Advance Pricing Agreement / Safe Harbour /
Thin Capitalisation
27 October 2012
Presentation by:
CA Yashodhan D. Pradhan
Presentation Overview
•
Advance Pricing Agreement (APA) – Introduction
•
APA: International Scenario
•
APA Scheme in India
•
Safe Harbour Provisions
•
Thin Capitalisation
Advance Pricing Agreement (APA)
Introduction to APA...
• An APA is a contract
• Usually for multiple years
• Between a taxpayer and at least one tax authority
• Mainly to prospectively resolve real or potential transfer pricing issues
• Involving transactions between related parties
Slide 4
...Introduction to APA
• Once APA has been entered into, the ALP will be
determined only in accordance with the APA
• The APA process is voluntary
• Supplements appeal and other DTAA mechanism for
resolving transfer pricing disputes
• Provides greater certainty on the transfer pricing method
adopted
• Mitigates the possibility of disputes
• Facilitates the financial reporting of potential tax liabilities
• Reduces the incidence of double taxation, and the costs
associated with both audit defense and documentation
preparation
Slide 5
Types of APA
Type
Nature
Unilateral APA
APA entered into between a taxpayer and the tax
administration of the country where it is subject to
taxation
Bilateral APA
APA entered into between the taxpayers, the tax
administration of the host country and the foreign tax
administration
Multilateral APA
APA entered between the taxpayers, the tax
administration of the host country and more than one
foreign tax administrations
Slide 6
Advantages of APA
•
Provides certainty of tax treatment by relevant tax authority
•
Investment decisions regarding overseas operations clarified: Projection of
future tax liabilities possible
•
Mitigates risk of a difficult potential TP audit/ future litigation
•
Substantially reduces possibility of future double taxation (bilateral or
multilateral APA)
•
APAs have the potential to cover most TP issues including:
- Tangible goods pricing.
- Services
- Intangibles issues involving royalties
- Cost-sharing issues
•
Taxpayer has participation in the process (unlike MAP)
Slide 7
Disadvantages of APA
•
Increases the risk of audits and adjustments in the related party country (in
case of unilateral APA)
•
Cost of implementation is high
- However, it’s likely that APA costs ≦ audit defense fees
- However, high cost involved in preparing APA application makes it
economically justifiable only when there is large volume of transactions
•
May reduce tax planning opportunities
•
Immediately draws attention to an entity’s tax
planning in different nations
•
Usefulness of APA diminished if no agreement
reached until period proposed to be covered
almost expires
•
Potential reluctance of taxpayers to disclose
information unless confidentiality is assured
Slide 8
Example
• Indian subsidiary engaged in machinery distribution, had very high profits
over a number of years
• Concern about exposure of foreign parent to adjustment by its tax
authority
• Earlier assessment: both foreign parent tax authority and Indian TP
authorities adjusted income, resulting in double taxation
• Goal: Obtain tax authority approval for resetting transfer prices
• Strategy: Obtain bilateral APA, adjust to closest point in the range (high
end)
Slide 9
APA: International Scenario
• More than 30 Countries allow APA
• Almost 20 years ago, only a few countries (e.g.
