KPMG FLASH NEWS. Transfer Pricing - Safe Harbour Rules Notified. Background. 20 September 2013 KPMG IN INDIA

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1 KPMG FLASH NEWS KPMG IN INDIA Transfer Pricing - Safe Harbour Rules Notified 20 September 2013 Background To reduce increasing number of transfer pricing audits and prolonged disputes, the Central Board of Direct Taxes (CBDT) had issued the draft Safe Harbour rules (SHR) on 14 August 2013, inviting public comments. (Our Flash News on the draft Safe Harbour Rules has also been attached) On 18 September 2013, the Ministry of Finance issued a press release stating that SHRs have been finalized after considering the comments of various stake holders. Pursuant to the press release, the final SHRs have been notified today. The key highlights of the Safe Harbour rules are as under: Safe harbours for various sectors, shall be as under Eligible International Transaction Software development services (IT services) and Information Technology Enabled services (ITES), with insignificant risks where the aggregate value of such transactions < INR 500 crores Safe ratios Harbour Operating profit margin to operating expense where the aggregate value of such transactions > INR 500 crores

2 Knowledge processes outsourcing services (KPO services), with insignificant risks Intra-group loan to wholly owned subsidiary (WOS) where the amount of loan: < INR 50 crores > INR 50 crores Explicit corporate guarantee to WOS where the amount guaranteed < INR 100 crores > INR 100 crores, and the credit rating of the borrower, by a Securities and Exchange Board of India (SEBI) registered agency is of the adequate to highest safety (explicit corporate guarantee does not include letter of comfort, implicit corporate guarantee, performance guarantee or any other guarantee of similar nature) Specified contract research and development services (Contract R&D services), with insignificant risks, wholly or partly relating to software development Contract R&D services, with insignificant risks, wholly or partly relating to generic pharmaceutical drugs operating expense 25 Interest rate equal to or greater than the base rate of State Bank of India (SBI) as on 30th June of the relevant previous year: plus 150 basis points plus 300 basis points Commission or fee of 2 or more per annum Commission or fee of 1.75 or more per annum operating expense 30 operating expense 29 Manufacture and export of: core auto components non-core auto components where 90 or more of total turnover relates to Original Equipment Manufacturer sales Validity for five years Operating profit margin to operating expense: As against the validity of 2 years proposed by the draft SHRs, the final SHRs are applicable for a period of 5 years starting with Assessment Year (AY) for the prescribed sectors. The option of being governed by SHRs shall continue to remain in force for the period specified by the taxpayer in the prescribed form (Form No. 3CEFA) or a period of five years whichever is less. No threshold for eligibility to SHR There are no thresholds/upper ceilings of transaction amount for eligibility to SHR. The threshold of INR 100 crores for IT, ITES and KPO sector as proposed by the draft SHR has been done away with. However, different safe harbour ratios are provided for transactions above and below INR 500 crores in the cases of IT and ITES services. Further, corporate guarantee transactions above INR 100 crores are now eligible for applicability of SHRs, provided the credit rating of the borrower (i.e. associated enterprise) done by a SEBI registered agency is of the adequate to highest safety. Categorisation of services and safe harbours The definitions of various eligible international transactions, including that of the IT, ITES, KPO and contract R&D services relating to software development, are largely retained same as those provided in the draft SHRs. To provide distinction from routine business process outsourcing services, the definition of KPO services has been modified to include only those services that require application of knowledge and advanced analytical and technical skills. The SHRs have also provided the definition of generic pharmaceutical drugs as a drug that is comparable to a drug already approved by regulatory authority is dosage form, strength, route of administration, quality and performance characteristics, and intended use. Further there is no reduction in the safe harbour ratios from those prescribed in the draft SHRs, except in case of KPO services where it has been reduced from 30 to 25. On the contrary, the safe harbour ratio for the IT and ITES services for the over INR 500 crores category is specified at a marginally higher rate of 22.

