The long-awaited draft direct tax code was finally released this month with the objective to simplify and rationalize tax provisions. From the perspective of transfer pricing, or the process of pricing contributions that are moved within an organization, the introduction of the advance pricing agreement (APA) mechanism is a key highlight of the draft code. This should provide significant comfort to taxpayers and put the status of the Indian tax system a notch higher, even at par with those of developed countries.

An APA is an arrangement between the taxpayer and the tax authorities made prior to actual transactions, with a view to solving potential taxation disputes in a cooperative manner. An APA is thus a pre-transaction analysis rather than a post-mortem. They can be applied for a variety of transactions—for example, dealings in goods or services, financing arrangements, transfer and use of tangible or intangible assets and so on—that may otherwise be fraught with confusion and litigation.

An APA seeks to determine an appropriate set of criteria for the computation of the transfer price, which may include the transfer pricing method to be applied, critical assumptions as to future events, and others. At the time of audit, tax authorities may limit the examination to verifying the initial data relevant to the APA proposal and determining whether or not the taxpayer has complied with the terms and conditions of the APA.

The tax authority may also examine the reliability and accuracy of the representations made in the APA. As prevalent in most developed countries, the draft code provides that an APA once executed would be applicable for a maximum of five consecutive fiscal years.

In several countries, the result of a concluded APA may be applied to open audit examinations relating to prior periods that are not covered by the APA in question. This would be allowed if there are no major changes in the circumstances and critical assumptions in the year of an audit not covered by the APA, as compared with the years already covered by the APA .

The application of an APA to prior periods saves a lot of time and effort of the taxpayer, as well as makes life easier for tax authorities, in resolving complex transfer pricing issues. The government should introduce such rollback options for APAs, while finalizing the relevant rules.

An APA could be either unilateral or bilateral. A unilateral APA involves the arrangement between a taxpayer and the tax authorities of the country in which the taxpayer is situated. A bilateral APA is an arrangement between a taxpayer, the authorities of the country in which the taxpayer is situated, and the authorities of the foreign country where the related party of the taxpayer —with whom the taxpayer has entered into some transaction—is situated.

In bilateral APAs, the tax officials of the two countries negotiate with each other in order to reach an agreed position. Due to concerns over double taxation, most countries, in fact, prefer bilateral APAs.

It is yet to be seen how the APA mechanism for India will be structured. But a good APA structure would, no doubt, help Indian and multinational companies tide over sticky tax situations.

Rahul Mitra is a partner and Nishant Saini is manager, transfer pricing practice, PricewaterhouseCoopers, India. Comment at