the United States, Canada and Australia) were
front-runners in the implementation of formal
APA schemes
• Up to 2010, the United States had signed the
highest number of APAs (over 950) in the world
• Following the introduction of the OECD
guidelines on APAs in 1995, a number of
countries began to enter into APA schemes
• The experiences of these countries (especially
the Asian countries due to economic similarities)
in the implementation of APA schemes, can be
used by India to implement a robust APA regime
Slide 10
APA: International Scenario
Country
Year of introduction
Type of APA
Term of agreement
Pre-filing
Japan
1987
Unilateral & Bilateral
3-5 years
Optional
USA
1991
Unilateral, Bilateral
& Multilateral
3-5 years
Mandatory
UK
1999
Unilateral, Bilateral
(No distinction in bi
and multilateral
18 to 21 months
Optional
China
2004
Unilateral, Bilateral
& Multilateral
3-5 years
Mandatory
India
2012
Unilateral, Bilateral
& Multilateral
Upto 5 years
Mandatory
Slide 11
APA Scheme in India…
• The APA regime was initially slated to be a part of the
Direct Taxes Code
• However, the scheme has been released in advance
with its introduction through the Union Budget 201213, and has been woven into the existing set of
Regulations
• Although the operating guidelines were spelled out
very recently i.e. on 30 August 2012, the Finance
Ministry had already taken some administrative steps,
including the appointment of an APA team, for the
implementation of the scheme
• Introduced through sections 92CC and 92CD and
Rules 10F to 10T
Slide 12
…APA Scheme in India
• At present, a parallel mechanism exists i.e. advance
rulings from the Authority for Advance Rulings (AAR)
• AAR is empowered to examine a prospective
contract of a resident taxpayer with a non-resident in
order to determine the taxability thereof
• The main difference: under the APA scheme, the tax
authorities may determine/quantify the value of the
international transaction or profits, whereas the
Authority for Advance Rulings does not have a power
to do so
Slide 13
Significant Features of the APA Framework in India…
• The use of existing prescribed methodologies with necessary
adjustments/variations or any other method to determine the arm's length
price
 One may choose any method in addition to the methods prescribed in the
Regulations
 This gives flexibility to agree upon a method that may be more suitable
 This also makes the APA regime more attractive to those MNEs that are
dealing with difficult scenarios where the prescribed methods may not best
reflect an arm’s length outcome
Slide 14
…Significant Features of the APA Framework in India…
• The duration (i.e. term) of an APA would be limited to a maximum of five
consecutive fiscal years
 Coverage of five years is consistent with the coverage of APAs in other
countries
 A period of three to five years is considered adequate as regards the cost of
the APA process, expected changes to the business and various conditions
affecting the transactions covered
Slide 15
…Significant Features of the APA Framework in India…
• APAs are binding on the taxpayer and the tax authorities unless there is a
change in the law or facts of the case
 This will give certainty to both taxpayers and the tax authorities.
 However, care should be taken to ensure that minor changes in the course of
business due to market dynamics do not render the APA void.
Slide 16
…Significant Features of the APA Framework in India…
• Approval of the Central Government will be necessary
 This suggests that the government intends to monitor and possibly even
control the APA process
 Other than its obvious effects, this will ensure that the APA process is
completed within a reasonable time frame
Slide 17
…Significant Features of the APA Framework in India…
• An APA applies to the determination of the arm's length price in respect of
prospective transactions only even if the transaction is a continuing one
 The APA process is a forward-looking exercise and is applicable only with
regard to prospective transactions that are either being contemplated to be
undertaken or those which are continuing transactions that will be carried out in
the following year by the taxpayer
 Further, as APA will involve the determination of the arm’s length price, a
detailed transfer pricing audit by a transfer pricing officer will not be undertaken
for the term of the agreement, however, the taxpayer will need to satisfy the
transfer pricing officer as regards the compliance with the terms of the
agreement, critical assumptions, correctness of the supporting data and
consistency of the applications of the transfer pricing method
Slide 18
…Significant Features of the APA Framework in India…
• The fees prescribed for the APA ranges from INR 1 million to INR 2 million
depending upon the amount of international transactions under
consideration
Amount of International Transaction entered into or proposed to be
undertaken in respect of which agreement is proposed during the
proposed period of agreement
Fee (INR)
Amount not exceeding Rs. 100 Crores
10 lacs
Amount not exceeding Rs. 200 Crores
15 lacs
Amount exceeding Rs. 200 Crores
20 lacs
Slide 19
…Significant Features of the APA Framework in India
• APA shall not be binding if there is a change in law or facts relating to the
agreement
• Void-ab-initio if agreement is obtained by fraud or misrepresentation of
facts
• If ROI already filed, the same can be modified after APA is entered into
• Assessment if already completed , the officer should assess or reassess as
per the APA
Slide 20
APA Rules…
Rule
