In line with the United Nations Practical Manual on Transfer Pricing for Developing Countries (2017) (UN 2017) and Organisation for Economic Co-operation and Developments (OECD 2013) Draft Handbook on Transfer Pricing Risk Assessment emphasising the development of risk assessment procedures to select cases for transfer pricing scrutiny, the Central Board of Direct Taxes (CBDT), in March 2016, introduced a series of measures. This was as part of the new guidelines to be followed by the revenue department in inspecting transfer pricing audits with respect to cross-border transactions. These fresh set of protocols fundamentally replaced the earlier set of guidelines issued in 2003 regarding the manual selection of similar cases by field officers.

Apart from the broader objective of effective initial risk identification and assessment for focused and more strategic audit as well as judicious deployment of available enforcement resources, the new policy reform is principally aimed at reducing the number of litigations on the transfer pricing front so as to promote the image of the economy as a non-adversarial tax regime, especially for the multinational companies. The investor sentiments are thought to be harmed by the numerous pending litigations and high tax adjustments around transfer pricing that several multinational enterprise (MNE)-affiliated companies have faced in India recently. This situation has arisen particularly due to the various complexities involved in reviewing these cases that the tax authorities and the judiciary have to deal with. The new series of guidelines are expected to remove the fear of onerous taxation and unreasonable litigation burden from the mindset of MNEs operating in India.

Rising litigations are a serious matter and are considered as the direct fallout of the rise in number and complexities of cross-border transactions especially over recent years. As per some rough estimates, the extent of intra-firm trade within transnationalcorporation (TNC) networks in global trade of goods and services is about 33%, where 80% of global trade is linked to the international production networks of the TNCs (WIR UNCTAD 2013). The trade within MNE networks is highly susceptible to trade mispricing and money laundering and can lead to serious losses of tax revenue for nations, as some recent studies have highlighted. According to the World Economic Forums Global Agenda Council on Illicit Trade, the shadow economy is worth $650 billion, and has probably risen to $1.77 trillion in 2015 due to illicit practices. Specifically due to Base Erosion and Profit Shifting (BEPS), the estimates indicate annual losses worth 4%10% of global corporate tax revenues ($100$240 billion annually), with the developing countries facing a much higher impact of transfer mispricing (OECD 2015). Another significant report by Global Financial Integrity (GFI 2015) shows that developing and emerging economies have lost $7.8 trillion over 200413 as illicit financial flows, where illicit outflows increased at an average rate of 6.5% per year. The mis-invoicing of trade transactions accounted for 83.4% of all illicit flows according to this report.

Among other important studies focusing on India, the GFI report has estimated that India has lost gross illicit assets worth $462 billion over the 19482008 period mainly through trade mis-invoicing of goods and other corrupt practices used for tax evasion (GFI 2010). In a more recent report, the GFI hasestimated that the amount of illicit financial flows out of India was about $505 billion over the 200413 period (GFI 2015) and was $13 billion in 2016 (GFI 2019). The report has noted that the rise in international trade has created more opportunities for trade mispricing especially since the introduction of trade liberalisation. Improving tax collection by curtailing trade mispricing and country-by-country reporting by multinational corporations (MNCs) are essential tools to check these illicit outflows. A study by Jansky and Prats (2013) analysed financial and ownership data of about 1,500 MNCs operating in India and found evidence of profit-shifting among them. The study found that MNCs with tax haven links reported 1.5% less profits, paid 17.4% less in taxes per unit of asset and 30.3% less in taxes per unit of profit than MNCs with no such links. These studies point towards the high susceptibility of trade transactions to mispricing and BEPS practices in the Indian case.

Certainly, transfer mispricing in cross-border transactions conducted within multinational networks requires a far sharper scrutiny, which developing countries like India cannot afford to overlook. Following the Arms-Length approach as per the OECD guidelines on transfer pricing, India had introduced new transfer pricing rules through amendments in the Income Tax Act and the Finance Act in 2001. These new guidelines provided broad instructions to revenue officers for auditing international transactions of corporations located in India using various transfer pricing appraisal approaches based on the Arms Length Principle (ALP).

Arms Length Method

Several challenges are posed by the Arms Length Method (ALM) in terms of practical applications both for the companies as well as the tax officers. This method requires the examination of international transfer payments by comparing it to another similar transaction or range of transactions conducted between unrelated parties. Given the individual nature of assets or services transferred in related party transactions of multinationals, finding an appropriate comparable transaction is extremely difficult. In several cases, the services or intangible asset transferred is unique, and a comparable service may not exist at all.

