A win-win in ‘advance’

With fiscal deficits on the rise, governments around the world are increasing the tax burden and policing the tax base closely. Over the years, tax administrations too have become more forceful and focused in their approach to tax audits. Taxpayers are responding to the shifting landscape by changing their business models dramatically. The convergence of these trends is causing a significant increase in tax controversy, leading to an era of tax risk and uncertainty.

India is no different. Among others, transfer pricing has emerged a key area of litigation over the last five years. According to Ernst & Young Global Transfer Pricing Survey 2012, in India at least 1,500 transfer pricing disputes were under litigation as of February 2011, and this number has more than doubled over the last 18 months. Based on data gathered, the estimated transfer pricing adjustments in India during FY2007-08 was $8.9 billion, as compared to $275 million during FY2001-02. The cost, lengthy processes, and inevitable uncertainty make litigation an undesirable alternative for taxpayers and governments.

Given the seriousness of transfer pricing issues in India, Finance Act 2012 introduced the Advance Pricing Agreement provisions with effect from July 1 this year. An APA between the taxpayer and tax authority is meant to determine (in advance) a set of criteria that would govern the transfer prices for specific inter-company transactions for a fixed period. An APA could determine the most appropriate transfer-pricing method, computation of arm’s length price, adjustments needed and so on, in relation to international transactions. This would be valid for five years at the most. APA gives flexibility to determine the arm’s length price using an unspecified method, as well as through adjustments or variations. However, no “rollback” provisions have been introduced. The Central Board of Direct Taxes has announced that the APA team will consist of nine members — two officers each in Mumbai and Bangalore, and five in Delhi.

Recently notified rules provide for unilateral, bilateral and multilateral APAs. While applications for unilateral APAs will be dealt by the Director General of Income Tax (International Taxation), bilateral and multilateral APAs come under a competent authority. Anybody who has undertaken, or is contemplating any international transactions may apply for an APA. The application may be withdrawn at any time before the APA is finalised. Rules provide for pre-filing consultation, furnishing annual compliance report, compliance audit and revision, and cancellation and renewal of APAs.

For most taxpayers, certainty on transfer pricing is the most-important benefit gained through the APA process. Bilateral APAs will also address the inconsistent and evolving interpretation and enforcement of transfer pricing rules in other countries, and the risk of double taxation. The APA process takes substantially less time than a transfer pricing examination followed by a dispute resolution mechanism, which could easily take up to five years or longer. It also reduces the risk of assessments, audits, penalties, interest and cost of litigation. In the present scenario, where taxpayers face the challenge of documenting and defending their transfer prices, APAs are expected to offer an opportunity to resolve transfer pricing issues with tax authorities in a mutually beneficial manner.

According to Ernst & Young’s survey in 2010, although only 23 per cent of parent respondents have used APAs as a controversy-management tool, the level of satisfaction among them is high — with 90 per cent indicating they will implement an APA in future. The principal APA jurisdictions remain those with developed transfer pricing regimes, such as the US, the UK, Canada, Australia and Japan.

APAs are expected to provide an alternative means of resolving transfer pricing disputes in advance. To be successful, an APA programme should create an atmosphere that encourages all parties to come to the table to find a mutually satisfactory arrangement. It is not easy to create such an atmosphere in the contentious world of transfer pricing. The tax administration should be able to make taxpayers feel confident about coming forward with their pricing issues, which often involve sensitive tax issues.

The tax administration should also work with taxpayers to find mutually satisfactory solutions, and bring together the pertinent operational groups in the administration to address the issues. The success of APA programmes in many countries offers a significant opportunity for the Indian tax administration to resolve international transfer pricing issues mutually, and in advance, saving the parties, domestic courts and tax administrations of other countries significant time, expense, and frustration.

Rajendra Nayak is Tax Partner, Ernst & Young

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