SAFE HARBOUR RULES – AN OVERVIEW (Part 1)

1. BACKGROUND
Determination of Arm’s Length Price [ALP] is often time-consuming, burdensome and costly if an Associated Enterprise [AE] provides a range of intra-group services. It may impose a heavy administrative burden on taxpayers and tax administrations that can be intensified by both complex rules and resulting compliance requirements in respect of Transfer Pricing [TP]. Further, in recent times we have seen a substantial increase in litigation on transfer pricing issues, especially in developing countries like India. This has led to consideration of Safe Harbour(s) [SH] in the services sector like KPO services, Contract R&D services, ITES, certain low value-adding services, etc., along with the manufacture and export of core and non-core auto components (which is not a service) in the TP arena to provide certainty for the taxpayers and tax administrators. As per the amended Indian SH rules, low value-adding intra-group services have also been added in the eligible international transactions. SH rules have generally been applied to smaller taxpayers and / or less complex transactions. They are generally evaluated favourably by both tax administrations and taxpayers, which indicates that the benefits of SH outweigh the related concerns when such rules are carefully targeted and prescribed and when efforts are made to avoid the problems that could arise from poorly designed SH regimes.

A substantial number of cases in litigation on transfer pricing issues in India are in respect of selection of comparables while determining the ALP. An SH may significantly ease the compliance burden, reduce compliance costs for eligible taxpayers in determining and documenting appropriate conditions for qualifying controlled transactions and eliminating the need to undertake benchmarking exercises and selection of comparables which may be questioned by the tax authorities. It will also provide certainty to the taxpayers by ensuring that the price charged or paid on qualifying transactions will be accepted by the tax administrations with a limited audit or even without an audit, increase the level of compliance by small taxpayers and enable the tax authorities to use their resources to concentrate on TP review in which the tax revenue at stake is more significant.

2. OBJECTIVES OF SAFE HARBOUR
The importance of SH in TP has increased because of the following reasons:
a) Globalisation of markets and firms,
b) Development of powerful IT and efficient communication systems leading to increasing amounts of intercompany transactions,
c) Tax disputes on account of Base Erosion and Profit Shifting,
d) Complex regulatory compliances,
e) Documentation requirements, complexity in application, deadlines, stringent penalties in case of non-compliance, burden of audit and various other factors to be taken care of by the taxpayer,
f) Resource constraints of tax authorities and assessment of risk by them in order to focus their limited resources on large and significant cases.

SH has been introduced with the objective of assisting the tax authorities as well as reducing the compliance burden on the taxpayers. It has also been designed to reduce the amount of litigations in cases where there is a difference of opinion between the tax authorities and the taxpayers and also to provide certainty.

3. SAFE HARBOURS AS PER OECD TP GUIDELINES
As per the OECD, SH are expected to be most appropriate when they are directed at taxpayers and / or transactions which involve low TP risks and when they are adopted on a bilateral or multilateral basis, as against unilateral SH which may have a negative impact on the tax revenues of the country implementing them, as well as on the tax revenues of the countries whose AEs engage in controlled transactions with taxpayers electing a SH. A bilateral or multilateral SH would involve multiple countries agreeing on a fixed set of SH, thereby enabling the taxpayer to select and implement the SH without undertaking a risk of transfer pricing adjustment in all such jurisdictions.

Some of the difficulties that arise in applying the ALP may be avoided by providing circumstances in which eligible taxpayers may elect to follow a simple set of prescribed TP rules in connection with clearly and carefully defined transactions, or may be exempted from the application of the general TP rules. In the former case, prices established under such rules would be automatically accepted by the tax administrations that have expressly adopted such rules. These elective provisions are often referred to as ‘safe harbours’.

4. DEFINITION AND CONCEPT OF SAFE HARBOUR
4.1 OECD TP Guidelines
As per OECD TP Guidelines 2017, an SH in a TP regime is a provision that applies to a defined category of taxpayers or transactions and that relieves eligible taxpayers from certain obligations which are otherwise imposed by a country’s general TP rules. An SH provides simpler obligations in place of those under the general TP regime. Often, eligible taxpayers complying with the SH provisions will be relieved from burdensome compliance obligations, including some or all associated TP documentation requirements.

