Vasan MS, Sr. Vice President – Global Taxation, Hinduja Global Solutions

Under Transfer Pricing regulation, Safe Harbor rules means binding rules laid down under law which mandates income tax authorities to accept the transfer price declared by the assesse, if opted for. Further section 92CB provides methods for determination of arm’s length price. Safe Harbor rules are in nature of safe harbor percentage of operating profit margins /interest rates/ corporate guarantee fees or commission specified in Rule 10TD(2) in respect of eligible international transactions. CBDT vide notification dated June 7th, 2017 revised the earlier safe harbor rules in India. The revised Safe Harbor margins set out by the Indian tax authority for Information technology and Information technology enabled services ranges between 17%-18% from that of 20%-22%.

However, to analyze whether these margins are attractive the question to be pondered over is :-

a) Whether downward revision is due to overall decrease in comparable company’s margin for all the listed eligible transactions identified for Safe Harbor rules.

b) Whether the margins mentioned under Safe Harbor Regime is defendable before the Transfer Pricing officers (TPO) under the normal transfer pricing audit process itself, if not opted for Safe Harbor.

The Safe Harbor regime may not be an attractive option in today’s pricing pressure and increase in cost elements, if the margin is not between 12% to 15%. With ever changing field of IT / ITES requirements, research and development in software or pharma or KPOs and also due to technological advancement and sophisticated tools brought in to navigate, the dependencies on outsourcing the routine jobs is reducing gradually. The IT /ITES sector is undergoing radical changes with Robotics and Artificial Intelligence tools installed for self-help by the customers and to like and decide, rather than explaining and billing for.

Further, the revised Safe Harbor margins also do not really align with its purpose for which notified in 2012. The purpose of Safe Harbor rules notified in 2012 was to check the geometric progression of litigation in the TP world of the Indian tax system due to aggressive audit practices adopted by TPOs. It was observed that more than 70% of the cases proven to be perceived high margins by the TPOs, was rejected by tax courts in India. Added to this, was the ambiguity in classifying the services as KPO vs. BPO and comparing with the third party Indian companies accordingly without looking through the activities performed. The taxpayers thus looked at the Safe Harbor regime as a lender of last resort to end their continued bleeding due to high tax demands and blockage of working capital for years’. Presently, the Transfer Pricing adjustments have come down from last year due to risk based assessments. That’s why the revised Safe Harbor margin is still higher and not attractive. The margins should match the Mutual Agreement Procedure (“MAP”) rates which are negotiated between two different country’s competent authorities. Only then, it could be attractive.

It is also seen that after 13 audit cycles, Indian TPOs focus mainly on FAR analysis and other TP differentiators to establish the net margins with that of the third party comparable and arrive at the arms-length nature of the given transaction. It is assumed that, if an enterprise has a reasonable margin of say 15%, it shall be at arms-Length for routine nature of transactions with the related parties. However, the rates enumerated in the table below starts with 17%-18% only.

The below tabulation shows the revised margins prescribed for Safe Harbor regime:

Eligible International transaction Revised Conditions for eligibility Net Margin from 2009-10 to 2015-16 Net Margin revised in 2016-17 for 3 years till 2018-19
Software Development Services The turnover threshold and margin percentage has been reduced Up to Rs.500 cr.- 20% of Operating Cost (OC) ; above Rs. 500cr. – 22% of OC Up to Rs.100 cr. – 17% of OC ; Rs. 100cr. to Rs. 200 cr. – 18% of OC
Information Technology Enabled Services The turnover threshold and margin percentage has been reduced Up to Rs.500 cr.- 20% of Operating Cost (OC) ; above Rs.500cr. – 22% of OC Up to Rs.100 cr. – 17% of OC ; Rs. 100cr. to Rs. 200 cr. – 18% of OC
KPO services Now the threshold limit is prescribed with employee cost percentage. Emphasis given to employee cost and margins identified accordingly 25% of the OC Up to Rs.200 cr. subject to employee cost to OC ; <40% – 18%; 40 to 60% -21% ; >60% – 24%
Intra- group Loans Credit rating made as the basis to charge interest
– INR loans No value threshold prescribed except where the AE’s credit rating not available SBI rate plus basis points shall apply SBI rate plus basis point based on credit rating
– Foreign Currency No value threshold prescribed except where the AE’s credit rating not available Not applicable SBI rate plus basis point based on credit rating
Corporate Guarantee Rate reduced as per loan value Up to Rs.100 cr. -1.75% ; above Rs. 100cr. -2% Up to Rs.100 cr. – 1% ; for above Rs. 100cr.- @1% but credit rating is required
Contract Research & Development Threshold limit prescribed
– Software related 30% 24% for up to Rs. 200 cr.
– Pharma related 29% 24% for up to Rs. 200 cr.
Manufacture and Export of Auto components No change
– Core 12% on OC 12% on OC
– Non-Core 8.5% on OC 8.5% on OC
Receipt of Low Value-adding Intra- group services This is introduced as a new item based on BEPS action plan 10 Not applicable 5% mark-up subject to maximum value of Rs. 10 cr. duly certified by accountant for the costs

Compliance costs still burdensome 

From the above table, it is very clear that the rates are more or less aligned to the market comparable for the said activities. The main gainer for the assessee would be “low value-adding intra group services”, which is added as part of safe harbor rules – eligible transactions. Following that, India has also included the same as part of the Safe Harbor rules which is a welcome move. This could be opted for, by Multi-national companies who do have cross-charges for various intra- group services. However, this also comes with a rider that the costs have to be certified by the qualified Accountant for reasonableness of allocation keys used and whether it is an operational expenditure or shareholder costs. The maintenance of all the TP documents and report in the prescribed format shall continue under the Safe Harbor Rules also. This implies that the compliance cost shall remain as it is. In fact, it might be doubled, as only eligible transactions can be opted for safe harbor and other transactions shall be subject to normal transfer pricing compliance and audit process.

Some welcome steps in the new regime

Another significant revision made by the CBDT to enable KPOs to opt for Safe Harbor regime, is to tag the employee cost to Operating Cost as a ratio for fixing the margins to be adopted. The higher the employee cost, the higher margin is expected under the regime. This is based on the assumption that KPO is more an intellectual arbitrage and higher skilled human driven process. Further, Identification of costs relating to ESOP and reimbursements shall form part of the employee cost. Also, CBDT in a welcome move has put to rest, disputes arising out of the inter-co loans borrowed in local currency vs. foreign currency within the Multi-National Enterprises (MNE), by distinguishing the interest rates for determination of arms-length treatment of such loans.

Conclusion and way forward

MNCs would prefer opting for DTAA relief and Mutual agreement procedure vis a vis Safe Harbor regime being more approachable. A Bilateral Advance Pricing Agreement (BAPA) between the Associated Enterprises (AE) could also be a better approach in the long term, as both tax jurisdiction agrees to the margins arrived at and allowed for the income/expenditure in the respective country.

It must be further noted that safe Harbor margins should be at par with APA or MAP margins for the eligible transactions. It should cover all the transactions so that the assessee need not comply once again with normal TP procedures for other international transactions. That discretion should be given to the TPO to approve other transactions not falling in the ambit of eligible transactions for Safe harbor, based on the margins earned while approving for the Safe harbor rules itself.

Thus definitely, this is a step towards Ease of doing business in the India TP environment where the litigation looms larger than the international transactions taking place between the AEs of the MNE group. However, Broad-basing the eligible transactions list and having lower margins will make it more attractive to opt for and reduce the time spent by TPOs during TP audits.

(The opinions expressed in this article are the author’s personal views.)

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December 2020