Volume 6, Issue 16

24 September 2013

Tax Alert

Transfer Pricing – Final Safe Harbour Rules Notified

Safe harbour means circumstances in which income tax authorities shall accept the transfer price declared by the taxpayer. Taxpayers were keenly awaiting safe harbour provisions for more than three years and the Central Board of Direct Taxes (CBDT) issued draft safe harbour provisions on 14 August 2013 for public consultation.  Please see our earlier Tax alert on draft safe harbour rules here.

The final rules after public consultation were notified on 18 September 2013 (Notification No. 73). These final rules are considerably accommodating compared to those in the draft version. The CBDT has rightly considered the suggestions/representations of various tax experts and stakeholders.

Eligible transactions

The following table provides a synopsis of the notified safe harbour provisions along with the changes compared to the draft provisions released last month:

Eligible International Transaction Safe Harbour Changes in the Final Notification
  Provision of software development services (excludes R&D services whether or not in the nature of contract R&D) Turnover up to INR 5 billion – Operating Profit (OP)/Operating Cost (OC) is 20% or more Turnover in excess of INR 5 billion – OP/OC is 22% or more
  • Threshold of INR 1 billion has been removed in the final notification
  • Higher mark-up of 22% in case turnover exceeds INR 5 billion
Provision of Information Technology-enabled Services or ITeS (excludes R&D services whether or not in the nature of contract R&D)
Provision of Knowledge Process Outsourcing (KPO) services (excludes R&D services whether or not in the nature of contract R&D) OP/OC is 25% or more
  • The definition of KPO has been amended to clarify that services requiring “application of knowledge and advanced analytical and technical skills” mainly with the assistance or use of information technology would qualify
  • Threshold of INR 1 billion has been removed in the final notification
  • Safe harbour margin has been lowered to 25% from 30% proposed in draft rules

Eligible International Transaction Safe Harbour Changes in the Final Notification
Provision of contract R&D services wholly or partly relating to generic pharmaceutical drugs OP/OC is 29% or more
  • Definition of “generic pharmaceutical drug” is introduced:
“Generic pharmaceutical drug” means a drug that is comparable to a drug already approved by the regulatory authority in dosage form, strength, route of administration, quality and performance characteristics, and intended use.
Providing corporate guarantee (does not include letter of comfort, implicit corporate guarantee, performance guarantee or any other guarantee of similar nature) Commission/fee @ 2% per annum on the amount guaranteed up to INR 1 billion.
Commission/fee @ 1.75% per annum in case the guarantee value exceeds INR 1 billion and the credit rating of the associated enterprise (AE) is of adequate to highest safety certified by the designated agency
  • Threshold of INR 1 billion has been removed in the final notification subject to the additional condition of satisfying the credit rating criteria
Advancing of intra-group loan to a non-resident wholly owned subsidiary Loan amount up to INR 500 million – SBI’s base rate + 150 basis points.
Loan amount in excess of INR 500 million – SBI’s base rate + 300 basis points.
No change
Provision of contract R&D service wholly or partly related to software development OP/OC is 30% or more No change
Manufacture and export of core auto components OP/OC is 12% or more No change
Manufacture and export of non-core auto components OP/OC is 8.5% or more No change

In the computation of the OP and OC referred above, the regulations suggest that foreign exchange fluctuations should be regarded as non-operating income/expense, which is apparently contrary to general understanding and judicial precedents.

Other aspects

  • One of the major changes in the final regulation is that the taxpayer has the choice of opting for safe harbour provisions for a period up to 5 years instead of 2 years proposed in the draft regulations. The taxpayer can opt for safe harbour provisions right from financial year (FY) 2012-13 itself!
  • The rules would not apply in case the transactions are entered into with an AE located in a notified territory (as defined in section 94A of the Income Tax Act) or in a no-tax or low-tax territory (where the maximum rate of income tax is less than 15%).
  • In case of eligible transactions such as the provision of software development services/ITeS, KPO and contract R&D, the safe harbour rules shall apply only in case the entity is not performing economically significant functions, and is thus assuming insignificant risks.
  • Adjustments to the comparable margins as well as the tolerance band prescribed in the present transfer pricing law would not be applicable under the safe harbour regime.
  • Similarly, the Mutual Agreement Procedure (MAP) would not apply where an eligible taxpayer has opted for safe harbour provisions.
  • Even if the safe harbour application is accepted, an eligible taxpayer would still need to comply with the annual compliance requirement of filing Form 3CEB and documentation.

