At Arms’ Length -Advance Pricing Arrangements- The need
of the hour
When the transfer pricing regulations were introduced in India
in 2001, transfer pricing was completely unknown. The onerous documentation
requirements and stringent penalties prescribed by the regulations were a cause
of concern for any taxpayer with international transactions, particularly as there
was no basis of knowing how the law would be implemented.
With the transfer pricing assessments having been
completed and the recent Supreme Court and Appellate rulings on the subject,
time has come to relook at the provisions and settle the controversies so that
there is more certainty and fairness in the manner in which the law will be
applied.
Moreover, the introduction of measures such as Advance Pricing
Arrangements (APAs) and Safe harbour benchmarks for certain activities, aligning
our transfer pricing regulations to OECD guidelines and other international best
practices coupled with a drastic reduction in the penalties would go a long way
in enhancing India’s reputation as an attractive foreign direct investment
destination – a goal which successive governments have sought to achieve.
By its nature, transfer pricing involves compliance with the rules of
at least two tax jurisdictions. The increased complexity of the transaction increased
transfer-pricing compliance requirements and enforcement initiatives by tax
authorities. Around the globe, taxpayers are faced with the complicated
challenge of complying with often very different local rules and expectations
from uncoordinated tax authorities, and responding to audits that could be done
at different times and the case is not so different in India where transfer
pricing is of recent origin when compared to other developed tax jurisdictions
like the US, UK and Australia etc.
An Advance Pricing Arrangement ("APA") is an
arrangement that determines, in advance
of controlled transactions, an appropriate set of criteria (e.g. method,
comparables and appropriate adjustments thereto, critical assumptions as to
future events) for the determination of the transfer pricing for those
transactions over a fixed period of time.
APAs represent a potential approach that can be used to
manage the challenge of responding to conflicting demands by different tax
authorities. First, as APAs are negotiated prospectively, they could lead to
reaching a principled Transfer Pricing Methodology that is not distorted by
reactions to past results.
Some countries allow for unilateral arrangements where
the tax administration and the taxpayer in its jurisdiction establish an
arrangement without the involvement of other interested tax administrations.
However, a unilateral APA may affect the tax liability of associated
enterprises in other tax jurisdictions.
Where unilateral APAs are permitted, the competent
authorities of other interested jurisdictions should be informed about the
procedure as early as possible to determine whether they are willing and able
to consider a bilateral arrangement under the mutual agreement procedure.
Because of concerns over double taxation, most countries
prefer bilateral or multilateral APAs (i.e. an arrangement in which two or more
countries concur), and indeed some countries will not grant a unilateral APA
(i.e. an arrangement between the taxpayer and one tax administration) to
taxpayers in their jurisdiction. The bilateral (or multilateral) approach is
far more likely to ensure that the arrangements will reduce the risk of double
taxation, will be equitable to all tax administrations and taxpayers involved,
and will provide greater certainty to the taxpayers concerned.
Recent judgments in the aspect of international tax in
India have brought to the for the issue of profit allocation or income
attribution and the concept of APAs also may be useful in resolving issues
relating to allocation problems, permanent establishments, and branch
operations.
An APA may cover all of the transfer pricing issues of a
taxpayer (as is preferred by some countries) or may provide a flexibility to
the taxpayer to limit the APA request to specified affiliates and intercompany
transactions. An APA would apply to prospective years and transactions and the
actual term would depend on the industry, products or transactions involved.
The associated enterprises may limit their request to specified prospective tax
years.
An APA can provide an opportunity to apply the agreed
transfer pricing methodology to resolve similar transfer pricing issues in open
prior years. However, this application would require the agreement of the tax
administration, the taxpayer, and, where appropriate, the treaty partner.
Second, the tax administration may continue to examine
the taxpayer as part of the regular audit cycle but without reevaluating the
methodology. Instead, the tax administration may limit the examination of the
transfer pricing to verifying the initial data relevant to the APA proposal and
determining whether or not the taxpayer has complied with the terms and
conditions of the APA. With regard to transfer pricing, a tax administration
may also examine the reliability and accuracy of the representations in the APA
and annual reports and the accuracy and consistency of how the particular
methodology has been applied. All other issues not associated with the APA fall
under regular audit jurisdiction.
