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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.

Attacking the Cash Box

A colleague of mine yesterday highlighted comments made recently by Robert Stack, deputy assistant secretary for international tax affairs at the US Treasury Department: “We are determined to put a big dent in the ‘cash box’ because countries cannot afford large piles of untaxed income.”

4871276_sBut what is a “cash box”, anyway?  The concept is pretty simple: it’s a company within a multinational group located in a low-tax jurisdiction that owns some sort of valuable asset. That company may not even have any employees, but since it owns the asset it is legally entitled to the profits that are generated by the asset, thereby ensuring that a portion of the multinational group’s income gets taxed at a very low tax rate.

But for tax authorities, restricting the use of such arrangements is trickier than it might seem. Let’s use an example to illustrate. Imagine there’s a company called SuperTech USA that develops a fantastic new product. SuperTech USA sets up a subsidiary on a lovely tropical island that happens to have a corporate tax rate of zero, and then has SuperTech Island Co purchase the designs and technology underlying that product. SuperTech Island Co hires a contract manufacturing company in China to make the product, and contracts other SuperTech affiliates around the world, possibly including SuperTech USA, to essentially act as local sales agents.  From that time onward, whenever SuperTech products are sold to consumers the local sales affiliates get some sort of arm’s length compensation for their services (maybe a sales commission), but SuperTech Island Co gets the rest of the revenue. If it’s really a good product with fat profit margins then it’s likely that the bulk of the group’s profits will actually belong to SuperTech Island Co and be subject to zero corporate income tax.

If you are interested in stopping this type of arrangement, how would you go about it? Perhaps you might consider blocking the initial purchase of the asset by SuperTech Island Co. But companies buy and sell assets all the time for perfectly reasonable business reasons, so any sort of simple rule prohibiting that won’t work. What about requiring all of SuperTech’s sales revenue to belong to the local sales affiliates rather than to SuperTech Island Co?  Allowing the owner of an asset to claim the income generated by that asset is a basic element of our notion of property rights, so we can’t easily tamper with that.

The OECD seems inclined to address the issue in a different way: require SuperTech Island Co to pay much more compensation to SuperTech’s local sales affiliates. That’s a transfer pricing issue, and would depend on making the argument that SuperTech Island Co is paying its sales affiliates less than what it would have to pay to unrelated sales agents. Given the abundance of sales people in this world eager to have a good product to sell, it seems likely that would be a difficult argument to make. Trying to tweak existing transfer pricing rules to address this particular situation would likely open an entirely new can of worms.

Instead, Stack indicated that the US government thinks a better approach would be for an international agreement to allow countries to tax income earned by companies domiciled outside their jurisdiction. In other words, Treasury would like to get other countries to agree to allow the US to tax the profits of SuperTech Island Co even though that company is not located in the US. Needless to say, however, reaching such an international agreement could be extremely difficult.

But the economist in me wonders if the root cause of this sort of arrangement is really something else: incorrect initial valuations of the asset.  If the price that SuperTech Island Co had to pay to acquire ownership of the asset fully reflected the future stream of income that could be expected from that asset, then it seems likely that there would not be much of an incentive to move the asset in the first place. With the transaction described above SuperTech USA would record a large amount of income in the year of the asset sale – on which it would pay US tax rates – in exchange for a stream of tax savings in future years.  It strikes me that a correct initial valuation of the asset should take this into account. And if it did, then perhaps the cash box problem would not be so much of a problem after all.