Such a provision could, for example, allow taxpayers to establish transfer prices in a specific way, e.g., by applying a simplified TP approach provided by the tax administration. Alternatively, an SH could exempt a defined category of taxpayers or transactions from the application of all or part of the general TP rules.

4.2 UN TP Manual
The UN TP manual defines SH as follows:
‘A provision in the tax laws, regulations or guidelines stating that transactions falling within a certain range will be accepted by the tax authorities without further investigation.’

As per the UN TP Manual, a practical alternative for a tax authority is to provide taxpayers with the option of using an SH for certain low value-adding services, provided it results in an outcome that broadly complies with the ALP. The SH may be based on acceptable mark-up rates for services. Several countries provide an SH option for certain services.

4.3 Toolkit for addressing difficulties in accessing comparables data for Transfer Pricing analyses [Toolkit]
The Toolkit prepared in 2017 in the framework of the Platform for Collaboration on Tax under the responsibility of the Secretariats and staff of the four mandated organisations, namely, International Monetary Fund, OECD, United Nations and World Bank Group, explains SH as follows:

‘An SH in a TP regime is a simplification measure through a provision that applies to a defined category of taxpayers or transactions and that relieves eligible taxpayers from certain obligations otherwise imposed by a country’s general TP rules. One of the merits of a well-framed SH is that it can reduce the need to find data on comparables and to perform a benchmarking study in every case.’

An SH may refer to two types of provisions:
‘Safe Harbour for TP’ – A mechanism to allow a tax administration to specify an appropriate TP method and an associated level or range of financial indicators that it considers to fulfil the requirements of the TP rules. Such an SH is applicable only in respect of a defined category of transactions.
‘TP Safe Harbour on process’ – The specification by a tax administration of a process that, when applied in respect of a defined category of transactions, is considered to produce a result that fulfils the requirements of the TP rules.

Both types of SH provide potential benefits to the tax administration and to taxpayers. In practice, SH may be appropriate in respect of a wide range of transactions, including:
* Manufacturing, especially in cases where the manufacturer does not have a right to valuable intangibles and does not assume significant risk. This is likely to include manufacturers that are in substance toll manufacturers or contract manufacturers;
* Sales and distribution entities, including sales agents, again in cases where the function does not exploit valuable intangibles or assume significant risk;
* Provision of services that do not involve the exploitation of valuable intangibles or the assumption of significant risk.

5. BENEFITS OF SAFE HARBOUR
5.1 Compliance relief
Application of the ALP may require collection and analysis of data that may be difficult or costly to obtain and / or evaluate. In certain cases, such compliance burdens may be disproportionate to the size of the taxpayer, its functions performed, and the TP risks inherent in its controlled transactions. A properly designed SH may significantly ease compliance burdens by eliminating data collection and associated documentation requirements in exchange for the taxpayer pricing qualifying transactions within the parameters set by the SH. Especially in areas where TP risks are small, and the burden of compliance and documentation is disproportionate to the TP exposure, such a trade-off may be mutually advantageous to both taxpayers and tax administrations.

5.2 Certainty
Another advantage of an SH is the certainty that the taxpayer’s transfer prices will be accepted by the tax administration, provided they have met the eligibility conditions of, and complied with, the SH provisions. The tax administration would accept, with limited or no scrutiny, transfer prices within the SH parameters. Taxpayers could be provided with relevant parameters which would provide a transfer price deemed appropriate by the tax administration for the qualifying transaction.

5.3 Administrative simplicity
An SH would result in a degree of administrative simplicity for the tax administration. Once eligibility for the SH has been established, qualifying taxpayers would require minimal examination with respect to the transfer prices of controlled transactions qualifying for the SH. This would enable tax administrations to secure tax revenues in low-risk situations with a limited commitment of administrative resources and to concentrate their efforts on the examination of more complex or higher risk transactions and taxpayers. An SH may also increase the level of compliance among small taxpayers that may otherwise believe their TP practices will escape scrutiny.

