The budget, which was released on July 6, includes specific amendments to the transfer pricing regulations (TPR) with a view to resolving controversies and providing more certainty to taxpayers.
Introduction of safe harbour rules
The compliance and administrative burden of having to go through a fact-intensive application of the arm’s-length principle with due application of judgement has led some jurisdictions to consider safe harbours as an effective way of dealing with transfer pricing issues.
Safe harbour (referred to as a comfort mechanism in the OECD guidelines) has been defined to mean circumstances in which tax authorities shall accept the transfer prices declared by the taxpayers. Generally, safe harbours provide for circumstances in which a certain category of taxpayers can follow a simple set of rules under which transfer prices are automatically accepted by the revenue authorities. Safe harbour provisions offer three main benefits to taxpayers and tax administrators: i) compliance relief ii) administrative simplicity and iii) certainty.
Safe harbours can take two forms, exclusion of certain classes of transactions from transfer pricing regulations; and stipulation of margins or thresholds for prescribed classes of transactions.
Although, India has emerged as a globally preferred destination for the outsourcing of services, taxation of captive units including the determination of their arm’s-legth price has become a contentious issue in the past, giving rise to considerable disputes. Similar problems relating to determination of appropriate arm’s-length prices have also been faced by subsidiaries of multinationals companies (MNCs) operating as contract manufacturers and low risk distributors in India. This dispute led to the introduction of the proposed safe harbour provisions in the finance bill.
Clause 41 of the Finance Bill 2009 has proposed to empower the Central Board of Direct Taxes (CBDT) to formulate safe harbour rules to alleviate the uncertainty faced by taxpayers and at the same time ensuring a reasonable level of taxable profit to the exchequer. Such rules will be formulated by the CBDT in due course.
In the context of transfer pricing of captive units, it is most relevant to cite the example of a similar issue faced by Mexican tax authorities in dealing with the transfer pricing for Maquiladoras, which are essentially contract manufacturers, undertaking manufacturing activities mostly for their US parent companies. Just as India is host to a large number of captive units, Mexico has a large number of Maquiladoras. These contract manufactures bear minimal business risk, being provided with manufacturing specifications and blueprints, quality standards, firm production forecasts and so on. To deal with this issue, Mexico has established the following safe harbours for the activity of Maquiladoras; (i) 6.5% return on total costs; (ii) 6.9% return on value of assets employed.
A couple of countries have adopted the safe harbour rules in their respective jurisdictions. The table below is a summary of the countries that have implemented safe harbour rules in their transfer pricing regulations:
Safe harbour rules
In respect of certain category of non-core intra-group services
Royalty/ technical know-how/ interest payment
For contract manufacturing (Maquiladoras) operations
In respect of intra-group non-core services
In respect of intra-group services (5% mark-up) and intercompany loans
In respect of preparation of contemporaneous documentation
In respect of intra-group services – service cost method (SCM) and low end services
The adoption of safe harbour rules provides many perceived benefits both for taxpayers and the revenue authorities.
a. A safe harbour mechanism would provide a measure of predictability as well as continuity for all the participating organisations.
b. Safe harbours would eliminate the possibility of litigation between the taxpayers and the revenue authorities through the process of automatic approvals and self assessment procedures.
c. The foreign investment climate would experience a boost especially in the sectors of information technology and information technology enabled services.
d. Safe harbours could significantly ease compliance by exempting taxpayers from collection and analysis of data that may be difficult to obtain and evaluate for application of the arm’s length principle.
e. Safe harbour results in a degree of administrative simplicity for the revenue authorities and the revenue authorities could then allocate more resources to the examination of other material transactions and taxpayers.
Certain challenges will also be faced by the taxpayers as well the revenue authorities while actually implementing safe harbour rules in India.
a. It will be difficult to establish satisfactory criteria for defining safe harbours, and accordingly could potentially produce prices or results that may not be consistent with the arm’s length principle. Further, obtaining relevant information for establishing and monitoring safe harbour parameters may therefore impose administrative burdens on the revenue authorities.
b. The foreign tax administration might challenge prices derived from the application of a safe harbour, with the result that the taxpayers could face the prospect of double taxation.
c. Safe harbours raise equity and uniformity issues. Safe harbours would create two distinct sets of rules in the transfer pricing area, one meeting the safe harbour rules and thus being relieved from regular compliance provisions and, the other being obliged to do business exclusively in conformity with the arm’s length principle.
d. The OECD guidelines also provide that provision of safe harbour rules could potentially have perverse effects on the pricing decisions of enterprises engaged in controlled transactions and are generally not compatible with the enforcement of transfer prices consistent with the arm's length principle.
