Income Tax 12 Feb,2020
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Union Budget 2020 – Key Transfer Pricing amendments
Vinita Chakrabarti Director – Transfer Pricing with a leading Firm in India
Saurabh DamaniManager – Transfer Pricing with a leading Firm in India

The Union Budget 2020 was presented in a backdrop of a slowing down of the Indian economy, with estimated GDP growth for 2019-20 being at an all-time 11 year low of 5%1. The Honorable Finance Minister introduced the Finance Bill, 2020 ('Bill') with the underlying theme of stimulating growth, simplifying tax structures, easing of compliances and reduction in litigation2. While the Bill has proposed numerous amendments in direct tax, transfer pricing ('TP') and indirect tax regulations, we have provided below a summary of the key TP proposals.

 1.  Preponement of Form No. 3CEB compliance timeline

The Bill has preponed the statutory due date for submission of all audit reports by one month prior to the due date for filing the return of income ('ROI'). For taxpayers who are required to comply with TP regulations, while the due date for filing of the ROI, has been unchanged (i.e. 30 November following the respective previous year ending on 31 March), the due date to file the TP certificate in Form No. 3CEB has accordingly been preponed to 30 October. Interestingly, due dates of the other TP compliance obligations remain unchanged.

The revised TP compliance timelines emanating post the amendments introduced by the Bill and effective from FY 2019-2020 are highlighted in Table 1 of Annexure3.

Going forward, as the TP study report would need to be prepared by 31 October (technically a precursor to the filing of the TP certificate justifying that the international transactions are at arm's length), this is likely to pose practical difficulties to taxpayers as data (for the relevant FY) is generally not updated / published till the end of October of the following year.

As the TP regulations permit use of multiple year data, in order to meet the compliance due dates, it is likely that the benchmarking analysis and the TP study reports shall now be prepared using the latest 2 years published data as taxpayers are unlikely to have information / insights on the third-year data. However, it has been experienced at the field audit stage, TP authorities have asked for updated margins of the respective FY itself. This would likely increase the burden on taxpayers as they may need to duplicate the benchmarking afresh at the time of the audits and the likely results may potentially be different from the earlier benchmarking results arrived at during the respective compliance period.

2.  Rationalizing the thin capitalization ('TC') regulations

The TC regulations currently enshrined in Sec 94B of the Income-tax Act 1961 ('the Act'), cover within their gamut:

  a.  debt taken by a taxpayer4 from its non-resident associated enterprise ('AE'); or

  b.  debt taken by a taxpayer from a non-resident lender guaranteed by its AE.

As regards guarantees being provided on the above debt, under the current provisions, for the purpose of 'allowability of the interest expense', the emphasis seemed to be on residency of the lender rather than residency of the AE guaranteeing the loan. This appeared to be an aberration from the global TP principles which typically evaluate the nature of the relationship and the adequacy of the pricing between the AE and the taxpayer.

To illustrate, currently, in case an Indian company ('I Co.') obtained a loan from a non-resident bank, guaranteed by its overseas AE, the same would attract provisions of Sec 94B of the Act. However, if the I Co. obtained a loan from an Indian resident bank, though guaranteed by its overseas AE, the same would fall outside the purview of Sec 94B of the Act. This apparently reduced the competitiveness of non-resident banks vis-à-vis their resident counterparts. In a country which is in need of foreign investment / funds for growth and development purposes, the above provisions seem detrimental to business.

Pursuant to the proposed amendments the TC rules ought not to apply in cases where a loan has been guaranteed by an AE (irrespective of whether the AE is a resident / non-resident) and the loan has been provided by an Indian resident bank or a PE of a non-resident bank in India.

The above welcome amendment ought to provide a level playing field to non-resident banks operating in India such as HSBC, Citibank, etc. vis-à-vis their resident counter-part banks such as SBI, Kotak, etc.

The nature of coverage as per the current and proposed provisions (effective from FY 2020-2021) are tabulated below in Tables 2 and 3 respectively in Annexure for ready reference.

