It is well recognised that India has developed as an investment jurisdiction for multinational enterprises (MNEs) for carrying on information technology, R&D and back-office operations. The resultant increase in transactions involving entities in multiple tax jurisdictions has given rise to transfer pricing (TP) issues in each of these jurisdictions.
In this backdrop, TP has evolved as one of the most significant and complex tax issues for both multinationals and the revenue authorities.
In recent audits, the Indian revenue authorities are seen to be adopting an increasingly aggressive approach on TP-related issues and a significant brunt of the TP onslaught has been borne by captive IT companies in India, specifically in the software services and the IT-enabled services/BPO industry as most of them enjoy the benefit of a tax holiday under the Income-Tax Act, 1961, and upward adjustments pursuant to an audit is not eligible for tax holiday benefits.
Typically, a mark-up of 10-15 per cent on costs could be considered to be reasonable for captive IT service providers keeping in mind the low level of risks which these entities bear.
However, in a number of cases, the revenue authorities have determined mark-ups of 25-35 per cent on costs to be the arms length margin for captive IT service providers.
While the Indian TP rules have outlined certain factors for judging comparability, it does not provide adequate guidance on certain key aspects relating to a TP analysis such as use of multiple year data, screening criteria for comparables, classification of income/expense items, quantitative adjustments, etc. The lack of quality comparable data in public domain is also a challenge leaving room for subjectivity in any transfer pricing analysis.
This challenge is further compounded by the approach adopted the transfer pricing officers (TPOs) during audits. A practical problem arises at the time of preparing the TP documentation report by the taxpayer, as at that point of time the relevant financial year data may not be available.
The TPOs have rejected the use of multiple year data and considered only the single year (the relevant financial year) data for determination of the arms length price. The TPOs are of the view that while the documentation based on prior year data could satisfy the mandatory and contemporaneous documentation requirements, the same does not necessarily limit them from making a TP adjustment if additional data available at the time of audit so warrants.
On occasions, during ongoing audits TPOs have used information which is not available in the public domain and have also eliminated loss making/low turnover comparables, creating a bias in favour of profitable companies in the comparable data, resulting in transfer pricing adjustments for the taxpayers. Captive IT service providers in India typically function in a risk-mitigated environment as compared to comparables who bear a range of risks such as R&D, market risks, service liability risk, etc.
While the TP regulations permit adjustment to comparable data to account for the risk differences, it does not provide guidance on the manner of making such adjustments. While TPOs acknowledge the need to factor such risk differentials, the approach adopted for making the risk adjustment has been quite subjective and arbitrary. In this backdrop, taxpayers may need to consider performing risk adjustments based on certain financial and economic models.
Scope for double taxation
TP regulations, including those introduced in India, are essentially anti-abuse mechanisms aimed at preventing shift of profits through inter-company transfer prices to a favourable tax jurisdiction. However, in case of a TP adjustment in the hands of the Indian entity, that is, an increase in income in the hands of the Indian entity does not automatically result in a corresponding increase in expenditure in the hands of the foreign entity, resulting in economic double taxation.
In the absence of a formal Advance Pricing Agreement (APA) programme in India, where a taxpayer and revenue authorities can agree in advance on the transfer price, a taxpayer has no option but to resolve issues through the normal domestic tax appellate procedure or the Mutual Agreement Procedure (MAP) prescribed under the tax treaties.
Under the MAP process, the foreign entity in the international transaction approaches its Competent Authority, which in turn will approach the Indian Competent Authority for resolution of the dispute.
Despite the underlying law being essentially the same in all countries, transfer pricing disputes have become a significant subject of the Competent Authority dispute-resolution process between treaty countries because these issues are factual in nature and often applied differently in each country.
The appropriate resolution of an issue in one situation may be entirely different from the same issues resolution for another taxpayer in the same business. This difference in views between tax authorities of two (or more) countries on what an appropriate transfer price should be increases the risk of international economic double taxation to an MNE.
In this situation, MNEs may desire to resolve their transfer pricing issues in advance by entering into an APA with the tax administration, in an effort to spare themselves the time and expense of a tax audit and potential dispute resolution proceedings. Introduction of such a mechanism in India should help in resolving these issues.
Compared to developed tax regimes, India is still on the learning curve in relation to transfer pricing. Keeping in view the difficulties being faced by MNEs operating in India, there is an urgent need to revisit some of the TP provisions and resolve the key issues by providing additional guidance and introducing more certainty and fairness in the manner in which TP regulations are applied.
Reducing penalties, introducing measures such as APAs, safe harbour benchmarks for captive IT service providers are some measures that would prove beneficial.