. Equity was not a preferred route, and loans and guarantees faced the ire of Indian tax authorities. The authorities were benchmarking loans given by Indian MNCs to their overseas subsidiaries, even in foreign currencies, with the State Bank of India’s base rate or prime lending rate. The guarantees were subject to a high guarantee commission of 3-7 percent. The earlier safe harbour rules were not of much help.
The revised safe harbour rules are, in that sense, a big step forward. The guarantee commission has been reduced from 2 percent to 1 percent, and the cap on guarantee amount has been done away with. In most cases that went into litigation, the tribunals have held a guarantee commission of 0.25 percent to 1.00 percent with most of them around 0.50 percent mark. Considering the fact that safe harbour cannot be equated with arm’s length price, a 1 percent guarantee commission seems reasonable and good for SMEs again to avoid litigation.
For outbound loans, the safe harbour rates now do take into consideration the currency of loans and credit rating of the associated enterprise. Depending on the credit rating of associated enterprise, the safe harbour interest rates for rupee-denominated loans can range from 9.75 percent to 14.25 percent, and for dollar-denominated loans can range from 2.92 percent to 7.42 percent. The only hitch here is that of procuring a credit rating for an overseas associated enterprise in all cases if the taxpayer has to opt for safe harbour. The taxpayer would have to weigh the cost benefit of obtaining the credit rating vis-à-vis the safe harbour.
Low Value Adding Intra-Group Services Added To The List Of Eligible Transactions This is a completely new addition and is definitely a big, bold, and positive move. It shows the intent of the Indian government to walk the talk on the Base Erosion and Profit Shifting (BEPS) Action Plan.
Indian counterparts of foreign MNCs receiving cross-charged intra-group support services can opt for safe harbour, if the value of the transaction does not exceed a sum of Rs 10 crore. Also, the mark-up charged by the associated enterprise in respect of such intra-group services should not exceed 5 percent. Also, the method of cost pooling, exclusion of shareholder costs and duplicative costs from the cost pool and, the reasonableness of the allocation keys used for allocation of costs to the taxpayer should be certified by an accountant. The revised rules also define what constitutes low-value intra-group services.
What certainly needs to be appreciated here is the fact that CBDT is willing to do away with the need to maintain and justify detailed benefit test documentation for SMEs.
This was the biggest source of litigation, and it was extremely burdensome and difficult for these SMEs to provide sufficient evidence to support the benefits derived by them from the intra-group services. This step would definitely provide greater certainty to the taxpayers and would provide compliance relief at the time of transfer pricing audits.