A joint effort by India and the US to amicably decide on their respective shares of taxes from IT and ITeS companies operating in both countries is threatening to unravel, owing to a big, seemingly unresolvable gap between the transfer pricing (TP) margins individually determined by them. While New Delhi is unwilling to accept the margins made by India-registered IT companies from services rendered to related parties in the US in certain past cases to be anything less than 18%, the US tax authorities want India to agree to a much lower rate of 12-13%.
The discord surfaced in the exploratory Indo-US tax talks under what is called a mutual agreement procedure (MAP) — a provision in the double taxation avoidance treaty between the two countries — held in Washington in February. The inability of both sides to make headway in the first round of MAP talks increased the uncertainty over the tax liability of over 200 companies wanting to avoid their profits to be taxed twice. In case an MAP-based settlement doesn’t materialse, these companies would have little option but to approach courts to resolve the disputes.
For the US taxman, the payments made by a US company to its Indian subsidiary is a business expense that needs to be deducted from the profits of the former. A higher TP rate could mean a higher deduction and a resultant lower tax revenue for the US and hence the inclination to disallow higher deductions. India, on the other hand, reckons the profits of these firms to be higher as can be seen from the 20-30% rate prescribed by it for firms in different businesses to escape transfer pricing scrutiny under safe harbour rules.
TP rates are meant to denote the arm’s length price (what would have been between unrelated parties).
A revenue department official told FE that India has suggested the 18% rate in the MAP talks after an analysis of the margins, adding it was difficult to accept lower rates. Although there are several ways for the revenue department to determine the transfer pricing rates, in case of IT and ITeS companies, the cost-plus method is usually allowed.
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With stark differences in the February talks, Indian revenue authorities, sources said, are now trying to find a middle path for making headway in the next round of talks.
Since the 12-13% rate is internationally accepted, India is finding it difficult to hold to the higher margins, analysts said. In fact, under the safe harbour rules (SHR), the 20-30% margins have forced the majority of the companies to be out of it and therefore, only 30 applications were filed for the same in FY14, the first year of SHR.
The Rangachary panel – SHR rates were fixed based on its recommendations – found that while IT companies were quoting profit margins of 15%, TP officials thought they should be as high as 24%. The panel finally settled for a 20% SHR but this is too high to gain traction. Similarly, in the ITeS sector, while companies with a turnover of under Rs 500 crore were quoting margins of 15%, the transfer pricing officers wanted an average of 26% and the panel, again, recommended 20%.
In case of contract R&D in the IT sector, the Rangachary panel took a middle path by fixing 30% as profit margin – to balance the base rate of 20% and profit margins of some of the companies as high as 50-60%.
The Indo-US MAP negotiations had got stuck with the US side pressing for the removal of SK Mishra, joint secretary in charge of the international tax division, and talks resumed only after he was replaced by Akhilesh Ranjan on July 10 last year, when finance minister P Chidambaram was visiting the US to woo investors.
As per the strategy firmed up by the Indian side, of the 100-plus US firms including Microsoft which have filed for a solution under MAP for past cases, around 70 have now filed for unilateral advance pricing agreements (APAs), which detail how various expenditures and income are to be treated by the tax authorities for a (future) period of five years.
But these are unilateral APAs, which are not recognised by the US. The idea is to turn them into bilateral APAs so that they get a deduction in the US for the tax paid in India.
For this to happen, both the sides will have to first agree on the TP rate. “The Indian side will have to find a solution. Probably, the way forward could be to tackle the existing cases at a higher rate and new cases at the rate closer to what the US wants,” said the official quoted earlier.