India: SKP Transfer Pricing 360˚

Last Updated: 3 May 2017
Article by SKP  

India aligning with global transfer pricing practices

India is swiftly moving towards global transfer pricing practices. This is evident from transfer pricing changes enacted by the Indian government during the last few years and further introduced vide Union Budget 2017.

After allowing the use of the 'range' concept while determining the arm's length prices with effect from financial year 2014-15, in 2016, India witnessed the introduction of Country-by-Country (CbC) reporting based on the recommendations of the Organisation for Economic Co-operation and Development (OECD) in Action Plan 13 of the Base Erosion Profit Shifting (BEPS) project.

Furthermore, in the Union Budget 2017, consistent with India's commitment demonstrated throughout the BEPS project, the Indian government has introduced significant changes in the Indian transfer pricing landscape which are largely in line with the OECD's recommendations under BEPS Action Plans. In this issue, we are discussing these changes in detail.

Curb on debt funding - limiting the deduction of interest paid to associated enterprises

OECD's BEPS Action Plan 4 dealt with Limiting Base Erosion Involving Interest Deductions and Other Financial Payments.

The primary objective of Action Plan 4 was to design rules in order to prevent base erosion/profit extraction by multinational enterprises through the use of abusive financing structures, which could be following:

  • Higher levels of debt in countries with high tax rates.
  • Intra-group borrowings to claim interest deductions in excess of the group's actual third party interest expense.
  • Funding the generation of tax exempt income by third party or intra-group financing.

Taking cues from BEPS Action Plan 4, the India government in the Union Budget 2017 has inserted a new section to restrict interest expenses claimed by an Indian company on the interest paid to its associated enterprises (AEs) to 30% of its earnings before interest, taxes, depreciation and amortisation (EBITDA). The above provision would be triggered only in cases of interest expenditure exceeding INR 10 million in a year and would not apply to banking and insurance companies. The excess interest that is not tax deductible would be allowed to be carried forward and adjusted in subsequent years, upto a maximum of eight years.

The restriction on interest cost is not confined only to loans provided by non-resident AE/related party but will also be extended to loans from third parties wherein implicit/explicit guarantee is given by the AEs or loans are indirectly funded by AEs.

For example, a large German MNC (G Co) has set up a manufacturing facility in India in the form of an Indian Subsidiary (I Co). G Co doesn't wish to have substantial equity infusion in I Co and thus is looking at the following options to fund the Indian operations:

  1. Provide loan in the form of External Commercial Borrowings;
  2. I Co borrows locally from the Indian branch of the Bankers of its German parent based on SBLC/parent company guarantee from G Co;
  3. I Co borrows locally in India from the Indian banking company without any guarantee of the parent company G Co. In each scenario, I Co pays interest on the loan amounting to INR 50 million and the EBIDTA of I Co is INR 100 million for that relevant year.

The implications of the proposed changes on the above scenarios would be:

In Scenario 1: the interest deduction would be restricted to 30% of EBIDTA i.e. only INR 30 million. The balance interest of INR 20 million would be allowed to be carried forward for adjustment in subsequent years.

In Scenario 2: even though the interest payment is to a non-related party, the interest deduction would be restricted since the loan from the Indian branch of German Bank is based on a guarantee from G Co. In this case, even if there was no explicit guarantee or SBLC from G Co, the tax authorities could contend that the loan is given on the basis of a relationship of G Co and I Co being a subsidiary. OECD specifies that an entity merely by being part of a multinational group could be benefited in several ways while dealing with bankers, vendors, etc and this is regarded as an implicit guarantee. It is pertinent to note that there is no clear definition of implicit guarantee and it would be an onerous task for I Co to prove that there is no implicit guarantee. This aspect is bound to result into litigation. This also results in economic double taxation since the Indian branch of the German bank is already paying Indian taxes on such interest income.

Scenario 3, since the loan is obtained from an Indian bank, I Co could argue that there is no implicit guarantee since the parent company does not have any relationship with the Indian Bank and hence, the interest paid to Indian bank is not covered by the above restrictions.

The intent of the proposed amendment is to discourage any tax planning through aggressive debt financing and thereby reduce the overall tax rate of the group.

Other issues

Interest deduction vis-à-vis arm's length price

The above provisions would apply even in a scenario wherein the interest amount (based on rate of interest) on the loans availed is concluded to be at arm's length and yet the deduction would be limited to 30% of the EBITDA.

