Revised circulars: A change in FinMin stance

The move reflects willingness of the finance minister and the CBDT to remain flexible to emerging needs of the new business models

The revised circulars issued by the government, last week, on the determination of transfer pricing (TP) for development centres (DCs) are truly an unprecedented and welcome initiative. They reflect the willingness of the finance minister, and the Central Board of Direct Taxes, led by the new Chair, Sudha Sharma, to remain flexible to the emerging needs and practical realities of the new business models. They could also mark a turning point in the attitude of tax authorities from adversarial to conciliatory.

The move of the finance ministry would address a fundamental problem faced by the tax administration. India is riddled with a large volume of international tax disputes, with most of them relating to transfer pricing. The financial year just gone by recorded TP adjustments of more than Rs 70,000 crore, an increase of 57 per cent over the previous year! Despite the assurances made by the finance minister publicly that the disputes will be minimised, the income tax department has continued to raise demands and make aggressive assessments.

The consequent litigation has clogged the judicial system and blocked revenues for the government. To make matters worse, the adversarial approach has contributed to the perception of India as one of the most difficult tax administrations in the world and raised doubts about its seriousness for attracting investments. India runs a serious risk of losing ground to other jurisdictions due to its adverse policies.

Responding to the all-round concerns about the mounting disputes, the prime minister had appointed the Shome Committee to examine the GAAR and retrospective provisions and the Rangachary Committee to look into the taxation of R&D centres. Both the committees provided a good roadmap for bringing the changes that Chidambaram alluded to in his first public message after taking over as the FM. He had assured that the government was committed to providing clarity in tax laws, a stable tax regime, a non-adversarial tax administration, fair mechanism for dispute resolution and an independent judiciary.

Keeping his promise, the FM has already announced significant changes in GAAR in tune with the Shome Committee recommendations. And now, the revised TP circulars reflect the recommendations of the Rangachary Committee. These are indeed welcome measures for the industry.

The IT sector has been the sunshine sector for India, putting it among the fastest developing economies of the world. The sector has helped inculcate a culture of knowledge and innovation and has been instrumental in enhancing job creation in the country. It has made India an attractive destination for software development centres of multinational companies. However, it has been facing serious roadblocks on account of India's tax administration.

Normally, the DCs undertake research and software development under contract with the parent, for which they receive compensation equal to their costs plus a profit margin. This method of reporting revenues, transactional net margin method (TNMM), is appropriate where DCs act as contractors, not having any ownership interest or bearing any significant business risks in the outcome of the research. The authorities have argued that this method results in insufficient allocation of profits to India and have been favouring the profit split method (PSM) for determining the transfer prices, especially where the research relates to products which are yielding significant profits to the parent.

The Rangachary Committee provided a strong and unequivocal endorsement of the TNMM followed by the taxpayers. It emphasised that the PSM is neither conceptually appropriate for contract research, nor practicable.

The committee also makes a fascinating diagnosis of what ails the tax system in India. In most cases giving rise to disputes, the committee found the interpretations and positions taken by the Income Tax Department aggressive and arbitrary, not supported by law. This is interesting, considering that Rangachary himself is a former Chair of the CBDT and the committee had two other senior officials from the department. Their views cannot be seen to be one sided, favouring the industry. Their rejection of the positions taken by the department is indicative of the adversarial attitudes of tax administration in India. In most cases, the judiciary reverses the decisions of the department, but in the meanwhile the taxpayers are left facing the protracted litigation process.

The initial TP circulars regarding DCs had come as a complete surprise to the industry and appeared to be contrary to the recommendations of the Rangachary Committee. Rather than providing clarity on the methods to be used on the pricing of services provided by the DCs, they confused the issue by emphasising that PSM is the preferred method for transfer pricing. Even the conditions required for the use of TNMM were too restrictive, bringing in subjectivity in their application.

The circular indicating PSM to be the preferred method is now withdrawn, and other revisions provide greater flexibility for taxpayers to qualify their arrangements as "contract research" eligible for TNMM. However, the revisions fall short of an explicit endorsement of the Rangachary Committee's recommendation for the use of TNMM. Let us hope that the CBDT officials apply the revised circular in conformity with the committee report. If so, the TP disputes and litigation could reduce drastically.

These changes and the other reform measures announced recently by the government are a step in the right direction and couldn't have come sooner. India's grim economic situation, compounded by a high current account deficit and the weakening of the rupee has perhaps persuaded the government to act tough and take decisive measures.

The recent decision to increase the domestic gas prices and link them to international prices is another example of such decisive measures. It should spur investment in exploration and production and boost domestic gas output.

The prime minister has also emphasised the need for long-term capital flows, including FDI. Investments would come, but only when such sure and positive signals are sent to investors to reinforce the government's seriousness about providing a conducive investment environment in the country.

Satya Poddar, Tax Partner, EY

(Shalini Mathur, senior tax professional, EY also contributed to the article)

(Views expressed are personal)