In this context, a further challenging aspect more common to developing countries is the lack of reliable and comprehensive databases to facilitate a direct comparability exercise due to resource constraints, inadequate corporate disclosure requirements, poor reporting of financial data by companies or underdeveloped systems of data compilation. Nil, insufficient or non-transparent disclosures of related party transaction details by companies are frequent in public documents, and create further difficulties in evaluation. The challenge is severe in the Indian case especially for the unlisted firms, which are several in number and usually escape corporate disclosure norms. The recent Census on Foreign Liabilities and Assets of Indian Direct Investment Companies 201718 published by the Reserve Bank of India (RBI 2019) indicates that at least 17,648 Indian direct investment companies with only inward foreign investment are unlisted. Further, the commercial databases may not provide detailed segmented transaction data of companies, largely limiting the scope of a transaction-by-transaction analysis via identifying appropriate comparables. In the Indian case, disclosure of unrelated party transaction segmented data is not mandatory, posing difficulties in identifying transactions for ALP comparisons via direct methods from commonly used commercial databases.

Given these complexities in practical application of the ALM using direct comparability criteria, indirect methods are often used, which principally compare the net margins of the companies or of a particular transaction. In actual experience, tax authorities have targeted several multinational companies in India for transfer pricing audits since 2005 and have levied high values of tax adjustments. In various cases where direct comparables could not be found, the transactional net margin method (TNMM) has been used. Table 1 indicates the sharp rise in transfer pricing adjustment cases and the amount of tax adjustments since 200506. In more than 24,000 cases that have been scrutinised by transfer pricing officers over the years, nearly half have faced tax adjustments.

The ample scope for subjectivity in ALP comparability computation gives rise to numerous points of disputes especially in cases where broad comparability methods like TNMM are applied. A number of tax adjustments have been disputed by the companies and have faced litigations and counter litigations. In fact, transfer pricing has been the major source of disputes in direct taxes making India the third highest country with the maximum number of transfer pricing disputes. A significant number of litigations pertain to the issue of choice of comparables and method of comparability, especially for the pricing of intangibles.

The complexities associated with these issues have caused an inordinate delay in the litigation resolution process, with an average time of two-and-a-half years taken by the tribunal courts to dispose each case (Deloitte and TaxSutra 2015). The concern of pending litigations is quite severe as more than 4,000 disputes were pending before the Dispute Resolution Panel, CIT (A) and Income Tax Appellate Tribunal (ITAT) in 2016. About 90,000 cases were pending at ITAT level (various tax cases) in March 2017 (Economic Survey 2018). A commonly held view is that the lower monetary threshold for transfer pricing audits (approximately 15 crore/$3.30 million at present) has contributed to this steady rise in disputes. The latest CBDT reforms have been guided by this perception, and are focused on checking this very aggressive tax regime followed under Indian regulations and on creating a regime with tax certainty, with minimum number of disputes and litigations.

Earlier in 2015, the revenue secretary had stated that the focus of international taxation should be on dispute resolution and the government was moving fast on this front. The exigency to ensure a fair and judicious dispute resolution regime had driven the introduction of different significant measures like the Advance Pricing Agreement (APA), Safe Harbour Rules, Dispute Resolution Panel (DRP) and Mutual Agreement Procedure (MAP). The first India APA annual report published in May 2017 by CBDT shows that since its initiation in 201213, 152 APAs have been concluded in four years and 815 applications were filed by 31 March 2017. Further, between April 2014 and February 2016, CBDT has resolved 180 cases involving 5,000 crore of funds through MAP with countries, namely the United States, Japan, the United Kingdom and China.

The DRP was introduced in 2009 by inserting Section 144C in the Income Tax Act, 1961 by the Finance Act, 2009 to provide an alternative dispute resolution mechanism for resolving transfer pricing disputes related to international transactions. However, the DRP has not proven to be a successful mechanism for resolving tax disputes since practical experience indicates that DRPs have rarely affirmed a position different from the one proposed by the assessing officers, due to this mechanisms statutorily constrained powers. Whilst these above alternative mechanisms have been ambitiously introduced to deal with the unplanned series of disputes and litigations, their efficacy in comprehensively addressing the fundamental issue of tax evasion seems limited. Since the majority of transfer pricing cases still go through the regular cycle of audits by the revenue department, the new CBDT norms have been brought in to check the possibility of incidence of disputes or litigations at the audit stage. Given the difficulties posed by numerous pending controversial legal disputes on the transfer pricing front and severe strain on revenue resources, the current step as a direct policy response to manage the situation is not surprising.

New CBDT Guidelines

As a particularly targeted approach to reduce the incidences of transfer pricing audits with respect to cross-border transactions in order to indirectly address the probable litigation burden in future, the CBDT has issued a new set of instructions to its field officers as Instruction No 3 of 2016 on 10 March 2016 to provide guidance on reference by an assessing officer to a transfer pricing officer (TPO) and on the role of assessing officer and TPO in the case of transfer pricing audits. This follows the issuance of an interim instruction of a similar form as Instruction No 15 of 2015 on 16 October 2015. The new set of guidelines have replaced Instruction No 3 dated 20 May 2003 issued to field officers regarding manual selection of cross-border transactions for scrutiny.

