‘Transfer pricing’, is a technical term used to refer to the price at which goods/ services are exchanged between different entities belonging to the same group. If it is as simple as it sounds, one may ask why talk on ‘transfer pricing’?
The answer comes from the fact that the different entities which transact with each other are located in different fiscal jurisdictions or are treated differently for tax and other fiscal purposes (ie Income-tax holidays, VAT/ other tax rebates granted by the States and so on).
This disparity in fiscal and tax treatment encourages multinational corporations to use a number of structures for tax purposes which are technically legal but optically incongruent with reality.
They may be as simple as pricing goods/ services in a manner that profits are booked in a country where tax rates are low; or extend to complex arrangements involving housing of intellectual property rights or financing arrangements. I had discussed the concept of transfer pricing in an earlier article .
Arm - length pricing
In the pursuit of preventing tax avoidance, many tax administrations have often taken aggressive stands on certain issues and the tax payers are left to grapple with litigation.
The so called ‘arm’s length pricing’ leaves too much room for subjectivity that, even if you were to adopt a position confirmed by law, you are bound to face resistance from the tax administration!
Most developed nations recently woke up to the burning need for a revolutionary tax mechanism to deal with the loss of revenue caused by transfer pricing mismatches. To address several growing challenges, the Organisation for Economic and Co-operation and Development (‘OECD’) in 2013 released its Action Plan on Base Erosion and Profit Shifting (‘BEPS’).
The plan listed 15 action points for instilling changes in the international tax rules. India, though not a member, is an observer of the OECD and has expressed interest in adopting several of the action points laid down by the OECD.
Actions and their roles
The OECD has differing time lines stretched over 2014 and 2015 under each of the action plans. The results of these actions are directed towards ensuring that profits are taxed where economic activities generating profits are performed.
Some of the Transfer Pricing related Action Plans relate to the following aspects -
> Country by Country Reporting (CbCR) - the need to improve transparency for tax administrations for taxpayers through improved transfer pricing documentation ie Country by Country Reporting (‘CbCR’) approach assumes relevance.
>The OECD has issued an updated guidance on transfer pricing documentation and CbCR necessitates the maintenance of a Master File and Local File to maintain documentation in the format of a Country by Country Report with aggregated indicators.
> Prevention of tax treaty abuse – suggests that all countries should consider significant tax policies of each contracting member before entering into a tax treaty with a view to prevent treaty abuse and double-taxation.
> Consistency in issues relating to value creation in intangibles ie if the legal owner performs and controls all of the functions related to the development/ maintenance/ controls of the intangible, bears all risks related to the intangible and so on, then he will be entitled to all returns arising from the use of intangible.
> Where more members contribute to the maintenance/ exploitation of intangibles, such enterprises must also share the anticipated returns derived from exploitation of intangible by receiving arm’s length compensation for their functions and risks assumed. An apt example for the saying ‘you reap what you sow’.
> Improvisation of transparency for tax administrations – the hierarchy of a particular country’s tax administration should aim at ensuring that there is transparency in administrative matters with a view to ensure that there is nil ambiguity with regard to tax related aspects.
Role of BEPS in developing countries
In view of a specific direction, the OECD had also carried out an exercise to develop an exclusive report to identify BEPS’ challenges which relate to developing countries.
In response to the BEPS questionnaire issued by the United Nations, India had highlighted that BEPS is a concern for India in view of the fact that Indian economy is also reliant on corporate tax from multinational corporations. India has identified certain major BEPS challenges such as — excessive payments towards finance and service charges to overseas affiliates; mispricing business functions conducted in India and so on, in its response.
Concluding thoughts
Taxpayers (overseas and domestic) would need to consider improving their documentation as mandated by Indian tax rules. The Indian tax authorities may show interest in understanding the value chain of multinational groups and reconcile their findings between local reporting and group transfer pricing disclosures.
The onus will continue to be on the taxpayers to substantiate the tax positions adopted. Tax payers must realize that transfer pricing documentation is no longer merely a compliance exercise but a strategic value tool to improve tax efficiency and reduce litigation.
(Arjun Narasimhamurthy from EY also contributributed to the article)
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