The Draft specifies conditions under which safe harbour rules will apply for IT, ITeS, pharma sectors

The income-tax (I-T) department released draft safe harbour rules aimed at reducing transfer pricing litigation across sectors on Wednesday.

This has been an area of increasing disputes in India with the tax department aggressively pursuing this source of revenue. The most recent assessment of such transfer pricing by the tax department saw increased claims of $9.5 billion.

Safe harbour rules are circumstances under which the tax department will accept the transfer price given by the assessee. They were part of the Finance Act of 2009 but due to the lack of consensus, the rules were not notified.

The draft rules follow the recommendation of the N. Rangachary committee that was set up by Prime minister Manmohan Singh last year to address the concerns of industry.

The draft rules specify conditions under which safe harbour rules will apply for the information technology (IT) sector, the IT-enabled services (ITeS) sector, contract research and development centres in IT and pharma sectors and auto component manufacturers. They also spell out conditions under which financial transactions between group companies such as outbound loans and corporate guarantees can escape the tax department’s scrutiny. They will, however, be applicable for only two assessment years beginning 2013-14.

The safe harbour rules will not be applicable to international transactions where the associated company is located in no-tax and low-tax jurisdictions or tax havens.

Transfer pricing refers to the practice of arm’s length pricing for transactions between group companies based in different countries to ensure that a fair price—one that would have been charged to an unrelated party—is levied.

The I-T department has invited comments from stakeholders until 26 August, after which it will finalize the rules.

The safe harbour rules, however, will apply subject to some stringent circumstances.

In cases where software development services, or ITeS, are provided and the total value of the international transaction is less than Rs.100 crore, the operating profit margin (OPM) that is declared in relation to operating expense should be more than 20%.

Mukesh Butani, chairman, BMR Advisors, said the scope of the rules was restrictive.

“I would have expected a bold decision to curtail litigation and settle past cases,” he said.

The proposed rules only cover companies that earn an operating margin of up to Rs.100 crore and will not benefit most captives that have been engaged in disputes on adjustments.

“An assumption that all players in software and IT earn such margins is flawed as the arms length margin is a function of assets, risks and functions,” he said. Companies that fall outside the specified limits won’t benefit and would have to continue litigating the matter, he said, adding that the safe harbour provisions will benefit small and medium-sized businesses and transactions.

In the case of knowledge process outsourcing (KPO) services and contract R&D in the IT sector, the OPM should be more than 30%.

For contract R&D in the pharmaceutical sector, the OPM should be 29%; for manufacture and export of core auto components, 12%; and for manufacture and export of non-core auto components, 8.5%.

Also, in the case of an intra-group loan not exceeding Rs.50 crore to a wholly owned subsidiary, the interest rate declared should be 150 basis points above the base rate of the State Bank of India as on 30 June. Where such transactions are more than Rs.50 crore, the interest rate should be 300 basis points above SBI’s base rate. One basis point is one-hundredth of a percentage point.

The taxpayer opting for safe harbour rules will not be able to invoke mutual agreement procedures (MAP) under double tax avoidance agreements.

Vijay Iyer, partner and national leader, transfer pricing, at EY, also said large companies wouldn’t be covered.

“Introduction of safe harbour rules in a positive step given that the industry has been waiting for more than three years for these. However, the Rs.100 crore transaction limit will put large companies outside the ambit of the safe harbour rules,” Iyer said.

“The operating margin requirements are also too high and there may not be many takers, especially in the contract R&D for pharma and IT sectors where the margin prescribed is almost 30%,” he said.

The National Association of Software and Services Companies (Nasscom) welcomed the draft rules.

“Our request to set up a consultation process in this regard has been accepted. While we are yet to analyse the specific provisions and fine print of the notification, we welcome this collaborative approach of the government and will work with the industry and government together to identify the implications and revert with a detailed feedback,” it said.