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Transfer Pricing Challenges Due to Covid-19: A Taxpayer’s Wishlist for Budget 2021!

Will Budget 2021 bring some relief to tax payers? Here are some highlight to explore possible solutions.

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The Covid-19 pandemic has posed significant challenges to the taxpayer from a transfer pricing perspective. Resolving these challenges may require intervention from the Government. Will Budget 2021 bring some relief to tax payers? Here are some highlight to explore possible solutions.

Comparable Analysis – Challenges Posed By Multi-Year Comparison

The most commonly used benchmarking methods under the transfer pricing law such as transactional net margin method or cost-plus method require benchmarking of the tax payer’s income or arm’s length price (“ALP”) with that of comparable companies by using multi-year data. For instance, while benchmarking income or ALP of financial year (“FY”) 2020-21, point data of the tax payer for FY 2020-21 will be compared with that of 3-year weighted average of comparable companies.

Because of the Covid-19 pandemic, companies have witnessed significant hit to their businesses in FY 2020-21. Comparing point data with average data of three years will result in skewed outcome from this exercise because 2/3rd of the comparable company’s benchmark will be weighted by prices or profitability of normal years.

To factor in this effect, one would have to make comparability adjustments, which more often than not have resulted in long drawn litigations. 

What Can Be Done To Address This Challenge?

One solution would be to permit tax payers to opt out of performing benchmarking exercise by using multi-year data set. For illustration, the tax payer can be permitted to benchmark using single year data of comparable companies for the FY 2020-21. 

An alternative solution would be to permit benchmarking by comparison of 3-year data of the tax payer’s income or ALP with the 3-year data of the comparable businesses.

Because comparable businesses would be more or less equally affected by the Covid-19 pandemic, this would ensure a like to like comparison. This would deliver a more consistent outcome and avoid the need to make comparability adjustments.

Fundamental Assumption Behind Advance Pricing Arrangements Tested

Advance pricing agreement or APA as is more popularly known is a mechanism to minimise disputes between the tax payer and the tax department. APAs seek to minimise disputes by getting the tax payer and the tax department to agree in advance on the assumptions relating to the methodology used in computing income or ALP for future years. The fundamental principle underlying the APA mechanism is that the business environment does not change drastically within the block of years covered by the APA.

Covid-19 pandemic has unsettled this fundamental assumption behind APAs as it has severely and adversely affected several businesses. The assumptions agreed upon in the APA may, therefore, not be achievable or relevant for the current year. Recognising such a situation, tax authorities in countries such as USA and New Zealand have provided relaxations to address this issue. These jurisdictions have either provided for renegotiation of APAs or for exceptions to APAs to handle the breach of APAs for Covid affected years.

The Government could consider bringing in similar relaxations in the upcoming Budget to address this anomaly caused by the Covid-19 pandemic.

Need To Be Liberal With Leverage In Pandemic Times

Thin capitalisation rules seek to prevent multi-national enterprises from shifting profits out of India by adopting thin capital structure for their group entities in India. In a thinly capitalised structure, the group entities in India would adopt higher leverage and make payments to parent entities in the form of interest.

In pandemic times, multi-national enterprises would be compelled to support their group entities in India as the parent entities would have much stronger balance sheets and credit ratings. Supporting through debt is one of the quickest, and relatively simpler route. In some instances, the ceilings stipulated by thin capitalisation rules could be breached leading to disallowances for the Indian group entities.

Given the extraordinary circumstance, this calls for providing some relief to tax payers from thin capitalisation rules. Jurisdictions such as Australia have adopted mechanisms to provide relief to tax payers in such circumstances. 

One-Time Guidance To Address Peculiarities Arising From The Pandemic

The Central Board of Direct Taxes (“CBDT”) could also consider issuing guidelines to deal with peculiarities arising from this pandemic. Such guidance could cover aspects such as manner of making adjustments to factor the effect of the pandemic on ALP, documentation to be maintained to substantiate these adjustments, identification of appropriate comparables, treatment of cost distortions caused due to the pandemic and its effect on business, treatment of intra-group loans, etc.

In such an extraordinary year, any relief would be a welcome relief.

(The views expressed by authors are strictly personal)

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.

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Union Budget 2021-22 Union budget 2021

S. Vasudevan

Executive Partner, Lakshmikumaran & Sridharan Attorneys

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Sriram Vijayaraghavan

Principal Associate, Lakshmikumaran & Sridharan Attorneys

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Harshit Khurana

Senior Associate, Lakshmikumaran & Sridharan Attorneys

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