DIRECT TAXES
| Reforms required in transfer pricing legislation Fri, 11 Feb 2011 21:20:32 GMT |
| On January 24, 2011, Union finance minister Pranab Mukherjee cited transfer pricing as a means adopted by multinational companies to evade taxes in India and park their income in offshore tax havens. Consequently, the ministry announced the setting up of a committee that would “look into the issue of revising the transfer pricing regulations” and submit its report by March end. Interestingly, the finance minister made his comments while discussing the issue of the government’s ongoing investigations into the source of black money parked by Indians in foreign tax jurisdictions. Drawing such a parallel will inevitably raise (unfounded) beliefs in the minds of the casual listener and liken MNCs to those who adopt devious methods to create and fatten their Swiss bank accounts as an explicit form of tax evasion. The FM’s reference to transfer pricing in the context of unearthing black money is unwarranted and misleading. Let me explain why. Transfer pricing regulations provide a framework to MNCs to adopt internal pricing policies that are market driven and not influenced by the relationship within the organisation. The primary objective of all tax authorities across the globe in enforcing transfer pricing policies is to ensure that MNC entities within their respective jurisdictions do not under report income in that jurisdiction. The temptation to under report income may be high in instances where the entity operates in a high tax rate environment. However, the determination of what a “fair” income would be is fraught with subjectivity – how does one decide with certainty that a car manufacturer (say) must necessarily earn a defined level of profits in a certain country? This uncertainty leads to disputes between tax authorities and the tax payer. While the former always finds and cites reasons why the business should have resulted in higher profits than what was reported, the taxpayer finds reasons to justify their performance by comparing their results to their independent peers in the same market. The transfer pricing environment in India has been extremely aggressive and latest estimates suggest that the tax authorities have made an upward adjustment to the income of foreign multinationals in India to the tune of `45,000 crore. Clearly, these astronomical numbers carry an implicit accusation that the foreign MNCs are evading taxes in India. But a closer look at the basis of arriving at these numbers tells a slightly different story and belies the FM’s claim that the MNCs are operating in the same manner as the other offenders holding “black money” abroad. One interesting study that provides a somewhat in-depth and rigorous account of illicit capital flows from India is “The Drivers and Dynamics of Illicit Financial Flows from India: 1948-2008” authored by Dev Kaur (November 2010) and published by Global Financial Integrity . According to this study, the total value of illicit assets held abroad represents about 72% of the size of India’s underground economy which has been estimated at 50% of India’s GDP (or about $640 billion at end 2008). The study also finds that India’s liberalisation policies had a negative impact on illicit flows in that liberalisation of trade and general deregulation led to an increase in illicit flows rather than their curtailment. The report states : “It seems that trade liberalisation merely provided more opportunities to related and unrelated companies to misinvoice trade, lending support to the contention that economic reform and liberalisation need to be dovetailed with strengthened institutions and governance if governments are to curtail capital flight.” While this lends support to a notional form of capitalistic exploitation of India’s resources post liberalisation, the issue of transfer pricing finds only scant mention and reference in the report. For example, there is not even a passive reference – let alone a formal finding – regarding the purported fact that MNCs are mis-pricing their products and services in the context of doing business in and out of India. Moreover, the report makes no attempts at deriving an economic impact of the presence of MNCs in India – their role in employment generation, technology transfer, multiplier effects on the secondary and tertiary sectors and other benefits that clearly add to the India growth story. Likening transfer pricing practices to the act of creating black money is therefore a stretched conclusion, and does not merit the slander and aspersion that comes with such a reference. From a practical perspective, the mere fact that income to the tune of `45,000 crore has been adjusted provides little insight to the basis of such adjustments. A large fraction of these adjustments are not based on sound economic principles – a fact that has been largely endorsed by the courts that have started adjudicating on such disputes in recent times. Take the following example as an illustrative case – the Indian subsidiary of a MNC does contract research in India and gets complete funding for such research (including the failed attempts at creating something commercially viable) by its overseas entity. Having borne the cost of such uncertain research, the foreign entity claims economic ownership on the outcome. This principle is largely consistent with the risk-return trade-off that is well accepted by economists – higher risk warrants a higher return, on average! However, the tax authorities have disputed such claims and have gone on to adjust the income of the Indian company by a corresponding share of global profits that the MNC has generated by commercially exploiting the outcome of the research activity. Result: an income adjustment exceeding Rs 1,500 crore! There are numerous other instances where the adjustments are devoid of economic merit and it is only a matter of time before which the courts will start hearing and opining on these adjustments. But by then, the cost of doing business in India would have far outweighed the benefit perceived by the MNCs of being in India and the India growth story will be put to a serious stress test. All this, by no means, undermines the need to reform the existing transfer pricing legislation in India. Additional guidelines and rules helping to resolve the uncertain tax climate will be a welcome change and will certainly aid in improving compliance and indeed tax revenues. But the issue of recovering black money is distinct from creating a better discipline in the transfer pricing laws. It is time to recognise this difference and treat the two problems in their own respective rights with no overlap in interpretation or enforcement. (The author is principal economist at Deloitte Touche Tohmatsu India . Views are personal) |
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