6. ADVERSE CONSEQUENCES
The availability of SH for a given category of taxpayers or transactions may have adverse consequences such as:
6.1 Divergence from the Arm’s Length Principle
Where an SH provides a simplified TP approach, it may not correspond in all cases with the Most Appropriate Method [MAM] applicable to the facts and circumstances of the taxpayer under the general TP provisions. SH involves a trade-off between strict compliance with the ALP and administrability. They are not customised to fit exactly the varying facts and circumstances of individual taxpayers and transactions. Any potential disadvantages to taxpayers diverging from ALP by electing SH are avoided when taxpayers have the option to either elect the SH or price transactions in accordance with the ALP. With such an approach, taxpayers that believe the SH would require them to report an amount of income that exceeds the ALP could apply the general TP rules. While such an approach can limit the divergence from ALP under an SH regime, it would also limit the administrative benefits of the SH to the tax administration.

The question of whether to opt for SH regime would actually depend on the scale of operations vis-à-vis the resultant tax impact.

Example
In the case of two assessees A & B who are engaged in the provision of Contract R&D relating to software development (where the SH Rules provide that the operating profit margin declared in relation to operating expense should not be less than 24%), the decision to opt for the SH regime may have to be considered based on the following:

Amount in crores

As we can observe from the above example, assessee A might consider opting for operating profit margin of 24% as provided in the SH Rules since the incremental cost which he might bear in India for opting for SH in exchange of having peace and certainty in a scenario where he could have got a resolution from the ITAT at, say, 22% of operating expenses, may not be quite large, being Rs. 0.84 crore approximately

However, for assessee B the situation may not warrant opting for the SH regime as the incremental costs based on the same assumptions as mentioned above could be quite significant over the years. It is, therefore, unlikely that the large captive payers would opt for such SH Rules.

Further, as the scale of operation increases and in cases where the data of comparable transactions is easily available, the determination of ALP would not be difficult, thus making the SH option less lucrative in such cases.

6.2 Risk of double taxation, double non-taxation and mutual agreement concerns
One major concern raised by an SH is that it may increase the risk of double taxation. If a tax administration sets SH parameters at levels either above or below ALP in order to increase reported profits in its country, it may induce taxpayers to modify the prices that they would otherwise have charged or paid to controlled parties in order to avoid TP scrutiny in the SH country. The concern of possible overstatement of taxable income in the country providing the SH is greater where that country imposes significant penalties for understatement of tax or failure to meet documentation requirements, with the result that there may be added incentives to ensure that the TP is accepted in that country without further review.

If the SH causes taxpayers to report income above arm’s length levels, it would work to the benefit of the tax administration providing the SH, as more taxable income would be reported by such domestic taxpayers. On the other hand, the SH may lead to less taxable income being reported in the tax jurisdiction of the foreign AE that is the other party to the transaction. The other tax administrations may then challenge prices derived from the application of an SH, with the result that the taxpayer would face the prospect of double taxation. Accordingly, any administrative benefits gained by the tax administration of the SH country would potentially be obtained at the expense of other countries, which in order to protect their own tax base would have to determine systematically whether the prices or results permitted under the SH are consistent with what would be obtained by the application of their own TP rules.

For example, let us consider Assessee A engaged in the provision of Contract R&D relating to software development to its AE in the US, where the SH provides that the operating profit margin declared in relation to operating expense should not be less than 24%. If the US considers 20% to be an appropriate ALP for payment by the US entity to Assessee A and if Assessee A opts for SH and offers a margin of 24%, such margin may not be accepted by the tax authorities in the US and may result in litigation there.

Where SH are adopted unilaterally, care should be taken in setting SH parameters to avoid double taxation, and the country adopting the SH should generally be prepared to consider modification of the SH outcome in individual cases under mutual agreement procedures to mitigate the risk of double taxation. Obviously, if an SH is not elective and if the country in question refuses to consider double tax relief, the risk of double taxation arising from the SH would be unacceptably high and inconsistent with the double tax relief provisions of treaties.

