Laying down tax rules

If dealing with the taxman was difficult so far, then after the GlaxoSmithKline (GSK) settlement with the US' Internal Revenue Service (IRS) earlier this month, life promises to get even more complicated for companies with trans-border business dealings. The GSK dispute with the IRS dates back 17 years and revolves around GSK's blockbuster, the antacid Zantac. The American taxman said GSK had shifted profits from its US to its UK operations, that while Zantac was only an improvement on the earlier Tagamet, the reason why it did so well in the US was due to the extra sales efforts of GSK's sales team in the US. GSK, however, said the sharp rise in US sales of Zantac was not so much due to the marketing team there but the result of the development efforts of the UK team. In theory, such issues are settled through the royalty charged on the drug, but there is the issue of arm's length pricing within the same firm, and that is where the taxman can come in""did GSK overcharge on the royalty from the US arm so as to transfer profits to the UK?

At a time when international companies are trying to sell in India drugs that have been discovered overseas, it is not difficult to envisage a similar problem arising here. What could complicate matters further is the contract research that is now being done in the country. In theory, the Indian taxman can demand some part of the global profits that accrue from this development work. Indeed, this argument could apply just as well to other R&D work going on in the country, in software for instance. What this means is that the finance ministry needs to start applying its mind to how it wants to deal with such situations, rather than leaving various tax commissioners all over the country to interpret transfer pricing in the manner they think best. Ideally, the issue is best dealt with by an Advance Pricing Agreement (APA), which lays down the method in which such transfer pricing is to be treated, sometimes even the exact value in a particular transaction. As yet, however, India does not have an APA mechanism, which, in any case, is a complicated business and requires bilateral treaties with various countries and requires advance econometric and other modelling exercises as well. The Advance Ruling Mechanism, which is what India has, is of little use here since it specifically excludes APA and, in any case, it is proving to be a lot less effective than previously imagined.

The trade-off here is between tax revenue and business opportunity. Till such time as India moves forward and adopts the concept of APA, the finance ministry needs to keep in mind that the economic imperative could be different from the taxman's perspective. So, if contract research or what is clubbed under the term "knowledge process outsourcing" is to face problems of the GSK kind with the taxman, it will affect the growth of such business in the country. That is, India needs to strike a balance between revenue gain and business loss.