Safe Harbour Provisions in Indian Transfer Pricing Regime

Recently, CBDT has notified the much awaited “Safe Harbour Rules”, which at present are applicable to certain select International Transactions. Rules 10TA to 10TG and Form no. 3CEFA have been notified and the same have come into force from the date of their publication in the Official Gazette i.e. 18th September, 2013. These Rules aim at reducing litigation in the arena of Transfer Pricing. This article analyses various provisions, their impact and potential issues that may arise there from.

Introduction

The genesis of “Safe Harbour Rules” (SHR) in India is found in the Finance (No. 2) Act, 2009 whereby the Government of India empowered CBDT to formulate safe harbour rules vide insertion of section 92CB. The Memorandum explaining provisions of the Finance Bill mentioned the objective for introduction of SHR is to reduce litigation. A safe harbour has been defined to mean circumstances in which the Income-tax authorities shall accept the transfer price declared by the assessee.

The United Nation’s Practical Manual on Transfer Pricing for Developing Nations released in the year 2013 defines Safe harbour rules as follows: “Safe harbour rules are rules whereby if a taxpayer’s reported profits are below a threshold amount, be it as a percentage or in absolute terms, a simpler mechanism to establish tax obligations can be relied upon by a taxpayer as an alternative to a more complex and burdensome rule, such as applying the transfer pricing methodologies”.

OECD Transfer Pricing Guidelines defines a safe harbour as “a provision that applies to a defined category of the taxpayers or transactions and that relieves eligible taxpayers from certain obligations otherwise imposed by a country’s general transfer pricing rules.”

Globally, SHR aim at reducing litigation and compliance cost, providing certainty, reduction in documentation etc. It would be pertinent to note that Indian SHR does not give any relief from maintenance of rigorous documentation to justify arm’s length pricing.

Let us proceed to analyse some of the salient features of the Indian SHR.

Applicability of SHR

Selection of Option (Rule 10TE)

Safe Harbour provisions are applicable in respect of select international transactions (Refer Table below) in respect of those assesses who specifically opts for the same by filing a declaration in Form 3CEFA. The validly exercised option shall continue to remain in force for the period specified in Form 3CEFA or a period of five years, whichever is less. An Assessee has an option to opt out of the safe harbour provisions for any assessment year by fur-nishing a declaration to the Assessing Office (AO) to that effect.

SHR applicability is subject to filing the return of income of the relevant Assessment Year (AY) in time as well as furnishing every year a statement to the AO, before furnishing the return of income of that year, providing details of eligible transactions, their quantum and profit margins or the rate of interest or commission.

Transactions with Tax Havens (Rule 10TF)

Benefit of safe harbour rules is not available in respect of transactions entered into with an associ-ated enterprise located in any country or territory notified u/s. 94A or in a no tax or low tax country or territory. To illustrate, an Indian company who has given a loan to its wholly owned subsidiary in one of the free trade zones of UAE, cannot opt for the safe harbour provisions.

Select International Transactions and Safe Harbour Limits

Other Important Features

Eligible Assessee

Rule 10TB defines “Eligible Assessee” to mean a person who has exercised a valid option for application of safe harbour rules in accordance with the procedure laid down in Rule 10E [refer paragraph on Selection of Option (Rule 10TE) supra] and is engaged in eligible international transactions (as mentioned in the Table herein above).

Significance of “Insignificant Risk”

Rule 10TB further provides that in case of assessees who are engaged in software development, ITES, KPO or contract R&D services in software or generic pharmaceutical drug sectors, they must be working with “insignificant risk” profile. Insignificant risk of the assessee is broadly classified as circumstances wherein foreign principal takes all major risks relating to capital and funds, performs most of the economically significant functions, conceptualises and designs the product, controls and supervises the assessee and owns legal, economic and commercial rights in the intangible generated or outcome of the services. (Refer Clauses 2 & 3 of the Rule 10TB)

Mutual Agreement Procedure

Rule 10TG provides that where the transfer price is accepted by the income tax authorities u/s. 92CB, the assessee shall not be entitled to invoke mutual agreement procedure under a DTAA or specified territory outside India as referred to in sections 90 or 90A.

Operating Expenses

Rule 10TA (j) defines “Operating Expense” as mentioned below:

“Operating Expense” means the costs incurred in the previous year by the assessee in relation to the international transaction during the course of its normal operations including depreciation and amortization expenses relating to the assets used by the assessee, but not including the following, namely:-

(i)    interest expense;

(ii)    provision for unascertained liabilities;
(iii)    pre-operating expenses;
(iv)    loss arising on account of foreign currency fluctuations;
(v)    extra-ordinary expenses;
(vi)    loss on transfer of assets or investments;
(vii)    expense on account of income-tax; and
(viii)    other expenses not relating to normal operations of the assessee;

Rule 10TA (k) defines “ Operating Revenue” as mentioned below:

“Operating Revenue” means the revenue earned by the assessee in the previous year in relation to the international transaction during the course of its normal operations but not including the following, namely:-

(i)    interest income;
(ii)    income arising on account of foreign currency fluctuations;
(iii)    income on transfer of assets or investments;
(iv)    refunds relating to income-tax;
(v)    provisions written back;
(vi)    extraordinary incomes; and
(vii)    other incomes not relating to normal operations of the assessee;

From the above definition, one can draw the conclusion that while doing benchmarking analysis (even otherwise than for safe harbour), one may adjust expenses and income on above lines such that revenue and expenses of other companies/entities become comparable by removing abnormality. For the purpose of safe harbour we need to consider depreciation and amortisation expenses, however for doing a normal TP analysis one may compare profits before depreciation and amortisation if there is a significant difference in assets employed of comparable companies.

