India: more certainty for investors, or less? Actions to take re the latest on GAAR, TP safe harbors, subsidiary PE

by DLA Piper
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Recent legislative and case-law developments have clarified India’s position on a number of tax and transfer pricing issues. While many of these developments are intended to increase certainty for foreign investors, a number of open questions remain. Although certainty is one element of rebuilding confidence in India, certain recent clarifications may not have the intended impact of attracting increased foreign direct investment.

Clarification of the General Anti-Abuse Rule

The Indian Central Board of Direct Taxes (CBDT) issued implementation rules for India’s General Anti-Abuse Rule (GAAR) on September 23, 2013. The implementation rules made the following clarifications on how the GAAR will be applied. The rules:

  • Confirmed the Indian Finance Minister’s January announcement that the GAAR’s effective date has been delayed until April 1, 2016
  • Included a safe harbor rule which would exempt transactions resulting in a tax benefit of less than INR 30 million (just over US$800,000)
    • Note that this is a tax-effected number, so the safe harbor transaction value will be larger, but will depend on the tax rate applicable to the particular transaction.
  • Provided three exemptions:
  • Exemption 1 - Foreign Institutional Investors (FIIs) that are subject to tax in India, have not claimed treaty benefits and have invested in Indian securities with the permission of the competent authority
  • Exemption 2 - Nonresidents investing directly or indirectly in an FII through offshore derivative instruments
  • Exemption 3 - Income from the transfer of investments made before August 30, 2010

The following are important considerations in evaluating these exemptions:

Exemption 1:  It is interesting to note that FIIs are not currently required to obtain the permission of the competent authority to invest in Indian securities. As a result, the intent of the “permission” requirement is not clear.

Exemption 2:  The reference to “indirect” investments relates to the controversial provisions in the current Indian Tax Act and the proposed Direct Taxes Code that subject certain indirect transfers of Indian shares by nonresidents to Indian tax. These provisions have been the subject of the long-fought US$2.2 billion dispute between Vodafone and the Indian tax authorities over Vodafone’s indirect acquisition of an Indian company from a nonresident in 2007.

Exemption 3:  Notwithstanding the April 1, 2016 overall implementation date and the August 30, 2010 cutoff date stated in this exemption, the implementation rules also state that a tax benefit obtained on or after April 1, 2015 will be subject to the GAAR, regardless of when the arrangement began. The varying implementations dates may create confusion for both taxpayers and the tax authorities.

Although the clarifications and exemptions contained in the implementation rules may increase certainty for foreign investors, lingering uncertainty remains in a number of areas. It will be important for the remaining uncertainty to be addressed and for the GAAR to be implemented in a consistent and transparent manner.

In the meantime, taxpayers should evaluate their transactions involving India in light of the implementation rules – in particular the safe harbor rule – which may allow flexibility previously unavailable. To the extent non-Indian companies have established financial statement reserves in anticipation of the GAAR, the safe harbor rule and exemptions may also provide an opportunity to release those reserves.

Understand the impact of the transfer pricing safe harbors

The CBDT issued final transfer pricing safe harbor rules on September 19, 2013. The primary rules are as follows:

  • The safe harbor provisions do not apply to transactions with group entities located in specified countries or in any country with a maximum tax rate below 15 percent.
  • If the safe harbor provisions are applied, the taxpayer is not eligible to use the mutual agreement procedure under the relevant Indian tax treaty.
  • The safe harbor provisions apply to the following transactions:
    • Providing software development services, information technology enabled services or knowledge process outsourcing services with “insignificant risk”
    • Making intercompany loans
    • Providing corporate guarantees
    • Providing contract R&D services relating to software development or generic pharmaceutical drugs with “insignificant risk”
    • Manufacturing and exporting of certain automotive components, where 90 percent or more of total revenue during the prior year arises from OEM sales.