An APA should be subject to cancellation, even
retroactively, in the case of fraud or misrepresentation of information during
an APA negotiation, or when a taxpayer fails to comply with the terms and
conditions of an APA. Where an APA is proposed to be cancelled or revoked, the
tax administration proposing the action should notify the other tax
administrations of its intention and of the reasons for such action.
Advantages of Advance Pricing Arrangements
An APA programme can assist taxpayers by eliminating
uncertainty through enhancing the predictability of tax treatment in
international transactions.
Provided the critical assumptions are met, an APA can
provide the taxpayers involved with certainty in the tax treatment of the
transfer pricing issues covered by the APA for a specified period of time. In
some cases, an APA may also provide an option to extend the period of time to
which it applies. When the term of an APA expires, the opportunity may also
exist for the relevant tax administrations and taxpayers to renegotiate the
APA. Because of the certainty provided by an APA, a taxpayer may be in a better
position to predict its tax liabilities, thereby providing a tax environment
that is favourable for investment.
APAs can provide an opportunity for both tax
administrations and taxpayers to consult and cooperate in a non-adversarial
spirit and environment.
The opportunity to discuss complex tax issues in a less
confrontational atmosphere than in a transfer pricing examination can stimulate
a free flow of
information among all parties involved for the purpose of
coming to a legally correct and practicably workable result. The
non-adversarial environment may also result in a more objective review of the
submitted data and information than may occur in a more adversarial context
(e.g. litigation). The close consultation and cooperation required between the
tax administrations in an APA program also leads to closer relations with
treaty partners on transfer pricing issues.
An APA may prevent costly and time-consuming examinations
and litigation of major transfer pricing issues for taxpayers and tax
administrations.
Once an APA has been agreed, less resources may be needed
for subsequent examination of the taxpayer's return, because more information
is known about the taxpayer. It may still be difficult, however, to monitor the
application of the arrangement. The APA process itself may also present time
savings for both taxpayers and tax administrations over the time that would be
spent in a conventional examination, although in the aggregate there may be no
net time savings, for example, in jurisdictions that do not have an audit
procedure and where the existence of an APA may not directly affect the amount
of resources devoted to compliance.
Bilateral and multilateral APAs substantially reduce or
eliminate the possibility of juridical or economic double or non taxation since
all the relevant countries participate. By contrast, unilateral APAs do not
provide certainty in the reduction of double taxation because tax
administrations affected by the transactions covered by the APA may consider
that the methodology adopted does not give a result consistent with the arm's
length principle. In addition, bilateral and multilateral APAs can enhance the
mutual agreement procedure by significantly reducing the time needed to reach
an agreement since competent authorities are dealing with current data as
opposed to prior year data that may be difficult and time-consuming to produce.
The disclosure and information aspects of an APA
programme as well as the cooperative attitude under which an APA can be
negotiated may assist tax administrations in gaining insight into complex
international transactions undertaken by MNEs. An APA programme can improve
knowledge and understanding of highly technical and factual circumstances in
areas such as global trading and the tax issues involved. The development of
specialist skills that focus on particular industries or specific types of
transactions will enable tax administrations to give better service to other
taxpayers in similar circumstances.
Through an APA programme tax administrations have access
to useful industry data and analysis of pricing methodologies in a
cooperative environment.
Disadvantages relating to Advance Pricing Arrangements
Unilateral APAs may present significant problems for tax
administrations and taxpayers alike. From the point of view of other tax
administrations, problems arise because they may disagree with the APA's
conclusions. From the point of
view of the associated enterprises involved, one problem
is the possible effect on the behaviour of the associated enterprises. Unlike
bilateral or multilateral APAs, the use of unilateral APAs may not lead to an
increased level of certainty for the taxpayer involved and a reduction in
economic or juridical double taxation for the MNE group. If the taxpayer
accepts an arrangement that over-allocates income to the country making the APA
in order to avoid lengthy and expensive transfer pricing enquiries or excessive
penalties, the administrative burden shifts from the country providing the APA
to other tax jurisdictions. Taxpayers should not feel compelled to enter into
APAs for these reasons.
