JUNE 02,2020

By Vinay Verma & Rohit Tiwari, Advocates, KRS Legal

COVID-19 pandemic has disrupted the economies of various countries including India. The major impact to Indian economy is downgrading of growth for fiscal year 2021 by credit rating agencies and World Bank due to temporary lockdown. The majority of the companies had to temporarily shut down its operations during the period of lockdown. To state, supply chain of the industry is in distress, service sector is impacted due to no labour, under-utilization of capacities, fixed cost expenditure and many others. This has also disturbed the work pace of the employees and thus, the capacity of people has not been put to optimum utilization. To tackle the situation, the Government of India announced a variety of measures in terms of food security, healthcare, sector related incentives, increasing the threshold of FDI investments and tax deadline extensions including fiscal stimulus to save collateral damaged to Indian economy due to COVID - 19 pandemic.

With respect to the income tax provisions, though there have been many thoughts around the adjustments that should be undertaken while working out the margins of the companies or preparation of robust documentations, I shall converse on certain tax amendments/concessions or clarifications that should be brought in by Government of India via notifications or circulars to provide more clarity and certainty to taxpayers in India.

1. Computation of arm's length price of an international/specified domestic transactions

Though to eliminate the impact of COVID-19 crisis, multinational enterprises may adopt economic adjustments suggested in OECD Guidelines, UN TP Manual and several transfer pricing judgments/rulings. Economic adjustments such as working capital or capacity under-utilization, extraordinary revenue loss, incurrence of extraordinary costs or foreign exchange fluctuation would support in preparing a robust transfer pricing documentation.

Amongst many other transfer pricing issues, I have deliberated on some of the important issues which should be considered by Government of India to provide an extra support to taxpayers in India:

1.1. Arm's length range of 35th to 65th percentile

Till March 2014, to arrive at the arm's length price, the margin of the tested party (company of which margin is to be compared) was compared with the arithmetic mean of the comparable companies.

To provide flexibility to taxpayers, the Government of India introduced the concept of arm's length range in place of arithmetic mean, applicable in case of all transfer pricing methods except Profit Split Method ("PSM") and Other Method. The aforementioned concept is applicable from April 2014 onwards. For PSM or Other Method, the earlier concept of arithmetic mean has to be adopted used for calculating the arm's length price. Also, the range concept applies only when the dataset is of at least 6 comparable companies.

The arm's length range is defined as 35th percentile and the 65th percentile of the dataset of comparable companies arranged in the ascending order. If the transaction falls within the aforesaid range, then the transaction is deemed to be at arm's length. Furthermore, in case of less than 6 comparable companies, the earlier concept of arithmetic mean has to be followed.

In order to provide flexibility in arriving at the arm's length price to the taxpayers in India for the current financial year, relaxation to the taxpayers be provided by enlarging the percentile range from 35th - 65th to globally accepted practices of 25th - 75th percentile range, which is more closer to economic realities. The above adoption would clearly demonstrate comparability in more realistic term at industry level in current fiscal year and would be more effective for determination of arm's length price of transactions.

Alternatively, the Government of India may also consider the reverting to the earlier provisions affording an option to the taxpayer to compare the margin of the tested party with the arithmetic mean of the comparable companies, to determine the arm's length price.

1.2. Tolerance band of 1% for wholesale traders and 3% for others

Under transfer pricing provisions, a variation between the arm's length price determined under section 92C of Income Tax Act, 1961 ("IT Act") and the price at which the international / specified domestic transaction has actually been undertaken does not exceed 1% of the latter in respect of wholesale trading activity and 3% of the latter in all other cases, the price at which the international / specified domestic transaction has actually been undertaken shall be deemed to be the arm's length price. The Government of India issued this notification pertaining to assessment year 2019-20.

Considering the impact of COVID-19 situation in India, the companies in India are bound to close their operations partially or completely during the lockdown period, hence, there could be a fall in margins of the tested party (company of which margin is to be compared).In such a situation, possibility arises that the variation between the arm's length price determined and the price at which an international transaction/specified domestic transaction has actually been undertaken exceeds 1% / 3%, and a suo motu adjustment is required in the return of income. This may cause hardship to the taxpayers. Hence, it would be imperative if the tolerance band of 1% or 3% is relaxed and the Government of India may consider reverting to earlier range of +/-5% irrespective of any category of taxpayer.

1.3. Impact on Advance Pricing Agreements ("APA")

The APA programme in India has been successful in providing certainty to the taxpayers opting for the scheme. All APAs are agreed with certain critical assumptions which are required to be met for the years covered in such APA.

In the on-going COVID-19 scenario, the multinational enterprises (which are contract manufacturing or limited risk bearing entities) may consider revision or re-negotiation of operating margins agreed or proposed to be agreed in the APAs.

Further, extra-ordinary costs are usually defined in the APAs wherein the impact of an act similar to COVID-19 situation on such costs is considered as non-operating in nature. In this regard, it would be necessary for statutory auditors of the entity to mention in the financial statements, the quantum and nature of such extra-ordinary costs separately. The APA authorities should consider adding a clause like "Force Majeure" which would support in dealing with such extra-ordinary events which are beyond the control of the parties in the agreement. The parties can take reference in this regard from Section 32 of the Indian Contract Act, 1872, if such clause is absent from the agreement.

