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.

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