India is good to invest because it has a rule of law. India is difficult to manage because laws are complex and it takes so much time for courts to decide. These two statements typically summarise the business perception of the country.

One such vexatious dispute between the MNCs and the income-tax department pertains to transfer pricing. Disputes arise because the tax authorities are wary of the fact that by manipulating transfer prices, MNCs can conveniently leave a lower taxable income in countries with high tax rates like India. This wariness exists across income-tax authorities of many countries. As a global practice, most tax laws to regulate MNC transactions mandate that the transfer prices should adhere to the “arm's length pricing”. This means that the inter-company prices should be as close as possible to those existing in transactions between two unrelated parties. Dispute arises on how to obtain and scientifically analyse the price behaviour for unrelated enterprises. Most frequent disputes arise on which companies should be taken as comparables and how the arm's length price is to be determined. Transfer pricing disputes are a big deal because of the big amounts of tax liabilities/tax collections they create for MNCs and tax authorities respectively. Also this leads to double taxation when the other jurisdiction refuses to agree to lower its tax base. Both MNCs and tax authorities incur huge litigation costs as it takes a long time for the issues to reach higher appellate authorities for a final solution,. For both, the costs are ‘dead losses'.

Latest measure

The Indian Government has taken proactive measure to reduce litigation. It introduced the law “safe harbour”. This requires the tax department to announce profit margins (or similar) which a taxpayer should disclose to avoid transfer pricing scrutiny of its tax return. However this has not been implemented as detailed rules are still awaited. Second to follow was establishment of mechanism of “Dispute Resolution Panel”. However, due to various reasons this has not been able to function as an effective dispute resolution mechanism. The latest measure is the provision of “Advance Pricing Agreement” (“APA”) contained in the draft Direct Taxes Code, 2010. As the name suggests, if implemented in the right manner, it provides a system whereby tax authorities and taxpayers agree for a transfer pricing methodology in advance to ensure that there is no litigation. Thus, for a taxpayer, an APA can be an effective tool for better managing the tax risks arising from international transactions. For tax authorities, an APA can similarly be an effective tool for better and more efficient administration of the transfer pricing laws. Consequently, APAs provide a win-win situation for all the parties involved.

An APA can be either unilateral or bilateral. A unilateral APA is an arrangement reached at between a taxpayer and tax authorities of one country – normally the country where income arises. On the other hand, a bilateral APA involves both countries involved in an international transaction and thereby removes chances of double taxation.

Conducive environment

The achievement of an APA involves extensive negotiation between the taxpayer and tax authorities in a collaborative environment. The introduction of an APA scheme must be accompanied by the development of an environment conducive to the success of a continuous negotiation process throughout an APA. All the stakeholders in the scheme must assume equal responsibility to enable a collaborative environment to develop. Highlighting the same, a recent paper by Deloitte emphasises that it is critical for the authorities to put in place a competent and sufficiently large team of professionals equipped to work on the APA system, ensure arrangement of specialist APA training for these professionals and effective coordination within arms of the revenue department.

(The authors are Senior Director and Director respectively of Deloitte Haskins & Sells.)

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