Author: Purti Srivastava, V year of B.B.A.,LL.B.(Hons.) from Bennett University, Greater Noida
Co-author: Indrayudh Chowdhury, V year of B.B.A.,LL.B.(Hons.) from Bennett University, Greater Noida
A tax has been defined as a compulsory monetary burden issued upon individuals by a competent authorityto aid the cause of the government’s revenue. A proper taxation system is one which keeps the government’s revenue consistent, stimulates growth in the economy, and increases industrial activity. In India, Article 265 of the Indian Constitution states that the right to levy taxes has not been given to anybody except by the authority of law. The authority of the law allows both the Central and the State government to make laws regarding taxation in India under the Union, State, and Concurrent Lists (Article 246(1), Article 246(3), and Article 246(2) respectively). The government uses the amount collected for its working and the upkeep and development of public infrastructure.
In this system of taxation, we have concepts of “safety harbor”, “transfer pricing”, and “arm length price”, all of which would be discussed by the authors in the current research paper. The paper would be divided into sub-chapters, all of which would discuss their own respective sub-topics. The researchers would analyze and write their findings on the various topics mentioned and also explore the co-relation existing between these topics and their application. The researchers would use the analytical approach of research methodology to complete this present paper.
SAFE HARBOUR AND ITS APPLICATIONS
Every citizen of India has an inherent duty to pay the taxes that have been levied on them by the competent authorities by the virtue of them being residents or working in India. The Government levies such taxes for the societal development and the welfare of its population, and thus, it is ultimately beneficial for a taxpayer (also known as an assessee) to fulfil his liability in order to help himself. An assessee’s tax liability is calculated based on his/her total income in the previous year according to the provisions of the Income Tax Act 1961 and the Income Tax Rules 1962, and such a person can avail certain exemptions and deductions to reduce his liability under the provisions of the Act. However, under no circumstances can an assessee avoid or evade his tax liability to reduce it as such an act would result in the contravention of the law of the land, leading to a possible fine or even imprisonment.
The concept of globalisation has also openeda nation’s economy to towards the rest of the world, allowing Multinational Corporations and Firms (also known as MNC’s) to enter domestic markets. These MNC’s, like every other ordinary assessee have to pay the tax liability due from them by virtue of the business they conduct on foreign soil. The problem that arises in this instance is that such corporations usually are always on the lookout for the lowest tax slabs available to them to shift their profits and revenue to for the motive of profit maximisation. This is where the concept of “Transfer Pricing” (also known as TP) is introduced, which is a technique used by MNCs to shift their profits out of the countries where they are currently operating in (with high tax rates) and into tax havens (with low tax rates) wherein the MNC sells itself (under the guise of a subsidiary) goods and services at an exorbitant price. If a subsidiary charges high prices on goods and services from its parent company, that means that the revenue and profits earned by the parent company in the country which it operates (with high tax slabs) will be shifted to its subsidiary in another country with less or even no taxation rates. This allows such corporations to evade their rightful responsibility by taking advantage of the relaxed guidelines and regulations established under the theme of globalisation. The Income Tax Act has laid down various provisions in Section 92 for the purpose of computing equitable tax liability in such situations so that the amount due to be taxable in India does not get diverted to other places by altering the charges for the goods or services and conducting intra-group transactions.
The concept of Transfer Pricing gives birth to the term “Arm Length Price”, which refers to a price which is proposed or applied in a transaction between persons other than associated enterprises, in uncontrolled situations. This term exists because Section 92 states that any income arising from an international transaction shall be computed having regard to the arm’s length price. The most appropriate technique for the calculation of the arm’s length price (provided under Rules 10A, 10AB, 10B, 10C, and 10CA)is chosen based on the nature of the transaction, which are – (a) Comparable uncontrollable price method, (b) Resale price method, (c) Cost plus method, (d) Profit split method, (e) Transactional net margin method, and any other method that may be prescribed by the Central Board of Direct Taxes (also known as CBDT).