Even though the OECD guidelines tend to view the adoption of a safe harbour rule as an avoidable measure, it cannot be denied that there are a few benefits for both the taxpayers and the revenue authorities drawn from the implementation of safe harbour rules. Especially in a country like India, where there are a multitude of organisations which are involved in the execution of routine, repetitive tasks such as transaction processing, or claims processing and so on, the provision of a safe harbour rule would definitely be perceived as a breather to such industries and save them a substantial proportion of compliance costs. A proper application of safe harbour rules for contract manufacturers could also make India a manufacturing hub (like China) in addition to being the service hub for the world. However, at the same time, it is also expected that the CBDT would give due consideration to all aspects associated with the safe harbour rules before releasing the rules and ensure that safe harbours are not viewed as a departure from the arm's length principle.
Alternate dispute resolution mechanism
At present, the TPR does not allow alternative mechanisms for reaching a settlement in case of a dispute except for recourse to the mutual agreement procedure (MAP) and advance rulings. A taxpayer aggrieved by an extreme position of the revenue authorities has no legal option available under which it can agree for a reasonable position to close the audit. In the absence of a formal alternate dispute resolution mechanism in India, taxpayers had no option but to undertake time consuming appellate proceedings, the outcome of which was uncertain, particularly in the case of transfer pricing.
As flow of foreign investment is extremely sensitive to prolonged uncertainty in tax related matters, the Financial Bill 2009 has amended the provisions of the income tax act so as create an alternate dispute resolution mechanism within the income tax department for expeditious resolution of disputes in cases involving foreign companies as well as cases involving transfer pricing adjustments.
The proposal is to create a dispute resolution panel (the DRP), comprising of three commissioners of income tax, wherein, taxpayers may approach the DRP before the revenue authorities actually makes a transfer pricing adjustment. The finance bill gives a detailed procedure which needs to be followed in the functioning of the DRP.
Benefits and issues
The creation of the DRP within the tax department is a welcome move by the revenue authorities as this will have several benefits not only for taxpayers but also for the revenue authorities. The objectives of creating such a dispute resolution mechanism are to achieve the following benefits;, (i) timely resolution of tax disputes, (ii) reduction in tax litigation in the future (iii) provides certainty to the taxpayers and (iv) administrative simplicity for the revenue authorities.
While the finance bill provides guidance on the administrative framework of the DRP, it does not clarify a plethora of issues which will need to be clarified once the bill gets enacted. A few of the issues which require the immediate attention of the CBDT are:
· Overall time limitation for the completion of assessment taking into consideration the time taken by the taxpayers to file the arguments and the time for issuance of guidance by the DRP;
· Whether non-transfer pricing issues will get covered under the DRP mechanism or will be settled under the normal appellate process;
· Will revenue authorities have any recourse in case of an adverse order from the DRP; and
· Whether taxpayers have an option of either approaching the DRP or following the normal appellate proceedings.
It is expected that the CBDT will provide some guidance on the above issues and certain others matters that may arise at the time of actual implementation of the process. However, considering the increase in disputes and litigation in transfer pricing and international taxation involving foreign companies, the introduction of this mechanism would speed up the normal appellate process and provide certainty to the taxpayers.
India, being new to this kind of mechanism would require reasonable time to mature and develop it into a well established judicial process. The CBDT should continuously monitor the functioning of the DRP and suggest appropriate administrative guidelines to ensure its smooth and effective functioning. It would also be better if the CBDT includes people from outside of the revenue department in the panel, for instance, industry experts and/or an experienced transfer pricing practitioner or economist, so that the panel can make well informed decisions.
India’s importance as the global off-shoring hub is growing unabated and we must not lose sight of the fact that there are competitors ready to grab a share of the global off-shoring pie. The effective measures in the form of safe harbour and dispute resolution mechanism will go a long way and help in improving the investment climate of the country.
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