Arm's Length Standard

India’s Finance Minister heralded the onset of advance pricing agreements (APAs) in his budget speech on March 16, 2012. The international business communities with significant business presence in India and large Indian multinational corporations with global operations have welcomed this legislation, which is widely expected to usher in a framework for resolving uncertainty in the implementation of transfer pricing rules in India. Media reports indicate that the Indian revenue authorities are also honing their preparedness in implementing this proposed legislation once the parliament formally approves it.¹

The introduction of APAs is a milestone event in the evolution of India’s tax policy. India has exhibited high real GDP growth over the past two decades, and is on track to become one of the three largest economies in the world by the end of 2030. This growth story is closely linked to enabling legislation that liberalized the economy in the early 1990s, transforming India from an inward-looking protectionist economy to a foreign direct investment (“FDI”)-driven economy that has seen a major increase in the presence of foreign multinational firms establishing a local presence in India. As the Indian economy has evolved, so has its tax policy. India has successfully introduced and implemented tax policy reforms addressing the issues emerging from a growing presence of international businesses in India. At the same time, the growth of the economy has seen an increasing number of Indian-based multinationals that have expanded the scale of their overseas operations. As the pace of inbound and outbound activities increased, India introduced transfer pricing rules during 2001-02 to provide a more systematic framework to determine the appropriate profit that should be earned by the taxpayer resident in India.

The years following the introduction of transfer pricing regulations have been difficult for those taxpayers that have been subject to large-scale income adjustments annually arising from transfer pricing issues, with a concomitant increase in litigation on this front. The global business community has complained that the Indian tax authorities’ approach to transfer pricing matters has been inconsistent, arbitrary, and unreasonable in terms of their application of transfer pricing principles. The amounts of income adjustments arising from transfer pricing audits in India has doubled every year for the past four years, with the latest year for concluded audits (FYE March 31, 2008) resulting in aggregate income adjustments of $10 billion.² Of particular concern to the business community is the lack of a suitable dispute resolution framework and the resultant uncertainty this has instilled in the business environment facing MNCs. Several past attempts to address this uncertainty have failed (I will discuss my opinion on the reasons for such failure in a later section of this article). Against this backdrop, APAs may usher in the much-needed certainty that businesses are looking for, and may be the last resort for taxpayers who want to conduct business in a more certain tax climate.

While I will briefly touch upon the main attributes of an APA program (based on the experience of other countries) in the next section, my primary focus in this article will be slightly different. First, I will address the importance of implementing a successful APA program from the standpoint of the Indian economy. Second, I will draw from the experience of other dispute resolution policies in India (namely, the proposed safe harbor rules and the dispute resolution panel) that have not achieved the desired result of reducing transfer pricing litigation and the reasons for this, and draw conclusions on how to learn from these initiatives to help the Indian APA regime succeed. I conclude by highlighting the importance of strategic interactions in coordinating international tax policy by multiple tax authorities in the success of India’s APA program.

An APA is a framework for a tax administration and a taxpayer to agree that the tax administration will accept the taxpayer’s tax outcomes as being consistent with the arm’s length principle, and thereby will refrain from auditing the taxpayer’s international transaction(s) covered by the APA, provided the taxpayer files its tax return in accordance with the agreed APA conditions for the APA covered years (which may be for five prospective years). The objective of an APA is to deliver certainty, for both the taxpayer and the tax authorities, of the tax outcomes of the taxpayer’s international transactions by agreeing in advance the arm’s length pricing methodologies to apply to the taxpayer’s international transactions covered by the APA. An APA may thus remove the threat of an audit, deliver a mutually acceptable tax outcome based on the terms of the agreement, and often substantially reduce compliance costs over the term of the APA. Thus, an APA can be an effective tool for taxpayers to better manage the tax risks arising from international transactions. For tax authorities, an APA can similarly be an effective tool for better and more efficient administration of the transfer pricing laws. Consequently, APAs ordinarily provide a win-win situation for all parties involved.

The salient features of India’s APA program, as introduced in the Finance Bill 2012, are:

Based on international experience with APAs, there are five main stages in the life of an APA. Those stages are:³

The business community is eagerly awaiting the Indian APA rules to confirm if the process to be followed in India will be consistent with the generally accepted processes in other countries.