However, sometimes the Transfer Price is not equal to the Arm Length Price, and therefore, there needs to be an adjustment in the transfer price of an international transaction under Section 92C. Such adjustment in international transactions cause a lot of friction between the MNCs and the government, leading to the inception of the concept of “Safe Harbour”. Safe Harbour is laid down under Section 92CB of the Indian Tax Code[1] as "circumstances under which the income-tax authorities shall accept the transfer price disclosed by the assessee." The Rule establishes a minimal operating profit margin that a taxpayer should expect to make for specific types of overseas transactions, which, if met, will be considered arm's length by Indian tax authorities.The arm's length principle can be a time-consuming and resource-intensive operation. It may create a significant administrative burden on taxpayers and tax administrations, which is worsened by the complexity of the rules and the resulting compliance requirements.
This have prompted Organisation for Economic Co-operation and Development (also known as OECD) member countries to evaluate whether and when safe harbour laws in the transfer pricing domain might be appropriate.Permanent Establishment (PE) was not covered by the previous safe harbour regulations, which only applied to determining arm's length price for transactions between legal companies.Transfer pricing involves a lot of disputes amongst taxpayers and tax authorities on how much should be the margins what should be the Arm’s Length Price (also known as ALP).
Safe harbour rules for international transaction are a mechanism to reduce litigation, and implies circumstances under which the taxation authorities shall accept the Transfer Price declared by the taxpayer. It provides for minimum operating margins in relation to an operating expense, which a taxpayer is expected to earn from certain international transactions if that is deemed to be acceptable by the tax authorities. Safe harbour rule generally contains details on the following –
a. Sector in which the assessee operates
b. Turnover for which they are covered
c. Margin that should be earned by them to be eligible for Safe Harbour Rules
It is the Central Board of Direct Taxes which has extended the application of the rates of the safe harbour rule as a means of dispute resolution mechanism for the issues and problems related to transfer pricing. Different rates have been mentioned under these rules for different categories of international transactions. For example, the transactions related to software development services will be eligible for safe harbour rules which has profit margin less than 17% and the size of the transaction is up to Rs. 100 Crores and 18% if the size of the transaction is above Rs. 100 Crores and is up to Rs. 200 Crores.
Safe Harbour Rules are guidelines which increase the ease of doing business in the domestic market and help ensure that corporations do not turn away from a country just due to the tax rates. It is a very important tool that helps stimulate the growth and development of an economy, but on the flip side, this rule can also be used by individuals with malicious intent looking to exploit the system and the benefits and leeway they provide. A person looking to decrease their tax liability may use this rule without hesitation to report a lower amount than what they owe to the government, thereby skirting the system. Therefore, the law has clearly laid down the categories under which an assessee is qualified to access the rule. The eligible assessees under the Safe Harbour Rules (Rule 10TB) are[2]
a. An assessee who provides software development services, information technology-enabled services, or knowledge process outsourcing services to non-resident affiliated firms with minimal risk.
b. A person who has taken out a loan within the group.
c. A person who has backed you up with a corporate guarantee.
d. The one who is offering low-risk contract research and development services to a foreign principal that are entirely or partially related to software development.
e. The assessee who is engaged in supplying contract research and development services to a foreign principal that are entirely or partially related to generic pharmaceuticals medications and pose no major risk.
f. An assessee engaged in the production and export of core or non-core auto components, with original equipment manufacturer sales accounting for 90% or more of total revenue in the previous year.
g. The one who receives low-value-added intra-group services from one or more of its members.
This measure ensures that only eligible entities are able to benefit from the rule of Safety Harbour and it is not exploited by other people for their ill-gotten gains.
There also exists certain transactions under which Safe Harbour Rules can be applied –
a. Software development services
b. Knowledge Process Outsourcing Services (KPOS)
c. Information Technology related services
d. Advance of intra group loan
e. Contract research and development services wholly or partly related to software development
f. Contract research and development services wholly or partly related to generic pharmaceutical drugs
g. Corporate guarantee
h. Manufacture and export of core auto components
i. Manufacture and export of non-core auto components
j. Receipt of low value-adding intra group services from one or more members of the group.