 3.  Attribution of profits to Permanent Establishment ('PE')

Attribution of profits to a PE has been a continually litigated matter in India. In the current context of the:

  —  slowing world economy with Governments alike tending to adopt protectionist measures in a bid to tax revenues arising in their respective jurisdictions;

  —  the Organization for Economic Cooperation and Development's ongoing work on the Digital economy;

  —  The Central Board of Direct Taxes' ('CBDT') draft report released in April 2019 pertaining to apportionment of profit to PE [wherein a formula-based approach was proposed giving weights to three factors namely, sales, manpower (employees and wages) and assets and in the case of digital businesses, an additional fourth factor being users]; etc.

this hugely vexed topic is expected to be one of the focal areas of international tax disputes in the coming decade.

The Indian Revenue authorities ('IRA') have often been belligerent in alleging that profits ought to be attributed to a PE, despite an arm's length price being received by the PE. Multiple approaches currently being adopted to attribute profits thereto include random attribution, attribution of profit based on the functional analysis, formulary apportionment, etc.

The Bill proposes to include profit attribution to PE within the scope of advance pricing agreement ('APA') and the safe harbor ('SH') rules5, seemingly in line with global best practices - developed economies such as Singapore, UK, Australia,Spain also cover profit attribution to PE within the gamut of their APA rules.

While this is a welcome amendment considering the rather contentious nature of the issue, few important points emanate:

 —  Admission of a PE is apparently the first step to being eligible to file an APA covering attribution of profits thereunder - for Multinational Corporations ('MNCs') who have historically believed that their Indian operations do not constitute a PE, they would need to revisit their positions accordingly;

 —  In case MNCs admit a constitution of PE to be covered in the above program, potential impact / ramifications of such admission in earlier years which are under litigation on the same issue, would need to be carefully evaluated;

 —  Is it likely to be accepted by the IRA that the income earned / attributed to a PE (as determined in an APA) is final, both from a TP and corporate tax perspective; and

 —  Practically, it needs to be seen how the principles of profit attribution would be actually considered during APA negotiations along with the manner in which the SH rules are framed on the subject.

 4.  Penalty for false entry or omission6

The Bill has introduced a new provision under Sec 271AAD of the Act to provide a penalty for taxpayers if the books of accounts contain a (i) false entry or (ii) any entry has been omitted7.

False entry has been defined as "invoice in respect of supply or receipt of goods or services or both issued by the person or any other person without actual supply or receipt of such goods or services or both".

It is proposed that a penalty equal to the aggregate amount of such false entry could be levied on

(a)  taxpayer i.e. the person maintaining the books or accounts; and / or

(b)  any other person, who causes the person referred to in (a) above to make the false entry.

While it is understood that this section has been introduced largely in a bid to curb malpractices, it should be noted that the above could have huge implications if not used maturely by the IRA. In the context of TP, it has been a widespread practice for field level officers, in several cases, to disallow payment of management fees or service fees charged by Indian subsidiaries to overseas group companies, in cases where the Indian subsidiaries have not been able to satisfactorily demonstrate the receipt of services through robust documentary evidence.

Taking into account, the above and the increased penalty exposure, it becomes imperative for taxpayers to build / maintain robust and contemporaneous documentation to demonstrate not only the receipt of services but also the benefits derived therefrom.

 5.  Receipt of dividend by non-resident taxpayers

It has been a prevalent practice for non-resident taxpayers to undertake TP compliances with respect to only those international transactions that generate taxable income in India.

Under the current provisions, dividend is exempt in the hands of the recipient. Accordingly, non-resident taxpayers earning dividend income were not historically undertaking TP compliances in India.

With the proposed amendment to abolish the dividend distribution tax, the dividend income shall be taxable in the hands of the non-resident shareholder, based on the provisions of the Act or the provisions of the Double taxation avoidance agreement ('DTAA'), whichever is more beneficial.

Assuming the non-resident shareholder is earning only dividend income from India, they would now need to undertake the following compliances.