Some issues/important points to be noted

Safe harbour provisions as notified now do leave some gaps or issues unanswered. Some of these issues which come to our mind are as follows:

(i)    Documentation

Clause (5) of Rule 10TD provides that the provisions of section 92D (pertaining to maintenance of documentation) in respect of international transaction shall apply irrespective of the fact that the assessee exercises his option for safe harbour in respect of such transaction. There is no respite from maintaining documentation even if one opts for safe harbour provisions.

(ii)    No Comparability Adjustment

Clause (4) of Rule 10TD provides that once the assessee opts for safe harbour provi-sions, he is not eligible for comparability adjustment and allowance under the second proviso to s/s. 92C which provides for al-lowance/variation of 3 % between the arm’s length price determined under the Income-tax Act, 1961 and the price at which the international transactions have actually been undertaken. This provision is appropriate in that if additional allowance/adjustment of 3 % is allowed to the safe harbour margin then it will dilute the acceptable profit margin to that extent.

However, the difficulty may arise when the foreign country does not accept the safe harbour margin of an Indian entity and disallows excess compensation/expenses (which may be required to fall within Indian SHR). In this situation, if Indian entity has opted for safe harbour benefit, then it cannot invoke Mutual Agreement Procedure also and it will have to live with some double taxation.

(iii)No Threshold-Safe Harbour

Unlike Domestic Transfer Pricing, there is no threshold for application of transfer pricing in respect of international transactions.

Global Trends

Developments at OECD

OECD has revised its stand on safe harbour pro-visions in the recently amended guidelines on Transfer Pricing. Earlier OECD members did not favour safe harbour rules as they challenge the fundamental concept of arm’s length principle. However, as number of countries have adopted safe harbour rules especially for smaller taxpayers and/or less complex transactions, even OECD recognized the need and importance of these rules.

The revised Section “E” on Safe Harbours in Chapter IV of the OECD Transfer Pricing Guidelines (issued on 16th May 2013) discusses some potential advantages and disadvantages of safe harbour provisions as follows:

Advantages of Safe Harbours:

(i)    They may simplify compliance and reduce compliance costs for eligible taxpayers;

(ii)    They provide certainty about the acceptance of the transactions with limited or no scrutiny;

(iii)    They allow tax administrations to allocate their administrative resources efficiently.

Disadvantages of Safe Harbours:

(i)    They deviate from arm’s length principle;

(ii)    They may increase the risk of double taxation especially when adopted unilaterally;

(iii)    They may provide an opportunity for tax planning;

(iv)    They may result in issues of equity and uniformity as taxpayers are allowed to adopt differential pricing for similar transactions in similar set of circumstances.

In light of the above analysis, the OECD Guidelines recommends bilateral or multilateral safe harbours and for that purpose it provides a sample MOU.

The United Nation’s Practical Manual on Transfer Pricing for Developing Nations released in 2013

Though apparently United Nations has not taken any stand in favour or against safe harbour rules, it recognises advantages and limitations of these provisions. Chapter 3 of the Manual contains discussion on Safe Harbour Rules. It states that Safe harbour rules can be an attractive option for developing countries, mainly because they can provide predictability and ease of administration of the transfer pricing regime by a simplified method of establishing taxable profit.

Korean Experience on Safe Harbour1

Before joining the OECD, the Republic of Korea’s national tax authority, the National Tax Service (NTS), employed a so-called “standard offer-commission rate” for import and export business taxation. Under this scheme, the NTS used a standard offer commission rate based on a survey  on actual commission rates. This was available as a last resort under its ruling only in cases where other methods for identifying the arm’s length rate were inapplicable in determining commission rates received from a foreign party. The NTS finally repealed this ruling as it considered the ruling to be contrary to the arm’s length principle.

Summation/Way Forward

Unilateral safe harbour provisions may result in some double taxation as tax treaties by and large provide relief from double taxation only in cases where income is taxed in accordance with provisions of the relevant tax treaty. Since safe harbour provisions are in the domestic tax law, relief may not be available under a tax treaty. Therefore, to avoid potential double taxation, the recent amendment to the OECD Transfer Pricing Guidelines advocates bilateral or multilateral safe harbour agreements. In fact bilateral or multilateral safe harbour agreements could be quite useful also in case of Cost Contribution or Cost Sharing Arrangements among Associated Enterprises of Multinational Enterprises situated in various jurisdictions.

Despite limitations, safe harbour provisions provide much needed certainty and will reduces litigation and compliance cost for small taxpayers. Some companies may like to bear the brunt of some additional tax as an additional cost of capturing a developing market.

Even if one feels that the prescribed margins provided in the Indian Safe Harbour provisions are higher, they may found to be acceptable considering the cost of litigation in terms of time, energy and money. Secondly, as it is a voluntary provision, if the assessee strongly feels that it can justify lower margin, it can opt out of the safe harbour provisions. There is an option to hop on and hop off from the safe harbour provisions which provides great flexibility to taxpayers. The only point of concern is that opting for safe harbour provisions should not become precedence in the year of opting out of it.

All in all, safe harbour provisions can land companies in the safe territory in a blissful state free of litigation if these provisions are administered in a fair, equitable and judicious manner.

1The United Nation’s Practical Manual on Transfer Pricing for Developing Nations released in 2013

2A maquiladora or maquila is the Mexican name for manufacturing operations in a free trade zone (FTZ), where factories import material and equipment on a duty-free and tariff-free basis for assembly, processing, or manufacturing and then export the assembled, processed and/or manufactured products, sometimes back to the raw materials’ country of origin.