Now that we know the eligibility and applicable rates for the safe harbour rules, let us look at the procedural aspect of the concept, which applies when an eligible assessee wants to apply the safe harbour rules to his transaction[1] –
a. An application must be first submitted to the Assessing Officer (also known as the AO) on or before the due date of furnishing the return in form 3CEFA. The form should clearly state the period for which the assessee wishes to apply the rules to.
b. In case of subsequent assessment years, the assessee should disclose the information of the eligible transactions, including their amount, profit margins, commission, and interest rates.
c. If the safe harbour option is found to be invalid by the competent authority (either the TPO or the Commissioner) for the subsequent period, it will also not be available for the next year.
d. By making a declaration with the assessing officer, the assessee can opt out of the safe harbour regulations for any subsequent period.
e. Upon the receipt of the application, the assessing officer must check the applicant’s eligibility and if necessary, the assessing officer may submit the matter to the TRP for determination of the assessee’s eligibility.
f. If the application is to be rejected, the assessing officer/TPO must give the applicant an opportunity to be heard.
g. The assessee then has 15 days from the date of receipt of the order to file an appeal against the assessing officer’s/TPO’s rejection order.
As discussed above, the safe harbour rule was introduced in the Indian taxation system in order to curbthe transfer of profits overseas in order to avoid tax liability. The introduction of this rule created certain benefits in the Indian economy which are listed below –
a. Simplifying and lowering the compliance costs for evaluating and verifying the necessary requirements for qualifying regulated transactions for qualified taxpayers.
b. The automatic approvals and self- assessment procedures have proved to be very beneficial.
c. Reducing or even eliminating the chance of litigation between the taxpayers and the revenue authorities.
d. Providing certainty to eligible taxpayers that the price charged or paid on qualifying controlled transactions would be accepted by tax administrations that have adopted the safe harbour rule, with a limited audit or without one beyond ensuring the taxpayer has met the safe harbour's eligibility conditions and complied with the provisions.
e. Advance knowledge and information about the range of profits or price, resulting in certainty in transactions.
f. Allowing tax administrations to shift administrative resources away from lower-risk transactions and taxpayers and toward more complicated or higher-risk activities and taxpayers.
g. Helps the taxpayers and the beneficiary for better planning of inter-group transactions.
As discussed above, the initiation of the Safe Harbour Rule in India bought forth numerous benefits that helped expand the domestic market, increased the government’s tax revenue, and also helped stimulate the economy. However, like all other things, the rules also come with certain drawbacks attached to it, which are discussed below –
a. Deviation from the arm’s length principle – When a safe harbour provides a simplified transfer pricing approach, it may not always correspond to the most appropriate technique under the general transfer pricing laws for the taxpayer's facts and circumstances. A safe harbour, for example, may compel the use of a specific method when the taxpayer may have judged that another method was the most suitable given the facts and circumstances. This could be construed as a violation of the arm's length principle, which calls for the adoption of the most appropriate approach.
b. Risk of double taxation, double non-taxation, and mutual agreement concerns – One of the main concerns raised by a safe harbour is that it may increase the likelihood of double taxation. In a country that provides the safe harbour, a tax administration may set certain parameters that are designed to increase reported profits and minimize the scrutiny that the transfer pricing procedures would bring. This could result in taxpayers in the country modifying the prices they have been charged or paid in order to avoid the scrutiny that the transfer pricing procedures would bring. When a country chooses to provide a safe harbour, it should carefully consider the various parameters that it sets in order to avoid double taxation. In addition, it should also be prepared to modify the safe harbour’s outcome in individual cases in order to minimize the risk of double taxation. This should be done in consultation with the other parties involved. If a country provides a safe harbour, but it does not consider double tax relief, then the risk of double taxation would be unacceptable. This would be inconsistent with the provisions of treaties.
c. Possibility of tax planning – Safe Harbours may also provide tax planning alternatives to the taxpayers. Entities may be enticed to change their transfer prices in order to move the taxable income to a different jurisdiction with a favourable taxation rate. People may also exploit these rules and committax evasion by entering into artificial arrangements.
d. Equity and Uniformity Issues – The division of taxpayers into two distinct categories, with one being given favourable conditions over the other to reduce their tax liability, would create equity and uniformity issues.
