Friday, July 27, 2007

Law Street in The Economic Times (July 2007)

Hi Readers,

All roads in tax land seem to lead to transfer pricing. It is time that India introduced alternate dispute resolution mechanisms - such as Advance Pricing Agreements. It would augur well for foreign investments if safe habour provisions were also introduced. For understanding the background, click here.

By the way, I love the new look of the online edition of The Economic Times.

For your convenience, the article is also cut and pasted here. Happy reading.



Transfer pricing a taxing issue
27 Jul, 2007, LUBNA KABLY

Anthony Bourdain in his book Kitchen Confidentia recalls the time when as a kid he had his first raw oyster, on a boat in France. “It tasted of seawater, of brine and flesh and somehow of the future.” Then it hit him, Food had power. “My life as a cook and as a chef had just begun” he described in his book. One has not tasted his dishes, but if he cooks as well as he writes, well then — compliments to the chef.

Perhaps it was the delicious smell of printing ink which wafted out of the Times of India building in Bombay (it was then not called Mumbai and the press was located in this building) that prompted one to be a journalist and continue as a columnist. Well, if food and ink had the power to sway Bourdain and this writer respectively, so do taxes.

In fact, they hold sway over all of us. It is interesting to know how taxes have been used down the ages to persuade people to buy, to stop buying, to operate in backward areas, to stop emitting carbon or even to stop putting on weight. Yes, tax has power. Googling away one found these two gems: Queen Elizabeth 1 (1558-1603) is said to have disliked beards and therefore established a tax on them. Actually, it was just the British way to garner more taxes, as beards were then in vogue. Years later, as beards were no longer in fashion in western Europe, in 1698, Peter the Great of Russia levied a tax on beards to bring Russian society in line with western European fashion. Strange, but true!

Fortunately, back home, we will not be hearing of new innovative taxes till the finance minister (or PC, as people in ET fondly call him) kick starts his budget discussions sometime in December. Yet, there has been enough excitement in tax land in recent days. To begin with, there was the long awaited order of the Supreme Court, in the case of Morgan Stanley. This decision has brought a sigh of relief to many MNCs that had set up captive processing entities in India. Even if such a captive processing entity creates a permanent establishment (PE) in India — thus bestowing the right on the Indian tax authorities to tax the profits attributable to this PE — there is a glimmer of hope. This order clearly points out that there can be no further profit attribution if the pricing between the foreign enterprise and its PE in India — the captive service provider — is at an arm’s length. However, if one looks closer at the order one notices that this tenet applies only if the functions performed and risks undertaken by the captive service provider are the same as that of the permanent establishment.

Thus, there is no automatic insulation from tax assessments. Indeed tax authorities and transfer pricing officers can still make enquiries and satisfy themselves about the arms’ length pricing.

Close on the heels of this order came the next one. The special bench of the Bangalore Income-tax Appellate Tribunal, in the case of Aztec Software and Technology Services Ltd (Aztec), seems to have taken away the insulation from transfer pricing adjustment, which was believed to be available to entities enjoying a tax holiday. The order of the commissioner of income tax (Appeals) in this case had held that transfer pricing provisions are special provisions relating to avoidance of tax and should be invoked only if the tax officer was satisfied that there is a motive and act by the taxpayer to avoid taxes in India. Companies enjoying a tax holiday, however, cannot have any such motive. But the ITAT has held otherwise.

The Indian tax authorities have been quite aggressive with transfer pricing assessment for the IT/ITES sector in recent years. Risk mitigated captive service providers are reeling under high profit margins that have been attributed to their operations in the course of transfer pricing audits. In fact, this ITAT order also acknowledges that industry averages, such as Nasscom man hour rates, cannot be blindly applied. The risks and functions of the entity have to be taken into consideration.

We know tax has power. It can also have negative power. Lack of clarity and convenience may result in taking away the shine from this sunrise sector. MNCs may think it best to operate from other shores. If there are inherent difficulties in introducing an advance pricing mechanism— which would enable MNCs to determine the transfer price payable to their captive service providers in India and prevent future litigation — then perhaps some safe harbour principles need to be introduced. Companies in India in the IT/ITES sector operating on a specified mark up as decided by the Central Board of Direct Taxes, after mutual consultation with the industry, could be deemed to have complied with the arm’s length principle.

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