The India growth story is currently on a cusp. The rapid growth enjoyed by India over the past two decades was primarily led by the services sector. The burgeoning optimism about India’s future growth prospects set in place an investment momentum that saw major increases in FDI flows into the country. India established its position as the “economy to watch out for.” This momentum seems to be waning in recent years, as evidenced by the data for FDI, which has dropped by 10 percent in 2009-10 and 13 percent in 2010-11. Foreign investors have started questioning the sustainability of Indian growth, given the state of the uncertain policy environment they are witnessing. Hence, India’s future may be driven by what investors perceive the policy environment to be, and uncertainty in this sphere could be a serious detriment to India’s growth.

Virtually all governments are keen to attract FDI as it can generate new jobs, bring in new technologies, and more generally, promote growth and employment. Given the potential benefits, policy makers continually reexamine their tax rules to determine they are attractive to inbound investment. At the same time, governments continually struggle to balance the trade-off between offering a competitive tax policy to promote FDI with the need to determine that an appropriate share of domestic tax is collected from MNCs. While a number of nontax factors are important drivers for FDI decisions, a sound and certain tax policy establishes a basis for fiscal stability that strengthens the business climate. Additionally, in certain cases, tax may be an important factor influencing location decisions. In this context, a well-functioning APA regime can be a significant enabler in India’s ability to provide greater certainty (with respect to tax policy) to the foreign and domestic investor, and can be an effective tool to influence the future of India’s economic growth.

A recent study analyzing the relationship between uncertainty in the corporate income tax regime and FDI⁴ found that countries with greater uncertainty in their local tax system suffer from lower FDI. In fact, this relationship was found to be even stronger for developing countries (which suffer from other impediments that fail to offset the impact of a lower FDI from greater uncertainty). In addition, this study also found that higher levels of corruption negatively impact FDI, while the presence of a well-functioning treaty network favors FDI. These results are noteworthy for framing domestic tax policy that will impact MNCs. As India remains vulnerable to global economic conditions, policy makers should remain focused on how it may provide greater certainty to taxpayers on the tax policy climate. APAs provide an excellent tool for achieving that objective.

At times, some Indian policy makers have asserted that the economic benefits offered by India to foreign MNCs (lower cost of services, a large demand base, and a positive demographic profile) will more than offset any possible downside from an aggressive tax policy environment. As a result, tax officials have remained distant to certain aggressive positions adopted in transfer pricing matters. The belief that the rate of FDI into the Indian economy will be immune to tax policy is questionable, as evidenced by the fact that Philippines has already outpaced India as the largest provider of business process outsourcing (BPO) services, and that countries like Sri Lanka, Vietnam, and China are slowly and steadily expanding their share of the IT and BPO sectors in the global business community. This is not to say that the growth of those countries has come at the cost of a declining share of India’s service sector, but the future may be very different. The appropriate question is – would India have performed even better than it has (in terms of attracting FDI) if there had been greater certainty in the tax environment? I strongly believe the answer to this question is in the affirmative. It is therefore in the country’s best interest to provide greater certainty for MNCs in terms of tax policy if they believe tax laws should act as enablers to the country’s future economic growth. Needless to say, a higher GDP growth rate will increase the tax base and will help in generating additional tax revenue to the government.

In the past, there were two significant developments in the Indian transfer pricing regime that could have instilled greater certainty regarding the transfer pricing rules in India – one that was announced but never implemented and another that was implemented but did not meet the intended result. I am referring to the safe harbor rules (SHR) and the Dispute Resolution Panel (DRP). It may be worthwhile for us to step back and take a closer look at why these initiatives did not help in reducing the tax uncertainty in India, so that any lessons to improve the efficiency of implementing the APA regime in India can be successfully adopted and implemented.

The SHR could have been valuable in reducing transfer pricing litigation, freeing up precious and scarce Indian Revenue resources so that they could focus on high impact audits and instill greater certainty to the tax policy environment. A safe harbor is a “rule” that would be applicable to a defined class of taxpayers for specified international transactions or business activities. The rules would notify a “minimum” safe harbor profit margin, so that all taxpayers meeting the requirements would be relieved from a transfer pricing audit. Over time, this would determine more predictable tax revenue for the government and the taxpayers would be able to rely on a certain tax policy without worrying about the costs of litigation. The finance minister announced the introduction of SHR in his budget speech of 2010, but no such notifications have been made by the Indian revenue authorities thus far. The question is – why did the government not act on this?

