The Indian tax department has traditionally been aggressive on tax audits. Transfer pricing regulations, introduced in 2001, witnessed large tax adjustments almost since inception, which till date have seen year-on-year increase in adjustments and consequent litigations.
The Indian tax department has traditionally been aggressive on tax audits. Transfer pricing regulations, introduced in 2001, witnessed large tax adjustments almost since inception, which till date have seen year-on-year increase in adjustments and consequent litigations. Many of these adjustments have not been able to stand judicial scrutiny. The Economic Survey 2017-18 attests to that, and states categorically that the success rate for these audits, both at tribunal and at high court level, is less than 25%, suggesting that many audit adjustments could have been avoided had the tax department done more evidence-based audit, looking at business cases more diligently. Such an aggressive tax regime may also have been inimical to providing an investment environment to prospective global investors.
The government, aware of the pitfalls of not having an effective dispute management system, has adopted measures to provide tax certainty to investors and reduce litigations. One such is to pick up reduced number of cases for audit. Earlier, transfer pricing cases for audit were picked up on the basis on quantum of intra-group transactions within an MNE group (related-party transactions), but now audit cases are selected based on riskiness of transactions. This step has reduced the number of cases. The riskiness of cases is based on the history of litigation in earlier years, on information received through exchange with other countries, and on the basis of information reported by different entities of the MNE group through country-by-country reports and master files, as suggested in OECD-G20 recommendation on BEPS.
Until 2012, the government relied largely on dispute resolution. In 2012, it brought a dispute prevention mechanism (after failed attempts to introduce Safe Harbour rules in 2009), which allowed taxpayers or prospective investors to know, a priori, the amount of profit that the MNE group needs to allocate to India. The advance pricing agreement (APA), so introduced, has been successful, attracting close to 1,000 taxpayers. The government has strengthened it by increasing its scope (inclusion of roll-back regime) and removing disputes for possible nine years, and adding internal capacity to handle the large number of applications. Through this, about 240 APAs have been concluded. The government has also given up its rigid position on Article 9(2) in tax treaties, and thereby made bilateral and multilateral APAs more attractive by including almost all treaty countries into the ambit of APAs. This will allow for a better investment regime.
While APAs have been applied for by all business segments, the services sector dominates. IT businesses constitute larger part of the services sector. Understandably, as IT services and BPO together constitute 45% of the total Indian services exports. The size of this segment is likely to double in seven years from the current $167 billion. By some estimates, cost savings to the source country for these exporters are 60-70%. The headwinds to growth are from the tax department, even in APAs, due to insistence of higher profit allocation to the Indian entity. Globally, such entities are allocated 5-7% of profit on cost, but the Indian tax department insists 20-24%. This adds to the cost of the MNE, and they tend to divert investments to other jurisdictions, such as the Philippines, Brazil, Thailand, etc. Even the comparability analysis, which is a hallmark of transfer pricing analysis, suggests it should be much lower than 12-14% profit mark-up. Tax authorities can thus be suggested to do a proper comparability analysis, looking at the domestic as well as global economic and business scenario.
The impact of lowering of the mark-up, based on such analysis, would lead India to increase its global share of such MNE set-ups, from 55% to a much higher number in quick time. The government should consider such a possibility.
A positive development on dispute resolution has been the greater traction in mutual agreement procedure (MAP) resolution—it allows for mitigating double taxation effects. One clear global development being seen is that many countries do not agree to higher allocation of profit mark-up in India. This results in double taxation, even if there may not be any transfer pricing adjustment in India. Indian authorities need to get into MAP with a framework agreement with some investor countries, such the UK, the APAC countries, in the same fashion they had previously done with the US, for the IT sector, and resolved close to 400 cases of double taxation. The objective of dispute management, therefore, has to be pegged at increasing investment and improving ‘ease of doing business’, and not focus only on tax collection.