A way to avoid tax disputes over transfer pricing

It is often said that while India obtained political independence in 1947, some degree of economic independence was obtained only in 1991 when the big-bang reforms agenda was unleashed. Foreign investors lost no time in latching on to the immense economic opportunities that we offered, and cross-border trade galloped.

The Tax Department witnessed this silently for quite a while, before it realised that the value of international transactions would be a goldmine for revenue accretion. The first transfer pricing (TP) Rules were announced in 2001— a decade after Big Bang.

Since then, a fair amount of grey hair has been split in the corridors of the Aayakar Bhavans which have formulated, amended, ruled and disputed the provisions on transfer pricing. The decade after the first TP rules were published was marked by some arbitrary orders. Later, the Income Tax Department started pursuing value-additions — such as the value of intangibles and inter-company and intra-company guarantees.

The complications of cross-border transactions and the need to toe the line with international benchmarks on TP — the Organisation for Economic Cooperation and Development (OECD) and the United Nations (UN) being the front-runners — tempted the Government to go the Committee way to bring some sanity to the subject.

The Rangachary Committee was set up in July 2012 to finalise safe harbour (SH) Transfer Pricing provisions: These provisions define the sectors in which operating margins on international transactions should be a minimum of 20-30 per cent. By ‘declaring’ a margin of at, say, least 20 per cent, businesses are reducing the chances of a dispute with tax authorities on the quantum of margins. It reduces the chances of tax authorities revising margins sharply upward, in case they feel the margins are on the lower side — a form of insurance against dispute. The tax payable will be 33 per cent of these margins.

Safe Harbour Rules

The SH rules take the trouble of defining a few industries — software development (with a detailed explanation on contract research and development), IT-enabled services (popularly called BPO), knowledge process outsourcing (KPO) and core auto components (with a negative definition for non-core auto components).

The question that crops up instantly is what happens if an entity enters into international transactions in, say, a garment export industry, which is not covered by the Rules? Would the SH rules not be applicable? It would appear that the answer should be ‘yes’.

The left-out industry segments are certain to ask for equality in law. Apart from the regular international transactions, the SH rules pick out inter-company loans and corporate guarantees for SH treatment, leaving out other intangible transactions such as advertising which have come to the limelight in recent decisions. An entity opting for the SH route would prefer a comprehensive solution.

With an exception for contract research and development, the SH rules spell out monetary thresholds — the value for software development, BPO and KPO services and inter-corporate guarantees has been pegged at Rs 100 crore, while the threshold for loans is Rs 50 crore.

Threshold Limits

Safe harbour limits for software development and BPO operations are operating margins of 20 per cent, and limits for contract R&D and KPO operations are operating margins of 30 per cent.

While the thresholds for the former appear just a bit higher than what could be at present, the ones for the latter seem certainly extremely high. Though contract R&D units operate under the umbrella of their parent companies, expecting operating margins of 30 per cent in an era of high costs and dwindling business is next to impossible.

The SH provisions for inter-corporate loans say that these should be priced at a minimum of 150-200 basis points above the SBI base rate, depending the loan size. This could contradict the policy of getting more FDI into India in an attempt to strengthen the ailing current account deficit. Guarantee commissions need to be priced at a minimum of 2 per cent of the guaranteed amount.

Operating margins for contract R & D in the pharma field are at 29 per cent, making one wonder what the allowance of 1 per cent vis-à-vis their software brethren is for, while the margins for manufacture of core and non-core auto components are at 12 per cent and 8.5 per cent, respectively.

All these provisions are proposed for two years, including the running year. Looked at holistically, it would appear that the SH provisions have been prepared with a conservative mindset.

The Government would do well to make the provisions more comprehensive and offer some incentive to the tax payer. In the current environment, reducing the margins to more realistic levels and increasing the duration of the safe harbour provisions would seem to be a good way to go.

(The author is Director, Finance, Ellucian.)

COMMENT NOW