6.3 Possibility of opening avenues for tax planning
SH may also provide taxpayers with tax planning opportunities. Enterprises may have an incentive to modify their transfer prices in order to shift taxable income to other jurisdictions. This may also possibly induce tax avoidance, to the extent that artificial arrangements are entered into for the purpose of exploiting the SH provisions. For instance, if SH apply to ‘simple’ or ‘small’ transactions, taxpayers may be tempted to break transactions into parts to make them seem simple or small.

6.4 Equity and uniformity issues
SH may also raise equity and uniformity issues. By implementing an SH, one would create two distinct sets of rules in the TP area. Insufficiently precise criteria could result in similar taxpayers receiving different tax treatment: one being permitted to meet the SH rules and thus to be relieved from general TP compliance provisions, and the other being obliged to price its transactions in conformity with the general TP compliance provisions. Preferential tax treatment under SH regimes for a specific category of taxpayers could potentially entail discrimination and competitive distortions. The adoption of bilateral or multilateral SH could, in some circumstances, increase the potential of a divergence in tax treatment, not merely between different but similar taxpayers but also between similar transactions carried out by the same taxpayer with AEs in different jurisdictions.

7. EXAMPLES OF SAFE HARBOUR IN RESPECT OF INTRA-GROUP SERVICES
As per the UN TP Manual, two SH that may be used by tax authorities in respect of intra-group services are as follows:

(a) Low value services that are unconnected to an AE’s main business activity. This SH is usually available for low value-adding services. The rationale for an SH is that there may be difficulties in finding comparable transactions for low value-adding services and the administrative costs and compliance costs may be disproportionate to the tax at stake.
(b) Safe harbours for minor expenses (i.e., amounts below a defined threshold). These are for situations in which the costs of services provided or received are relatively low, so the tax authority may agree to not adjust the transfer prices provided they fall within the acceptable range. The rationale for this SH is that the cost of a tax authority making adjustments is not commensurate with the tax revenue at stake and therefore the taxpayer should not be expected to incur compliance costs to determine more precise ALP.

8. SAFE HARBOUR FOR LOW VALUE-ADDING SERVICES
Low value-adding services are services which are not part of an MNE group’s main business activities from which it derives its profits but are services that support the AE’s business operations. A determination of an AE’s low value-adding services would be based on a functional analysis of the enterprise which would provide evidence of the main business activities of an AE and the way in which it derives its profits.

Low value-adding intra-group services are services performed by one or more than one member of an MNE group on behalf of one or more other group members which:
a) Are of a supportive nature;
b) Are not part of the core business of the MNE group (i.e., not creating the profit-earning activities or contributing to economically significant activities of the MNE group);
c) Do not require the use of unique and valuable intangibles and do not lead to the creation of unique and valuable intangibles;
d) Do not involve the assumption or control of substantial or significant risk by the service provider and do not give rise to the creation of significant risk for the service provider.

Some common examples of low value-adding services for most MNE groups (i.e., provided they do not constitute the core business of the group) are human resources services, accounting services, clerical or administrative services, tax compliance services and data processing.

For an AE that is a distributor and marketer of an MNE’s products, marketing services would fail to qualify as administrative services as they are directly connected to the enterprise’s main business activity. Similarly, for an MNE whose core business is recruitment and human resources management, human resources services of a kind similar to those provided to independent customers would not qualify for the low value-adding SH despite the mention of human resources services in the section above.

9. MINOR EXPENSE SAFE HARBOUR
In the Minor Expense SH option, a tax authority agrees to refrain from making a TP adjustment if the total cost of either receiving or providing intra-group services by an AE is below a fixed threshold based on cost and a fixed profit mark-up margin is used.