To determine whether there is “insignificant risk,” the Indian tax authorities will review a number of factors that focus on whether the foreign principal is performing the most significant functions, providing the funds and most significant assets (including intangibles) and overseeing the services performed in India, while the Indian entity is assuming no significant economic risk and retaining no ownership (legal or economic) in any developed intangibles.

Thus, in order to apply the safe harbor rules, it will be important for companies to review their agreements with Indian affiliates to ensure they clearly document these factors. Importantly, the safe harbor rules also make clear that the terms of intercompany agreements are not definitive – these factors must be implemented in practice to qualify. As a result, companies should also perform an operational review to ensure these factors are being applied by the business.

The safe harbor percentages for qualifying transactions are as follows:

  • Software development services – operating margin of at least:
    • 20 percent (up to INR 5 billion) or
    • 22 percent (over INR 5 billion)
  • Information technology enabled services – operating margin of at least:
  • 20 percent (up to INR 5 billion) or
  • 22 percent (over INR 5 billion)
  • 25 percent
  • Bank of India base rate plus 150 basis points (up to INR 500 million)
  • Bank of India base rate plus 300 basis points (over INR 500 million)
  • 2 percent of debt per year (up to INR 1 billion)
  • 1.75 percent of debt per year (over INR 1 billion if the beneficiary of the guarantee has a credit rating of “adequate to highest safety”)
  • 30 percent
  • 29 percent
  • 12 percent (for core automotive components)
  • 8.5 percent (for non-core automotive components)
  • Knowledge process outsourcing services – operating margin of at least:  
  • Making of intercompany loans – interest rate of at least:
  • Providing corporate guarantees – commission of at least:
  • Contract R&D services (software development) – operating margin of at least:
  • Contract R&D services (generic pharmaceutical drugs) – operating margin of at least:
  • Manufacturing and exporting of automotive components – operating profit of at least:

These safe harbor percentages are available for five years beginning with the 2012-2013 Indian tax year, which is an improvement over the previously proposed two-year period. The previously proposed ceiling, which would have excluded taxpayers with over INR 1 billion in annual revenue from eligibility, has been eliminated from the final rules. Thus, larger taxpayers may also benefit from these rules.

On the other hand, when viewed from an international perspective, the safe harbor percentages appear high. As a result, although they create certainty from an Indian perspective, they could also cause Indian affiliates to be overpaid from an arm’s length perspective. This may create effective tax rate disadvantage compared with the traditional transfer pricing approach. Perhaps more importantly, it could result in double taxation, because the payor’s jurisdiction may not respect the safe harbor rates as arm’s length. Further, taxpayers are required to provide detailed documentation to the Indian tax authorities in order to apply the safe harbor rules - so taxpayers may not benefit from an administrative standpoint by using the safe harbor principles, rather than the traditional transfer pricing documentation approach.

Additionally, as described below, the Indian tax authorities have taken a very broad view of whether subsidiaries or other affiliates constitute permanent establishments (PEs) of a parent company or other related principal. The “insignificant risk” requirement requires the non-Indian principal to be heavily involved in the activities of the Indian company applying the safe harbor rule. This creates a potential for multinationals to be whipsawed, because the Indian tax authorities could assert that the non-Indian principal’s level of involvement causes the Indian company to become its PE in India. Thus, for the “insignificant risk” rule to work in practice, multinationals will have to walk a fine line in their level of involvement in the activities of an Indian affiliate opting into the safe harbor rules.

Accordingly, multinationals should consider the advantages and disadvantages of applying the safe harbor rules in their particular situations. For some taxpayers, the certainty provided by the safe harbor rules will outweigh the downside risks. For others, the transfer pricing and PE risks, combined with a lack of a meaningful administrative benefits, will weigh against opting in.

Consider new cases on subsidiary PEs

In two recent cases, the Indian Income Tax Appellate Tribunal (ITAT) has held that Indian subsidiaries of multinational companies constitute Indian PEs of their non-Indian affiliates. Although it is clear that countries may deem a subsidiary to be deemed a PE of an affiliate, the international consensus is that this requires an analysis based on general PE principles (i.e., without taking into account that the two companies are affiliates). The Indian tax authorities have taken an aggressive approach to applying this principle, and the ITAT has agreed in these cases.