Wide coverage

It is pertinent to note that the definition of debt covers any instrument eliciting a payment of interest and therefore, instruments such as Compulsory Convertible Debentures (CCDs), Convertible Bonds, etc. which are hybrid and quasi equity instruments would also be covered.

Furthermore, the provisions apply not only to the payment of interest, but also similar considerations for the purpose of debt. Hence the aggregate of interest and guarantee fee would be restricted to 30%, the excess being disallowed in the current year to be carried forward.

Effect on loss making/low profit making companies

The companies incurring losses at EBIDTA level cannot claim interest deduction as such and would have to carry it forward. It should not be making a significant difference as instead of carry forward of business loss in entirety, it would be carried forward in two components – interest and business loss. However, interest disallowed/excess interest would be allowed to be carry forward upto a maximum of eight years.

Immediate impact on few industries

This amendment would significantly impact Indian companies engaged in the business of manufacturing, real estate, and infrastructure as these companies require significant funding which may not always come in the form of equity. Furthermore, in these sectors there is a huge capital outlay with a long gestation period and no income arises at the initial stage. In such cases, the interest may lapse after eight years and it would be considered sunk cost for tax purposes. As such, a fixed ratio of 30% of EBIDTA for all the industries would be detrimental to capital intensive industries. On a related note, the restriction may act counter-productive to the 'Make in India' campaigning of the Indian government.

International experience

As mentioned above, while these changes are proposed under the BEPS Action Plan, there are some jurisdictions which have either already introduced a similar cap on interest allowance or are proposing to introduce going forward.

Introduction of Secondary adjustment concept

Union Budget 2017 has introduced another important provision in the Indian transfer pricing regulations by way of the provision relating to 'secondary adjustment'.

As a background, the Indian Income Tax Act requires application of the arm's length principle for inter-company transactions. If such transactions are not at arm's length, the taxpayer is required to make a transfer pricing adjustment. This is generally referred to as a 'primary transfer pricing adjustment'.

In recent times, the tax authorities in India have also resorted to the concept of secondary adjustment – which in effect re-characterises the same international transaction for the purpose of transfer pricing analysis. While the issue has been litigated by the taxpayers up till the higher appellate levels, the Indian government has now inserted a new section which formally introduces the concept of secondary adjustment.

It states that where as a result of a primary adjustment, there is an increase in the total income or reduction in the loss, as the taxpayer's case may be, the excess money which is available with the AE, if not repatriated to India within the time as may be prescribed, shall be deemed to be an advance made by the taxpayer to such an AE and the interest on such an advance, shall be computed as the income of the taxpayer, in the manner as may be prescribed.

It further explains that an adjustment has to be made in the books of accounts of the taxpayer to reflect that actual allocation of profit is consistent with the arm's length price determined as a result of the primary adjustment. The purpose of adjusting the books of accounts for the primary adjustment is stated to remove the imbalance between cash account and actual profit of the taxpayer.

This is explained with the following illustration:

India Company A (I Co A) is a wholly owned subsidiary of Foreign Company B (F Co B) and renders 100% services to F Co B and I Co A is remunerated on a cost-plus basis:

  • Actual transaction price: Cost of 100 + 10% mark-up = 110
  • Arm's length price: Cost of 100 + 15% mark-up = 115
  • Primary adjustment in the hands of I Co. A: 115 – 110 = 5 on which tax will be paid
  • Excess cash in the hands of F Co. B = 5.

Secondary adjustment seeks to address the impact of excess cash of 5 in the hands of F Co B.

  • I Co. A and F Co. B must record 5 in their books of accounts respectively
  • The amount recorded of 5 must be received within the stipulated period else interest would be applied at a specified rate (yet to be prescribed).

In other words, if the amount of primary adjustment is not received from F Co B then it would be treated as an advance by I Co A on which interest would be applied in a prescribed manner. Secondary adjustment is a mechanism to ensure that the full impact is given as if the international transaction were originally undertaken at arm's length price.

The taxpayer shall be required to carry out secondary adjustment where the primary adjustment to transfer price:

  • has been made suo motu by the taxpayer in his return of income; or
  • made by the Assessing Officer has been accepted by the taxpayer; or
  • is determined by an advance pricing agreement entered into by the taxpayer; or
  • is made as per the safe harbour rules; or
  • is arising as a result of resolution of an assessment by way of the mutual agreement procedure under an agreement entered into for avoidance of double taxation.

