When the transfer pricing regulations were introduced in India in 2001, transfer pricing was completely unknown. The onerous documentation requirements and stringent penalties prescribed by the regulations were a cause of concern for any taxpayer with international transactions, particularly as therewas no basis of knowing how the law would be implemented.
With the transfer pricing assessments having been completed and the recent Supreme Court and Appellate rulings on the subject, time has come to relook at the provisions and settle the controversies so that there is more certainty and fairness in the manner in which the law will be applied.
Moreover, the introduction of measures such as Advance PricingArrangements (APAs) and Safe harbour benchmarks for certain activities, aligning our transfer pricing regulations to OECD guidelines and other international best practices coupled with a drastic reduction in the penalties would go a long way in enhancing India’s reputation as an attractive foreign direct investment destination – a goal which successive governments have sought to achieve.
By its nature, transfer pricing involves compliance with the rules of at least two tax jurisdictions. The increased complexity of the transaction increased transfer-pricing compliance requirements and enforcement initiatives by tax authorities. Around the globe, taxpayers are faced with the complicated challenge of complying with often very different local rules and expectations from uncoordinated tax authorities, and responding to audits that could be done at different times and the case is not so different in India where transfer pricing is of recent origin when compared to other developed tax jurisdictions like the US, UK and Australia etc.
An Advance Pricing Arrangement ("APA") is anarrangement that determines, in advance of controlled transactions, an appropriate set of criteria (e.g. method,comparables and appropriate adjustments thereto, critical assumptions as tofuture events) for the determination of the transfer pricing for thosetransactions over a fixed period of time.
APAs represent a potential approach that can be used tomanage the challenge of responding to conflicting demands by different tax authorities. First, as APAs are negotiated prospectively, they could lead toreaching a principled Transfer Pricing Methodology that is not distorted by reactions to past results. Some countries allow for unilateral arrangements where the tax administration and the taxpayer in its jurisdiction establish anarrangement without the involvement of other interested tax administrations.
However, a unilateral APA may affect the tax liability of associated enterprises in other tax jurisdictions. Where unilateral APAs are permitted, the competent authorities of other interested jurisdictions should be informed about the procedure as early as possible to determine whether they are willing and ableto consider a bilateral arrangement under the mutual agreement procedure.
Because of concerns over double taxation, most countries prefer bilateral or multilateral APAs (i.e. an arrangement in which two or morecountries concur), and indeed some countries will not grant a unilateral APA(i.e. an arrangement between the taxpayer and one tax administration) to taxpayers in their jurisdiction. The bilateral (or multilateral) approach is far more likely to ensure that the arrangements will reduce the risk of doubletaxation, will be equitable to all tax administrations and taxpayers involved, and will provide greater certainty to the taxpayers concerned.
Recent judgments in the aspect of international tax inIndia have brought to the for the issue of profit allocation or income attribution and the concept of APAs also may be useful in resolving issues relating to allocation problems, permanent establishments, and branch operations.
An APA may cover all of the transfer pricing issues of ataxpayer (as is preferred by some countries) or may provide a flexibility tothe taxpayer to limit the APA request to specified affiliates and inter-company transactions. An APA would apply to prospective years and transactions and the actual term would depend on the industry, products or transactions involved.The associated enterprises may limit their request to specified prospective taxyears.
An APA can provide an opportunity to apply the agreed transfer pricing methodology to resolve similar transfer pricing issues in open prior years. However, this application would require the agreement of the tax administration, the taxpayer, and, where appropriate, the treaty partner.
Second, the tax administration may continue to examine the taxpayer as part of the regular audit cycle but without reevaluating the methodology. Instead, the tax administration may limit the examination of the transfer pricing to verifying the initial data relevant to the APA proposal and determining whether or not the taxpayer has complied with the terms and conditions of the APA. With regard to transfer pricing, a tax administration may also examine the reliability and accuracy of the representations in the APA and annual reports and the accuracy and consistency of how the particular methodology has been applied. All other issues not associated with the APA fall under regular audit jurisdiction.
An APA should be subject to cancellation, even retroactively, in the case of fraud or misrepresentation of information during an APA negotiation, or when a taxpayer fails to comply with the terms and conditions of an APA. Where an APA is proposed to be cancelled or revoked, the tax administration proposing the action should notify the other tax administrations of its intention and of the reasons for such action.
Advantages of Advance Pricing Arrangements
An APA programme can assist taxpayers by eliminating uncertainty through enhancing the predictability of tax treatment in international transactions.Provided the critical assumptions are met, an APA canprovide the taxpayers involved with certainty in the tax treatment of the transfer pricing issues covered by the APA for a specified period of time. In some cases, an APA may also provide an option to extend the period of time to which it applies. When the term of an APA expires, the opportunity may also exist for the relevant tax administrations and taxpayers to renegotiate the APA. Because of the certainty provided by an APA, a taxpayer may be in a better position to predict its tax liabilities, thereby providing a tax environment that is favourable for investment.
