Union Budget 2018 is going to be the last full-year budget before the upcoming Lok Sabha Elections in 2019 and therefore there is a lot of speculation that it will be a populist budget. However, in an interview on 24 January, Prime Minister Narendra Modi gave indications that his Government will stay the course of the reforms agenda that transformed India from being among the “fragile five” economies of the world to becoming a “bright spot.”
The Government constituted a six-member task force under the chairmanship of Mr. Arbind Modi (Member, Central Board of Direct Taxes) on 22 November 2017 to draft a new income-tax law and replace the existing Income-tax Act, 1961. The task force is expected to submit its report in six months. Considering that there may be an overhaul of the existing income-tax provisions in the near future, the limited expectation from Budget 2018 will be to create a truly business-friendly environment in India and supplement the development agenda of the Government.
Joining the race to the bottom
India Inc. expects to see a reduction in the overall corporate tax rate in line with the suggestions made by the Finance Minister (FM) in his Budget Speech of 2015-16.
The recently announced US tax reforms reducing the headline corporate tax rates from 35% to 21% and a 20% excise tax levy on payments made by US corporations to their foreign subsidiaries coupled with a “territorial” tax regime like in Britain and Japan whereby US corporations will not be subject to any tax on capital gains and dividend income from investments in foreign subsidiaries will put pressure on the FM to reduce corporate tax rates. US corporations will be attracted to retain profits in the US, thereby impacting transfer pricing (TP) policies and remuneration to Indian subsidiaries. US MNCs operating in India would start to relook at the profits and the applicable taxes in India as that adds to their tax burden. As per an Organization for Economic Cooperation and Development (OECD) report of September 2017 an annual survey of tax policy, eight industrial countries cut their corporate tax rate by an average 2.7 percentage points. “An increase in corporate tax rate competition,” OECD secretary general José Angel Gurría wrote in the introduction to the report, “raises challenging questions for governments seeking to strike the right balance between maintaining a competitive tax system and ensuring they continue to raise the revenues necessary to fund vital public services, social programs and infrastructure.”
Given these recent developments, the FM will now be under even greater pressure to announce a corporate tax rate cut to keep India’s tax rate globally competitive.
R&D Circular 6 moderation
India competes with several countries in Europe and Asia for investment in R&D center hubs. While other countries provide incentives to MNCs for setting up global R&D hubs there, the Indian administration is not very clear in that regard. The conditions in Circular 6 act as a barrier to these companies to scale up their Indian operations. For example, if critical decisions are required for the smooth functioning of an R&D center, it will need to be based outside India for characterizing it as a contract R&D unit. This prevents the Indian company from going up the value chain and it remains a low-end service provider. If India needs to inculcate a culture of innovation and high-end R&D, an ecosystem of research needs to be created. The terms of Circular 6 therefore need to be reworked to encourage multinationals to move their key decision making to India and thus enable Indian R&D centers to move up the value chain.
Rationalize Safe Harbour Rules (SHR)
A reasonable safe harbour margin needs to be provided for contract manufacturers to promote Make in India. While the CBDT has rationalized the margin for various services such as IT, IT-enabled services, knowledge process outsourcing and R&D, no change has been made to the safe harbour margin for contract manufacturers of core and non-core auto components, which are very high. A reasonable cost-plus margin should be prescribed for toll manufacturing/contract manufacturing arrangements by MNCs with their Indian manufacturing units under TP regulations.
In case of overseas borrowing, the rates prescribed in the SHR are reasonable, but the mandatory condition of having the credit ratings of the overseas borrower approved by CRISIL may prove to be cost-prohibitive for the taxpayer in adopting the SHR.
Amendment in limitation of interest provisions
The introduction of the interest limitation rule in the Finance Act, 2017 demonstrated India’s commitment to the OECD-G20 Base Erosion and Profit Shifting (BEPS) project, even though Action Plan 4 dealing with limiting base erosion through interest and other financial payments did not constitute a minimum standard. Despite the fact that the regulations adopted the higher-end percentage of earnings before interest, tax, depreciation and amortization (EBITDA) as recommended by Action 4 of capping interest deductible between 10% and 30%, it may not be sufficient in case of capital-intensive industries with long gestation periods.
There may also be some groups which as per their group strategy are highly levered. In such cases, it will be a hardship for the taxpayers to apply only the fixed interest to EBITDA ratio for interest deduction limitation. BEPS Action Plan 4 provides for a Group Ratio Rule wherein a group’s overall third-party interest as a proportion of the group’s EBITDA is computed and that ratio is applied to the individual company’s EBITDA to determine the interest restriction.
This would take into account the actual third-party debt and leverage at the global level vis-à-vis third parties. This would also address the issue relating to inherently highly leveraged industries since the global leverage ratio would take into account the significant debt and would be commensurate with the leverage ratio required at the individual country level. Given this, a relatively fair leverage requirement at the India level would emerge.
Another issue that needs clarity is the term “implicit” in reference to “implicit or explicit guarantees” provided by an associated enterprise (AE). The revenue officers without any clarity may be tempted to color any loan taken by the Indian subsidiary of a foreign multinational corporation from third-party banks as being backed by an “implicit” guarantee provided by the foreign parent.
Concept of base erosion on an overall basis
Currently, the law on TP in India is debatable on the concept of base erosion. A non-resident AE and a resident AE should be assessed on a consolidated basis rather than a standalone basis for base erosion evaluation. However, this principle has recently been ignored and both the entities have been treated individually, leading to double taxation. It is recommended that clarification in this regard be issued to uphold the principles of base erosion by considering non-resident and resident entities together and not on a standalone basis.
Number of comparables for the applicability of the range concept
The requirement to select at least six comparable companies for adopting the “range” seems to ignore the ground realities of many industries where the availability of quality data in the public domain on comparable companies is a challenge. Such industries would not be able to adopt the range concept as it is currently envisaged. Further, if during the audit stage the number of final comparables falls below the mandated 6, due to the rejection of certain comparable companies, the method of determining ALP will change from the “range” concept to the “arithmetic mean” concept, which might add to the complexities and increase litigation. Hence, it is recommended that no minimum number of comparable entities be specified as a prerequisite for the use of the “range” concept.
Broadening the interquartile range to 25%–75%
The rules provide a 35th to 65th percentile range of the data set, which may not provide relative reliability on the comparable price. This range is narrower than the interquartile range of 25th to 75th percentile, restricting the set of finally selected comparables. Further, the use of the interquartile range is a globally accepted best practice and also closer to the economic realities wherein prices, or margins, are compared to those within a range and not at a particular point. It is recommended that the rules be modified to provide that the interquartile range from the 25th to 75th percentile be used to test the arm’s length nature of a transaction. The 35th to 65th percentile range creates issues while resolving issues with other jurisdictions.
To conclude, Budget 2018 provides an opportunity to the Government to create a truly business-friendly environment in India and supplement its development agenda.
The Government is promoting various programs such as Make in India and Ease of Doing Businesses in India to generate employment opportunities, boost investment in India and attract resources for infrastructure development. With these objectives in mind, it is very critical that the tax administration provide clarity to the taxpayers. A clear guideline on TP issues would reduce unnecessary controversy and make it easier for taxpayers to do business in India.
The author of this blog is Archana Gupta, Director, International Tax and Transfer Pricing, EY India