The aim is to exclude from TP examinations services for which the charge is relatively minor. The rationale is that the costs of complying with the TP rules would outweigh any revenue at stake. It also considers the potential administrative savings for a tax authority by avoiding TP examinations of minor expenses. An important requirement is that the same fixed profit margin should be used for inbound and outbound intra-group services for a country. The SH provides taxpayers and tax authorities with certainty. The minor expense SH may contain the following requirements:
* A restriction on the relative value of the service expense (e.g., less than X per cent of total expenses of the AE receiving the services) or alternatively, a restriction on the absolute value of the service expense,
* A fixed profit margin,
* The requirement that the same profit margin is used in the other country,
* The documentation requirements that are expected.

An example of an SH for services is set out as follows.

For inbound intra-group services:
a) The total cost of the services provided is less than X per cent of the total deductions of the AEs in a jurisdiction for a tax year, or less than a defined absolute amount in the local currency;
b) The transfer price is a fixed profit mark-up on total costs of the services (direct and indirect expenses); and
c) Documentation is prepared to establish that the SH requirements have been satisfied.

For outbound intra-group services:
a) The cost of providing the services is not more than X per cent of the taxable income of the AE providing the services, or not more than a defined absolute amount in the local currency;
b) The transfer price charged is based on a fixed profit mark-up on the total costs of the services (direct and indirect expenses);
c) The same profit margin is used in the other country; and
d) Documentation is created to establish that these SH requirements have been satisfied.

At present there is no minor expense safe harbour rule prescribed as part of the SH regime in India.

10. RECOMMENDATIONS ON USE OF SAFE HARBOUR AS PER OECD TP GUIDELINES
TP compliance and administration is often complex, time-consuming and costly. Properly designed SH provisions, applied in appropriate circumstances, can help to relieve some of these burdens and provide taxpayers with greater certainty.

SH provisions may raise issues such as potentially having perverse effects on the pricing decisions of enterprises engaged in controlled transactions and a negative impact on the tax revenues of the country implementing the SH, as well as on the countries whose AEs engage in controlled transactions with taxpayers electing an SH. Further, unilateral SH may lead to the potential for double taxation or double non-taxation.

However, in cases involving smaller taxpayers or less complex transactions, the benefits of SH may outweigh the problems raised by such provisions. Making such SH elective to taxpayers can further limit the divergence from ALP. Where countries adopt SH, willingness to modify SH outcomes in mutual agreement proceedings to limit the potential risk of double taxation is advisable.

Where SH can be negotiated on a bilateral or multilateral basis, they may provide significant relief from compliance burdens and administrative complexity without creating problems of double taxation or double non-taxation. Therefore, the use of bilateral or multilateral SH under the right circumstances should be encouraged.

It should be clearly recognised that an SH, whether adopted on a unilateral or bilateral basis, is in no way binding on or precedential for countries which have not themselves adopted the SH.

For more complex and higher risk TP matters, it is unlikely that SH will provide a workable alternative to a rigorous, case-by-case application of the ALP under the provisions of these Guidelines.

11. RANGACHARY COMMITTEE – INDIAN SAFE HARBOUR COMMITTEE
The Prime Minister’s Office issued a press release on 30th July, 2012 announcing the constitution of a Committee to Review Taxation of Development Centres and the IT Sector under the Chairmanship of Mr. N. Rangachary, former Chairman, CBDT & IRDA (the Rangachary Committee), for seeking resolution of tax issues through an arm’s length exercise in the form of a review by the Committee including, inter alia, SH provisions announced but yet to be operationalised having the advantage of being a good risk mitigation measure and provide certainty to the taxpayer.

The Committee was mandated to engage in sector-wide consultations and finalise the SH provisions announced sector-by-sector. The Committee was also to suggest any necessary circulars that may need to be issued.

The Committee has submitted six reports including specific sector-wise / activity-wise reports for the following:
1) IT Sector,
2) ITES Sector,
3) Contract R&D in the IT and Pharmaceutical Sector,
4) Financial Transactions-Outbound Loans,
5) Financial Transactions-Corporate Guarantees,
6) Auto Ancillaries-Original Equipment Manufacturers.

12. OVERVIEW OF INDIAN SAFE HARBOUR
Businesses flourish only if there is certainty and SH provisions offer that certainty. These SH provisions of the Income-tax Act, 1961 [the Act] specify that from the perspective of TP provisions, if the assessee fulfils certain defined conditions, the Tax Authorities shall accept the TP declared by the taxpayer.

