Last Updated : Feb 22, 2017 06:02 PM IST | Source:

Tax monetisation post demonetisation; lack of clarity on funding

Thin Cap rules are based on globally acceptable principles. However, one must be cognizant of certain sectors like infrastructure, steel, construction which have hugely leveraged balance sheets.

Manish Sabharwal

Indian government seems to be asking again - show me the money. First, it was the demonetisation drive when Indians were asked to show the money lying with them. Now, it seems to be the turn for Multinational Enterprises (‘MNEs’) to face this question. In Budget 2017, the government has asked MNEs operating in India which face transfer pricing (‘TP’) adjustment, to get the differential cash into India. TP is a discipline in tax law which requires that transactions between group companies must happen at fair value/ arm’s length, to protect India’s tax base. Any mispricing in intra-group transactions faces TP adjustment.

So this is how the proposed concept works. Let us take the case of an Indian subsidiary which is providing software development services to its foreign associated enterprise (‘AE’). Let us assume that it operates on a pricing model of cost plus 15 percent mark-up. Assume further that post an audit, the tax officer concludes that the Indian subsidiary should earn say 20 percent mark-up, similar to comparable third parties. Accordingly, the differential 5 percent should be taxed in India as TP adjustment. However, there was no requirement earlier that the differential 5 percent should be repatriated into India.

The government realized that even if it taxes the additional 5 percent through TP adjustment, the Indian subsidiary is still in an advantageous position as compared to another company which actually charges cost plus 20 percent. To plug this disparity, Budget 2017 asks companies which face TP adjustment, to get the differential cash into India. Else, the Tax Department would assume the differential to be a loan from Indian subsidiary to the foreign AE, on which interest would be imputed (also called ’Secondary adjustment’).

While the provision, which is also prevalent in other countries (like US, France, Canada) is no ‘tax terror’, the drafting leaves potential for chaos. One of the key concerns is that the current drafting suggest that the provision applies retrospectively i.e. even on past TP adjustments. This is surely avoidable. There are also concerns about the impact on already concluded Advance Pricing Agreements (‘APAs’) wherein the government has negotiated and agreed on intra-group pricing of some MNEs. The Government should clarify that what has been agreed would not be re-analysed.

Another key TP amendment in Budget 2017 is the introduction of thin cap rules. Subsidiaries are typically flexible on how they are funded by AEs – debt or equity. Considering that the interest paid on debt is tax deductible (as compared to no tax deduction on dividend), there was an inclination to receive funding from AEs as debt. Budget 2017 recommends that from financial year (‘FY’) 2017-18 onwards, if the interest/ EBIDTA ratio of Indian companies exceeds 30 percent due to excessive interest paid to AEs, the excessive interest paid to AEs would be disallowed. The disallowed interest though can be claimed in the next 8 years as and when the interest/ EBIDTA ratio falls below the 30 percent threshold.

Thin Cap rules are based on globally acceptable principles. However, one must be cognizant of certain sectors like infrastructure, steel, construction which have hugely leveraged balance sheets. Since some of these sectors are critical for India’s growth story, sectoral specific exemptions from thin cap rules may be explored. Again, for debt which has already been taken in the past, grandfathering may be allowed keeping such debt out of thin cap ambit.

As one talks about TP amendments in Budget 2017, one must credit the government for relaxation of domestic TP rules. Earlier, majority of domestic intra-group transactions were also covered in TP. Going forward though, unless one of the transacting entity/ unit is tax exempt, TP provisions would not be applicable. The rationale is to cover only those intra-group transactions where there is motivation to do mispricing for tax avoidance.

Summarily, the TP provisions in Budget 2017 seem to be a case of good intention and “not so good” drafting. If some of the concerns expressed above are not taken care of while incorporating them in the law, the MNEs operating in India would have some question marks (?) to deal with on intra-group transactions.

The writer is Partner at Price Waterhouse & Co. LLP
First Published on Feb 22, 2017 06:02 pm