Archive for India

Transfer Pricing and the Regulatory Climate in India

16530988_sWhen Barack Obama met with Prime Minster Narendra Modi in India last week, one of the items discussed was rather unusual for presidential summits: transfer pricing. But it seems that this attention from the highest levels of government may be having results.

First of all, the US and India seem to have reached agreement on a number of transfer pricing-related issues, including resolving a huge number of competent authority cases involving the transfer pricing of US firms such as IBM, Cisco, Microsoft, and Yahoo.  The Times of India reports:

NEW DELHI: India and the US have agreed on a “broad framework” for resolving transfer pricing disputes involving America companies, paving the way for increasing business ties between the two countries. Sources said the two sides reached the agreement after several rounds of negotiations…The pact also includes the promise to adhere to bilateral advance pricing arrangements (APAs) which would help US firms determine their tax liability in advance and create certainty on tax issues.

Over 150 US companies have applied for APAs in India, but these have all been for unilateral APAs, given the absence of a framework to negotiate bilateral APAs between the US and India. So there’s a lot of potential for US firms to dramatically reduce the uncertainty, at least on the tax side, of doing business in India.

Obama and Modi also met with a number of CEOs to discuss how to improve economic relations between the US and India. During the session Ajay Banga, CEO of Mastercard, specifically singled out transfer pricing as a major impediment to US firms that want to do business in India. Interestingly, yesterday the White House announced that Mr Banga is being appointed to the Advisory Committee for Trade Policy and Negotiations. This presumably means that transfer pricing will continue to receive attention at a very high level of the US government.

Finally, it’s worth noting that the day after Obama’s visit the Indian government announced that they were going to drop a half-billion dollar transfer pricing case against Vodafone.  From the Wall Street Journal:

“The [cabinet’s] decision gives a message to investors,” said India’s telecommunications minister, Ravi Shankar Prasad, after a meeting of the cabinet on Wednesday. “The government—led by Narendra Modi, the prime minister—wants to convey a clear message to investors world over that this is a government where decisions will be fair, transparent and within the four corners of the law.”

Time will tell, but as of now it appears that the present Indian government has reached the same conclusion as many other observers: India’s tax authorities are hurting the country more than they are helping it. So we could be witnessing the start of a new kind of climate change in India.

The Most Aggressive Tax Authorities in the World?

Earlier this week there was a court ruling in India related to transfer pricing. As reported by Business Standard:

3087367_sThe Bombay High Court on Tuesday ruled in favour of Shell in a transfer-pricing order that sought to tax the energy giant’s 2009 investment in its Indian subsidiary. The order will have an impact on other multinationals fighting the tax department on similar grounds.

The income-tax department had sought to add Rs 15,220 crore to Shell India’s taxable income after Shell Gas invested in its local arm at Rs 10 a share. The tax department valued Shell India’s shares at Rs 180 apiece in January 2013 and charged it with undervaluing those to evade tax… The court rejected the tax department’s argument that the Shell case was distinguishable from Vodafone’s case, which won a similar reprieve in October.

In a narrow technical sense this verdict matters simply because it means that the tax authorities in India can no longer try to apply Indian transfer pricing regulations to capital transactions such as the issuance of new shares. This will make life a bit simpler for many companies in India (including some of my clients) that have recently felt obliged to prepare transfer pricing documentation to support balance sheet transactions.

But the broader implications are more interesting. To my knowledge, India was the only country in the world that even attempted to apply transfer pricing rules to capital transactions. And that is just one of many ways in which the Indian tax authorities have very aggressively interpreted and applied transfer pricing rules to multinationals doing business in India. In transfer pricing circles, India has a reputation. This ruling is the latest in a string of court decisions that indicate that the Indian judicial system thinks that the Indian tax authorities have been overstepping their bounds.

This is a good illustration of how subjective transfer pricing can be. The fundamental principle behind every transfer pricing analysis – whether conducted on behalf of a company or a tax authority – is clear enough: transactions must be consistent with the arm’s length standard, meaning that the prices applied to intra-group transactions should be the same as market (or arm’s length) prices. But in practice, it’s often impossible to determine exactly what prices or rates of compensation would be agreed upon between unrelated parties, because such transactions are never actually observed in the real world.

As a result, there’s frequently no obviously correct arm’s length price to apply, and multinationals as well as tax authorities often have substantial latitude in how they interpret and apply the arm’s length standard to intra-group transactions. And just as some multinationals are particularly aggressive in how they approach transfer pricing, so are certain tax authorities, like those in India.

What effect does the behavior of the Indian tax authorities have on the business climate in India? Many companies (as well as some politicians in India) would argue that they effectively view the Indian tax authorities’ harshly aggressive transfer pricing enforcement as an extra tax that companies must pay to do business in India. Many are willing to pay that tax in order to reap the advantages that they get from being in India, but it is a real effect nonetheless, as it probably does dissuade some firms at the margin from undertaking certain economic activity in India.

And I find that very interesting. As a student of economics one learns a lot about how to analyze the effect of explicit taxes on behavior. Some students even learn about the importance of institutions and organizations in facilitating or hindering economic transactions (though generally I think such subjects are woefully under-taught in most economics programs).  But relatively little emphasis is paid to qualitative, subjective phenomena such as differential enforcement of transfer pricing regulations from country to county, or the broader category of “business climate”. To me this serves as a useful reminder that even such hard-to-measure economic forces or behaviors can have very real economic effects.