The key feature which has been introduced now is the reference to TPOs by assessing officers on the basis of risk-based parameters rather than the value of international transactions. The earlier approach of evaluating every international transaction above a threshold value of 15 crore for transfer pricing audit through manual selection has been abandoned. The risk-based scrutiny approach is expected to restrict audits to only those cases where the revenue risk to the government is substantial. Specific guidelines have been provided to the assessing officer regarding the selection of cases for scrutiny on the basis of transfer pricing risk parameters, which involve selection on the basis of broad-based selection filters through computer assisted scrutiny selection (CASS) or through the compulsory manual selection system with specifically defined criteria.

Clearly, this amendment has been introduced to ensure that the valuable time of revenue authorities and the judiciary are spent on worthwhile cases, by strictly reducing the number of cases being audited itself, thereby indirectly addressing the huge dispute resolution burden. However, the practical implementation and the effectiveness of the new measure in addressing the problem of transfer mispricing is largely dependent on the choice of transfer pricing risk-parameters, which are not defined clearly by the guidelines beyond some indicative aspects for non-transfer pricing risk parameters. A typical transfer pricing risk assessment process involves identifying cases with a high degree of transfer pricing risk that requires a detailed further scrutiny. Prudent judgment by a specialised team of tax personnel is crucial both at the initial risk assessment stage as well as during the audit. The limitation of database and information on related party transactions and company financials in the tax return documentation filed by companies as well as in commercial databases commonly used for ALP comparability analysis in transfer pricing audits may largely inhibit the risk assessment procedure based on informed conclusions as well as the conduct of accurate audits subsequently.

As another policy step with a similar objective to reduce audits, the power of assessing officer to make transfer pricing adjustments has been abolished, and only the TPO is allowed to make any transfer pricing tax adjustment. Further, the number of important and complex cases assigned to each TPO annually has been limited to 50 cases only to enable them to devote more quality time on each case. This step aims to check the unreasonable batch processing of cases giving rise to unsustainable transfer pricing adjustments as in the past. This also reduces the number of revenue officials empowered to question any cross-border transaction with regard to transfer pricing.

Also, before referring the case to a TPO, an assessing officer is required now to give a structured opportunity of being heard to the taxpayer in order to check unwarranted litigation. In essence, this and the above-mentioned policy changes introduced are specifically designed to provide a boost to taxpayer confidence by controlling the volume of disputes and to support a tax regime conducive to foreign investors, as promised by successive governments in India over years. Indeed, the quantum of transfer pricing litigation is expected to fall by about half as a result of the new policy norms.

Prima facie, the latest norms appear to adeptly address the issue of enormous number of possible revenue and legal disputes around transfer pricing in future years by bringing certainty and uniformity in assessment, but some very basic issues with respect to the precise evaluation of cross-border transactions by foreign firms remain completely unaddressed. Given the high revenue risks facing the Indian exchequer on account of BEPS practices in recent years, there is a crucial need to closely scrutinise the vast range of cross-border transactions, especially those involving MNC affiliates. This requires a far more aggressive and thorough audit of their foreign transactions, as is currently followed by a rising number of jurisdictions of the world. Due to the ceasing of the earlier threshold value for selecting transfer pricing cases for audit, a large number of such transactions that faced revenue scrutiny earlier shall remain unaudited now. Whereas a risk-based audit approach may help to deploy the available revenue resources in effective ways on selective cases, how these particular cases will be selected and scrutinised after weighing several risk factors is fairly ambiguous.

Also, susceptibility to mis-invoicing in traded goods is substantially high in India, as indicated by the GFI (2015) in its reports. Whereas this high risk area calls for urgent policy attention globally, customs data was not analysed usually from a specific transfer pricing perspective until recently. A prior customs notification introduced in 2004 (Notification No 128/2004) prohibited the mention of the Indian or foreign partys name in the product-wise disaggregated trade data, which made it not very useful for comparability purpose under ALM as related parties could not be identified. Disappointingly, in a very recent customs notification (Notification No 140/2016) introduced in November 2016, the publication of Daily List of Imports and Exports has been discontinued without any cogent reason, which makes the usage of trade data for transfer pricing comparability analysis particularly difficult now.

