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Hide And Seek?
Scindia House in the South Mumbai area of Ballard Pier is a far cry from the typical government office. For one, it is spacious and well maintained. The few visitors are usually in suits. And, you will be hard-pressed to find paan stains. Most importantly, for the better part of the day, the officers seem to be at work. The offices in the building are roomy, some even bigger than in private sector tax firms. Scindia House is home to the international tax division of the income tax department in Mumbai. By some estimates, its FY13 tax mop-up will bring in Rs 25,000 crore.
Photo Credit :
The suits, of course, are donned mostly by tax consultants — there to present their clients’ cases before the authorities. These consultants, from the Big 4 (PwC, Deloitte, Ernst & Young, KPMG) as well as second-tier firms, are perhaps the best brains in tax planning that money can buy. Should you ever commit the cardinal sin of calling them tax evaders, they will correct you with: “tax planning is not tax evasion”. They are known to burn the midnight oil, but judging by their energy levels, they seem to have had a good night’s rest.
The income tax officers at Scindia House toil late, but not really by choice. They just happen to be an overworked lot. Seen as a punishment posting for not being ‘flexible’ enough, these officers are known to be quite harsh. They have targets to meet and not enough time in which to do so. In Mumbai, every year, around 100 transfer-pricing cases are handled by some eight officers; ditto with other international transactions. And unlike the courts, which can take time in deciding cases, these officers need to complete their assessments within the prescribed deadline, since the I-T Act prescribes a time limit for disposal of cases.
Simply put, transfer pricing is the price at which a multinational group transfers assets between its entities in different countries. Meaning, the price paid by, say, a US parent to its Indian entity for goods manufactured in India and then sold back. If the price is too low, the profit of the Indian company reduces (meaning, it pays lower taxes in India); if it is too high, the US entity shows a lower profit — though for the MNC, it is profit-neutral globally. A zero-sum game, if you will — with enough scope for wrangling between sovereigns.
Enter a low-tax jurisdiction, a.k.a. a tax haven. No longer do corporations directly outsource their manufacturing to China. They set up companies in, say, low-tax Switzerland to oversee operations of a manufacturing subsidiary in China. The work in China is probably given on a contract basis by the Swiss entity. So, the Chinese contractor gets a mark-up of around 15 per cent of his cost of production. And, then, the product is given to a distributor (another subsidiary) in, again, say India, to sell to the Indian market. The Indian distributor subsidiary sells at a percentage above the price he pays for it. Now, the difference between the price the Swiss entity pays the Chinese entity, and the price it receives from the Indian distributor is its own profit — profits that are taxed in Switzerland; not in India, China or in the US. And what is the tax rate for holding companies registered in Switzerland? Between 9 per cent and 11 per cent on average (compared to a 30 per cent floor rate in India). No wonder tax authorities around the world are an indignant lot.
Seventy per cent of global trade is within and among group companies of multinational enterprises, according to an Organisation for Economic Cooperation and Development (OECD) report; and they have put in place systems that help them manage tax most efficiently by manipulating pricing. You begin to get an idea of how serious the problem is.
And, the authorities cannot do anything about it. Stig Sollund, director-general in the tax law department of Norway’s Ministry of Revenue, during a recent visit to Mumbai, said while it is important to identify the value of assets transferred to a low-tax jurisdiction, the job is a challenge because the assets are not necessarily legally registered in the country that wants to tax them.
In December 2012, Starbucks, faced with the threat of a customer boycott, offered to pay about £20 million in taxes to the UK over two years. The British, known for actively protesting against tax avoidance by corporates — they once took to the streets against an arrangement that helped Vodafone escape paying tax in the UK on a lucrative deal — were indignant at the fact that in 14 years of operations in the UK, and making billions in profits, Starbucks had paid only £8 million in taxes. The coffee chain managed this by paying a royalty of 6 per cent to a subsidiary in the Netherlands, and taking a loan from its US parent at LIBOR-plus-4 per cent, according to the UK public accounts committee.
