Govt should amend transfer pricing rules, make it easier for IT/ITES companies to do business
July, 09th 2014
The Information Technology (IT) industry has helped India transform from a rural and agriculture-based economy to a knowledge-based economy and a global player in providing world-class technology solutions and business services.
India is currently referred to as the back office of the world owing mainly to IT and IT-enabled services (ITES) sector. Indian IT companies have carved a great niche for themselves in the global market and are known for their IT prowess. Global giants are using the successful outsourcing strategy and keeping ahead of their rivals thanks to the competitive advantage gained by investing in India.
The IT sector in India has been at the forefront on enabling entrepreneurship in the country, building global success stories and contributing to Indian exports, employment and image. With over 15,000 technology start-ups and IT small and medium enterprises today, India is the second-largest hub globally, after China.
While the industry has created a strong focus on sustaining growth, there are a number of Transfer Pricing (TP) issues that have created hurdles in doing business for companies, increasing litigation and uncertainty, thereby impacting future investment for companies engaged in IT/ITES services.
FULL COVERAGE: Union Budget
In addition to numerous judicial rulings on TP issues, the Indian TP laws witnessed various developments on the Safe Harbour front, the Dispute Resolution Panel (DRP), the Advance Pricing Agreement (APA) programme, etc. However, despite the above, there is a mounting need to provide clarity on the various transaction specific issues and on TP principles in India.
In the run-up to the Union Budget 2014, which shall be tabled before Parliament on July 10, the new government has publicly reiterated on various platforms that its aim after assuming office (in line with its election manifesto of 'inclusive development' and 'economic growth' as propagated), shall be to set a direction to increase the ease of doing business and restore confidence in the economy.
President Pranab Mukherjee, in his speech to both houses of Parliament last month, also stated that the new government will "embark on rationalisation and simplification of the tax regime to make it non-adversarial and conducive to investment, enterprise and growth."
Accordingly, there is anticipation as to whether Finance Minister Arun Jaitley shall be able to "walk the talk" and introduce reforms and guidelines relating to the existing Indian TP laws, to assist in reducing the current litigious climate and provide an investment favourable environment for MNEs operating in India.
Following are the recommendations for entities operating in the IT/ITES sector.
Rationalisation of Safe Harbour (SH) provisions: These provisions, which were aimed at small and medium enterprises, met with a tepid response from taxpayers to date, primarily on account of the much higher margins prescribed. Moreover, as apprehended, revenue authorities randomly used the sub-categories as detailed in the SH rules (BPO, KPO, contract R&D) as a framework to categorise companies in several jurisdictions and used the SH margins as the base rather than the outer limit in determining the arm's length margins (ignoring the fact that the SH margins are not reflective of the arm's length concept, but instead premium prices to avoid litigation and achieve certainty).
It is recommended that the SH rules be revisited with presumed profits pegged at more realistic levels. The prescribed SH in the lower range ought to be calibrated down by at least five per cent and in the higher range by 10 per cent. This is because the SH rules in their current from if accepted, are likely to entail huge incremental tax outlays, coupled with difficulty in aligning the same with global TP policies of MNCs. Rationalisation of the SH norms would make the SH programme appealing to small and medium enterprises and make it a viable mode of proactive dispute resolution, potentially reducing the burden on the APA programme which currently seems the only viable mode of effective dispute resolution in India.
Further, in the prevailing SH rules, though software development is a separate category with a SH of 20 percent and contract R&D with insignificant risk is another category with SH of 30 percent, there currently exists a very fine line of distinction between contract R&D and software development and is rather ambiguous and subject to the interpretation and understanding of the Revenue authorities. Clarifications / detailed guidance along with illustrations on what activities would come under each of the above categories would be helpful to taxpayers.
Permitting Roll Back of APAs: In respect of the APA programme, which seems to be emerging as the effective option to manage dispute resolution and providing certainty to taxpayers, permitting "Roll Back" provisions (which permit the results of the APA to resolve the past cases in dispute) and commitment of additional resources in the APA teams would be welcome.