  Nature of compliance Value of international transaction - Threshold ('INR') Due Date
  Filing of the TP certificate in Form No. 3CEB No monetary threshold for filing 31 October
  Preparation and maintenance of TP Study Report pls shift this above the 3CEB row… In case the value of transactions is in excess of INR 1 crore 31 October
  Filing of Form No. 3CEAA - Part A In case the value of transactions is in less than of INR 50 crore 30 November
  Filing of Form No. 3CEAA - Part A and B In case the value of transactions is in excess of INR 50 crore 30 November

It would need to be seen how taxpayers benchmark dividends and justify the arm's length price of such payments (considering dividends are in essence an appropriation of profits which are arrived at after providing for all expenses). Moreover, determination of the amount of dividends to be paid also is typically a rather subjective exercise depending upon the management philosophy and could be influenced by factors such as the company's profitability, capital needs and extent of leverage in the financial structure, shareholder expectations, etc.

 6.  Amendments proposed in Sec 144C of the Act relating to the Dispute Resolution Panel ('DRP')

The DRP provisions have been expanded to include coverage to all non-residents with effect from Assessment Year ('AY') 2020-21 and to include cases where the Assessing Officer ('AO') has proposed any variation which is prejudicial to the interests of the taxpayer (even though it may not result in any variation to the taxpayer's income or loss).

Expanding coverage of eligible taxpayers is a welcome amendment as even non corporate assesses such as individuals, partnership firms, Limited Liability Partnerships, etc. shall be eligible to avail of the DRP route, which is often perceived as a fast track mechanism to reach the Income-tax Appellate Tribunal (Tax courts).

Further allowing eligible assesses to avail of the DRP route against prejudicial directions of the AO or those initiated by the TP Officer ('TPO') without there necessarily being any variations in the income or loss as stated above, should afford taxpayers an opportunity to contest against various observations made by the AO/TPO such as recharacterization of services, rates at which particular income is taxable (under the Act or the respective DTAAs), etc.

Way Forward

To summarize, while the TP related Budget wish list seemed to seek several amendments including aligning of the 'range' with the globally accepted inter quartile range, doing away with the additional requirements in the Indian MF templates, etc., the Union Budget 2020 has introduced several positive TP amendments, most of which seem to be in line the Government's commitment of reducing litigation. It would be interesting to see the manner and efficacy with which the proposed amendments are actually implemented by the IRA - this should be the determining factor to measure their success.

Annexure

Table 1 - compliance timelines

Nature of compliance Due date
Filing of return of income 30 November
Filing of master file ('MF') in Form No. 3CEAA 30 November
Filing of MF designation form in Form No. 3CEAB 31 October
Preparation and maintenance of TP study report 31 October
Filing of Form No. 3CEB 31 October

Table 2 - Current provisions as per Section 94B of the Act

Sr. No. Residential status of the lender / guarantor Residential status of AE referred in proviso Applicability of provisions
1 Resident Resident / Non-resident No
2 Foreign branch of a resident Resident No
3 PE in India of a non-resident (engaged in banking or non-banking business) Resident / Non-resident Yes
4 Non-Resident Resident / Non-resident Yes

Table 3 - Proposed provisions as per Section 94B of the Act

Sr. No. Residential status of the lender / guarantor Residential status of AE referred in proviso Applicability of provisions
1 Resident Resident / Non-resident No
2 Foreign branch of a resident Resident No
3 PE in India of a non-resident engaged in banking business Resident / Non-resident No
4 PE in India of a non-resident engaged in business other than banking business Resident / Non-resident Yes
5 Non-Resident Resident / Non-resident Yes

_____________________

 1.  Budget highlights published by Ministry of Finance on 1 February 2020

 2.  Budget speech dated 1 February 2020

 3.  Effective for compliances due for FY 2019-20 and onward

 4.  Resident assessee or permanent establishment of a foreign company

 5.  Effective from 1 April 2020

 6.  Effective from 1 April 2020

 7.  Sec 271AAD(1) of the Act