The Finance Bill 2017 proposed few changes in relation to transfer pricing and aligning the Indian regulations to the Base Erosion and Profit Sharing ('BEPS') Action Plan.
One of the taxpayer friendly proposal is the omission of reporting of transactions with persons such as directors, relatives of directors, an entity in which the taxpayer has substantial interest, etc. This amendment will take effect from Financial Year (FY) 2016-17. The low number of referrals made to the TPO in relation to such transactions in the recently concluded assessments was an indicator for this change. However, transactions which affect the profit linked exemption seeking entities and tax holiday units would still continue.
The other proposed change being inclusion of the concept of secondary adjustment in respect of transfer pricing adjustment exceeding INR 10 million. This represents an internationally recognized method to align the economic benefit of the transaction with the arm's length position.
As per OECD guidelines, secondary adjustment, i.e. the excess funds transferred, may be in the form of constructive dividend, constructive equity contributions or constructive loans. India has framed the provisions in order to treat the funds which have not been repatriated to India within the prescribed time period as an advance and an interest on the same to be imputed based on the prescribed rate. Countries such as USA, South Africa, Canada, Korea, etc. treat them as either deemed dividend or capital contribution. UK has also proposed to introduce secondary adjustment which is similar to that introduced by India.
Some key points which require a thought:
- The provision relating to secondary adjustment comes into effect from FY 2017-18, however, one of the exception states that FY commencing on or before 1 April 2016 would not be covered. The Government needs to provide clarity on the applicability of this proposed provision to FY 2016-17.
- There is no clarity in the tax treaties entered by India on whether it covers the allocation of funds as a result of secondary adjustment; it may lead to double taxation.
- The interest rate to be prescribed in the case of secondary adjustment should ideally be LIBOR and not Prime Lending Rate.
- The Government needs to provide clarity on the period from which the interest on the secondary adjustment needs to be computed.
- There is no clarity whether it is within the powers of the Assessing Officer ('AO') to compute the interest and tax thereon during the assessment proceedings if the funds are not repatriated to India within the prescribed time period.
- Likelihood of complications and further disputes in application of secondary adjustment where transactions with various related entities or various transactions are aggregated.
The interesting proposal of limiting the deduction of interest expense (exceeding INR 10 million) to 30% of EBITDA or interest paid to related entity, whichever is less, is with the intent of India's continued commitment to be aligned to the BEPS Action Plan. This stems up from the fact that multinational groups have been achieving favorable tax results by adjusting the amount of debt in a group entity.
While this change is to align with the BEPS Action Plan, there are certain deviations such as the restriction applies to interest payments made to related entities whereas BEPS Action Plan includes even third party interest expense. BEPS Action Plan limits the deduction of net interest whereas the proposed Indian regulation considers gross interest. Another difference is that the excess capacity (allowable deduction in excess of actual interest expense) is allowed to be carried forward whereas only disallowed interest expense is allowed to be carried forward as per proposed Indian regulation.
Certain countries, such as Argentina, Australia, Canada, China and Japan have adopted the debt-equity ratio to restrict the interest payments whereas other countries, such as Finland, Germany, Spain, South Africa and United Kingdom, have adopted the methodology of restricting the deduction of interest payments to a percentage of EBITDA. Argentina, re-characterizes the excess interest as dividend on which tax is withheld whereas UK and Spain allow carry forward of the excess capacity.
Some key points which require a thought:
- In the first year of application of the proposed provision, it is likely that there could be double taxation to the extent of the excess interest which is disallowed since it would be taxed in the country of the lender as well as in India.
- Where the interest expense is not at arm's length, it is not clear if the disallowed interest expense allowed for carry forward should be restricted to the arm's length interest.
- From the proposed provisions it could be possible to carry forward the disallowed interest even in cases where the return of income is not filed within the prescribed due date.
- The proposed provision does not clarify what happens in peculiar situations like, business restructuring, mergers and acquisitions etc.
The Indian Government has introduced a positive change by reducing the compliance burden from the taxpayers on domestic transfer pricing. On the other hand, there could be certain challenges for taxpayers on introduction of secondary adjustment and limitation of deduction for interest expense.
Devang Buddhadev, Senior Manager and Ruben Menezes, Manager at Deloitte Haskins & Sells LLP
[The views expressed in this article are personal views of the authors]