India introduces secondary adjustment and interest limitation rules

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1 6 April 2017 Global Tax Alert News from Transfer Pricing India introduces secondary adjustment and interest limitation rules EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Executive summary On 31 March 2017, India s Finance Bill, 2017, presented before the Indian Parliament on 1 February 2017, received Presidential assent and was enacted with effect from 1 April From a transfer pricing (TP) perspective, the two key changes relate to the introduction of a secondary adjustment provision and an interest limitation rule. The secondary adjustment provision in the Indian Tax Law (ITL) is introduced to address the collateral consequences arising from a primary TP adjustment. The provisions relating to secondary TP adjustment are generally applicable for primary TP adjustments made from the financial year onwards. The secondary TP adjustment is required where a primary adjustment to the transfer price occurs in one of the following circumstances: Voluntarily made by the taxpayer in the tax return Made by the tax officer and accepted by the taxpayer Determined by an Advance Pricing Agreement (APA) entered into by the taxpayer Made as per the safe harbor rules Resulted from a Mutual Agreement Procedure (MAP) resolution The primary adjustment, if not repatriated to India within the prescribed time, shall be deemed to be an advance made by the taxpayer to such associated enterprise (AE). Also, interest on such advance shall be computed in the hands of the taxpayer in such manner as prescribed.

2 2 Global Tax Alert Transfer Pricing With the introduction of rules for limiting interest deductions with effect from the financial year, interest expenses incurred by an Indian company (other than a banking or insurance company) from the AE borrowings or borrowings guaranteed by an AE shall be restricted to the lower of the following: (i) total interest of 30% of the earnings before interest, taxes, depreciation and amortization (EBITDA); or (ii) interest paid/payable to the AE and the excess interest will not be deductible. Such excess interest would however be allowed to be carried forward up to the following eight financial years for set off against the taxable income subject to the ceiling prescribed. Multinational enterprises (MNEs) would need to review the impact of the above amendments on their TP arrangements in India as well as on their finance and treasury structures for Indian operations. Detailed discussion Background The Finance Act, 2017 has introduced some significant changes to the ITL with the objective of strengthening the anti-abuse measures as well as to align with international practices. The key changes include introduction of secondary adjustments in the TP regulations and interest limitation rules. The amendments are discussed below. Introduction of secondary adjustments The provisions relating to secondary adjustments are applicable in the case of primary TP adjustments made from the financial year onwards. These provisions are primarily intended to ensure that profit allocations between the AEs are consistent with the primary TP adjustment. A secondary adjustment has been defined to mean an adjustment in the books of accounts of the taxpayer and its AE to reflect that the actual allocation of profits between the taxpayer and its AE are consistent with the transfer price determined as a result of primary adjustment. The primary adjustment is defined to mean the determination of the transfer price in accordance with the arm s length principle resulting in an increase in the total income or reduction in the loss, as the case may be, of the taxpayer. When does this apply? The new provisions provide that the taxpayer shall be required to carry out the secondary adjustment where the primary adjustment to the transfer price was: Made voluntarily by the taxpayer on its income-tax returns Made by the tax officer and accepted by the taxpayer Determined by an APA entered into by the taxpayer with the Indian Tax Administration Made as per the safe harbor rules framed under the ITL Or Resulted from the resolution of an audit adjustment by way of the MAP under a double taxation avoidance agreement (tax treaty) However, an exception has been carved out according to which, such secondary adjustments shall not be carried out by the taxpayer if both: 1 The amount of the primary adjustment made in the case of a taxpayer in any financial year does not exceed INR10 million (approx. US$150,000) The primary adjustment is made in respect of the financial year or any earlier financial years What are the consequences of a secondary adjustment? According to these provisions, where as a result of a primary adjustment to the transfer price, there is an increase in the total income or reduction in the loss of the taxpayer, the excess money (i.e., the difference between the arm s length price determined in the primary adjustment and the price at which the international transaction has actually been undertaken) which is available with its AE, needs to be repatriated into India within the prescribed time. In cases of non-compliance with the above requirement, such excess money shall be deemed to be an advance made by the taxpayer to such AE. Further, the interest on such advance shall be computed as the income of the taxpayer in a prescribed manner. The time limit for repatriating the excess money into India and the manner of computation of interest in the event of non-repatriation are yet to be prescribed. Introduction of interest limitation rules In line with the best practice recommendations of Action 4 of the Organisation for Economic Co-operation and Development (OECD)-G-20 Base Erosion and Profit Shifting (BEPS) project, a new section to limit interest deductions has been introduced in the ITL applicable from the financial year.

