Safe Harbour Provisions in India Transfer Pricing: A Double Edged Sword in the hands of CBDT
By G.Anandhi, Grant Thornton India Transfer Pricing, Hyderabad
Introduction: In exactly eight years since the introduction of transfer pricing provisions in India, the Finance Act 2009 has brought in the proposed ‘safe harbour’ rules to the Income-tax Act, 1961 (the law governing income-tax in India), much to the cheer of Indian taxpayers, especially Information Technology (“IT”) Sector.
It may be recalled here that in early June this year, NASSCOM, the group representing the country’s IT industry, met with the Finance Minister and presented before him, their pre-budget lobby for introducing safe harbour provisions for th IT industry, especially in these difficult conditions of economic downturn, lack of adequate external comparables and the protracted and long pending disputes with Indian tax authorities in transfer pricing assessments. The Finance Minister in his newly appointed position has done well by heeding to the requests of the major sunrise sector of India – the IT Sector, whose revenue is worth US$ 47 billion annually.
The Finance Minister in his budget speech stated the objective behind introducing ‘safe harbour rules’ inter-alia is “to reduce the impact of judgemental errors in determining transfer price in international transactions”. Let’s examine in this article, the mechanism of ‘safe harbour provisions, the positive and adverse effects from OECD Transfer Pricing Guidelines, 1995 (“OECD TP Guidelines”) and some ‘safe harbour provisions’ in USA, Singapore and Australia.
Safe Harbour- the rationale and mechanism:The OECD TP Guidelines state the difficulties faced by tax payers and tax administrations in applying the arm’s length principle as the rationale for having safe harbour provisions. The conditions for qualifying for the safe harbour with reference to transfer pricing could vary from a total relief to certain identified taxpayers from compliance with country specific transfer pricing laws and regulations or, at the least, the obligation to comply with country specific procedural rules. Some examples of the rules for availing of safe harbour are: a) establishing transfer prices by a simplified method provided by the tax administration (in India, CBDT); b) complying with specific information reporting and record maintenance provisions, with regard to the intra-group transactions. Further, these rules require substantial involvement of the tax administration to monitor the taxpayers’ adherence to the procedural rules.
The Guidelines clearly differentiate the ‘safe harbour’ provisions from ‘advance pricing arrangements’, the latter are decided in advance by the taxpayer and the tax administration; as well as ‘thin capitalisation’ rules, which are designed to prevent ‘excessive’ debt in the hands of overseas group companies.
Pros and Cons of Safe harbour provisions:Some of the positive factors about having safe harbour provisions to the taxpayers are:
· Simplified compliance with arm’s length principle;
· Affords flexibility in cases where there are no matching or comparable companies or transactions;
· Advance information or knowledge about the range of profits or prices to qualify for the safe harbour helps in better planning of intra-group transactions;
· Substantial reduction in time and efforts involved in search for comparables in external databases;
· Reduction in cost in terms of simplified procedures for compliance and record maintenance;
· Certainity about acceptance of the transfer prices by tax authorities in transfer pricing assessments or even the taxpayer may be spared of a detailed scrutiny, if the transfer prices fall meet with the specified mark-up or pricing;
For the tax authorities, the safe harbour provisions substantially reduce the administrative burden involved in terms of minimal examination (or limited number of companies being picked up for detailed scrutiny) of the transfer pricing compliance by the taxpayers. They can choose to concentrate their time and resources on larger taxpayers, transactions or issues and be more lenient to the small taxpayers.
Recommendations to CBDT:However, the implementation of safe harbour provisions is not without its adverse effects in a greater degree to the taxpayer and in lesser terms to the tax authorities. The following aspects need the attention of CBDT while formulating specific safe harbour rules:
a) Potential double taxation: Availing of safe harbour provisions in one country with specified transfer price may lead to different transfer prices reported by the associated enterprise in another country following the arm’s length principle. This may trigger the risk of paying taxes twice in two different countries. The CBDT shall provide for circumstances in which the taxpayer availing of the safe harbour provision can get the necessary relief from double taxation in another country, say, if the results of safe harbour meet with the arm’s length principle.
b) Transfer Pricing Adjustments:The taxpayer may more likely to dispute a transfer pricing adjustment in the country where he has availed safe harbour provisions to prevent potential double taxation. The CBDT should clearly bring out the conditions necessitating transfer pricing adjusments due to adoption of safe harbour provisions.
c) Conflicting provisions:Different countries may have their own safe harbour provisions, inter-alia, to safeguard their share of taxes and for administrative convenience. The possibility of conflicting approaches and methods with respect to the same industry segment or transactions in such a case cannot be ruled out. Hence it is well expected of the CBDT to study the safe harbour laws of various countries, atleast the major countries with whom Indian corporates have most of their international ties and come out with mutually satisfying safe harbour parameters.
d) Shifting of profits:There is a potential threat for the Indian tax authorities in introducing safe harbour provisions as it may give opportunities to taxpayers to shift taxable income/ profits to low tax jurisdictions or tax havens by beneficial treatment of differences in transfer prices using safe harbour over the prices determined by applying arm’s length principle. The CBDT shall do well in having a balancing act by way of a cost-benefit analysis while introducing specific safe harbour provisions.
