India: Safe Harbour Is More Or Less Safe To Sail Now

Last Updated: 20 June 2017
Article by SKP  

Safe Harbour provisions in India since its introduction in 2013 had hardly received any positive response for over last three years as compared to the phenomenal success of Advance Pricing Agreement (APA). The reasons were very obvious – the safe harbour margins were very high and not necessarily reflecting the arm's length scenario and the APA's for similar transactions were being inked at lower percentages.

Taking a cue from the above, the Central Board of Direct Taxes (CBDT) vide notification dated 7 June 2017 has revised the Safe Harbour Rules by relaxing the rates and making few other prominent changes, which would make it an attractive option, especially for SMEs.

Generally, safe harbour means circumstances in which Income Tax Authorities shall accept the transfer price declared by the taxpayer. The revised safe harbour provisions are applicable from 1 April 2017, i.e. (Financial Year) FY 2016-17 and shall continue to remain in force for three years (instead of five years in the old safe harbour regime). For example, if the eligible assessee exercises the option to opt for safe harbour provisions in FY 2016-17, the provisions shall apply for FY 2016-17 and two subsequent financial years i.e. up to FY 2018-19. Where the taxpayer is eligible under the old safe harbour regime (notified in 2013) up to FY 2016-17, he shall have the right to choose the safe harbour option (either old or revised) one whichever is most beneficial to them.

Changes in circumstances under which transactions can qualify for safe harbour provisions
The following table provides a synopsis of the revised safe harbour provisions along with the changes compared to the provisions released in 2013:

Eligible transaction Revised Safe Harbour rates pursuant to the notification issued on 7 June 2017 Comments
Provision of software development services or Information Technology (IT) enabled services. 17% operating margins if the annual transaction value does not exceed INR 1 billion (approximately USD 15 million).

18% operating margins if the transaction value is between INR 1 to INR 2 billion (approximately USD 15 million to USD 30 million)
The revised rules have reduced the safe harbour margin (from 20% or 22%) but have introduced a cap on the value of international transaction that would qualify for safe harbour provisions. Earlier regulations did not have any cap on the value of transactions.
Provision of Knowledge Process Outsourcing (KPO) services. For annual transaction value that does not exceed INR 2 billion (approximately USD 30 million) operating margins of:
  • 24% where employee cost is at least 60% of operating expense; or
  • 21% where employee cost is at least 40% but less than 60% of operating expense; or
  • 18% where employee cost is less than 40% of operating expense.
Employee cost has been defined to include all costs that are generally grouped under the head employee cost in the profit and loss account and it also includes outsourcing expenses to the extent of employee cost are on actuals or 80% of total expenses, if bifurcation into employee cost and other outsourcing cost is not available.
The revised rules have reduced the safe harbour margins (from 25%) but have introduced a cap on the value of the international transaction that would qualify for safe harbour provisions. Along with that, now the operating margin is variable and dependent on the employee cost as a percentage of operating expense as compared to a blanket 25% earlier.
Providing corporate guarantee Irrespective of the guaranteed amount, the safe harbour rate has been reduced to 1% per annum of the amount guaranteed. The revised rules have reduced the safe harbour guarantee fees (from 1.75% or 2%) to 1% and made its application more simplified irrespective of the guaranteed amount and credit rating of the Associate Enterprise (AE).
Provision of contract Research and Development (R&D) services (relating to software development or generic pharmaceutical drugs). 24% operating margin if the annual transaction value does not exceed INR 2 billion (approximately USD 30 million). The revised rules have reduced the safe harbour margins (from 30% or 29%) but have introduced a cap on the value of the international transaction.
Manufacture and export of auto components For core auto components - 12% operating margin;
For non-core auto components - 8.5% operating margin
There is no change in the safe harbour rates.
Advancing of intra-group loans (for loans denominated in INR and foreign currency)
CRISIL Credit rating or equivalent of the AE Loan in INR – SBI base rate plus BPS Loan in foreign currency – LIBOR plus BPS
AAA to A 175 150
BBB-, BBB or BBB+ 325 300
BB to B 475 450
C to D 625 600
Not available and the amount of loan advance to all AE's does not exceed INR 1 billion as on 31 March of the previous year. 425 400
Safe harbour interest rates are now based on currency in which loan is denominated and also CRISIL credit rating. The revised safe harbour provisions acknowledge the difference in the currency has an impact on the base rate on which spread is added and have accepted the concept of interest rates linked to LIBOR which was till now heavily litigated by the Tax Authorities.
Receipt of low value adding intra-group services The value of the transaction, including a markup not exceeding 5%, does not exceed a sum of INR 100 million.

