Vishnu Bagri, Partner, Accretive Business Consulting talks to Sudhakaran of CyberMedia News regarding the urgency of handling Transfer Pricing and Advance Pricing Arrangements suitably in the coming Budget, and how it will affect the IT industry. Excerpts:
As the Union Budget is going to be tabled on February 26, there are a lot of talks with respect to Advance Pricing Arrangements (APA). Could you please elaborate the concept of APA?
Taxpayers are often faced with the daunting task of determining an arm’s length price where one may simply not exist, leaving them in the uncertain position of not knowing whether the requirements of the legislation have been complied with.
This is particularly the case where the taxpayer is dealing in transfers of non-traditional goods and services as many of these transfers by their very nature are unique.
The consequence is that these transfers may not actually have an arm’s length comparison for the purposes of determining an appropriate arm’s length transfer price. The APA program is an administrative response for assisting in a proactive management of one’s transfer pricing risks.
APA is an agreement between a taxpayer and tax authorities that allows both to set out in advance the method of determining the transfer pricing for specified inter-company transactions over a given period of time.
The aim of the APA is to give businesses an opportunity to reach an agreement with the tax office on the future application of the arm’s length principle in their international dealings with related parties, thereby resolving any uncertainty around these dealings. APAs are negotiated in a cooperative environment in which the tax office and a business agree on a transfer pricing methodology that will result in an appropriate allocation of income and expenses between the related parties.
The Government also benefits under the regime because of the certainty in its tax collections as well as greater administrative efficacy, both of which are important as inter-company transactions and transfer pricing in India become increasingly complex. Potential transfer pricing issues are thus resolved in a spirit of mutual agreement and cooperation rather than the adversarial audit environment.
APAs may be unilateral (involving the tax authority of one country) or bilateral / multilateral (involving tax authorities of two or more countries).
The concept of unilateral APA’s is already proposed in the proposed Direct Tax Code expected to be effective April 1, 2011. The industry believes that it would augur well to introduce the framework in the forthcoming budget itself and not wait for another year. India is probably experiencing the maximum litigation on transfer pricing matters and media reports suggest that the latest cycle of transfer pricing audits resulted in a demand of approximately Rs 10,000 crore.
The IT industry has been on the forefront of these demands causing it to loose its distinct competitive edge, at a time when companies across the globe are struggling to revive from the recession. The APA program is likely to provide a mechanism for the industry to manage their tax risks in a proactive way and allow it to focus on build an efficient global operating model. It is a procedural tool for managing the transfer pricing dilemma.
What could be its implications on the Indian IT sector and also the exchequer? Will this help small and medium enterprises?
Today, as the Indian IT sector perseveres to retain its competitive edge in the global market, a mechanism to obtain certainty on its transfer pricing issues would augur very well. The Indian IT sector probably has the maximum litigation cases on transfer pricing matters and significant resources are being expended in managing the tax risks. Transfer pricing adjustments made by the revenue authorities are also not eligible for the export incentives adding to the cost of business.
The government also benefits under the regime because of the certainty in its tax collections as well as greater administrative efficacy. Since the introduction of TP legislation in 2001, the Transfer Pricing Directorate has made an adjustment of Rs 23,000 crore (about $5 billion). However, in most of these cases, the taxpayer has not accepted the order of the department and approached the higher courts for respite. We observe that in most cases involving the IT industry the Tribunal has accepted the taxpayer’s position and reversed the order passed by the assessing officers.
APA would provide an opportunity to resolve potential transfer pricing issues in a spirit of mutual agreement and cooperation rather than the adversarial litigation environment.
The APA process could be expensive and time-consuming and thus discourage the small and medium enterprises to benefit from the same. In this regard, the Indian legislature should consider developing a simplified procedure for small and medium taxpayers. A combination of safe harbor provisions with a simplified procedure would actually encourage the SME taxpayer to be more forthcoming on its tax compliances and not view the tax authorities as anti-business.
How do you look at the opinion that the government should consider reforming the international tax system in the country for the benefit of the industry?
This is a step in the right direction. However, it is vital to be done systematically and suitable to the Indian industry. In the growing participation of global companies in the Indian economy as well as the participation of Indian companies in the international economy, international tax system in the country should be extensively revisited to bring in comprehensiveness in tax treaties, mutual agreement procedures and improving the system of competent authorities. Such an indication will necessarily improve the investment climate in India and reduce the fear of tax complexities.