Search giant Google did one better. Last year, its overseas tax rate was reported to be 2.4 per cent owing to a manoeuvre which tax experts call ‘Double Irish with a Dutch sandwich’. It routed advertising revenues to an Irish subsidiary, with a holding company in the Bahamas routing it through the Netherlands, all low-tax countries. The move helped Google save a substantial sum in tax. Margaret Hodge, chair of the UK public accounts committee, is reported to have said during hearings: “We’re not accusing you of being illegal, we are accusing you of being immoral.”
Shouldn’t multinational companies be barred from accumulating profits in a low-tax jurisdiction? Al Meghji, one of the most respected tax attorneys in the US, says what is required is that there should be a connection between the profits allocated to a jurisdiction (for the purpose of taxation) and what is going on there (as operations). Transfer pricing ought to do that, at least theoretically. Transfer pricing should be about allocating the right profits to the right jurisdiction, he says.
“There is need for rules that will allow you to disregard artificial transactions such as payment of royalty to related parties in tax havens,” says Sollund.
Zone Of Conflict
If making it to the top of lists is a measure of one’s influence, then this list is telling. President Pranab Mukherjee, India’s finance minister a year ago, was the highest placed individual in a TP Week list of most influential figures in global transfer pricing, based on a survey of 800 readers. And why not? As Ketan Dalal, joint tax leader at PwC India, says, “Seventy per cent of the global litigation arising out of transfer pricing is from India.” In 2011, the I-T department made additions of Rs 45,000 crore to companies’ tax returns using transfer pricing provisions. Perhaps, owing to the tremendous outcry on account of such adjustments, the department is being tight-lipped about the numbers for the 2012 season which concluded in January 2013. Estimates put it at between Rs 60,000 crore and Rs 75,000 crore.
The tax advisors are, however, an outspoken lot with the dispute between the two sides becoming acrimonious. Sanjay Tolia, head of PwC’s Mumbai transfer pricing team, explains: “Sometimes firms are made to pay tax on (notional) profits that are not even in the system.”
The face-off is not new. A few years ago, the tax department decided to extract a share of the profits made by Microsoft’s global operations. Its logic: when so much of Microsoft’s back-end work is carried out in India, its office here should be treated as more than just a BPO unit of the company (with only a token profit being offered for taxation in India). The I-T department looked at the proportion of Microsoft’s patents filed in India vis-a-vis the number filed globally, and also the strength of its workforce in India in comparison with its global headcount. The information garnered was used to apportion some of Microsoft’s global profits to India for taxation.
Then, there is the case of Maruti Suzuki. In 2004-05, Maruti was paying Rs 198 crore to Suzuki for the use of its brand. The I-T department argued that the use of its brand name by Maruti was boosting Suzuki’s appeal in India and, therefore, compensation was to be recovered from Suzuki (as tax).
A senior tax department official defends this position, arguing that if at some point Suzuki wants to introduce its own brand in India, it will be able to piggyback on the visibility created by the Maruti Suzuki co-branding. As an example, he cites the case of Mercedes which was popularised in India in the 1970s in partnership with the Tatas. Subsequently, when it re-entered India with its brand of luxury cars, it had an advantage over competitors such as Audi and BMW. So, branding is a service that Maruti is providing Suzuki. In a judgement in January this year, relating to LG’s marketing spend, the Delhi High Court held that the Indian subsidiary has to pay tax on excess marketing expenditure it incurred (on the principle that it is to be recovered from its global parent).
Or take the case of Shell, which infused funds into its Indian subsidiary to the tune of Rs 870 crore in March 2009. The tax department in January added Rs 15,220 crore to Shell’s income for the year 2007-08, arguing that the infusion was made at below market prices. Tax professionals find this completely unacceptable. Manisha Gupta, senior director of transfer pricing at Deloitte, says applying transfer pricing provisions, which pertain to cases of tax avoidance, to subscription of shares is stretching the concept. Samir Gandhi, transfer pricing leader at Deloitte explains, “It needs to be appreciated that there is no income that arises either in the hands of the Indian entity issuing shares or in the hands of the foreign related party” (Shell, though, may be in for relief, with sources saying that the finance minister is not pleased with the I-T order).