3 Global Tax Alert Transfer Pricing 3 When does this apply? The said provisions are applicable to an Indian company or a permanent establishment (PE) of a foreign company in India (collectively referred to as borrower ) if the following conditions are met: The borrower is engaged in any business or profession other than banking or insurance The borrower incurs expenditure in the nature of interest or similar consideration exceeding INR10 million (approx. US$150,000) in a financial year Such interest expense or similar consideration is deductible in computing the taxable income of business/profession The debt is issued 2 by a nonresident AE of the borrower or by a third party lender but an AE either provides an implicit or explicit guarantee to such lender or deposits a corresponding and matching amount of funds with the lender The term debt has been defined to mean any loan, financial instrument, finance lease, financial derivative or any arrangement that gives rise to interest, discounts or other finance charges. How is the interest limitation computed? If the above conditions are satisfied, the excess interest shall not be deductible in computing the taxable income of the taxpayer. The excess interest is computed as the excess of 30% of the EBITDA of the borrower for the relevant financial year or interest paid/payable to the AE, whichever is less. In other words, the interest deduction is limited to the lower of the borrower s 30% of EBITDA or interest actually paid/payable to the AE. How is the excess interest treated? For any financial year, if the interest expenditure is disallowed for being in excess of the limitation prescribed, the provisions allow for carry forward of such excess interest expense. Accordingly, such portion of the interest expense can be carried forward up to the following eight financial years immediately succeeding the financial year for which such disallowance was first made. Further, the deduction for such carried forward excess interest would be allowed against the future taxable income so long as the interest expenditure is within the celling as prescribed. Implications When a TP adjustment is made to one member of a group (primary adjustment), it is likely to give rise to a number of collateral consequences which may include correlative allocations, conforming adjustments, secondary adjustments and set-offs, on which no guidance previously existed in the ITL. By introducing the concept of secondary adjustment in the ITL, the Finance Act, 2017 now requires appropriate adjustments to be made to conform a taxpayer s accounts so that they reflect the primary adjustment, followed by repatriation of the funds into India within a prescribed time or alternatively, treat the same as an interest-bearing advance. While the stated objective of the provision is to align Indian TP regulations with international practices, the provision could trigger additional income tax consequences, including the risk of double taxation. Taxpayers who are likely to be subject to a primary TP adjustment should therefore review the implications of this provision on their TP positions in India as well as in the other respective country and proactively consider measures such as a MAP or APAs for managing TP controversy. Introduction of the interest limitation rule in the ITL demonstrates India s commitment to the OECD-G20 BEPS, even though Action 4 dealing with limiting base erosion through interest and other financial payments does not constitute a minimum standard. While the interest limitation rule introduced by the Finance Act, 2017 is broadly in line with recommendations contained in the Action 4 final report, there are some deviations as well (e.g., the fixed ratio rule is not supplemented by the group ratio rule, the limitation is applied on the total interest expense and not on net interest expense). MNEs would need to review the impact of the new rule on their intra-group finance and treasury structures involving their Indian operations. Further, given the farreaching consequences of TP related BEPS Actions 8-10, MNEs should also review their financing arrangements to ensure they are compliant from a TP perspective.

4 4 Global Tax Alert Transfer Pricing Endnotes 1. A literal reading of the provision may suggest the secondary adjustment can apply to even financial year and earlier financial years if the quantum of primary adjustment exceeds INR10 million. The literal interpretation however may not be in line with the legislative intent since it would result in substantial retroactivity in the application of the provision. 2. Debt issued by nonresident AE in the context appears to refer to debt borrowed from nonresident AE. For additional information with respect to this Alert, please contact the following: Ernst & Young LLP (India), National Tax Leader, Mumbai Sudhir Kapadia sudhir.kapadia@in.ey.com Ernst & Young LLP (India), National International Tax Services Leader, Hyderabad Jayesh Sanghvi jayesh.sanghvi@in.ey.com Ernst & Young LLP (India), National Transfer Pricing Leader, New Delhi Vijay Iyer vijay.iyer@in.ey.com

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