Changes relating to the Dispute Resolution Panel (DRP): Restricting Revenue's right to appeal post the DRP rulings would be welcome, as this renders the DRP ineffective. Further recasting the DRP with experienced senior members who have 'independent' charge of the same (absolving them of their current dual responsibilities) and no revenue collection responsibilities would make the panel a truly empowered one. Making the DRP autonomous and measuring their success based on the number of cases under dispute which have been effectively resolved by them, shall be particularly beneficial and add credence to the Indian administrative machinery.
Domestic TP: The 'Specified Domestic Transaction' provisions were introduced in Finance Act 2012 to cover all domestic transactions between affiliates if the aggregate amount of all such transactions entered into by the taxpayer in the previous year exceeded Rs 5 crore in the previous year. Increasing the threshold limit to Rs 15 crore, coupled with reduction in compliance burden especially for cases with no tax arbitrage, i.e. to entities subject to the same tax rates, would make these provisions more meaningful. Also, providing clarifications that such transactions could be covered within the purview of the APA programme (which currently covers only international transactions) would be welcome.
Data for comparability analysis: In this respect, clarifications should be introduced in the existing Indian TP regulations permitting the use of contemporaneous data / multiple year data for comparability analysis, including:
*Taxpayers' average results (being the past two to three years' financial results) be considered for comparison with the financial results of the same time period for the comparable companies.
*Directing tax authorities to use only contemporaneous data as available to taxpayers at the time of setting their transfer price and preparing the documentation. *Use of foreign comparables being permitted in cases where the tested party is outside India (as part of a regional and global approach to benchmarking).
*Specific guidelines being introduced restricting tax authorities from adopting secret comparables that are not available to the taxpayer at the time of setting the transfer price.
Adjustments to comparable data: As there is currently no guidance / instructions providing for the manner in which adjustments are to be made to comparable data, adjustments in areas such as differences in levels of working capital, risk profiles, volumes, etc. are not generally being permitted by tax authorities in the course of TP audits. Accordingly, suitable guidance providing for the manner of carrying out adjustments to comparable data is necessary and should be introduced having due regard to the taxpayer's business strategies and other bonafide peculiarities.
Arithmetic mean vs. Inter-quartile range: The computation of a single arm's-length price, as currently prescribed, poses practical difficulties since arriving at an appropriate TP involves a subjective commercial analysis. The Indian TP regulations could therefore be amended to permit application of the concept of an arm's-length range of prices, similar to provisions contained in the OECD regulations and those of other developed nations.
Elimination of retrospective amendments and making them effective since their date of their introduction, i.e. prospective - this is imperative and shall sync in well with the new government's pledge to bring in clarity in interpretation and implementation of tax laws.
Absence of Article 9(2) in the Double Taxation Avoidance Agreements restricting Bilateral APAs and Mutual Agreement Procedure (MAP): India does not have Article 9(2) in its DTAAs with certain major trading partners including Belgium, Germany, France, Singapore and the Republic of Korea. In the absence of Article 9(2), the Competent Authority of India has so far followed the practice of not admitting cases of economic double taxation under its MAP and similar positions have been adopted in the APA programme. This position of the Indian government ought to be revisited as MAP / Bilateral / Multilateral APAs would ensure elimination of double taxation and therefore would facilitate increase in the number of bilateral and multilateral APAs being filed. This would also assist India in projecting itself as a coming of age and mature tax jurisdiction seeking to achieve effective global tax dispute resolution, in a true sense.
Need clarification on contentious issues like applicability of TP provisions to transactions which are per se not taxable, such as issuance of share capital. It is common knowledge to fund a subsidiary by subscribing to its share capital. Issue of shares to a parent neither transfers underlying assets nor gives rise to income and hence ought not to be taxed under TP regulations. Moreover, in an economy like ours, for which capital is the need of the hour, any justification of a portion of capital infusion being deemed as income is contradictory and projects India as an immature tax jurisdiction.
THE WAY FORWARD
India has earned a dubious distinction of accounting for 70 per cent of global TP disputes by volume - seemingly ironic for a country which accounts for only two per cent of global trade. As India's international trade is becoming increasingly voluminous and complex, the Indian TP regulations need to be amended to address business realities and bring the regulations in line with global best practices.