When Vodafone sold its BPO operations in India to Hutch (FY08), it was not expecting the I-T department to make a claim that the transaction should have shown an additional Rs 8,500 crore as profit. Vodafone and the I-T department are currently wrangling over whether it was an international transaction in the first place, and therefore subject to transfer pricing provisions (The Rs 11,200-crore case pertaining to Vodafone’s purchase of Hutch’s Indian telecom operations, in which it won a favourable ruling in the Supreme Court last year, is a separate dispute with the I-T department).
It is not difficult to see the reason behind all the bad blood between MNCs and the taxman. The stakes have become large when it comes to tax planning in India. For the taxpayer, there is much to shield and, for the department, there is much to unearth.
In the developed world, transfer pricing once invoked a rule known as ‘arm’s length principle’. The principle meant that the transfer price would be decided based on the price at which two entities at an arm’s length made a similar transaction (transfer pricing arises only out of related party transactions). But just as no two people are similar, neither are two transactions the same. So, the rules provide for taking an average of comparable transactions. Where the disagreements start is the comparables to be considered.
A transfer pricing officer in Mumbai says that an investment bank recently tried to push through data from KPOs as comparables. Obviously, profit margins for a KPO are far lower than that of an investment bank. The analysis was rejected. Sometimes, the taxpayers complain that the department is comparing a new firm with something that already has an established presence (with a moat that would make it eligible for better returns).
Taking potshots at I-T department, Anish Mehta, tax leader at consulting firm BDO, points out that there have been cases where a back office service firm is compared with a KPO servicing niche sectors (which can have margins of up to 90 per cent in some cases). The department ends up comparing apples and oranges, he says.
The I-T Case
Transfer pricing officials say that when they see entries such as management or advisory fees paid to related entities in Singapore or Malaysia, their alarm mechanism kicks in. It is the duty of the taxpayer to prove that the management was actually conducted out of Malaysia and not India. After all, they argue, it is most likely that operations in India would be managed by an Indian from within the country.
For example, in 2007-08, according to the assessing officer, TCS paid around 10 per cent of its receipts to its sales and marketing offices abroad for their efforts in winning the company orders from clients located there, transfer pricing officers grew suspicious. They argued that the company’s foreign set-up was more of a liaison office which did the bidding of the Indian parent, and hence should be entitled to a commission of only around 2 per cent and not the 10 per cent that was paid.
Transfer pricing in financial transactions can be even more vexing. For example, when an Indian firm gives a loan to its subsidiary abroad (where interest rates are likely to be lower), the I-T department insists that it levy the same interest rate as it would on an unrelated company in India (or at a benchmark such as the prime lending rate). Guarantee commission is another area of constant conflict. When an Indian company stands guarantee for a loan taken by its subsidiary, the department adds a notional guarantee commission to be received from the subsidiary. After all, nobody will stand guarantee for another’s loans unless there is a fee involved. But, “sometimes the department treats up to 10 per cent of the loan value as guarantee commission”, says Tolia. Hindalco had to defend a tax claim of Rs 1,100 crore last year on similar grounds. It subsequently managed to it reduced to Rs 250 crore on appeal.
The taxman’s attitude is not beyond reproach. Veteran tax consultant T.P. Ostwal is very critical of the transfer pricing mechanism. “It’s not just that we are driving MNCs mad with our transfer pricing system. We have ended up driving ourselves mad too. We have reached a point where Indian companies earning profits abroad are being penalised,” he says.
Most solutions for dealing with the challenges of transfer pricing are impractical. However, there is one way out that holds promise — Advance Pricing Agreements (APA). A success in the developed world, the measure has recently been implemented in India. APAs, as the name suggests, are advance agreements between the taxpayer and the department on the transfer pricing implications of individual transactions. They are a safeguard against future litigation.
Uday Ved, senior tax partner at KPMG, says the experience with APAs has been good so far. Tax officials seem willing to consider arguments of the taxpayer, with the agreements usually inked after tough negotiation.
Of course, it’s still early days. APAs, which were introduced in March 2012, have reached only what is known as a pre-filing stage. If they stay the course, they could ease the transfer-pricing conflicts.
(This story was published in BW | Businessworld Issue Dated 20-05-2013)
Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.