Another problem with a unilateral APA is the issue of
corresponding adjustments. The flexibility of an APA may lead the taxpayer and
the related party to accommodate their pricing to the range of permissible
pricing in the APA. In a unilateral APA, it is critical that this flexibility
preserve the arm's length principle since a foreign competent authority is not
likely to allow a corresponding adjustment arising out of an APA that is
inconsistent, in its view, with the arm's length principle.
Another possible disadvantage would arise if an APA
involved an unreliable prediction on changing market conditions without
adequate critical assumptions, as discussed above. To avoid the risk of double
taxation, it is necessary for an APA program to remain flexible, because a
static APA may not satisfactorily reflect arm's length conditions.
An APA program may initially place a strain on transfer
pricing audit resources, as tax administrations will generally have to divert
resources earmarked for other purposes (e.g. examination, advising, litigation,
etc.) to the APA programme. Demands may be made on the resources of a tax administration
by taxpayers seeking the earliest possible conclusion to an APA request,
keeping in mind their business objectives and time scales, and the APA programme
as a whole will tend to be led by the demands of the business community. These
demands may not coincide with the resource planning of the tax administrations,
thereby making it difficult to process efficiently both the APAs and other
equally important work. Renewing an APA, however, is likely to be less
time-consuming than the process of initiating an APA. The renewal process may
focus on updating and adjusting facts, business and economic criteria, and
computations. In the case of bilateral arrangements, the agreement of the
competent authorities of both Contracting States is to be obtained on the renewal
of an APA to avoid double taxation (or non-taxation).
Another potential disadvantage could occur where one tax administration
has undertaken a number of bilateral APAs which involve only certain of the
associated enterprises within an MNE group. A tendency may exist to harmonise
the basis for concluding later APAs in a way similar to those previously
concluded without sufficient regard being had to the conditions operating in
other markets. Care should therefore be taken with interpreting the results of
previously concluded APAs as being representative across all markets.
Concerns have also been expressed that, because of the
nature of the APA procedure, it will interest taxpayers with a good voluntary
compliance history. Experience in some countries has shown that, most often,
taxpayers which would be interested in APAs are very large corporations which
would be audited on a regular basis, with their pricing methodology then being
examined in any event. The difference in the examination conducted of their
transfer pricing would be one of timing rather than extent. As well, it has not
been demonstrated that APAs will be of interest solely or principally to such
taxpayers. Indeed, there are some early indications that taxpayers, having
experienced difficulty with tax administrations on transfer pricing issues and
not wishing these difficulties to continue, are often interested in applying
for an APA. There is then a serious danger of audit resources and expertise
being diverted to these taxpayers and away from the investigation of less
compliant taxpayers, where these resources could be better deployed in reducing
the risk of losing tax revenue. The balance of compliance resources may be
particularly difficult to achieve since an APA programme tends to require
highly experienced and often specialised staff.
Requests for APAs may be concentrated in particular areas
or sectors, e.g. global trading, and this can overstretch the specialist
resources already allocated to those areas by the authorities. Tax
administrations require time to train experts in specialist fields in order to
meet unforeseeable demands from taxpayers for APAs in those areas.
In addition to the foregoing concerns, there are a number
of possible pitfalls as described below that could arise if an APA program were
improperly administered, and tax administrations who use APAs should make
strong efforts to eliminate the occurrence of these problems as APA practice
evolves.
For example, an APA might seek more detailed industry and
taxpayer specific information than would be requested in a transfer pricing
examination.