Now that we have discussed the eligibility criteria, procedural aspect, and the benefits and drawbacks of the Safe Harbour Rules, let us analyse their applicability in a taxation system.[2]
Compliance and administration of transfer pricing is frequently complicated, time-consuming, and costly. Safe harbour laws that are properly conceived and utilised in suitable circumstances might help to alleviate some of these difficulties and provide greater assurance to taxpayers. Safe harbour provisions may raise issues such as having adverse effects on the pricing decisions of enterprises engaged in controlled transactions, as well as a negative impact on the tax revenues of both the country implementing the safe harbour and the countries whose associated enterprises engage in controlled transactions with taxpayers electing a safe harbour. Additionally, unilateral safe harbours may result in the possibility of double taxation or non-taxation.
However, in circumstances involving smaller taxpayers or less complex transactions, the advantages of safe harbours may exceed the drawbacks. Making such safe harbours available to taxpayers as an option can help to reduce pricing divergence from arm's length pricing. When countries use safe harbours, it's a good idea to be open to change safe-harbour decisions through mutual agreement proceedings to reduce the possibility of double taxation. Safe harbours, when agreed on a bilateral or multilateral basis, can give significant relief from compliance requirements and administrative complexity without causing double taxation or non-taxation difficulties. As a result, in the correct conditions, the usage of bilateral or multilateral safe harbours should be advocated.
A safe harbour, whether unilaterally or bilaterally adopted, is not binding on or precedential for countries who have not adopted the safe harbour. Safe harbours are unlikely to provide a viable alternative to a rigorous, case-by-case application of the arm's length principle under the provisions of these guidelines for more complicated and higher-risk transfer pricing problems.Country tax administrations should carefully assess the benefits and concerns of safe harbour rules before deciding whether or not to employ them.
The safe harbour guidelines' publication is a good move and a conciliatory step toward reducing transfer pricing disputes and thereby enhancing India's overall investment climate from a tax standpoint. However, there are a few concerns that come up during the discussion that need to be addressed for better execution and clarity.
• The global business environment changes with each passing year; the negative / positive influence of these changes should be considered when determining the ratios; otherwise, the ratios may not reflect international industry benchmarks or the current economic condition. There is currently no such provision or clarification byThe Chairperson of Central Board of Direct Taxes (CBDT).
• The requirement to keep necessary paperwork for overseas transactions has not been eliminated. Though one can grasp the logic, this level of partial comfort is unacceptable.
· There is a possibility of double taxation since one jurisdiction (where Safe Harbour Rule is implemented) reports larger than arms-length income than another jurisdiction (where SHR is not implemented). Additionally, taxpayers will need to assess the implications of a subsequent adjustment.
• Even if SHR is used, there will be a lot of subjectivity because IT & ITES and R&D are the most difficult areas that require thorough technical examination.
The researchers hope that by providing more transparency and addressing the above problems, the goal of introducing SHR to the public will be attained to the greatest extent possible.
[1]https://bathiya.com/safe-harbour-a-primer-into-a-promising-transfer-pricing-concept, last seen on 4th May 2022 at 10:36 PM. [2]https://www.oecd.org/ctp/transfer-pricing/Revised-Section-E-Safe-Harbours-TP-Guidelines., last visited 02/05/2022. [1] Income Tax Act, 1961. [2] https://ebizfiling.com/blog/all-about-safe-harbor-rules-in-india-know-the-safe-harbor-rates-in-india/, last visited 02/05/2022.