The provision states that secondary adjustment shall not be carried out if:

  1. i the amount of primary adjustment made in any previous year is less than INR 10 million; and
  2. ii primary adjustment pertains to period prior to financial year 2016-17.

While the Indian government has started to take a cue from the OECD transfer pricing Guidelines and international practices, it must be noted that as per the OECD's Guidelines as well as regulations of quite a few countries, secondary adjustment may take the form of constructive dividends, constructive equity contributions, or constructive loans.

Countries such as the USA, Canada, France, Spain and few other European Union countries provide for all three mechanisms, whereas South Africa and China have specifically opted for constructive dividend mode of secondary adjustment.

However, the Indian government has proposed to adopt only the constructive loan mechanism for the purpose of computing the secondary adjustment.

Post the introduction of secondary adjustment provisions, it is crucial for taxpayers to be more cautious in pricing their intra-group transactions and failure to do so may expose them to secondary adjustments in addition to the primary adjustment.

Other important indicators

Advance Pricing Agreement (APA) Program

The Indian APA programme that was introduced by the government in late 2012 followed by the Rollback provisions 2014 has received an overwhelming response from the taxpayers. The programme endeavours to provide certainty to taxpayers in the domain of transfer pricing by specifying the methods of pricing and setting the prices of international transactions in advance. Since its inception, more than 800 applications (both unilateral and bilateral put together) have been filed in a span of five years.

As on 31 March 2017, CBDT has signed 152 APAs with the taxpayers. These include 11 bilateral APAs and 141 unilateral APAs. In financial year 2016-17, a total of 88 APAs (8 bilateral and 80 Unilateral APAs) were entered into. Financial year-wise break-up of APAs signed are:

It is worthwhile to mention that the average time span for concluding a APA in India worked out to around 1-1.5 years, vis-à-vis the global average of more than two years.

The APA applications filed by the taxpayers pertain to various sectors of the economy like information technology, aviation, oil and gas, automobiles, electronics, etc. The international transactions covered in these agreements include the receipt of intra-group services, Provision of IT Enabled Services, Provision of Software Development Services, Provision of Engineering Design Services, Provision of Marketing Support Services, Import of Traded Goods, Payment of Interest on ECB, Receipt of Interest, Receipt of Guarantee Fee, Receipt of License Fee, Export of Goods, Receipt of Technical Support Services, Provision of Business Support Services, etc.

The progress of the APA Scheme strengthens the Government's resolve of fostering a non-adversarial tax regime. The Indian APA programme has been appreciated nationally and internationally for being able to address complex transfer pricing issues in a transparent manner.

Mutual Agreement Procedures (MAP)

MAP is an alternative mechanism available to taxpayers through Double Tax Avoidance Agreements (DTAAs) for resolving disputes giving rise to double taxation. In the last two years, the tax administering body in India – Central Board of Direct Taxes ('CBDT') has invigorated the MAP proceedings with many countries.

A historical framework agreement was reached in January 2015 with the USA, which has invoked the highest number of MAP requests relating to transfer pricing disputes. This resulted in more than 100 cases getting resolved in FY 2015-16, involving transfer pricing disputes amounting to approximately INR 50,000 million, which was unprecedented. In FY 2016-17 also, the momentum of resolution of MAP cases continued and 66 MAP cases relating to transfer pricing issues and 42 cases relating to treaty interpretation were agreed to be resolved during the meeting held in October, 2016.

Assessment approach

During the year 2016, CBDT has revised its criteria for carrying out transfer pricing scrutiny assessments vide instruction number 3 of 2016. The revised criteria demonstrates a shift in the approach of selecting cases for a detailed transfer pricing scrutiny based on purely monetary thresholds to a risk-based approach.

This move can be looked upon as a step towards aligning the assessment criteria to international practices and making the assessment proceedings more transparent.

In fact, in the last year's cycle of assessment, we have seen a considerable reduction in a number of cases referred for specific transfer pricing assessments purely based on the quantum of transactions. The attention of the Indian tax authorities is evident to be shifted to the risk-based selection approach. Now, it is highly expected that the quality of assessments by the tax authorities should rise in terms of applying business and commercial considerations while evaluating the related party transactions.

To view the full article click here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.