Transfer Pricing 101

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One of the main difficulties facing foreign companies in India is the issue of transfer pricing. In the past, it’s cast a chill on investor sentiment and cemented India’s reputation as a land of inconsistent and unpredictable tax rules.

Foreign companies such as Vodafone Group, Cairn Energy and Royal Dutch Shell have been embroiled in litigation surrounding transfer pricing and retrospective application of taxes.

Not only has this delayed business plans in India due to anxiety about tax outcomes, it’s also given birth to a new catchphrase, “tax terrorism” – the sudden levy of massive retrospective tax bills on companies by overzealous authorities.

Several cases of “tax terrorism” have triggered a showdown between multinationals and Indian tax authorities, even scaring off foreign institutional investors who had been approached to pay retroactive tax by the Income Tax Department.

What is transfer pricing?

Transfer pricing refers to the pricing of transactions between related parties, such as a parent company and its subsidiary. Because the two parties are associated, the transaction may be priced differently than if it had been between two unrelated parties (known as the “arm’s length” principle).

The transfer pricing mechanism ensures that revenue is properly captured so all taxes due are accounted for, rather than evaded. The term refers to the calculation of profits made by multinationals and how they’ve shifted to the parent company.

In India, transfer pricing has also become a political issue, largely because of the negative impact it’s had on the ease of doing business for international companies and their Indian operations.

In 2012, the government introduced advance pricing agreements (APA) between taxpaying organizations and the Central Board of Direct Taxes (CBDT) that calculate taxes for future international transactions for a predetermined period.

APAs give companies and tax authorities the opportunity to negotiate a tax rate and avoid going to court later. They cover a five-year period and can be either multilateral, bilateral or unilateral.

What do transfer pricing and APAs mean for multinationals doing business in India?

In October 2014, the government introduced a “rollback provision” enabling retrospective application of APAs, thereby avoiding litigation over transfer pricing.

By agreeing on transfer pricing rates and methodology before transactions occur, it helps avoid disputes that can go on for years across multiple tribunals.

Vodafone, one of India’s largest telecom service providers, has borne the brunt of the government’s tax collecting efforts since acquiring Hutchison Essar Telecom services in 2007.

In 2015, the Bombay High Court sided with the telecom major, which had challenged the tax authorities’ demand to add USD 1.3 billion to the taxable income of one of its units. Vodafone has since been pursued for more than USD 2 billion in a separate capital gains tax case.

In the latest legal news, the CBDT released its first annual report on the APA programme in India, which revealed 815 applications had been filed in India since the programme was launched.

It showed that 42 applications for bilateral APAs since February 2016 have come from the US. The UK and Japan followed, with 39 and 17 bilateral applications received, respectively.

Of the 815 applications, the CBDT has entered into 152 agreements (141 unilateral), roughly half of which are with the IT and financial sectors.

While APAs are one outlet for foreign companies to avoid lengthy tax battles in India, they still have reason to be nervous. In April, tax authorities demanded Cairn Energy UK Ltd. pay USD 1.6 billion in interest on a USD 2.9 billion retrospective tax bill.

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