Volume 6, Issue 15

21 August 2013

Tax Alert

Draft Safe Harbour Rules: Headed to Safer Grounds?

The Central Board of Direct Taxes (CBDT) has finally released the most awaited “safe harbour” provisions in transfer pricing regulations. Safe harbour means circumstances in which income tax authorities shall accept the transfer price declared by the taxpayer. Safe harbours are being used across transfer pricing jurisdictions such as Australia, USA, Japan, Mexico, Brazil, New Zealand, Singapore and South Africa as an effective means of dispute resolution. They seek to reduce the compliance burden for taxpayers as well as the administrative burden for tax authorities.

The Union Budget 2010 provided an indication of the introduction of safe harbour rules. However, no rules had been formalised until now despite several assurances from the Government. Last year, a committee was formed, under the chairmanship of Mr Rangachary, to review the taxation of development centres and the information technology (IT) sector. One of the terms of reference to the committee was to engage in sector-wise consultations and finalise the safe harbour provisions. Following the recommendations of the Rangachary Committee, the CBDT has now released draft safe harbour rules for public consultation.

Highlights of the proposed rules

  • The safe harbour rules are not mandatory but eligible taxpayers having eligible international transactions may opt to be governed by them. The following safe harbours are proposed to be applicable for financial years 2012-13 and 2013-14 for various categories of international transactions:
  Eligible International Transaction Safe Harbour (Circumstances/Ceilings) SKP’s  Comments
1 Provision of the following services to associated enterprises where aggregate value does not exceed INR 1 billion (approximately USD 18 million): Operating profit margin on cost is: Separate categorisation for KPO services deviates from the recommendations of the Rangachary Committee that had categorised KPO under ITES with a safe harbour of 20%. This may lead to litigation with respect to the classification of services given the thin line of difference between ITES and KPO services.
  • Software development services
20% or more
  • Information technology enabled services (ITES)
20% or more
  • Knowledge process outsourcing (KPO) services
30% or more
  Eligible International Transaction Safe Harbour (Circumstances/Ceilings) SKP’s  Comments
2 Intra-group loans advanced to a non-resident wholly owned subsidiary where: Interest rate declared by the taxpayer is: Various Tribunal rulings have upheld LIBOR / EURIBOR plus rates as an appropriate benchmark for loans given by Indian companies to their foreign subsidiaries. However, the safe harbours prescribe use of the SBI base rate ranging from 11–12%, which is higher than the LIBOR plus rates that ordinarily range from 4–6%.
  • Amount does not exceed INR 500 million (approximately USD 9.09 million)
Equal to or greater than the State Bank of India (SBI) base rate as on 30 June of the relevant previous year + 150 basis points
  • Amount exceeds INR 500 million
Equal to or greater than the SBI base rate as on 30 June of the relevant previous year + 300 basis points
3 Provision of explicit corporate guarantee to a wholly owned subsidiary where amount guaranteed does not exceed INR 1 billion (approximately USD 18 million) Commission/fee of 2% or more per annum on amount guaranteed Safe harbours have been prescribed for explicit guarantees. However, the position on implicit guarantees such as the issue of performance guarantees, letters of comfort, stand-by letters of credit needs clarity.
Further, considering Tribunals have upheld the guarantee commission of 0.5% to be at arm’s length, the safe harbour prescribed seems to be on the higher side.
4 Provision of specified contract research and development (R&D) services to associated enterprises wholly or partly relating to: Operating profit margin on cost is: A separate classification for R&D for software services may result in interpretation issues due to an overlap with general software development services.
Safe harbours have not been prescribed for contract manufacturers of pharmaceutical products.
  • Software development
30% or more
  • Generic pharmaceutical drugs
29% or more
6 Manufacture and export of core auto components to associated enterprises Operating profit margin on cost is 12% or more Unlike software/ITES/KPO where safe harbour is applicable for captive service providers, in case of export of auto components, the provisions are applicable to all manufacturers whether they are on contract/toll/entrepreneurs. This could result in a blanket application of safe harbour rules for all auto component manufacturers resulting in disparity irrespective of the functions performed and risks assumed by the taxpayer.
7 Manufacture and export of non-core auto components to associated enterprises Operating profit margin on cost is 8.5% or more
  • While the rules clearly define the types of activities that fall under software development, ITES, KPO and contract R&D services, disputes may arise with respect to the classification of various services. For example, a taxpayer may view content management and engineering and design services as ITES subject to a safe harbour of 20% while the rules specifically classify them as KPO services subject to a higher safe harbour of 30%.
  • For transactions of the nature of software development, ITES, KPO services or contract R&D; a taxpayer would be eligible to opt for safe harbour if he carries insignificant risks. The rules define the factors to be considered for determining the level of risk undertaken. These factors are nearly in line with the earlier Circular No. 6/2013 issued by the CBDT with respect to R&D services.
  • Furthermore, to avoid any ambiguity the rules have also defined constituents of operating expenses and operating revenues. For example, gains or losses arising out of translation of foreign currency items are considered as operating. Therefore, it brings clarity with respect to the treatment of certain expenses/revenues for determining mark-up.
  • While opting for safe harbour, the taxpayer would have to sacrifice its rights to use any comparability adjustments with respect to differences in working capital, risks or benefits of the 3% variation (tolerance band). These shall be presumed to have been allowed while the taxpayer is selecting the option to adopt these safe harbours.
  • Irrespective of whether the taxpayer exercises its option for safe harbour, compliance in terms of documentation and furnishing of the Accountant’s report in Form 3CEB is still required.
  • When the transfer price determined by the taxpayer having regard to the safe harbour provisions is accepted by the income tax authorities, the taxpayer shall not be entitled to invoke the Mutual Agreement Procedure (MAP) for avoidance of double taxation under the tax treaty.
  • Safe harbour provisions shall not apply in case of international transactions with any country/territory notified or in a low/no tax country/territory (i.e. a country in which the maximum marginal rate of tax is zero or less than 15%).
  • To exercise its option to be governed by safe harbour rules, every taxpayer must furnish a self-attested Form 3CEG to the Assessing Officer listing details of the eligible international transaction, details of the associated enterprise, etc. before 30 November.