In Convergys Customer Management Group Inc. v. ADIT, the taxpayer was a US company with a subsidiary in India. The Indian company provided call center and back-office support to the US company. The US company had no business activity in India and bore the vast majority of the risk related to the Indian company’s services. The ITAT found that the US company frequently sent employees to visit the Indian subsidiary to supervise, direct and control its activities and that these employees had a fixed place of business at their disposal. The ITAT further found that because of the US company exercised complete control and guidance over the Indian subsidiary, the Indian subsidiary was effectively the US company’s PE in India.

It is not clear from the facts of the case whether the US company’s employees actually conducted the US company’s business from the Indian company’s premises. Instead, the ITAT focused on the level of control exerted by the US company over the Indian subsidiary – a level of control that does not appear uncommon in parent/subsidiary relationships. Thus, Convergys casts doubt on the generally held view that incorporating a subsidiary and compensating it at arm’s length insulates a parent company from PE risk. This case also creates uncertainty as to how low the PE threshold is for subsidiaries of multinationals, particularly where the subsidiary is performing relatively routine administrative functions and the parent exercises common parent-level management functions.

On the other hand, the ITAT recognized that when attributing profits to a PE, once an arm’s length amount of profit has been attributed, no further profits should be attributed to a PE. Nevertheless, the ITAT went on to lay out a formula-based approach to profit attribution that was inconsistent with general transfer pricing principles. Thus, Convergys casts further doubt on both the level and quantity of PE/attribution risk when operating in India through a subsidiary.

In Abacus International Pvt Ltd v. DDIT, the taxpayer was a Singapore company with a subsidiary in India. The Indian subsidiary marketed the parent’s computerized reservation system (CRS) to travel agents in India. As Indian travel agents made reservations through the CRS, the Singapore company paid the Indian subsidiary a marketing fee equal to 25% of its revenues.

The ITAT held that the Indian subsidiary was a dependent agent PE of the Singapore parent. It was not clear whether the Indian company actually concluded contracts in the parent’s name. The ITAT focused on the fact that the subsidiary marketed the Singapore parent’s CRS to the Indian travel agents, that the travel agents then booked flights on the CRS, and that the Singapore company generated all of its Indian sales through the Indian subsidiary. Thus, as in Convergys, the ITAT appears to have applied a low threshold to find that an Indian subsidiary is a PE of a foreign parent in a relationship that is not uncommon in multinational groups (i.e., a local marketing service provider for a foreign principal).

However, the ITAT did provide some helpful guidance by confirming that general transfer pricing principles (i.e., functions, risks and assets) should be used to attribute profits to the PE. After analyzing the Indian subsidiary’s profits in this light, the ITAT determined that it had earned more than an arm’s length amount of profit and that, as a result, no additional profits should be attributed to the Singapore parent’s PE in India. Thus, although the Singapore company was deemed to have a PE in India by virtue of its subsidiary’s activities, the parent received credit for the profits of the subsidiary and was not subject to additional Singapore tax.

These two cases, taken together, raise a number of issues, primarily:

  • Multinationals should review the level of involvement of non-Indian affiliates in the activities performed by Indian companies and assess the associated PE risk.
  • Provided that the Indian company has earned an arm’s length profit from its activities, although it may constitute a PE for a foreign affiliate, there may be no additional profit attributable to the PE.
  • There is lingering uncertainty as to how profits should be attributed to a PE – through general transfer pricing principles (functions, risks, and assets), through a formulary approach, or through some other mechanism – so taxpayers should ensure that their transfer pricing policies and documentation for India are robust and take into account recent developments.

Thus, although it is now clear that a subsidiary may create a PE in India for the parent company, both the PE threshold and the methodology for attributing profits remain uncertain.

These issues further cut against the Indian government’s goal of establishing a level of certainty to help restore India’s place as a preferred destination for foreign direct investment.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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