Transfer pricing: a fiscal challenge

Transfer pricing: a fiscal challenge

Transfer pricing is the process of determining the price at which parties affiliated to each other buy and sell products such that there is no leakage of tax. Transfer pricing is of relevance to international transactions where inappropriate transfers could result in the loss of tax revenue to one country or another.

As is now well known, countries across the world, including India, appear to be bound for severe fiscal deficits in the coming years, and tax authorities will be induced to close all possible loopholes in the fiscal regimes that they govern. At the Organisation for Economic Co-operation and Development (OECD), economists have indicated that nearly 60% of world trade occurs between different arms of multinational companies. In today’s fiscal situation, it would be unthinkable for revenue authorities to pass up such a large fiscal opportunity.

At the same time, there are two other critical factors that come into play. First, a large number of multinational companies, faced with slowing growth in their core markets, will use the management of taxes to offset reductions in their profits elsewhere. Second, there is in general a greater awareness created, in many countries, due to the emergence of a common body of knowledge on transfer pricing, which can now be used for the evolution of meaningful tax opinions and judgement.

This last element can be seen in India, where several useful rulings have come to the fore. These have dealt with, among others, the manner in which the arm’s-length pricing concept (that market rates should prevail even in transactions between affiliates) should be applied, the imposition of logic when rejecting transfer pricing studies done by companies, and the prohibition of cherry-picking among comparables when setting benchmarks (so that companies do not choose to compare themselves only with those others which will reduce the taxes they pay when establishing a fair transfer price). The crystallization of these rulings will provide companies and revenue departments a firmer basis on which to base their actions.

Rulings can sometimes raise as many questions as the answers they provide. The likely implementation of the Direct Taxes Code from next year provides an opportunity for all stakeholders to come together with cogent recommendations that could make their way into the Bill that will be passed.

Transfer pricing is an area where revenue interests have to balance art with science. Though most of us would like to make transfer pricing as close to a scientific endeavour as possible, in practice this may be difficult. Any company will always have unique characteristics, which, if ignored, could place it at a disadvantage compared with others. Consequently, we have to ensure that a simplistic approach to transfer pricing does not create the unintended consequence of taking away a level playing field in some industries.

Given that it is going to take time for all parties to reach the necessary level of maturity in this area, the challenge is to ensure that in the interim, neither revenue nor companies are affected adversely. This may involve companies spending resources to establish a robust documentation process, persuading tax authorities to look at substance over form while assessing transfer pricing structures, and so on. Perhaps in the interim, say, for a period of two-three years, some form of safe harbour provision could be provided to give an element of certainty to companies.

Almost all large Indian companies either have substantial multinational operations or are themselves associates of foreign multinationals or of their subsidiaries. The implications of transfer pricing can have a substantial impact on the net profits of such companies. It is, therefore, worthwhile for audit committees to dedicate sufficient time to assess the transfer pricing mechanics of the companies they audit.

Govind Sankaranarayanan is chief financial officer, Tata Capital Ltd. He writes on issues related to governance.

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