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Union Budget 2017: Provides certainty to taxpayers and tax authorities

In Budget 2017, the finance minister has proposed a new provision to enable a ‘secondary’ transfer-pricing adjustment to be made to a taxpayers income under the Income Tax Act, 1961 (Act).

Arun Jaitley (Reuters)

In Budget 2017, the finance minister has proposed a new provision to enable a ‘secondary’ transfer-pricing adjustment to be made to a taxpayers income under the Income Tax Act, 1961 (Act). Transfer-pricing rules recompute the taxable profits of an Indian enterprise arising from its international transactions with associated enterprises located abroad by using the arm’s length price that would have been charged between unrelated enterprises. This reallocation of income is achieved through an upward adjustment (primary adjustment) to the Indian enterprise’s income, which results in higher taxes in India. The argument for a secondary adjustment is that while the primary adjustment corrects the allocation of income and tax to India, it does not address the underlying excess cash remitted to the foreign associated enterprise, arising from the non-arm’s length pricing of the international transaction. This cash benefit can be reversed by a secondary adjustment rule which results in a tax on the excess cash remitted abroad due to non-arm’s length pricing. The proposed secondary adjustment provision in the Finance Bill treats the excess cash remitted abroad as a result of the non-arm’s length international transactions as a deemed advance or loan made to the foreign associated enterprise and taxes the imputed interest on the deemed loan.

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All other countries which tax on the basis of secondary adjustments (e.g., France, the US, Canada, South Africa, Korea, Spain, Bulgaria, Luxembourg, the Netherlands, Germany and Austria) apply a withholding tax by treating the excess cash remitted abroad as a deemed dividend or capital contribution to the foreign AE. South Africa is the only country which previously taxed secondary adjustments on a deemed loan basis but switched to a deemed dividend basis in 2015. The reason was the significant administrative and compliance burden in keeping track of secondary adjustments in the form of deemed loans, the computation of interest, i.e., rate, the allocation of the loan between different associated enterprises and the capitalisation of unpaid interest, the absence of any legal or contractual basis for the foreign associated enterprise to repay the unilaterally-determined deemed loan and pay the deemed interest, the difficulties in the accounting treatment of the deemed loan and the complexities of addressing the relevant currency of the deemed loan and deemed interest. The UK has issued a consultation paper in 2016 proposing a constructive loan basis for taxing a secondary adjustment and is still analysing the feedback before deciding on whether to take this forward. In the Indian context, there are further complications which may crop up from the deemed loan characterisation because of the exchange control regulations under the Foreign Exchange Management Act for which there is a separate regulator, Reserve Bank of India.

An alternative and simpler mechanism for the secondary adjustment is to address it as a deemed remittance liable to a full and final withholding tax. The argument for a further tax on account of a primary transfer-pricing adjustment is when there are outbound payments from India to non-residents in other kinds of cross-border transactions, there is a final withholding tax in India on that payment. Therefore, a similar tax (secondary adjustment tax) that mimics a final withholding tax can be considered to address the cross-border fund flows resulting from non-arm’s length transfer-pricing between the Indian taxpayer and its foreign associated enterprise. Given that the cash repatriated on account of non-arm’s length pricing is not in the nature of a return on equity and that the relationship between the Indian entity and its associated enterprise may not be that of a shareholder, the secondary adjustment tax should not be equated with the tax on distributed profits of a domestic company (dividend distribution tax) under section 115-O of the Act. The secondary adjustment tax should instead be equated with the final tax withholding on payments like royalty and fees for technical services to non-residents which, in the Act and in India’s major tax treaties, is at a rate of 10%. Therefore, a separate provision could be introduced in the Act (in Chapter XII-Determination of Tax in Certain Special Cases) under which the primary adjustment amount could be taxed at a specific rate of 10% (secondary adjustment tax) if this amount is not repatriated to the Indian enterprise within a prescribed time-period. This would be a one-time tax which will obviate all the monitoring and other challenges likely to be faced in a deemed loan and deemed interest regime and provide certainty to both taxpayers and the tax authorities.

The author is of-counsel, BMR & Associates LLP. Views are personal

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