3 Continued applicability of SHR The taxpayer can opt-out of the safe harbour regime from the second year onwards, by filing a declaration to that effect with the AO. Further, the option exercised by the taxpayer can be held invalid by the Transfer Pricing Officer (relating to the eligibility of the taxpayer or of the international transaction or both), if there is any change in the facts and circumstances on the basis of which the option exercised by the taxpayer was initially held to be valid. However, such withdrawal cannot be done without providing the taxpayer an opportunity of being heard. In such case, the taxpayer has a right to file his objection with the Commissioner. Timelines prescribed and taxpayers granted right to object against adverse order The Rules provide for a time bound procedure for determination of the eligibility of the taxpayer and of the international transactions for SHR. In case action is not taken by AO/TPO within the following time lines, the option exercised by the taxpayer shall be treated as valid:- reference by the AO to the TPO shall be made (for determination of the eligibility of the assessee or eligibility of the international transactions or both) of an assessee within a period of two months from the end of the month in which Form No. 3CEFA is received by him; TPO shall pass an order determining the validity of the option exercised by the taxpayer within a period of two months from the end of the month in which reference received from the AO; Further, the taxpayer shall have a right to file an objection with the Commissioner against adverse order regarding the eligibility of taxpayer/international transaction. Here again, if the Commissioner does not passes an order within a period of two months from the end of the month in which the objection has been received by him from the taxpayer, the option exercised by the taxpayer shall be treated as valid. Procedural requirements To exercise their option to be governed by the SHRs, the taxpayer is required to file specified form (Form No 3CEFA) with the AO on or before the due date for furnishing the return of income for the relevant assessment year, in case the option is exercised only for that assessment year; or the first of the assessment years, in case the option is exercised for more than one assessment years. In case SHRs are opted at once for more than one assessment years, the taxpayer for each assessment years following the initial assessment year, needs to furnish a statement to the AO providing details of eligible transactions, their quantum and details of the profit margins or the rate of interest or commission, before furnishing return of income of that year. Even where the taxpayer opts to be governed by the SHRs, they will be required to comply with the regulations regarding mandatory documentation and filing the Accountant s report for each AY under consideration, like any other taxpayer. Safe harbour rules shall not apply if an AE is located in any country or territory notified1 under Section 94A of the Act, or low tax (less than 15 tax rate) country or territory. Our comments The notification of the safe harbour rules is a welcome development and yet another conciliatory step towards minimising transfer pricing disputes and improving the overall investment climate in India from a tax perspective. Considering the various changes adopted in the final SHRs as compared to the draft, it appears that the consultative approach adopted by the revenue authorities found relevance. The increase in application term of SHRs to five years and the discretion granted to taxpayer to choose SHRs for a period of his choice (any one, more or all of the five years) is a positive modification, aimed at providing long-term certainty and greater flexibility to taxpayers. The provision of the time-bound mechanism for determination of eligibility (of the assessee and the international transactions), and the taxpayer s right to file objection with the Commissioner against the adverse orders of the AO/TPO are encouraging measures. However, no time limitation seems to have been prescribed for the AO s verification of the transfer prices to be in accordance with the relevant safe harbour ratio. Similarly, no specific timeline is provided for the AO s review of taxpayer s continued eligibility to SHR in the assessment years other than the initial assessment year. Given these uncovered situations, the success of the safe harbour regime may depend on the ground-level administration measures to be implemented by the tax department. The Form No. 3CEF requires information on the nature of business or activities of the taxpayer as well as details of the eligible international transactions opted for the SHRs. The return of income needs to be furnished before the date of furnishing of Form 3CEFA.

4 The removal of threshold of INR 100 crores for the IT and ITES activities is a positive step as even taxpayers with larger revenue base would be able to opt for the Safe Harbour regime. While the reduction in safe harbour ratio in the case of KPO services to 25% (from 30% in the draft SHRs) is a welcome change, various safe harbours (featuring between 20 to 30 ) may still seem to be in a higher range by various stakeholders. Contrary to industry expectations, the categorisation between IT, ITES, KPO services and contract R&D services relating to software development has not been done away with. While modifications are made to further clarify the KPO services, there may still be room left for subjective interpretations of various definitions and consequent controversies on categorisation of services. Moreover, the new provisions added in the final SHRs relating to AO s review of taxpayer s continued eligibility in subsequent assessment years may further add to the uncertainty on categorisation of services and eligibility for the safe harbours. No respite is provided from maintenance of mandatory documentation for taxpayers opting for SHRs. Further, one would hope for a clarification that safe harbours would not become a basis for the revenue authorities to challenge the arm length pricing of the taxpayer in prior years or to challenge the arm s length pricing for taxpayers not opting for SHRs. Safe harbours are generally considered incompatible with the arm s length principle. However, even internationally, safe harbours rules have been evaluated favourably where the benefits of simplified transfer pricing compliance and administration outweigh the possible concerns. Therefore, the safe harbour regime to successfully work in India would need effective implementation measures by the tax department. This is to ensure that the primary objective for introduction of safe harbours, which is reduction in transfer pricing litigation and related uncertainty, is effectively achieved. Larger captive players may still not find the revised Safe Harbour rates lucrative enough to opt for the same. In such cases, opting for an Advance Pricing Agreement (APA), which could result in closer approximation of the arm s length price, may be rather preferable option. While bilateral APAs would completely mitigate the risk of double taxation, a tax payer opting for safe harbour rules will not be able to avoid possibility of economic double taxation.

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