Transfer Pricing: Un-Safe Harbour?

Transfer Pricing is the price at which intra-group transactions or transactions between associated enterprises take place. International transfer pricing involves a foreign associated enterprise. By law, transfer pricing must be at arms length and the arms length measures have been defined by the I-T Act. But since it is no exact science and a highly litigious area, Revenue in many countries has provided safe harbours – that is, limits within which the transfer price is acceptable. Often, eligible taxpayers complying with the safe harbour provision are relieved from burdensome compliance and documentation obligations. This week the CBDT released Draft Safe Harbour Rules for IT, ITES, KPO and Contract R&D Services provided to a non-resident associated enterprise, manufacture and export of core auto components as well as intra-group loans and guarantees. But low thresholds and high mark ups could make for rather un-safe harbours. To discuss that, I am joined By S Gayathri of Essar, Vijay Iyer of Ey and Rupak Saha of GE India.
 
Doshi: Gayathri, I would like to start with you. In almost four sectors, the prescribed threshold for transaction sizes is Rs 100 crore- no transactions above that will be eligible for safe harbours and then you have got minimum profit margins ranging from 20-30 percent. Do you think that these are very low thresholds? They exclude a large number of transactions and that these are very high operating profit margins; unrealistically high?

UN-SAFE HARBOUR?
SECTOR: Software Development Services
        
TYPE: Insignificant Risk            
AMOUNT: Upto Rs 100 cr                         
MINIMUM OPM: 20%
 
UN-SAFE HARBOUR?
SECTOR: IT Enabled Services TYPE: Insignificant Risk
AMOUNT: Upto Rs 100 cr
MINIMUM OPM: 20%
 
UN-SAFE HARBOUR?
SECTOR: KPO Services
                                                              
TYPE: Insignificant Risk
AMOUNT: Upto Rs 100 cr
MINIMUM OPM: 30%
 
Gayathri: It is very important to understand what really are the objectives of safe harbour rules across the world and the way they implement it. So typically, the objective is simplicity of provisions and reduction in compliance for the tax payer and administrative hassles for the authorities, so that they are able to focus on the larger issues, larger transactions and there is definitely a large degree of predictability and certainty. So based on these parameters if you were to look at these rules and also having in mind what other countries have been doing, I am not sure that the threshold limit per se is all that bad. I believe it is with a design, it is with the understanding of what the authorities think is a lot, is a segment which can do with less than normal scrutiny. Having said that, the range if you look at the profit margins they are certainly not aligned with what (interrupted….).
 
Doshi: So give me instances where because I think they were impacted let us say by ITES or for large groups like yours- corporate guarantees- which carry a two percent commission or intra-group loans.I think Deloitte did a working out and they said loans less than Rs 50 crore will amount to a safe harbour interest of about 11.2 percent; for more than Rs 50 crore the safe harbour interest works out to about 12.7 percent- rates which they say are against tribunal decisions and way too high? UN-SAFE HARBOUR?
SECTOR: Contract R&D (Software Development)                        
TYPE: Insignificant Risk
AMOUNT: All
MINIMUM OPM: 30% UN-SAFE HARBOUR?
SECTOR: Contract R&D (Generic Drugs)                           
TYPE: Insignificant Risk
AMOUNT: All
MINIMUM OPM: 29% UN-SAFE HARBOUR?
SECTOR: Intra-Group Loan
TYPE: Sourced in INR, To Non Resident, Wholly Owned Subsidiary
AMOUNT: Less than Rs 50 cr
MINIMUM OPM: SBI Base Rate + 150 bps
 
UN-SAFE HARBOUR?
SECTOR: Intra-Group Loan
TYPE: Sourced in INR,To Non Resident, Wholly Owned Subsidiary
AMOUNT: More than Rs 50 cr
MINIMUM OPM: SBI Base Rate + 300 bps
 
UN-SAFE HARBOUR?
SECTOR: Corporate Guarantee Fee                                                       
TYPE: Explicit, To Non Resident, Wholly Owned Subsidiary
AMOUNT: Upto Rs 100 cr
MINIMUM OPM: 2% p.a.
 
Gayathri: Absolutely, they are a way too high. So we would take an example- it is like I said- globally there are a few segments which have come under safe harbor; they are invariably intra-group services and loans. Now as far as loans are concerned, they do it with a combination of debt-equity thin cap rules and the interest rates per se and definitely the benchmark there is far lower because they are invariably linked to the London Inter Bank Offered Rate (LIBOR). Here we have a very specific case where they relate only to India sourced or rupee sourced loans which itself lends itself to a lot of interpretation. So, if you were to extend it to external commercial borrowings (ECBs) for example which are then further lent by way of offshore derivative instruments (ODIs) then you are possibly going to compare with the LIBOR plus whatever- let us say five percent- which could just work out to 5-7 percent.
 
