Fine-tuning transfer pricing law

Foreign firms with operation in India enjoy greater opportunities to avoid Indian taxes. Methods of tax avoidance in India include routing profits through subsidiaries located in tax havens. This, however, is old and hackneyed. The latest technique takes advantage of a provision in the US tax laws enabling the foreign company to reduce its tax liabilities.

According to the US law, American firms need not pay tax on their non-American income if they declare that they will not repatriate the money to the US. This avoids tax in their home country.

Companies having intellectual property rights resort to round-tripping. The American parent can sell the patents to a subsidiary in a low tax country and such subsidiary can receive royalty payment from the American parent. We are also familiar with parent company investing in Indian company through Mauritius. The Indian company can buy-back the shares and repatriate the profits to Mauritius.

UNDERSTATING INCOME

The modern practice, however, concerns the transfer pricing law. Expenses are allocated to high tax countries and profits to low tax countries. According to NASSCOM, the Association for the IT industry in India, there are about 750 captives in the country employing 400,000 professionals and accounting for $10.6 billion in revenues. It is these software companies that take full advantage of transfer pricing to understate income from Indian operations. Foreign IT firms make clever use of tax laws and take advantage of tax arbitrage between nations to minimise their tax liabilities in India.

Tax administration in India has woken up to the reality and found that transfer pricing resulted in a revenue of Rs 22,800 crore being understated in 2010-11 by the Indian arms of foreign companies. The Finance Minister has taken note of the tendency to shift profits from India since India exhibits higher growth and profitability than other countries. The normal rule is that the cost of service that the Indian subsidiary provides to the parent should be similar to what it would be in the case of an unrelated party. When companies undervalue related party transactions, it is called mis-pricing.

DISPUTE RESOLUTION PANEL

Transfer pricing audit is at a nascent stage in India. Departmental Officers often take a conservative view of the transaction leading to disputes. Finance Act, 2009 created an alternative dispute resolution mechanism within the income tax department to provide speedy disposal of the cases. This took effect from October 1, 2009.

The Panel comprises of a collegium of three Commissioners of Income Tax constituted by the Central Board of Direct Taxes for this purpose. Any variation in the income or loss proposed by the assessing officer must be referred to the Dispute Resolution Panel (DRP) if such variation is prejudicial to the interest of the assessee.

Under Section 144C of the IT Act, 1961, the Panel can go into the objections and issue such directions as it thinks fit for the guidance of the assessing officer to enable him to complete the assessment.

The Panel must consider the draft order proposed along with the objections and evidence from the company and examine the records relating to the draft order. The panel may confirm, reduce or enhance the variation proposed in the draft order, so however, that it shall not set aside any proposed variation or issue any direction for further enquiry. In the latest ruling on the subject, the Karnataka High Court examined the powers of the DRP under Section 144C. The question involved was the entitlement of the company to exemption under Section 10A of the Act.

The draft order had proposed rejection of the excess claim for relief. There was no finding in the draft order that the company was not entitled to the benefit under Section 10A. The DRP held that the company was not entitled to exemption under 10A at all and issued directions to the assessing officer to deny the exemption claim in Toto. Normally, the directions of the DRP are binding on the assessing officer. In the case before the Karnataka High Court, there was no proposal to hold that the company is not entitled to any benefit under Section 10A.

It was only the excess claim that was rejected in the draft order. The DRP, held the High Court, had no jurisdictions to deny the whole claim under Section 10A. The order of the DRP was set aside.

The court did not go into the merits of the case. It observed that no exemption was available under Section 10A, action can be taken under Section 147 of the Act in accordance with law. The rights of revenue should not be compromised. A perusal of the judgment in 338 ITR GE.I.T.C.P. Ltd, vs. DRP, Karnataka will indicate how complicated the provisions of the transfer pricing law are at the moment.

(The author is a former Chief Commissioner of Income-Tax.)