SH Rules benefit assessees by allowing them to adopt a TP mark-up in the range prescribed, which would be acceptable to the Income Tax Department with benefits of compliance relief, administrative simplicity and certainty and hence would avoid protracted litigation.

After its enactment vide the Finance (No. 2) Act 2009, the first set of rules was notified on 18th September, 2013 – Rules 10TA to 10TG and Form 3CEFA (for international transactions), and Rules 10TH to 10THD and Form 3CEFB (for domestic transactions) for a period of three years, followed by a revision in 2017 in the SH Rules, which were made applicable till F.Y. 2018-19.

The CBDT vide Notification No. 25/2020 dated 20th May, 2020 extended the applicability of Rule 10TD(1) and (2A) (applicable for A.Y. 2017-18 to A.Y. 2019-20) for A.Y. 2020-21 also. Of the categories of the eligible international transactions, the category of software development, ITES and KPO appears to have been popularly opted for.

The CBDT has issued Notification No. 117/2021 dated 24th September, 2021 to extend the applicability of SH Rules under Rule 10TD of the Income-tax Rules to A.Y. 2021-22. The amended rule is deemed to come into force from 1st April, 2021.

Considering that the TP References in smaller cases has substantially reduced, it would have been good to revise these SH limits downward by around 2 per cent points to make it a more attractive option.

A comparison of the erstwhile and revised SH is given below:

A.Y. 2017-18 is the overlapping year for which the taxpayers had an option to exercise either of the two SH rules depending upon whichever was most beneficial to them.

The downward revision of SH margins in case of software development and ITES, Contract R&D and KPO in the revised SH Rules was long overdue and a welcome move. The revised margins are also closer to the margin range being concluded in the vast majority of APAs concluded in the IT-ITES space. As a result of the reduction in the margins, the expected savings of taxpayers due to avoidance of litigation is likely to outweigh the premium paid (if any) due to higher than arm’s length margins especially for small and medium taxpayers with lower cost bases.

This move also highlights the Indian Revenue’s intention to attract appropriate cases to the SH scheme and away from the APA scheme thereby covering the higher value and non-routine cases for the more complex cases that need a deeper understanding and negotiation by the Indian Revenue.

Another interesting feature of the revised SH rules is the gradation of the SH margin thresholds for the KPO sector based on the percentage of employee cost incurred rather than covering all the KPO activities under a single umbrella. The streamlining of margins prescribed for KPO on the basis of employee cost ratio may not be the best course of action but it does seek to align with the premise that a technically skilled workforce would lead to a higher employee cost and signify a higher value addition commanding a higher operating margin. The employee cost has been defined comprehensively.

The definitions of ITES and KPO are very broad and general and the revised SH rules did not modify / clarify them. Keeping in view the litigations that have occurred, detailed definitions would have been welcome as they would have set a clearer line of distinction between KPO and ITES. The applicability of SH for transactions of software development and ITES, contract R&D and KPO has been reduced to Rs. 200 crores. Hence, after F.Y. 2016-17, taxpayers having transaction values greater than Rs. 200 crores cannot opt for SH but can only opt for APAs to attain certainty.

13. CONCLUDING REMARKS
Complying with the ALP can be burdensome. Even good faith efforts to ensure compliance result in uncertainty because the Tax Authorities may analyse the transaction in a different way and come to a different conclusion. Though it is important for the Government to be diligent, and the enterprises to be honest, easing out more on compliance procedures would enable enterprises to focus more on their core activities and in turn generate more business and profits, thereby keeping the wheel of taxation turning and intact.

A fair and transparent SH regime goes a long way in plugging tax leakage and leads to significant tax certainty. Country tax administrations should carefully weigh the benefits of and concerns regarding safe harbours, making use of such provisions where they deem it appropriate.

In Part 2 of this Article, we will deal with the remaining aspects of Indian SH Rules and jurisprudence.