In principle, this should not be the case and the
documentation required for an APA should not be more onerous than for an examination,
except for the fact that in an APA the tax administration will need to have
details of predictions and the basis for those predictions, which may not be
central issues in a transfer pricing examination that focuses on completed
transactions. In fact, an APA should seek to limit the documentation, as
discussed above, and focus the documentation more closely on the issues in
light of the taxpayer's business practices. Tax administrations need to
recognize that :
a) publicly available information on competitors and
comparables is limited;
b) not all taxpayers have the capacity to undertake
in-depth market analyses; and
c) only parent companies may be knowledgeable about group
pricing policies.
Another possible concern is that an APA may allow the tax
administration to make a closer study of the transactions at issue than would occur
in the context of a transfer pricing examination, depending on the facts and circumstances.
The taxpayer must provide detailed information relating to its transfer pricing
and satisfy any other requirements imposed for the verification of compliance
with the terms and conditions of the APA. At the same time, the taxpayer is not
sheltered from normal and routine examinations by the tax administration on
other issues. An APA also does not shelter a taxpayer from examination of its
transfer pricing activities. The taxpayer may still have to establish that it
has complied in good faith with the terms and conditions of the APA, that the
material representations in the APA remain valid, that the supporting data used
in applying the methodology were correct, that the critical assumptions
underlying the APA are still valid and are applied consistently, and that the
methodology is applied consistently. Tax administrations should, therefore,
seek to ensure that APA procedures are not unnecessarily cumbersome and that
they do not make more demand of taxpayers than are strictly required by the
scope of the APA application.
Problems could also develop if tax administrations misuse
information obtained in an APA in their examination practices. If the taxpayer
withdraws from its APA request or if the taxpayer's application is rejected
after consideration of all of the facts, any nonfactual information provided by
the taxpayer in connection with the APA request, such as settlement offers, reasoning,
opinions, and judgments, cannot be treated as relevant in any respect to the examination. In addition, the fact that a taxpayer
has applied unsuccessfully for an APA should not be taken into account by the
tax administration in determining whether to commence an examination of that taxpayer.
Tax administrations also should ensure the
confidentiality of trade secrets and other sensitive information and
documentation submitted to them in the course of an APA proceeding. Therefore,
domestic rules against disclosure should be applied. In a bilateral APA the
confidentiality requirements on treaty partners would apply, thereby preventing public
disclosure of confidential data.
An APA program cannot be used by all taxpayers because
the procedure can be expensive and time-consuming and small taxpayers generally
may not be able to afford it. This is especially true if independent experts
are involved. APAs may therefore only assist in resolving mainly large transfer
pricing cases. In addition, the resource implications of an APA program may limit
the number of requests a tax administration can entertain. In evaluating APAs,
tax administrations can alleviate these potential problems by ensuring that the
level of inquiry is adjusted to the size of the international transactions involved.
At present, only a few OECD Member Countries have
experience with APAs. Those countries which do have some experience seem to be
satisfied so far, so that it can be expected that under the appropriate
circumstances the experience with APAs will continue to expand. The success of
APA programs will depend on the care taken in determining the proper degree of
specificity for the arrangement based on critical assumptions, the proper
administration of the program, and the presence of adequate safeguards to avoid
the pitfalls described above, in addition to the flexibility and openness with
which all parties approach the process.
There are some continuing issues regarding the form and
scope of APAs that require greater experience for full resolution and agreement
among Member countries, such as the question of unilateral APAs. While it is
too early to make a final recommendation whether the expansion of such
programmes should be encouraged, it seems likely that in certain circumstances
they will aid in resolving transfer pricing disputes. Unilateral versus bilateral (multilateral) arrangements Wherever possible, an APA should be concluded on a bilateral
or multilateral basis between competent authorities through the mutual
agreement procedure of the relevant treaty. A bilateral APA carries less risk
of taxpayers feeling compelled to enter into an APA or to accept a
non-arm's-length agreement in order to avoid expensive and prolonged enquiries
and possible penalties. A bilateral APA also significantly reduces the chance
of any profits either escaping tax altogether or being doubly taxed, Moreover,
concluding an APA through the mutual agreement procedure may be the only form
that can be adopted by a tax administration which lacks domestic legislation to
conclude binding agreements directly with the taxpayer.
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