Most importantly, to ably address the serious revenue risks posed by transfer pricing, there is a pressing need to adopt a multipronged approach by the Indian tax administrators. This requires a stricter and closer evaluation of various cross-border transactions by a more effective and capable revenue machinery. Necessarily, the serious data shortcomings need to be duly addressed by developing a comprehensive database by introducing robust reporting rules and related party trade disclosure norms. The efficacy of risk-based audits may remain largely limited in scope unless backed by other serious policy measures like enhanced transparency in reported data and a cautiously designed strategy for a selection of high risk cases. Also, more judicial benches devoted to examine transfer pricing disputes may help to tackle the issue of pending litigations expeditiously.

A move towards country-by-country reporting under the Multilateral Competent Authority Agreement initiated since 2015 aims to map global operations of a multinational firm, but may cover very large multinationals mostly and reports may not be available in the public domain. At present, the arms-length norm to judge transfer pricing is the key international tax tool in use to audit the cross-border transactions, and is followed worldwide despite all its difficult aspects. Any policy path towards a minimal audit zone such as risk-based audits within an ALM framework needs a very serious rethink and thorough careful strategic designing before implementation, especially in present times when cross-border intra-firm transactions are rising in scale, volume and complexities while simultaneously posing grave international tax evaluation challenges globally.

References

CBDT (2016): Instruction No 3 / 2016, New Delhi, dated 10 March 2016, F No 500/9/2015-APA-II, Foreign Tax and Tax Research Division-I, Central Board of Direct Taxes, Department of Revenue, Ministry of Finance, Government of India.

(2017): Advance Pricing Agreement (APA) Programme of India, Annual Report 201617,https://www.incometaxindia.gov.in.

Customs Notification (2004): Publication of Daily List of Imports and Exports Rules 2004, Notification No 128/2004-Customs (NT) dated19 November 2004, Gazette of India, Extraordinary, Part 2, Section 3, Sub-section (i), Central Board of Excise and Customs, Department of Revenue, Ministry of Finance, Government of India.

(2016): Notification No 140/2016-Customs (NT) dated 25 November 2016, Gazette of India,Extraordinary, Part 2, Section 3, Sub-section (i), Central Board of Excise and Customs, Department of Revenue, Ministry of Finance, Government of India.

Dave, Sachin (2019): Customs Departments Work Closer to Vet MNC Transfer Pricing, Economic Times, 6 June.

Deloitte and TaxSutra (2015): Transfer Pricing Disputes Trends, Report 2015, http://www.tp.taxsutra.com/tptrendsreport2015.pdf.

Economic Survey (2018): Chapter 9, http://mofapp.nic.in:8080/economicsurvey/.

GFI (2010): The Drivers and Dynamics of Illicit Financial Flows from India: 19482008, Global Financial Integrity, http://www.gfintegrity.org/report/country-case-study-india.

(2015): Illicit Financial Flows from Developing Countries: 20042013, Global Financial Integrity, http://www.gfintegrity.org/wp-content/uploads/2015/12/IFF-Update_2015-Fi....

(2019): India: Potential Revenue Losses Associated with Trade Misinvoicing, Global Financial Integrity, https://gfintegrity.org/report/india-potential-revenue-losses-associated....

Jansky, Petr and Alex Prats (2013): Multinational Corporations and the Profit-shifting Lure of Tax Havens, Christian Aid Occasional Paper Number 9, http://www.christianaid.org.uk/Images/CA-OP-9-multinational-corporations....

Ministry of Finance (2014): Annual Report 201314, Budget Division, Ministry of Finance, Government of India, http://mof.gov.in/reports/AnnualReport2013-14.pdf.

(2015): Annual Report 201415, Budget Division, Ministry of Finance, Government of India, http://mof.gov.in/reports/AnnualReport2014-15.pdf.

OECD (2013): Public Consultation: Draft Handbook on Transfer Pricing Risk Assessment,Organisation for Economic Co-operation and Development, http://www.oecd.org/tax/transfer-pricing/Draft-Handbook-TP-Risk-Assessme..., 30 April.

(2015): BEPS Project Explanatory Statement 2015 Final Reports, OECD/G20 Base Erosion and Profit Shifting Project, Organisation for Economic Co-operation and Development, http://www.oecd-ilibrary.org/docserver/download/2316341e.pdf.

RBI (2019): Census on Foreign Liabilities andAssets of Indian Direct Investment Companies 201718, RBI Bulletin, 28 January, https://www.rbi.org.in.

UNCTAD (2013): Global Value Chains: Investment and Trade for Development, World Investment Report, 2013, United Nations Publication.

United Nations (2017): United Nations Practical Manual on Transfer Pricing for Developing Countries, New York: United Nations Publications, pp 41758.

World Economic Forum (2015): State of the Illicit Economy, Briefing Papers, http://www3.weforum.org/docs/WEF_State_of_the_Illicit_Economy_2015_2.pdf.

Go here to see the original:

Risk-based Audits for Transfer Pricing : Some Key Concerns - Economic and Political Weekly