Doshi: Let me take that to Rupak Saha. Mr. Saha, GE, has several contract research and development (R&D) businesses in the country pertaining to what I understand software development or you could even describe those businesses ITES- I think that is one key point that comes into contention in the safe harbour rules and again your response to whether the thresholds are too low and the minimum operating profit margins are too high?
 
Saha: Two things, I think you have asked quite a few questions. So, I think the margins are generally in line with what the Rangachary Committee has said. I hadn’t seen the Rangachary Committee report earlier, but I guess the reports have been just now released in public along with these notifications. So, the fact is that they have put the margins consistent with what the Rangachary Committee has recommended. So far as the threshold is concerned yes, I agree that it is very low and those thresholds were nowhere there in the Rangachary Committee report and I think over there they are guided by fear of tax base erosion and given the way the fiscal deficit is, I have some level of sympathy as to why they have kept this. Now one can always argue therefore whether this will meet the larger objective of the safe harbour by itself, but equally they have to balance so many other variables including the fiscal deficit. It is what it is.
 
Doshi: Okay, so you are being generous Mr. Saha from a macro monetary situation. But I have to ask you to think from a business operational situation and discard the Rangachary Committee for a minute and just look at these margins as standalone and tell me whether these are the kind of margins that safe harbour rules elsewhere in the world require?
 
Saha: No before I go to elsewhere and while you are asking me to discard Rangachary report, let me stay a little bit on the report. I was also a little bit taken by surprise when the Committee report said that for most of this IT software and IT enabled services, the tax payer themselves volunteered up to 15 percent. So from 15 percent, they have gone to 20 percent and then where the Central Board of Direct Taxes (CBDT) has gone a little bit way off from the Rangachary report is that they have introduced this category called KPO- the KPO is nowhere to be seen in the Rangachary report; it is actually carved out of the ITES services where the Rangachary report also said it should be cost plus 20. But as I said at this point in time the CBDT is completely engulfed with the fear of base erosion and so far as the international comparison is concerned, I agree that we are way off from I guess many countries who are attracting these kind of investments. But I also have this new thinking I guess and I never used to think like this before, but what India is thinking along these lines, many of the other countries are following and you know this - whether it is the tax on indirect transfer or base erosion and so on and so forth. There are many other countries which follow what India is doing. So who knows after a few years whether other countries such as China etc. would also look at these kind of mark ups.
 
Doshi: So, you are saying we might be setting the lead. My two corporate guests are playing it slightly politically correctly, if I may say so, and they are also giving the government a lot of leeway for the current fiscal and monetary situation we are in. You look at this objectively for me Mr Iyer and tell me whether these margins are realistically possible. Are these on the higher side, do you think this is fair or do you think even if they are on the higher side, this is the price you pay for certainty if you want safe harbour rules?   
 
Iyer: Let me start with the interest number- so that defies economics because the rate of interest you charge is a factor of the currency in which you charge it. It is not based on the source of the funds. So, if today I am lending in foreign exchange but the source of those funds are internal accruals, I still don’t need to charge a rupee interest rate. I will charge what the particular currency would justify as an interest rate. So, if it is a dollar denominated loan I can charge as much as what a dollar loan would cost and not just because the funds are coming from rupees, it should be 11 percent interest rate, so that really defies economics. Probably there is a thought on saying that probably the opportunity cost of that fund is whatever it is but then you are not factoring in the currency risk that is being borne by this lender who is now lending in foreign exchange.
 
Coming to the Contract R&D, the classification itself is so confusing that we may probably need an IT expert to answer that question but I can’t seem to figure out what is the classification between the IT services and contract R&D, the number itself is way to high at 30 percent and it is probably more than what even the transfer pricing officers are doing.
 
