The Finance (No 2) Act (FA), 2009 introduced provisions in the Indian Income-tax Law (ITL) that empowered the Central Board of Direct Taxes (CBDT), the apex Indian Tax Administration, to issue transfer pricing “safe harbor” rules. A “safe harbor” is defined in the ITL as circumstances in which the Tax Authority shall accept the transfer price declared by the taxpayer. The CBDT on 14 August 2013 released draft safe harbor rules for public comments. After considering comments of various stake holders, on 18 September 2013, the CBDT issued the final safe harbor rules.
The rules provide minimum operating profit margins in relation to operating expenses a taxpayer is expected to earn for certain categories of international transactions, such as provision of software development services, information technology enabled services, (ITES), knowledge process outsourcing (KPO) services, contract research and development (R&D) services, manufacture and export of automotive components etc. that will be acceptable to the Tax Authority. The rules also provide acceptable norms for certain categories of financial transactions such as intra-group loans made or guarantees provided to nonresident affiliates of an Indian taxpayer.
The transfer price contained in the safe harbor rules shall be applicable for five years beginning from financial year (FY) 2012-13. The safe harbor rules, optional for a taxpayer, contain the conditions and circumstances under which the norms/margins would be accepted by the Tax Authority and the related compliance obligations. The taxpayer has flexibility in electing the years to be governed by the safe harbor rules within the five year period. Where a taxpayer’s transfer price is accepted by the Tax Authority under the safe harbor rules, the taxpayer shall not be entitled to invoke the mutual agreement procedure (MAP) under an applicable tax treaty.
Applying the arm’s length principle can be a resource-intensive process. It may impose a heavy administrative burden on taxpayers and tax administrations that can be exacerbated by both complex rules and resulting compliance demands. These facts may lead to consideration of whether and when safe harbor rules would be appropriate in the transfer pricing area. Some of the difficulties that arise in applying the arm’s length principle may be avoided by providing circumstances in which eligible taxpayers may elect to follow a simpler set of prescribed transfer pricing rules in connection with clearly and carefully defined transactions.
In the Indian context, a number of taxpayers find themselves in the challenging position of documenting and defending their transfer pricing issues. Transfer pricing controversy is on the rise due to increasingly well-staffed tax authorities applying more sophisticated and sweeping transfer pricing tools. Hence, specifically targeted safe harbor rules can provide certainty that the taxpayer’s transfer prices will be accepted, provided they have met the eligibility conditions of, and complied with, the safe harbor provisions.
Some of the concerns raised by stakeholders on the draft rules have been addressed in the final rules. The rules now are applicable for a period of five years compared to two years proposed in the draft. Further, the eligibility threshold of turnover of less than INR 1 billion for software development and ITES transactions have been done away with, potentially allowing a larger number of taxpayers to qualify.
However, some of the provisions contained in the rules do seem to raise questions on whether the norms correspond in all cases to an outcome that may arise if a taxpayer properly applied the arm’s length principle using the most appropriate method applicable to the facts and circumstances under the general transfer pricing provisions. One major concern in such cases is that it may increase the risk of double taxation if the country where the AE is resident does not accept the safe harbor norms as arm’s length. The fact that the rules also preclude exercising the MAP option increases the risk of double taxation. The Organisation of Economic Cooperation and Development (OECD) recently approved a revision to its guidance on safe harbors (Chapter IV of the OECD Transfer Pricing Guidelines). The OECD encourages the use of safe harbors on a bilateral or multilateral basis as they provide significant benefits without raising the risk of double taxation or double non-taxation.
Properly designed safe harbors may also significantly ease compliance burdens by eliminating data collection and associated documentation requirements in exchange for the taxpayer pricing qualifying transactions within the parameters set by the safe harbor. However, the Indian rules still seem to require taxpayers who elect the safe harbors to maintain prescribed documentation.
Taxpayers should evaluate the impact of these rules on their inter-company pricing arrangements and consider options for transfer pricing risk management.
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