 Procedure to be followed for opting for safe harbour

An eligible taxpayer can opt for the safe harbour provisions by filing Form 3CEFA. This is a self-declaration form and needs to be signed by a person authorised to sign tax returns. The rules have prescribed certain timelines for processing an eligible taxpayer’s application that are summarised in the following table:

Particulars Timeline
Application in Form 3CEFA in the initial year/first year Before due date for filing Return of Income.
For FY 2012-13, the due date is 30 November 2013.
Assessing Officer (AO) to verify the eligibility Within two months from the end of the month in which form 3CEFA is filed
In case the assessing officer doubts the valid exercise of the safe harbour option

Make reference to the Transfer Pricing Officer (TPO) Within two months from the end of the month in which form 3CEFA is filed
TPO to decide the eligibility of the option Within two months from the end of the month in which the reference is received from the AO
If aggrieved, taxpayer to file an objection with the concerned commissioner against the order of the TPO Within 15 days of receipt of order
Commissioner to decide the eligibility of the option Within two months from the end of the month in which the objection is filed by the taxpayer

The rule further states that in case of failure to adhere to the above stated timelines by the AO/TPO/ commissioner, the option for safe harbour exercised by an eligible tax payer shall be treated as valid.

In addition to filing Form 3CEFA in the initial year/first year, an eligible taxpayer, in the subsequent year, is also required to furnish a statement providing details of eligible transactions. However, no form has been prescribed for this as yet.

SKP’s Comments

The very introduction of safe harbour provisions signals the Government’s continued focus on bringing reforms on the cross-border tax front. Widening the scope of safe harbour provisions by removing the threshold limits set for eligible transactions is a welcome step. This could substantially reduce the time and efforts presently required in transfer pricing audits for both parties – the tax authorities as well as taxpayers. The time limit set for processing a safe harbour application is appreciable and would encourage the taxpayers to opt for the safe harbour provisions.

The safe harbour rates seem to be on the higher side, however, one must acknowledge that these rates are generally not arm’s length rates but are provided by the tax authorities as a midpoint to enthuse taxpayers to opt for safe harbour and avoid protracted litigation. In that sense, the tax on the higher mark-up is a cost of avoiding protracted litigation. Therefore, this is extremely desirable for small captive units.

The larger captive players may not find the rates attractive enough to opt for the same as it would result in double taxation (the home country tax authorities may not accept the safe harbour mark-up rates) since the safe harbour rules are unilateral. Such large players should consider the option of an Advance Pricing Agreement (APA) especially in view of the positive attitude of the APA team and favourable responses to initial negotiations.

Another concern at this stage is the litigation that may occur due to interpretation of the definition of software development services, KPO and contract R&D services, where the CBDT has notified different safe harbour margin rates. In our view, since all these service providers are not assuming any economically significant risks, which is an eligibility criterion itself for safe harbour provision, one blanket rate of safe harbour margin could have been considered by the CBDT.

There is still no respite from transfer pricing compliances, especially the maintenance of documentation when a taxpayer’s option of safe harbour is accepted.

The taxpayer now needs to evaluate the option of filing for safe harbour by considering various factors such as the current mark-up rate, volumes involved, past assessments, the management’s appetite for future litigation, etc. This analysis needs to be done on an immediate basis given that the financial statements for FY 2012-13 are in the final stages of closing and the due date for opting for safe harbour for FY 2012-13 is 30 November 2013.