Similarly, I would think that in Contract R&D for pharma, the numbers are much higher than what the transfer pricing officers are doing. They have upheld cost plus 18 in the past and not very distant past, as recent as January 2013 so to move on to 29 percent for Contract R&D for pharma also does not make sense and similarly for KPO. So these are the three numbers which are way too high. UN-SAFE HARBOUR?
SECTOR: IT Enabled Services
TYPE: Insignificant Risk
AMOUNT: Upto Rs 100 cr
MINIMUM OPM: 20%
 
UN-SAFE HARBOUR?
SECTOR: KPO Services                                                               
TYPE: Insignificant Risk
AMOUNT: Upto Rs 100 cr
MINIMUM OPM: 30%
 
UN-SAFE HARBOUR?
SECTOR: Contract R&D (Software Development)                        
TYPE: Insignificant Risk
AMOUNT: All
MINIMUM OPM: 30%
 
UN-SAFE HARBOUR?
SECTOR: Contract R&D (Generic Drugs)                           
TYPE: Insignificant Risk
AMOUNT: All
MINIMUM OPM: 29%
Doshi: If the entire attempt is to reduce litigation in the transfer pricing space, do you think this is going to work. Is it going to do enough?
 
Gayathri: I certainly think that a lot of tweaking is called for. One basic thing is certainty - one of the hallmarks of a safe harbour regime. Just look at how it has been prescribed. It is for two years, of which one year is over and half of the next year is over, almost half is over. So you have a retrospective situation on the other hand and standing today one cannot be sure even if let’s say one says, okay I will give in into 2 percent – what happens to the previous years when one went for 1 percent with no commission at all. Can I still dispute, can I still challenge and then what happens after the next year. The other one being simplicity of provisions. Let us say an assessee- once again taking the same example of two percent- files the return and the assessing officer takes it up after a year and then says I don’t think you quite fit into this, you aren’t eligible. Then he goes back to the regular assessment, he might not even or let us say 30 percent having accepted even if he is not charged, he pays up tax. At the end of it he does not know why did he have to pay tax on 30. Maybe in earlier year he had paid 25, he can’t defend that, he does not know what to do in the future; so it is all one mixed bag. UN-SAFE HARBOUR?
Safe harbours available for financial years 2012-13 and 2013-14
 
Doshi: One of the big concerns that even I have come across in all my conversations is several consultants as well as tax heads telling me that will these now reasonably high operating margins be deemed as arms length in the months to come or in the years to come outside of safe harbours – is that one of your key concerns?   
 
Saha: I think that risk is certainly there. Now that these are in the public domain as well and are blessed in a way by the Rangachary Committee report. It has given a shot in the arm to the Revenue by saying that look, these are probably the best benchmarks, which we should work on and not only the revenue authorities I would think because the committee report comes out with these rates, a lot of adjudicating authorities including the courts would be influenced. Therefore, definitely there will be a problem with the tax payers now to justify something which is significantly lower than these benchmark rates. That is for sure.
 
Let me very quickly also talk on this corporate guarantee and inter-company loan. My sense is that the government should have perhaps refrained from coming on safe harbour at all in case of this inter- corporate loan and guarantees. I think those kind of safe harbour works where the currency volatility between two countries are kept at a minimum but given the currency volatility we have, it is very difficult to negotiate issues of the type which Vijay mentioned.
 
For example, while Vijay said, if it is a foreign currency loan it should be benchmarked with international benchmarks but the other concern on the Indian side is that, when one is borrowing from Indian funds, you should at least make a positive contribution out of your margin. Now, what I was quite taken aback in the Rangachary Committee report is that they think or according to that report, the entire cost of funds and the opportunity earnings around that they premise that that should be met by the interest earnings from the loan. Now that is wrong because in this basic economic concept of interest rate parity, the lender’s return would have probably been met by- let us say if it is a dollar loan- dollar rate of return plus the INR depreciation against the dollar. On the corporate guarantee perhaps the 2 percent, I think they raise a little bit of rationale considering that again the committee report says that most of the banks, they charge around that type of fee for any guarantee commission; so, that is the benchmark that they are taking.
 
Doshi: The verdict on safe harbour rules?
 
Iyer: Certainly it is a positive move from where we were. It took us three years to get this out; so at least we have got something out now. We have got a pretty well written Rangachary Committee report which sets the tone for this Circular so we can talk in the context of Rangachary Committee and the government and say look this is what they have said. They have raised a lot of doubts about these numbers and so like the 30 percent number is not there for KPOs. There is a 22 percent for BPOs of a certain scale. Some points which we can bring it back to the table and have a discussion. I would expect some level of rationalisation of this whole thing and if that is done, I think that will be a positive move. We don’t expect 100 percent of tax payers to buy into safe harbours, but even if we get 30 percent takers, I think that will be success. If Safe Harbour Opted: The tolerance band (1% - 3%) will not be available If Safe Harbour Opted: Taxpayer required to maintain usual mandatory transfer pricing documentation under Sec 92D Safe Harbour not available for transactions with no tax/low tax jurisdictions (Maximum marginal Tax Rate is less than 15%)