Anchorage issue with safe-harbour rules

Not enough advantages for large firms, with liability seemingly higher than under an advance pricing agreement

The finance ministry had announced safe-harbour rules to bring down transfer pricing disputes with multinational companies (MNCs) but bigger firms might not opt for these.

The reason is that tax liability under these rules is higher than those under an advance pricing agreement (APA) or simply normal assessment appeal process, experts said.

Safe-harbour is a provision in a statute or a regulation which specifies when something would be deemed to not breach the overall rule. It is usually done in connection with an overall and less precise standard, to provide a legitimate avenue to avoid prosecution/litigation.

I-T NOTICES IN ‘12-13

IBM asked to pay tax of

Rs 1,090 cr
Gillette asked to pay tax of
Rs 118 cr
Vodafone adjustment of
Rs 1,300 cr
Hindalco adjustment of
Rs 1,063 cr
Microsoft adjustment of
Rs 5,135 cr  
Shell adjustment of
Rs 15,000 cr
Indian arms of MNCs can adopt safe-harbour rules to settle their tax liability. Under certain conditions, the liability is not questioned by the tax department under these rules, which enable MNCs to apply for these for a maximum of five years from the current assessment year. Alternatively, companies can go for APAs to also know their liability in advance of the normal appeal process.

The recently issued rules by the Central Board of Direct Taxes said the safe-harbour margin would be 20 per cent for transactions up to Rs 500 crore in routine information technology (IT) and IT-enabled services and 22 per cent for over Rs 500 crore. For knowledge processing outsourcing (KPO), it would be 25 per cent and for contract research and development, 30 per cent. In APAs, the margin is generally 15-17 per cent, nothing more than a mark-up on operating cost.

Calculations
Samir Gandhi, partner, Deloitte Haskins & Sells, gives an example. Suppose a company comes under the routine IT area and has an operating cost of Rs 500 crore; then, the safe-harbour margin is 20 per cent. This meant Rs 100 crore. On this, the company would pay the tax, of almost 35 per cent. So, this would be Rs 35 crore. Now, suppose under APA, the margin is taken as 15 per cent. Then, 15 per cent of Rs 500 crore would be Rs 75 crore and 35 per cent tax on that would mean Rs 26.2 crore. So, the company would have to pay Rs 8.8 crore more tax in the case of safe-harbour.

This difference will increase if the company’s transactions are more, usually the case with IT companies, as safe margin will also rise to 22 per cent for transactions over Rs 500 crore. For example, IBM was asked to pay Rs 1,090 crore tax in 2012-13.

In case the company is in KPO, the difference would increase further and in case these are engaged in contract research and development activities, rise still more.

MNCs would consider this difference with APA and the hassles in case it goes for litigation if it adopts the normal appeal process, Gandhi said. Besides, the parent company gets tax deduction in the case of APA but not in the case of safe-harbour rules, he explained. For, the latter are already set by tax officials, while an APA is a negotiation between these companies and tax authorities. All this would be assessed by big MNCs, which might dissuade them for going by safe-harbour rules, he added.

Rahul Mitra, leader (transfer pricing) at PwC India, said while the rules still entice small companies, larger players having a cost base of at least Rs 200 crore might not opt for these even in the IT and ITeS sector. They might prefer APA for upfront resolution.

Besides, companies could apply for safe-harbour rules only if Indian companies bear insignificant risk in the operations. This means much of the risks like providing capital are borne by the parent company. This would provide much arbitrariness in the hands of a transfer pricing officer (TPO), Gandhi said.

Official discretion
Another arbitrariness given to a TPO are in what to term as normal IT and ITeS companies, as distinct from KPO and contract research & development ones. These are to be judged by tax officers on the basis of some conditions. “Even I can’t differentiate between KPO and normal IT/ITeS firms. It is a technical matter which requires the skill of software development,” said Gandhi.

A TPO is to judge whether a company is in KPO or not on the basis of six norms under the rules, such as whether the Indian arm is involved in animation, content development and management, business analytics, financial analytics, etc.

Similarly, contract R&D activities are to be judged on the basis of eight conditions — whether Indian arms are producing new theorems and algorithms in theoretical computer science, development of IT at the level of operating systems, development of internet technology, etc.

The point of safe-harbour rules was to bring more and more companies under these. So, the rules were relaxed from those drafted initially. For example, the draft rules had suggested a ceiling of Rs 100 crore in the case of routine ITeS, IT and KPO companies. This means companies whose transactions are more than Rs 100 crore were not eligible. This ceiling was  removed in the final rules.

The disputes generally arise due to differences in calculation of profit between Indian arms of MNCs and tax authorities.