APAs can provide an opportunity for both taxa dministrations and taxpayers to consult and cooperate in a non-adversarial spirit and environment.The opportunity to discuss complex tax issues in a less confrontational atmosphere than in a transfer pricing examination can stimulate a free flow of information among all parties involved for the purpose of coming to a legally correct and practicably workable result. Then on-adversarial environment may also result in a more objective review of the submitted data and information than may occur in a more adversarial context(e.g. litigation). The close consultation and cooperation required between the tax administrations in an APA program also leads to closer relations with treaty partners on transfer pricing issues.
An APA may prevent costly and time-consuming examinations and litigation of major transfer pricing issues for taxpayers and tax administrations. Once an APA has been agreed, less resources may be needed for subsequent examination of the taxpayer's return, because more information is known about the taxpayer. It may still be difficult, however, to monitor the application of the arrangement. The APA process itself may also present time savings for both taxpayers and tax administrations over the time that would be spent in a conventional examination, although in the aggregate there may be no net time savings, for example, in jurisdictions that do not have an audit procedure and where the existence of an APA may not directly affect the amount of resources devoted to compliance.
Bilateral and multilateral APAs substantially reduce oreliminate the possibility of juridical or economic double or non taxation sinceall the relevant countries participate. By contrast, unilateral APAs do not provide certainty in the reduction of double taxation because taxadministrations affected by the transactions covered by the APA may considerthat the methodology adopted does not give a result consistent with the arm's length principle. In addition, bilateral and multilateral APAs can enhance the mutual agreement procedure by significantly reducing the time needed to reach an agreement since competent authorities are dealing with current data as opposed to prior year data that may be difficult and time-consuming to produce.
The disclosure and information aspects of an APAprogramme as well as the cooperative attitude under which an APA can be negotiated may assist tax administrations in gaining insight into complex international transactions undertaken by MNEs. An APA programme can improve knowledge and understanding of highly technical and factual circumstances in areas such as global trading and the tax issues involved. The development of specialist skills that focus on particular industries or specific types oftransactions will enable tax administrations to give better service to other taxpayers in similar circumstances.
Through an APA programme tax administrations have access to useful industry data and analysis of pricing methodologies in a cooperative environment.
Disadvantages relating to Advance Pricing Arrangements
Unilateral APAs may present significant problems for tax administrations and taxpayers alike. From the point of view of other tax administrations, problems arise because they may disagree with the APA's conclusions. From the point of view of the associated enterprises involved, one problem is the possible effect on the behaviour of the associated enterprises. Unlike bilateral or multilateral APAs, the use of unilateral APAs may not lead to an increased level of certainty for the taxpayer involved and a reduction in economic or juridical double taxation for the MNE group. If the taxpayer accepts an arrangement that over-allocates income to the country making the APA in order to avoid lengthy and expensive transfer pricing enquiries or excessive penalties, the administrative burden shifts from the country providing the APA to other tax jurisdictions. Taxpayers should not feel compelled to enter into APAs for these reasons.
Another problem with a unilateral APA is the issue of corresponding adjustments. The flexibility of an APA may lead the taxpayer and the related party to accommodate their pricing to the range of permissible pricing in the APA. In a unilateral APA, it is critical that this flexibility preserve the arm's length principle since a foreign competent authority is not likely to allow a corresponding adjustment arising out of an APA that is inconsistent, in its view, with the arm's length principle.
Another possible disadvantage would arise if an APA involved an unreliable prediction on changing market conditions without adequate critical assumptions, as discussed above. To avoid the risk of double taxation, it is necessary for an APA program to remain flexible, because a static APA may not satisfactorily reflect arm's length conditions.
An APA program may initially place a strain on transferpricing audit resources, as tax administrations will generally have to divert resources earmarked for other purposes (e.g. examination, advising, litigation,etc.) to the APA programme. Demands may be made on the resources of a tax administration by taxpayers seeking the earliest possible conclusion to an APA request,keeping in mind their business objectives and time scales, and the APA programmeas a whole will tend to be led by the demands of the business community. These demands may not coincide with the resource planning of the tax administrations, thereby making it difficult to process efficiently both the APAs and other equally important work. Renewing an APA, however, is likely to be less time-consuming than the process of initiating an APA. The renewal process mayfocus on updating and adjusting facts, business and economic criteria, and computations.
In the case of bilateral arrangements, the agreement of th ecompetent authorities of both Contracting States is to be obtained on the renewalof an APA to avoid double taxation (or non-taxation).
Another potential disadvantage could occur where one tax administration has undertaken a number of bilateral APAs which involve only certain of the associated enterprises within an MNE group. A tendency may exist to harmonise the basis for concluding later APAs in a way similar to those previously concluded without sufficient regard being had to the conditions operating in other markets. Care should therefore be taken with interpreting the results of previously concluded APAs as being representative across all markets.
