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Important Transfer Pricing Proposals in the Finance Bill 2017 | CA Prakash Hegde and CA Raghavendra N.

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Important Transfer Pricing Proposals in the Finance Bill 2017

By CA Prakash Hegde and CA Raghavendra N.

In order to get a fair share out of the profits of Multinational Corporations (‘MNC’s), most of the countries across the world have introduced the transfer pricing regulations in their income-tax legislations.  As the business dynamics change and as new kinds of businesses develop, to keep pace with such changes and developments, the transfer pricing regulations also need to be updated by the countries so that the objective of getting a fair share of profit is fulfilled.  Hence, changes / amendments in these regulations are part of a never-ending process.

A comprehensive transfer pricing legislation to cover international transactions was introduced in India via the Finance Act 2001.  Few Specified Domestic Transactions (‘SDT’) to cover certain transactions that may occur between the domestic companies were brought within the purview of transfer pricing regulations via Finance Act 2012 effective Financial Year (‘FY’) 2012-13.

In the Finance Bill 2017, the Finance Minister (‘FM’) Mr Arun Jaitley has proposed to introduce two important changes affecting international transactions and one change affecting the SDT.    The proposed changes affecting international transactions are the introduction of the concepts of (i) Secondary adjustment and (ii) Thin capitalization rules and the proposal affecting the domestic transactions is to restrict the applicability of the provisions of SDT only to tax holiday scenarios.

Each of the above proposals has been discussed in the ensuing paragraphs.

  1. Secondary adjustment

The price at which an international transaction is carried out (i.e. transfer price) could be subject to adjustment resulting in increase of taxable profit of the taxpayer.  Where an adjustment has been made to the transfer price of a transaction, it is called ‘primary adjustment’ and the taxpayer is required to pay additional taxes arising due to such primary adjustment.

Secondary adjustment means an adjustment in the books of account of the taxpayer to reflect the impact of primary adjustment.   This results in addition of notional interest on such excess amount lying with an Associated Enterprise (‘AE’) due to primary adjustment, where such amount is not transferred to the taxpayer.

In order to align the transfer pricing provisions in line with OECD guidelines and international best practices, the FM has proposed to introduce provisions relating to secondary adjustment in the Act by inserting a new section 92CE.  Under the provisions of new section 92CE, a secondary adjustment is to be made where a primary adjustment is made to the transfer price under the following situations:

  • Suo motu adjustment made by the taxpayer in his return of income
  • Adjustment made by the assessing officer and accepted by the tax payer
  • Adjustment determined by an advance pricing agreement
  • Adjustment made as per safe harbor rules
  • Adjustment arising as a result of mutual agreement procedure

However, the new section excludes the carry out of a secondary adjustment in the following cases :

  • the amount of primary adjustment in any FY does not exceed Rs 1 Crore and
  • the primary adjustment is made in respect of FY 2015-16 or any prior year

It may be noted that though the above two exceptions appear to be cumulative due to the conjunction ‘and’.  However, based on the intention and reading of the provisions, there seems to be a drafting error and the correct conjunction to be considered is ‘or’ instead of ‘and’.

This proposed amendment would be applicable from FY 2017-18 and thereafter.

The provisions have ignored the possibility of double taxation as the Double Taxation Avoidance Agreements do not provide clear guidelines on this kind of a secondary adjustment and relief for the same.  Further, the country of residence of the AE may have its own regulations for transfer of funds representing the amount of primary adjustment in India.  From the perspective of the India Companies’ law read with Accounting Standards, clarification / amendment may be needed to allow the taxpayer company to make adjustment in its books of account.  Therefore, this proposed amendment is likely to cause a few practical challenges.

It is expected that the Government would soon provide clarity on matters regarding issues like the period within which funds may be repatriated to India, the manner of computation of interest etc.

It is worth to note that secondary adjustment rules are already a part of transfer pricing regulations in different forms in many countries like USA, France, Canada, South Africa etc.

  1. Thin capitalization rules

The amount of profit reported by a company for income-tax purposes depends on the way it is capitalized.  Taxable profit would be lower with an increased borrowed funds as compared to share capital as the provisions of income-tax law allows deduction of interest paid or payable in arriving at taxable profits while dividend paid is not deductible, thereby making debt a more tax efficient option of finance than equity.

The memorandum to the Finance Bill 2017 states that the Organisation for Economic Co-operation and Development (‘OECD’) in its Base Erosion and Profit Shifting (‘BEPS’) project had taken up the issue of base erosion and profit shifting by way of excess interest deduction by MNCs in Action plan 4 and the OECD has recommended several measures in its final report to address this issue.

In view of the above, the FM has proposed to insert new provisions (section 94B) restricting the claim of interest expenses by an entity on payments made to its AE to 30% of its Earnings Before Interest, Taxes, Depreciation and Amortization (‘EBITDA’) or interest paid / payable to AE, whichever is less.

These provisions would be applicable to an Indian company or a permanent establishment (‘PE’) of a foreign company, if it is the borrower and pays interest in respect of any form of debt borrowed from a non-resident or to a PE of a non-resident and who is an AE of such borrower. The debt shall be deemed to have been borrowed by an AE where it provides an implicit or explicit guarantee to the lender or deposits a corresponding and matching amount of funds with the lender.

The provisions would be applicable to interest expenditure exceeding Rs 1 crore per FY and also allow carry forward of disallowed interest expense up to 8 assessment years.  Taxpayers engaged in the business of banking or insurance are excluded from the purview of the said provisions.

This proposed amendment would be applicable from FY 2017-18 and thereafter.

Capital intensive and infrastructure companies with long gestation period may get affected by the above provisions.  Further, there is no clarity on the limit for a company which has negative EBITDA and a complete disallowance in such situation seems to be too harsh.

  1. Domestic transactions to be regulated only in a tax holiday scenario

The existing provisions of the transfer pricing regulations apply to the following domestic transactions:

  1. Payments made or to be made to persons referred to in section 40A(2)(b) of the Act
  2. Any transaction referred to in section 80A
  3. Inter-unit transfer of goods or services referred to in section 80IA(8) of the Act
  4. Transactions between the taxpayer and other person referred to in section 80IA(10)
  5. Any transaction referred to in any other section of Chapter VI-A or section 10AA to which section 80IA(8) or 80IA(10) are applicable
  6. Any other transaction as may be prescribed

 It is relevant to note that the transfer pricing regulations for the above transactions are applicable only where the aggregate of such transactions in the FY exceeds Rs. 20 Crores.

The domestic transfer pricing regulations were introduced with the intention of disallowing any tax arbitrage which a taxpayer may get by shifting profit from a person / unit taxable / taxable at a higher rate, to another person / unit which is not taxable / taxable at a lower rate.  However, covering of payments to persons referred in section 40A(2)(b) did not achieve the said objective and therefore, the FM in the Finance Bill 2017 has proposed to exclude the same from the purview of domestic transfer pricing regulations.  The FM has stated that the proposal is being made to reduce the compliance burden of the taxpayers.

This is a welcome amendment and will help the taxpayers from getting away with the hassles of maintaining documentation and obtaining of accountant’s report etc.  This proposed amendment would be applicable from FY 2016-17 and thereafter.

Conclusion:  As noted above, the first two amendments affect the international transactions of a taxpayer adding additional burden, whereas the last one affects the domestic transactions and provides relief to the taxpayer.  We hope that the Government will issue suitable clarifications to provide sufficient clarity on various open issues with respect to the first two amendments discussed above.