It is my belief that the primary reason SHR did not take off is that some felt such rules would not work in the Indian context because of unwarranted comparisons that were made with similar rules that existed in other countries. The economic landscape in India is different from that of many other developing countries, and the ground realities in India, in terms of the extent of transfer pricing litigation, are different. Hence, India should have enacted legislation customized to the facts specific to India. What might have worked well is a regime that defined a safe harbor for IT and BPO services (with suitable definitions, possibly using the approach followed in the service tax rules that allows tax officials to clearly identify services that would be subject to service tax in India), with a cap to exclude large taxpayers. Indeed, because the safe harbor rate could be specified by the Income Tax Rules, one could estimate the “revenue neutral” rate that would allow the tax authorities to be no worse off with these rules than without them.⁵ The bottom line is that this initiative appears to have failed given the tensions and possible mistrust between the tax authorities and taxpayers, and misplaced judgments regarding what would and would not work in the Indian context. Consequently, an opportunity was lost. It may still permissible to introduce SHR, and I believe this opportunity should be taken up in earnest again.

The constitution of a DRP was the next big initiative that might have brought India closer to several international jurisdictions in the implementation of transfer pricing rules. Because transfer pricing is not an exact science, it is plausible that there may be more than one result that could be considered “reasonable” as an arm’s length outcome. Given the lack of any arbitration or settlement mechanism in India, these differences in concluding an appropriate arm’s length price between the taxpayer and the tax authorities resulted in a large volume of disputes that remained unresolved at the level of the CIT (Appeals) or the courts. DRP was expected to be the perfect forum, where taxpayers and the tax authorities could “settle” these cases in a mutually acceptable manner. Unfortunately, that did not happen.

Perhaps the single most important reason why the DRP did not meet the intended result was that the provision was enacted in an asymmetric manner, whereby the taxpayer had the right to appeal an order passed by the DRP, but the tax authorities did not. This asymmetry made it impossible to reach any settlements, because there was no guarantee that the taxpayer would not appeal against the DRP’s order after having agreed to it. Settling transfer pricing disputes at the DRP would have provided great relief for taxpayers. But an issue of mistrust was pervasive, and led to the DRP’s lack of effectiveness.

In light of these unsuccessful initiatives, it is pertinent to ask – what lies in store for the APA regime in India? There is reason to believe that the APA regime in India will actually succeed, and the skeptics should give it the chance it deserves. There are several reasons for this. To begin with, India has come a long way in its learning curve when it comes to transfer pricing. Hence, debatable issues can be discussed in a meaningful way in the course of the APA negotiations. Moreover, the government has indicated that a separate team of tax officers will be responsible for administering the APA program – this will be useful from a resourcing standpoint. Informal indications suggest that the Indian tax authorities plan to engage specialists (economists, statisticians, and lawyers) as part of the APA negotiating team so that complex issues can be adjudged in an informed manner by specialists in their respective fields. Last, but not the least, it is important that bilateral negotiations involving two or more tax authorities are driven in a manner whereby both parties recognize the positives of reaching an amicable resolution. This is discussed in more detail in the next section.

The introduction of APAs is a landmark legislative change in India’s transfer pricing regime. This is an opportunity for taxpayers and tax authorities to obtain greater certainty on tax laws related to transfer pricing in India. The economic benefit of a successful APA program is immense, and its impact on FDI (and therefore India’s growth) is a critical component for policy makers to keep in mind as they implement this law. While past attempts to usher greater certainty to MNCs in the form of safe harbor rules and the Dispute Resolution Panel have achieved limited to no success, the reasons for the breakdown of those initiatives appears to be a pervading mistrust between taxpayers and the tax authorities. An APA program would be a forum that would provide an opportunity to build mutual trust and certainty between taxpayers and the tax authorities. Hence, there is reason to be optimistic about the prospects of such a program. Finally, nontax behavioral issues intrinsic to the nature of strategic interaction between multiple tax authorities may also cause APAs to fail; hence, it is important to recognize the importance of this program in a larger context, and strive to achieve a coordinated solution that will be a win-win for all stakeholders.

¹ On March 16, 2012, Business Standard, a leading financial newspaper in India, reported that “(t)he ministry of finance, Department of Revenue, has announced the selection of Batsala Jha Yadav as the director of Advance Pricing Agreement.”

² As reported in various publications of TaxSutra.

³ For a detailed and thorough discussion on APA’s, including a country by country analysis of APA’s and their practical experience, please refer to the Deloitte Whitepaper – “Recommendations for a model Advance Pricing Agreement scheme in India,” June 2011.

⁴ “Corporate Income Taxation Uncertainty and Foreign Direct Investment” by Martin Zagler and Cristiana Zanzottera (2008).

⁵ Deloitte, in its white paper on safe harbors, provided a methodology for estimating this revenue neutral rate.

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