Concerns have also been expressed that, because of the nature of the APA procedure, it will interest taxpayers with a good voluntary compliance history. Experience in some countries has shown that, most often, taxpayers which would be interested in APAs are very large corporations which would be audited on a regular basis, with their pricing methodology then being examined in any event. The difference in the examination conducted of their transfer pricing would be one of timing rather than extent. As well, it has not been demonstrated that APAs will be of interest solely or principally to such taxpayers. Indeed, there are some early indications that taxpayers, having experienced difficulty with tax administrations on transfer pricing issues andnot wishing these difficulties to continue, are often interested in applying for an APA. There is then a serious danger of audit resources and expertise being diverted to these taxpayers and away from the investigation of less compliant taxpayers, where these resources could be better deployed in reducing the risk of losing tax revenue. The balance of compliance resources may be particularly difficult to achieve since an APA programme tends to require highly experienced and often specialised staff.
Requests for APAs may be concentrated in particular areas or sectors, e.g. global trading, and this can over stretch the specialist resources already allocated to those areas by the authorities. Tax administrations require time to train experts in specialist fields in order to meet unforeseeable demands from taxpayers for APAs in those areas.
In addition to the foregoing concerns, there are a number of possible pitfalls as described below that could arise if an APA program were improperly administered, and tax administrations who use APAs should make strong efforts to eliminate the occurrence of these problems as APA practice evolves.
For example, an APA might seek more detailed industry and taxpayer specific information than would be requested in a transfer pricing examination. In principle, this should not be the case and the documentation required for an APA should not be more onerous than for an examination, except for the fact that in an APA the tax administration will need to have details of predictions and the basis for those predictions, which may not be central issues in a transfer pricing examination that focuses on completed transactions. In fact, an APA should seek to limit the documentation, as discussed above, and focus the documentation more closely on the issues in light of the taxpayer's business practices. Tax administrations need to recognize that :a) publicly available information on competitors and comparables is limited;b) not all taxpayers have the capacity to undertake in-depth market analyses; andc) only parent companies may be knowledgeable about group pricing policies.
Another possible concern is that an APA may allow the tax administration to make a closer study of the transactions at issue than would occurin the context of a transfer pricing examination, depending on the facts and circumstances.The taxpayer must provide detailed information relating to its transfer pricingand satisfy any other requirements imposed for the verification of compliance with the terms and conditions of the APA. At the same time, the taxpayer is not sheltered from normal and routine examinations by the tax administration on other issues. An APA also does not shelter a taxpayer from examination of its transfer pricing activities. The taxpayer may still have to establish that it has complied in good faith with the terms and conditions of the APA, that the material representations in the APA remain valid, that the supporting data used in applying the methodology were correct, that the critical assumptions underlying the APA are still valid and are applied consistently, and that the methodology is applied consistently. Tax administrations should, therefore, seek to ensure that APA procedures are not unnecessarily cumbersome and that they do not make more demand of taxpayers than are strictly required by thescope of the APA application.
Problems could also develop if tax administrations misuse information obtained in an APA in their examination practices. If the taxpayer withdraws from its APA request or if the taxpayer's application is rejected after consideration of all of the facts, any non factual information provided by the taxpayer in connection with the APA request, such as settlement offers, reasoning, opinions, and judgments, cannot be treated as relevant in any respect to the examination. In addition, the fact that a taxpayer has applied unsuccessfully for an APA should not be taken into account by the tax administration in determining whether to commence an examination of that taxpayer. Tax administrations also should ensure the confidentiality of trade secrets and other sensitive information and documentation submitted to them in the course of an APA proceeding. Therefore, domestic rules against disclosure should be applied.
In a bilateral APA the confidentiality requirements on treaty partners would apply, thereby preventing public disclosure of confidential data.
An APA program cannot be used by all taxpayers becausethe procedure can be expensive and time-consuming and small taxpayers generallymay not be able to afford it. This is especially true if independent experts are involved. APAs may therefore only assist in resolving mainly large transfer pricing cases. In addition, the resource implications of an APA program may limit the number of requests a tax administration can entertain. In evaluating APAs, tax administrations can alleviate these potential problems by ensuring that the level of inquiry is adjusted to the size of the international transactions involved.
At present, only a few OECD Member Countries have experience with APAs. Those countries which do have some experience seem to be satisfied so far, so that it can be expected that under the appropriate circumstances the experience with APAs will continue to expand. The success of APA programs will depend on the care taken in determining the proper degree of specificity for the arrangement based on critical assumptions, the proper administration of the program, and the presence of adequate safeguards to avoid the pitfalls described above, in addition to the flexibility and openness with which all parties approach the process.
There are some continuing issues regarding the form and scope of APAs that require greater experience for full resolution and agreement among Member countries, such as the question of unilateral APAs. While it is too early to make a final recommendation whether the expansion of such programmes should be encouraged, it seems likely that in certain circumstances they will aid in resolving transfer pricing disputes. Unilateral versus bilateral (multilateral) arrangements Wherever possible, an APA should be concluded on a bilateral or multilateral basis between competent authorities through the mutual agreement procedure of the relevant treaty. A bilateral APA carries less risk of taxpayers feeling compelled to enter into an APA or to accept a non-arm's-length agreement in order to avoid expensive and prolonged enquiries and possible penalties. A bilateral APA also significantly reduces the chance of any profits either escaping tax altogether or being doubly taxed. Moreover, concluding an APA through the mutual agreement procedure may be the only form that can be adopted by a tax administration which lacks domestic legislation to conclude binding agreements directly with the taxpayer.
