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Safe Harbour Draft Rules: A Beginning

Published on Fri, Aug 16,2013 | 14:09, Updated at Fri, Aug 16 at 14:09Source : 

By: Samir Gandhi, Leader, Transfer Pricing & Manisha Gupta, Senior Director, Deloitte Haskins & Sells

India as an emerging market economy is not only a preferred destination for outsourcing of services by foreign multinationals but is also increasingly seeing a number of Indian owned companies expanding their global footprint. However, the outsourced/captive units are experiencing significant transfer pricing adjustments to their margins whilst the Indian parent companies have suffered huge adjustments on their intra-group capital financing arrangements during the course of audits over the last few years. This has proven to be a stumbling block for for Indian companies acquiring a global reach and attracting foreign direct investment into India as it defeats the very purpose of the offshoring i.e. cost arbitrage and importantly availability of trained man power.

With a view to alleviate the uncertainty faced by such taxpayers and at the same time ensure an acceptable level of taxable profit in India, introduction of safe harbour provisions is a step in the right direction.  A safe harbour provides circumstances in which a taxpayer can follow a simple set of rules / pricing based on which the transfer prices would be automatically accepted by the tax authorities.

The objectives of safe harbour provisions are to confer the following benefits on taxpayers and tax administrators: i) compliance relief; ii) administrative simplicity; and iii) certainty. Many tax authorities apply safe harbour as a better administrative practice rather than a means of the best arm’s length result to achieve the above benefits. While this benefits tax payers in reducing compliance cost, tax authorities also can focus their limited resources on bigger and more complex transactions.

Finance (No. 2) Act, 2009 empowered the CBDT to formulate safe harbour rules specifying circumstances under which the transfer prices of the tax payers would be accepted. Consequently, based on the Rangachary Committee recommendations the CBDT has released draft safe harbour rules for public comments which provide that it would be applicable for fiscal years 2012-13 and 2013-14. The proposed safe harbour rates/margins prescribed are:

  • Software development and information technology enabled services with insignificant risk- 20% cost plus mark-up for companies having international transactions not exceeding INR 100 crores (USD 17 million approx.));
  • Knowledge process outsourcing with insignificant risk- 30% cost plus mark-up again applicable to companies with the threshold of international transactions not exceeding INR 100 crores (USD 17 million approx.);
  • Contract research and development for software with insignificant risk - 30% cost plus mark-up and for contract research and development for generic pharmaceutical drugs - 29% cost plus mark-up. No threshold has been provided for contract research and development;
  • Interest on loans to wholly owned subsidiaries sourced in Indian Rupees - base rate of State Bank of India as on 30th June of the relevant previous year plus 150 basis points where loan amount does not exceed INR 50 crores (USD 8 million approx.) and plus 300 basis point where it exceeds INR 50 crores;
  • Guarantee fee on explicit corporate guarantees- 2% on the amount guaranteed where the amount guaranteed does not exceed INR 100 Crores (USD 17 million approx.);
  • Manufacture and export of core auto components - operating margin of 12%; and
  • Manufacture and export of non-core auto components - operating margin of 8.5%.

Once the safe harbour rules are opted for by a taxpayer no margin variation benefit (of 3% or 1% as the case may be) or any other comparability adjustment such as, capacity, risk, working capital, etc., would be permitted.

Whilst the above recommendations seem to be more or less in line with the Rangachary Committee reports, it is interesting to note that the Committee in its report on safe harbour provisions for IT_software and ITeS sectors nowhere distinguished between KPO and IT/ITeS or prescribed the safe harbor margin of 30%. In fact, the business process outsourcing services provided under KPO in the safe harbor rules were included under ITeS services in the Rangachary Committee report.

The Rules provide that KPO means services of geographic information system, human resources services, engineering and design services, animation or content development, business analytics, financial analytics and market research. More guidance would be required on the specific nature of activities which would fall within the category of KPO services. Additionally, guidance is also required on the remedy available to the taxpayer should the Assessing Officer / TPO not accept the taxpayers classification of ITeS / KPO category.

On corporate guarantees, the Rangachary Committee  in its Report specifically mentions that, significant number of outbound guarantees are big-ticket guarantees exceeding USD 100 million or INR 500 crores and accordingly recommended safe harbour commission rates based on a graded approach from INR 50 crs to INR 250 crs rather than an upper limit.  However, the Rules prescribe an upper threshold of 100crs INR which would not allow a number of taxpayers to qualify for safe harbour rules.  Also, it may be noted that, the Rules have been prescribed only for explicit corporate guarantees and do not cover comfort letters, performance guarantees or implicit guarantees.

Safe Harbour Rules on interest provide that it applies only to loans provided by taxpayer to its wholly owned subsidiaries and covers only rupee sourced lending transaction i.e. other than loans which are lent from the Indian taxpayers foreign currency sources like export proceeds, proceeds from external commercial borrowings etc. The current base rate as at 30th June 2013 of SBI is 9.70% which means that for loans upto INR 50 crores the safe harbour interest for FY 2013-14 is 11.2% and for loans exceeding INR 50 crores it is 12.7%. It is worth noting that these rates seem to be far higher that what has been decided in a number of Tribunal decisions.

Contract R&D software providers have been prescribed a safe harbour margin of 30% whereas software development services have a safe harbour margin of 20%.  The challenge which would arise is the demarcation between the two which could in most instances be very narrow and would therefore require detailed technical knowledge of the industry. The assessing officer will therefore be required to have this expertise or should rely on industry expert classification provided by the taxpayer for such determination. Also, it is to be noted that, contract R&D for pharma is applicable only to generic pharma drugs and not to other services like clinical research, new drug discovery etc., in the pharma and biological research and development value chain.

Whilst there is no doubt that the release of the long-awaited safe harbor rules is in the right direction and a very welcome step,  it is hoped that the Revenue authorities either at the field level or during the course of APA /MAP negotiations will not consider the safe harbor margins to be the deemed arm’s length price. To this end, it would be good if the Rules could specifically incorporate the Recommendations of the Rangachary Committee which mentions that a directive should be given to the Assessing officer /TPO that safe harbours should not become a rebuttable presumption for a taxpayer who opts not to go for it and has an arm’s length price below the safe harbor.


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