Where taxpayer is spoilt for choice

Taxpayers with international transactions can now opt for the safe harbours recently announced by the Government, or the normal transfer pricing assessment, or an advance pricing agreement (APA).

Safe harbour rules and APA were introduced as the Government recognised that the existing system of litigation was inadequate in providing foreign investors certainty in transfer pricing and, in turn, adversely impacted India-bound investments. While the APA regime is in line with international practices, the safe harbour rules are groundbreaking in the sense that no other country has prescribed such rules covering a wide gamut of important sectors.

APA provisions allow taxpayers to negotiate an acceptable transfer pricing arrangement with the Central Board of Direct Taxes. The APAs seek to provide certainty for the next five years, unless there is a change in the taxpayer’s business or the underlying facts. The safe harbour rules also provide certainty on the margin for the five-year period. Though, prima facie , both seem to offer taxpayers certainty on transfer prices, there are crucial differences. The accompanying table shows the sectors/ transactions covered under safe harbour rules.

The higher margins under safe harbour rules are purportedly the price for avoiding litigation. However, there are several strings attached. The safe harbours are only available for companies that bear “insignificant business risks”. The term “insignificant” can have conflicting interpretations. Also, the rules seek to distinguish between business and knowledge process outsourcing, and between research and development for software and software development. All these are open to interpretation and, therefore, may potentially lead to litigation.

Once a taxpayer opts for safe harbour, tax authorities will examine whether it meets the required conditions, and whether the classification adopted by the taxpayer is acceptable. The officer involved in the current transfer pricing assessment will undertake this scrutiny too. Consequently, agreeing for higher margins may not assure certainty.

Further, the definition of operating income and expenditure lacks flexibility. For example, the rules consider foreign exchange gain/ loss as non-operating. So, if the rupee depreciates, then the foreign exchange gain (which is taxable income) will not be a part of the operating income when computing the margin for safe harbour. Therefore, the mark-up under safe harbour will exceed the foreign exchange gain. It will be the reverse if the rupee appreciates. However, in times of unexpected devaluation (as has happened recently), the rules do not provide any safety valve to moderate the impact on tax. Another drawback is the lack of significant economic adjustments.

The above issues can be addressed effectively in an APA, particularly when the transactions are complex and require detailed discussion with tax authorities. A bilateral APA may be more preferable as, conceptually, safe harbour rules do not provide relief from double taxation. However, a lot will depend on how the APA process is conducted in the years to come. The challenges for APA authorities include managing the workload and continuing with an approach that bolsters taxpayers’ confidence and leads to a negotiated solution.

A taxpayer may still opt for safe harbour if the volume of transactions is small, the characterisation of the business is simple, and there is the least likelihood of differences in interpretation. However, where the volume of transactions is not significant but there are frequent changes in the business profile, it may be better to remain in normal litigation.

Thus, the safe harbour rules, APA scheme, and normal litigation are different means to reach a transfer pricing arrangement that satisfies the taxpayer and the Revenue.

S.P. Singh is Senior Director and Richa Gupta is Director, Deloitte Haskins & Sells

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