Conclusion: Safe harbour provisions truly represent CBDT’s double edged sword entrusted in its hands by the newly proposed Finance Bill. On the one hand, these provisions provide the needed relief of certainity, simplified method and relief to tax authorities from their administrative burden, on the other end it could have adverse effects, if not suggested or applied in appropriate cases of taxpayers/ transactions.
The CBDT shall take abundant caution while exercising the powers entrusted by the law, be more pragmatic in its approach while formulating safe harbour rules keeping in mind the interests of both the taxpayers and tax authorities, and come out with ‘safe harbour’ parameters with clear cut guidelines as to its applicability for taxpayers, to avoid any new set of complications in its implementation.
Some Safe harbour provisions prevalent in foreign jurisdictions:
USA: Under the US Transfer Pricing Regulations, the Temporary service Regulations issued in July 2006 provide for a methodology called the Services Cost Method (SCM). The SCM is essentially a cost safe harbor, allowing certain “covered services” to be charged out or allocated to a related entity without a markup. To qualify for the SCM, the services: a) must not contribute significantly to fundamental risks of business success or failure; b) must not be on a list of excluded transactions; and c) must be either a low margin services (taxpayer can find a set of comparables with a median of 7.0 percent or less) or be a “specified covered service” as found in a revenue procedure issued by the IRS. In addition to the above qualifications, taxpayers are obliged to fulfill certain documentation requirements and meet required deadlines to support the SCM election.
Brazil: Brazilian transfer pricing rules contain various safe harbour provisions for the benefit of the taxpayers. As per a safe harbour provision, transfer pricing rules will apply to exports only if the average export price is lower than 90% of the average price of the same goods, services, rights etc. sold in the Brazilian market, during the same period and under similar payment conditions. Another safe harbour provision exempts the taxpayer from detailed documentation (only export documents will suffice) if the taxpayer has a minimum of 5% net profit (annual average profit of the current year plus two preceding years) on its total export revenues to related parties or whose export revenue in the calendar year does not exceed 5% of its total revenue in the same period. There is yet another safe harbour provision which states that exports involving related parties with the purpose of entering new markets shall not be subject to transfer pricing adjustments as provided by the law, with the exception of exports to tax havens.
China: There is no safe harbour rules under Chinese corporate income tax (“CIT”) regime. The chinese tax authorities prefer a case by case analysis.
Russia: Under the earlier transfer pricing rules, 20% deviation to the transfer price was allowed to comply with the arm’s length principle. Now, with the new transfer pricing legislation to be adopted by the autumn this year, the safe harbour provision has been abolished and is replaced with compliance with arm’s length pricing.
Singapore: The Singapore IRAS accepts as arm’ length, a mark-up of 5% for provision of related party services of ‘routine’ nature and that the service provider does not provide similar services to unrelated parties.
Mexico: The Mexican Income tax law provide ‘safe harbours’ for traditional Maquiladaros (contract manufacturers) with a requirement as regards profit or return on foreign owned assets and thus provide protection to foreign principals from attribution of their profits on the export operations, subject to safe harbours or other transfer pricing options are met under the Mexican Income tax law, including a ‘self assessment’ option to prepare and maintain an arm’s length profitability, plus 1% of the value of the foreign owned assets.
Japan: The newly amended Japanese transfer pricing provisions allow the use of ‘cost’ (gross direct and indirect cost) as the arm’s length price for certain service transactions - a list of low value services have been prescribed like accounting, tax or legal services, debt collection etc., The conditions attached to this are: these services do not form a significant part of the service provider’s business activity and do not involve any intangible property in the provision of services.
Kazakhstan: Kazakhstan’s transfer pricing policy is incompatible with the guiding principles for WTO members. Hence in its quest to make it to the WTO, the10% Safe harbour threshold is proposed to be abolished in the revised transfer pricing law.
Canada: A transfer pricing penalty equal to 10% of the amount of any unfavourable annual net adjustment to a taxpayer’s income or expenses for a year may be levied if the unfavourable net adjustment exceeds the statutory safe harbour, which is the lesser of $5,000,000 and 10% of the taxpayer’s gross revenue.
Australia: Australian transfer pricing rulesprovide for safe harbour provisions in respect of availing of and provision of intra-group services, based on the category of activities and the function, risk and asset analysis of the related parties. For example, if the total direct and indirect costs of providing the service is not more than AUD$500,000 in a year and the total amount charged for the service is not more than 15% of the total expenses (availing from related parties) or the revenue (providing to related parties) of the group, subject to adequate documentation, the acceptable transfer price is fixed at cost of providing the services plus a mark-up of 7.5%. With additional documentation, it could be upward at 10% (in case of services availed) or downward at 5% (in case of services provided).
Cyprus: The new transfer pricing code is expected to provide for certain safe harbour margins to determine an appropriate contribution to the taxable profit in Cyprus, taking into account specific functions performed and risks assumed.