Transfer pricing — fix the bugs

KUNJ VAIDYA | Updated on November 14, 2017 Published on March 11, 2012

Mr Kunj Vaidya, Associate Director - Transfer Pricing, Price Waterhouse & Co.

Much of the transfer pricing disputes can be avoided by adopting global best practices and acting on the safe harbour provisions.

With a whopping $9 billion in adjustments in the most recently concluded transfer pricing audit cycle, transfer pricing today takes the premium spot in Indian tax-related litigation. This puts the total transfer pricing adjustment to date, to a new high of $19 billion — if the transfer pricing wing of the Indian revenue authority were a company, it ould be high on the Fortune 500 list.

It is not only the amount involved, but also the sheer volume of cases affected by the transfer pricing adjustment that is mind boggling. It would be safe to assume that more than 70 per cent (in volume) of the transfer pricing disputes are contributed by inbound captive service providers — software and back-office processing service companies. The revenue department seems to be under the impression that such companies should earn significantly high margin on their cost base.

Almost all transfer pricing disputes involving captive service providers revolve primarily around comparables (as we know, transfer pricing is the art of setting arm's length price through use of comparables).

What's intriguing is that most of these disputes (in volume) can be put to rest by following two best practices that are already prevalent in most of the countries. However, the irony is that these practices have been ignored for more than ten years since the transfer pricing regulations were introduced in India.

Two requirements

While computing the margins earned by companies comparable to Tested Party (that is, in the current context, the captive service providers), the Indian regulations prescribe the following two requirements among several others:

Use of arithmetic mean: If more than one comparable is found, the Indian transfer pricing regulations stipule that an arithmetic mean of the margins of all such comparables should be used to determine the arm's length margin. Global best practice: The global best practice is to use median instead. Most of the countries also allow use of inter-quartile range.

Use of current year data: The Indian transfer pricing regulations insist on use of the comparables' data for the same year in which the inter-company transaction was effected. This breathes impossibility.

The regulations require use of same year data to compare the prices/margins, which would be available, by definition, only after close of the year. Not only that, such data is required to be reported under company law just around the time when the tax return is due. And, the reality, based on empirical data, clearly shows that such data is not available (in entirety) in the public domain until at least another six months have passed from the data of tax return filing.

So, taxpayers are required to set their inter-company prices during the year using data that will be available only after more than a year from the end of the relevant financial year.

Global best practice: Most of the transfer pricing regulations in foreign countries allow use of 3-5 years of historical data to set and examine the arm's length nature of the inter-company prices.

If these two bugs are fixed, it would reasonably put to rest almost 70 per cent of the current transfer pricing-related litigation.

Avoiding disputes

That brings us to the question: How can these disputes be avoided? Much of the current transfer-pricing disputes, especially those relating to captive service providers, can be avoided by just acting on the safe harbour provisions introduced in 2009.

These provisions empowered the tax authorities to establish a range of outcomes within which it would be safe for companies to operate without being challenged. Unfortunately, it's been almost three years, but such rules are yet to see the light of the day.

Thus, by adopting to the two most widely accepted global best practices and introducing safe harbour provisions for captive service providers there will only be real transfer pricing issues left to be tackled. And, to address these, the Government would do well to introduce Advance Pricing Agreements.

Published on March 11, 2012
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