Description
10F
Meaning of expressions
10G
Person Eligible to apply
10H
Pre-filing Consultation
10I
Application for advance pricing agreement
10J
Withdrawal of application for agreement
10K
Preliminary processing of application
10L
Procedure
10M
Terms of the agreement
10N
Amendments to Application
10O
Furnishing of Annual Compliance Report
10P
Compliance Audit of the agreement
10Q
Revision of an agreement
10R
Cancellation of an agreement
10S
Renewing an agreement
10T
Miscellaneous
Slide 21
…APA Rules…
Rule / Form
44GA
Description
Procedure to deal with requests for bilateral or multilateral advance pricing agreements
Forms
3CEC
Application for a pre-filing meeting
3CED
Application for an Advance Pricing Agreement
3CEE
Application for withdrawal of APA request
3CEF
Annual Compliance Report on Advance Pricing Agreement
Slide 22
…APA Rules…
• Eligibility:
 applicable to all “persons” undertaking international transactions or
contemplating to undertake international transactions
• Pre Filing Consultation:
 Mandatory
 Detailed information required
 Option to keep the names ‘anonymous’
 Request to DGIT in form no. 3CEC
 Neither binding on the Board nor the taxpayer to enter into an APA
 Objective is to enable both parties to:
 determine the scope of the agreement
 identify transfer pricing issues
 determine the suitability of international transaction for the agreement
 discuss broad terms of the agreement
• Application for APA:
 To be filed in Form no. 3CED
Slide 23
…APA Rules…
• Withdrawal:
 Applicants can withdraw any time before the finalisation of the terms
 However, the fee which has been paid would not be refunded
 Form 3CEE prescribed
• Preliminary processing and procedure:
 includes vetting the application for any deficiencies
 If the application is allowed in the preliminary processing phase, the main
processing of applications would be conducted by the APA team in the
following manner:
 holding meetings with applicant
 calling for additional documents/ information/material from the applicant
 visiting applicant’s business premises
 making inquiries as may deems fit in the circumstances of the case
• Agreement and terms:
 Approval of the Central Government required
 Should include – International transactions covered, agreed methodology, ALP
if any, critical assumptions, time period, definition of terms and other conditions
if not covered in the prescribed APA scheme
Slide 24
…APA Rules…
• Annual Compliance Report:
 To be furnished in quadruplicate to DGIT for each of the years covered in the
agreement
 One copy each would be sent by the DGIT to the CA India, to the jurisdictional
CIT and one copy to the TPO
 To be filed within thirty days of the due date of filing the income tax return for
that year, or within ninety days of entering into an agreement, whichever is later
• Compliance audit:
 The TPO to carry out the compliance audit of the APA for each of the year
covered in the agreement
 required to furnish his report within six months from the end of the month in
which the annual compliance report is received by him
 Covered transactions under the APA scheme would not be audited by the
TPOs under the routine transfer pricing assessment procedure
 The compliance audit is not a general feature internationally
Slide 25
…APA Rules
• Revision of an APA:
 An APA can be revised in case of:
 change in critical underlying assumptions
 change in such law other than that which renders it non-binding
 request from CA in the other country
 The revision order is required to be in writing citing reasons of revision
required and:
 revisions can be initiated by the Board / DGIT/ CA/ taxpayer
 opportunity of being heard to be provided
 non-agreement by the taxpayer on the proposed revisions may result in
cancellation of the APA
• Miscellaneous:
 Mere filing of a application for an agreement under these rules shall not
prevent the operation of Chapter X of the Act for determination of arms‟
length price under that Chapter till the agreement is entered into
Slide 26
What is Lacking? or What is Just Not Right?
• No provisions for rollbacks
• No mention of timeframe to conclude
• No provisions re confidentiality safeguards
• Cancellation of agreements may not work in bilateral / multilateral scenario
• Provisions regarding critical assumptions need to be explained further
Slide 27
Processes
Bilateral / Multilateral
APA
CBDT Approval
CBDT Approval
DGIT
Competent Authority
in India
APA Team
Agreement
Agreement
Unilateral APA
Discussions
Competent Authority
Of AE’s Country
Agreement
APA Team
Discussions
Taxpayer
AE
Taxpayer
India
Outside India
Slide 28
Way Forward
• Obtaining an APA involves extensive negotiation between the taxpayer and
the tax authorities in a mutual environment
• Indian tax authorities need to develop an environment conducive to the
success of a continuous negotiation process
• An APA scheme has the ability to deliver significant benefits including
savings in compliance and administrative costs
• However, the law must clarify certain aspects such as secrecy of business
information to safeguard the interests of the taxpayer
Slide 29
Safe Harbour
Introduction to Safe Harbour
• Safe Harbour Rules are the circumstances under which tax authorities
automatically accept the transfer prices declared by the taxpayer
• Provides certainty and compliance relief
• Could be in the form margin threshold or exclusion of certain classes of
transactions from TP regulations
• Safe Harbour and Presumptive Taxation provisions (Similar in nature)
Slide 31
Why are Safe Harbour Rules so Important to India?
