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Safe Harbour Draft Rules: Contrary To Judicial Precedents?

Published on Fri, Aug 16,2013 | 14:10, Updated at Fri, Aug 16 at 14:10Source : 

By: Vishal Rai, Tax Partner, EY

The CBDT has issued the Draft Rules in relation to Safe Harbours for various sectors / transactions on 14 August 2013. In its statement on Safe Harbour Rules, the CBDT has stated that it has adopted the safe harbour rules as recommended by Rangachary Committee.

The key transactions sought to be covered by the Draft Rules and the proposed safe harbour profit  / rate are as under:

- For provision of software development services (as defined), IT enabled services (other than R&D) upto Rs 100 crores - an operating margin (operating profit / operating cost) of 20% or more
- For provision of knowledge process outsourcing (KPO) services upto Rs 100 crores - an operating margin of 30% or more
- For specified contract R&D services wholly or partly relating to software development - an operating margin of 30% or more
- For specified contract R&D services wholly or partly relating to generic pharmaceutical drugs - an operating margin of 29% or more
- Interest rate on intra-group loans to wholly owned subsidiary (WoS)
(i) upto Rs 50 crore - SBI's base rate (as on 30th June of the relevant previous year) plus 150 bps
(ii) For loans more than Rs. 50 crores -  SBI's base rate (as on 30th June of the relevant previous year) plus 300 bps
- Commission for explicit corporate guarantees not exceeding more than Rs. 100 crore to WoS - 2% p.a. or more of the guaranteed amount
- For for manufacture and export of core auto components  - an operating margin of 12% or more
- For for manufacture and export of non-core auto components  - an operating margin of 8.5% or more

The CBDT has attempted to provide a comprehensive definition of various terms such as the services mentioned above. Being technical in nature the terms would need evaluation by the technical personnel in the assessees' organization. Along with the definition of various services, the Draft Rules have also defined operating expenses and operating revenue. In this regard, foreign exchange gain / loss and provision no longer required written back has been proposed to be treated as non-operating items. The tax authorities have been advocating these particular positions in the course of TP audits as well but they are contrary to judicial precedents. Several tax payers are disputing the same at various forums. Some more thought is recommended on classification of such items.

The Draft Rules provide that safe harbour provisions can not be availed by an assessee transacting with an AE located in any country where the maximum marginal rate of income tax is less than 15%. Further, per the Draft rules, an assessee exercising his option for safe harbour would still need to comply with TP documentation and reporting requirements. One of the objectives of safe harbours is to reduce the compliance burden on the assessee so the CBDT would do well to exempt the assessees from maintaining comprehensive documentation as prescribed under section 92D and suggest a more pruned down list of documentation.

The Draft Rules provide that the assessees eligible to avail the option of safe harbours for provision of software services, IT enabled services, KPO services and contract R&D services should bear insignificant risk. To identify assessees with insignificant risk, factors similar to those prescribed in Circular 6 have been prescribed. The term "economically significant function" has not been defined and reference may be drawn to Circular 6 and the overall context for the same.

Assessees seeking to opt for the safe harbours would need to apply to the Assessing Officer for the same in a prescribed format (Form 3CEG) before due date of return filing. Where the assessee opts for the safe harbour and the same is accepted by the income-tax authorities, the assessee would not be entitled to invoke mutual agreement procedure under DTAA.

Further, the statement by CBDT on Safe Harbour Rules states that where the safe harbour rules are not applicable in the case of an assessee engaged in providing contract research and development services with insignificant risks, the Transactional Net Margin Method (TNMM) shall be considered as the most appropriate method for the determination of arm’s length price. This is a welcome clarification as this was not explicitly stated in Circular 6 issued by the CBDT thought it seemed to be the intent of Circular 6 and is consistent with the recommendations of the Rangachary Committee. The CBDT would need to have a reference to this clarification in the proposed Rules so that there is no ambiguity on this very important issue.

The CBDT has requested that all stakeholders provide their comments on the Draft Rules by 26 August 2013. All stakeholders should provide their comments and suggest changes as they deem appropriate so that the final set of rules can have their inputs.


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