A major challenge that Indian outbound investors face is the difficulty in claiming credits for foreign taxes. Tax treaties provide a general rule that taxes paid by a resident in the other country, in accordance with treaty provisions, should be eligible for foreign tax credits (FTC). Further, the unavailability of underlying tax credit (UTC) for dividends received from foreign subsidiaries leads to economic double taxation. This issue is more glaring as dividend income from domestic companies are presently tax-exempt in the hands of shareholders.
Do you think India should extend tax holiday period of the units located in Software Technology Parks and Export-Oriented Units?
There should be continuity of tax holiday for another 2-3 years, specifically for the SME sector and companies in tier II and III cities. Today India is amongst the very few economies with a positive growth. Most economies worldwide are struggling in recovering from the recession and are evaluating tax measures favoring national neutrality i.e. encouraging the welfare of only their respective economies. In such times the India government should support the industry to retain their competitive edge as a global player.
Finally, what are your expectations from the forthcoming Union Budget, which would help the IT/BPO industry in the country?
In addition to the introduction of Advance Pricing Agreements and extension of the tax holiday, we hope the coming budget would introduce a rationalized system for foreign tax credits to remove the complexities in claiming credits for taxes paid in overseas jurisdictions. Further, mechanisms (such as a tax-imputation system or credits against the dividend distribution tax) for providing a credit for the tax on dividends paid by Indian holding companies on the dividend received from foreign enterprises is also expected.
Also, the previous budget had introduced safe harbor provisions; however, the rules are yet to be notified. The safe harbor provisions announced in Budget 2009 provided that safe harbors would be defined by the Revenue authorities, and taxpayers meeting the safe harbor thresholds laid down in these provisions would not be subject to transfer pricing scrutiny. However, the detailed rules to operationalize the safe harbor provisions are still awaited. The industry is looking at an early release of the safe harbor rules so as to ensure its expeditious implementation.
What are the advantages and disadvantages of APA according to you?
Advantages
One of the most significant benefits to the taxpayer is that an APA can deal with difficult transfer pricing issues that may not have arisen previously. APAs can provide significant benefits to a wide range of businesses because they can deal with real-time issues, including highly integrated operations and novel situations.
APA can assist taxpayers by eliminating uncertainty and provides an opportunity for both tax administrations and taxpayers to consult and cooperate in a non-adversarial spirit and environment.
Getting the APA regime fast prevents costly and time-consuming examinations and litigation of major transfer pricing issues for taxpayers and tax administrations.
Bilateral and multilateral APAs substantially reduce or eliminate the possibility of juridical or economic double or non taxation since all the relevant countries participate.
Disadvantages in case not done well
A possible disadvantage would arise, if an APA involved an unreliable prediction on changing market conditions without adequate critical assumptions.
An APA might seek more detailed industry and taxpayer specific information than would be requested in a transfer pricing examination. Thus it could add an administrative burden together with high compliance costs.
Problems could also develop if tax administrations misuse information obtained in an APA in their examination practices.
What, according to you, are the main hurdles that Indian IT companies face in the tax front? And how will APA benefit them?
The Indian TP Authorities have been rated among the top ten toughest tax authorities for transfer pricing. In recent audits, the Indian revenue authorities are seen to be adopting an increasingly aggressive approach on TP-related issues. Audits are intensive in IT and ITES sectors. APA could be a useful risks management tool for the companies.
How do you look at the issue of transfer pricing, which is a major issue for many multinational companies? How would the APA regime help address the TP issue?
The Indian IT companies face intensive audits as most of them enjoy the benefit of a tax holiday and upward adjustments pursuant to an audit is not eligible for tax holiday benefits. Typically, a mark-up of 10-15 per cent on costs could be considered to be reasonable for the low level of risks which these entities bear and which mostly exist in India whereas the revenue authorities have determined mark-ups of 25-35 per cent on costs to be the arm’s length margin.
Also an increase in income in the hands of the Indian entity does not result in a corresponding increase in expenditure in the hands of the foreign entity, resulting in economic double taxation. To add, captive subsidiaries of foreign companies have faced the highest scrutiny in transfer pricing audits with media reports suggesting that the adjustments could amount to approximately Rs 10,000 crore for AY 2006-07.