Furthermore, there is a requirement that the method of cost pooling, the exclusion of shareholder costs and duplicate costs from the cost pool and the reasonableness of the allocation keys used for allocation of costs to the taxpayer by the overseas AE should be certified by an accountant.

Low value adding intra-group services have been defined to mean services performed by one or more MNE of the group on behalf of other members of the same MNE group and which:
  • Are in the nature of support services;
  • Are not a part of the core business of the MNE group;
  • Are not in the nature of shareholder/duplicate services;
  • Should not involve/create unique and valuable intangibles;
  • No significant risk is undertaken by service provider;
  • Does not have reliable external comparable services to arrive at arm's length price and do not include services like R&D, manufacturing, IT, software development, KPO, BPO, purchasing, sales, marketing, insurance, etc.
This is a completely new addition to the rules which is aligned to BEPS Action Plan 8-10.

All conditions to qualify to become an eligible taxpayer remains unchanged under the revised safe harbour regime except for the addition of receipt of low value adding intra-group services.

The revised Rules have also broadened the definition of operating expenses on which safe harbour margins are applied, so as to include:

  • Costs relating to employee stock option plan or similar stock-based compensation provided for by the AE of the taxpayer to the employees of the taxpayer;
  • Reimbursement to AE of expenses incurred by the AE on behalf of the taxpayer;
  • Amounts recovered from AE on account of expenses incurred by the taxpayer on behalf of those AEs and which relate to normal operations of the taxpayer.

The reimbursement and the recovery of expenses included in the operating expenses should be at cost.

The definition of operating revenue has also been revised so as to include costs relating to employee stock option plan or similar stock-based compensation provided for by the AE of the taxpayer to the employees of the taxpayer.

There are no changes in the procedural aspects under the revised safe harbour regime which means that the taxpayer has to lodge its option of availing safe harbour in Form 3CEFA by the due date of filing return of income (for FY 2016-17 it is 30 November 2017).

SKP's comments

The recent measures taken by the Indian government in the transfer pricing arena by aligning Indian transfer pricing regulations with global best practices and introducing steps to reduce the transfer pricing litigation are commendable. Rationalising the safe harbour margins would now bring the government closer to achieving its earlier objective of reducing the transfer pricing disputes, providing administrative simplicity and certainty to the taxpayers and at the same time offer an alternative to APAs.

The cap on the value of international transactions would imply that it would largely benefit the SMEs. The lower safe harbour rates coupled with the reduction in the tax rate for SMEs announced in the budget earlier this year would imply a significant reduction in the tax outflow for SMEs. By aligning the revised safe harbour margins with the margins that are generally agreed to under the APA signed recently, the government perhaps has signalled its willingness to reduce the APA margins further in such cases. With the revised safe harbour margins one can definitely expect some withdrawals of APA's that are filed and lower number of APA's now, it also provides a great opportunity for MNC's to pursue APA's and negotiate a further lower markup thereby reducing their overall tax costs in India.

Similarly, revision of the safe harbour for outbound financial transactions – loans and guarantees are a welcome move. For loan transactions, while the interest rates and segregation of loans into foreign currency and INR denominated loans are fair, the obligation of credit rating being required of the overseas AE by CRISIL might be a burdensome and costly affair for the taxpayers opting for safe harbour provisions. However, the tax payer's position of adopting LIBOR-based rates for foreign currency denominated loan stands vindicated with the safe harbour provisions and we can now hope that revenue authorities can put to rest the existing litigation in this area.

Safe harbour on low value added intra-group services is a big, bold and positive move and just shows the intent of the Indian government to walk the talk on BEPS Action Plans. There is a huge amount of litigation on management cross charges and the safe harbour now introduced in this area will give a big boost to certainty and investors confidence.

Companies are advised to relook at their existing transfer pricing policies and re-evaluate them in light of revised safe harbour rules. Adopting to the safe harbour or APA is definitely recommended to keep the litigation at bay.

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.

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