Another point to emphasize here is that once the extra-ordinary costs are identified, the APAs should state whether the Indian entity may recover the same on cost-to-cost basis from its foreign associated enterprises ("AEs"). On the other hand, the aforementioned AEs may not be able to reimburse the same to its subsidiary entity, on account of the fact that such AE would have also borne the impact of COVID-19, then whether the Indian entity should bear the same on its own, thereby reducing the net profitability.

The Indian entity would be required to document the details of such extra-ordinary costs for discussion/negotiation with APA authorities.

1.4. Identification of "Extra-Ordinary" costs

Another issue which can arise is the classification of costs as extra-ordinary in nature.

Operating expenses means the costs incurred by the taxpayer in relation to the international transaction or specified domestic transaction during the course of its normal operations and does not include extraordinary expenses. Just to reiterate, the identification of extra-ordinary costs or income should be undertaken by the statutory auditor of the company, being the person aware of each part of the expense incurred by the company. This would support the taxpayer as well as tax authorities to exclude such costs / income while computation of margin earned by the company. Accordingly, the details of costs identified as ‘extra-ordinary' in nature should be adequately thought through and documented appropriately.

For instance, in case of inventory of goods which became obsolete on account of non-movement of stock, the taxpayer may have to make the provision for diminution in value of stock anticipating the loss in the value of stock. Such provision of inventory made by the taxpayer should be treated as extra-ordinary in nature by the tax authorities.

The reference can be also be drawn from the definition of operating costs/revenue provided in Rule 10TA of Income Tax Rules, 1961 [i.e. Safe Harbor Rules] wherein extra-ordinary cots/revenues have been excluded specifically as the same does not pertain to normal operations of the company.

The abovementioned issues would majorly arrive in the case of captive service providers or limited risk entities who are remunerated on a total cost plus mark-up basis.

1.5. Secondary adjustment provisions

Secondary Adjustment occurs on account of "primary adjustment" determined in relation to the transactions undertaken by an entity with AEs to arrive at the arm's length price. In other words, non repatriation of money in India arising on account of primary adjustment leads to applicability of provisions of secondary adjustment. The aforesaid provisions are introduced via Section 92CE of IT Act. The Government of India may consider the postponement of such repatriation of money beyond the financial year ("FY") 2019-20 and 2020-21, as part of relief to taxpayers in India.

1.6. Limit on interest deduction

Section 94B of the IT Act was introduced with the intent to limit the interest deduction for thinly capitalized company. The provisions state that interest to the extent of 30 percent of Earnings before interest, taxes, depreciation, and amortization ("EBITDA") shall be allowed for deduction of interest payment to non-resident AE or deemed to be AE. Furthermore, any excess interest not allowable will be carried forward for 8 years for set-off in future. The aforesaid provisions are not applicable wherein the interest payment is below INR 10 million.

Considering the impact of COVID-19 crisis and providing boost to the economy, the Government of India may increase the limit of INR 10 million and percentage of EBITDA required to be satisfied, as these measures may majorly affect the start-up companies or capital intensive companies in India.

1.7. Comparability analysis and adjustments

Comparability analysis requires comparison of margins of tested party with that of comparable companies. However, the issue of data being available at the time of documentation is always a challenge. Based on the guidance provided, multiple year data is used for the purpose of comparability i.e. two years data prior to the year under consideration is also used.

As explained above, the margin of tested party may see a drastic decline in FY 2020-21. However while preparing, transfer pricing documentation for the year, the data of comparable companies for the same year may not be available and the taxpayer may have to compare its own margin for current year with margin of comparables for the prior two years.

This may lead to a distorted comparison and may be prejudicial for the taxpayer.

Moreover, the negative impact of COVID-19 situation would be majorly reflected in FY 2020-21, therefore it is possible that the margins of tested party in FY 2020-21 would be on lower side or negative. In such a situation, weighted average of last three year margins of the tested party vis-a-vis weighted average margins of comparable companies, can be considered to determine the arm's length price of the transaction. A similar concept is being adopted by some of the countries in their transfer pricing regulations. The Government of India may consider providing certain relaxation on similar terms as a part of relief to taxpayers in India.

In some cases to justify the margins, the taxpayers may resort to a more sophisticated analysis using statistical technique. For example, reduction in the margin of comparable companies can be justified by performing a multivariate regression analysis where margins of companies in the same industry is considered as the dependent variable and other factors such as GDP, interest rates and other key macro/micro economic factors as independent variables.

2. Conclusion

Going forward, the taxpayers would be required to formulate the policies which are rational and economically viable. Furthermore, appropriate documentation is the key to justify the amendments made in the policies or classification undertaken in identification of operating costs. The measures relating to few amendments to Ind-AS/Auditing Standards, may emerge as a relief to the taxpayers in India. Certain other important relaxations are also required from Government of India to support the taxpayers to conduct the business effectively.

[The views expressed are strictly personal.]