• India is a globally preferred country for outsourcing of services
• However, the outcomes of the TP assessments concluded in the last
couple of years have increased the uncertainty over taxation issues
• Safe Harbour Rules once introduced, will provide some certainty to MNEs
• Captive service providers in India to benefit
Slide 32
Industries / Transactions that Need Immediate Attention
• Indian IT/ITeS industry
• Management Service Charges
• Royalties
Slide 33
Global Scenario
• Safe Harbour provisions are being practiced by several mature practices
across the globe
• in Australia and New Zealand, a 7.5 per cent markup on cost is generally
accepted as an arm’s length margin for the non-core services
• US has prescribed a Safe Harbour for routine services. Here the services
charged at cost (without mark-up) are considered to be at an arm’s length
• Brazil have introduced safe harbour provisions in respect of exports
Slide 34
Safe Harbour Provisions in India
• Contained in Section 92CB
• No Rules prescribed by CBDT yet and hence, no clarity
• Awaited since 2009
• Risky from double taxation perspective
• Harmful in case of genuine business losses and downturns
Slide 35
Advantages and disadvantages of Safe Harbour Rules
• Reduces litigation burden
• Provides a measure of predictability
• Significantly reduced compliance
• Administrative simplicity
• Risk of double taxation
• Difficult balancing act
Slide 36
Thin Capitalisation
The Concept of Thin Capitalisation
• A company is said to be thinly capitalized when its capital is made up of a
much greater proportion of debt than equity
• In other words, when its gearing or leverage, is too high
• This is perceived to create problems for two classes of people
 consumers and creditors bear the solvency risk of the company, which
has to repay the bulk of its capital with interest; and
 revenue authorities, who are concerned about abuse by excessive
interest deductions
Slide 38
The Concept of Thin Capitalisation
• Specific rules aimed to discourage thin capitalization often require that the
debt-to-equity ratio meet a specific ratio in order for the company to be
allowed to deduct interest expenses
• Thin capitalization refers in some countries to the situation where a
company has excessive debt in relation to its arm’s length borrowing
capacity
• Here, the rules do not specify the debt-to-equity ratio, but do specify that in
order to claim interest deductions, a company must ensure – and be able to
document from a transfer pricing perspective – that the terms and
conditions of its intercompany financing are comparable to those it could
have obtained from third-party lenders (for example, in the United Kingdom)
Slide 39
Why is Thin Capitalisation Considered as a Problem?
• Thin capitalization is a problem from a tax perspective because the returns
on equity capital and debt capital are treated differently for tax purposes
• Returns to shareholders on equity investments are not deductible for the
paying company, being distributions of profit rather than operating
expenses
• On the other hand, returns to lenders on debt – most commonly in the form
of interest – are normally deductible for the payer in arriving at profits
assessable to corporate tax
• This can result in attempts by multinational enterprises to present what in
substance is equity investment in the form of debt, and thereby receive
more favourable tax treatment
Slide 40
Why is Thin Capitalisation Considered as a Problem?
• As of now, India does not have any Thin Capitalisation Rules
• Direct Taxes Code proposes to introduce this concept
• Income tax department is seriously thinking of applying thin capitalization
rules in India
• This will allow them to classify some parts of the interest paid as dividend
Slide 41
Conclusion
• APA is a step in a right direction, however, concerns relating to
confidentiality of information etc. need to be addressed
• Safe Harbour Rules are eagerly awaited by MNEs. However, the taxpayers
are wary of possible double taxation issues
• Thin Capitalisation is yet to be formally introduced in India. Its introduction
will depend on the adoption of Direct Taxes Code
Slide 42
Yashodhan D Pradhan
Principal Consultant
Vispi T. Patel & Associates
Contact No.: +91 9820888009
Email: yashodhanpradhan@yahoo.co.uk ,yashodhan@vispitpatel.com