SKP’s Comments

  • The draft rules cover most of the controversial issues in India such as financial transactions, R&D, software and IT services. The safe harbour provisions are a boon especially for small players who are spared the time and resources spent on long disputes and hence a welcome move made by the tax administration.
  • However, it remains to be seen if the field officers, in cases where the taxpayer does not opt for safe harbour provisions, use the safe harbour rates specified for these sectors as a benchmark, without giving taxpayers an opportunity to be heard. While the Rangachary Committee Report dated 13 October 2012 cautions the field officers against such a practice, only time will tell.
  • In addition to the above, the provisions do not reduce the compliance burden for taxpayers as they are expected to comply with the documentation requirements under the transfer pricing regulations irrespective of the application of safe harbour provisions.
  • Further, it is pertinent to note that the safe harbours have been derived considering the experience/intelligence gathered from the last few rounds of revenue audits. These rates seem to be on the higher side possibly due to the macroeconomic factors affecting the entire sector as a whole that may not be relevant for individual taxpayers. In such situations, blindly resorting to safe harbour rules for determining the transfer price may result in double taxation at the group level since the safe harbour transfer price may not be accepted as the arm’s length standard by foreign tax administrations. This could be especially damaging since taxpayers opting for safe harbours are not permitted to invoke MAP under the respective tax treaties.
  • Overall, taxpayers must exercise the option for safe harbour with caution, giving due regard to past assessment trends, volume of transactions, nature of transactions, the stand taken by foreign tax jurisdictions for such transactions, and the functional analysis undertaken.