Keeping pace with the international best practices and its commitment towards OECD BEPS Initiative/ G20, India through Finance Act 2017 has brought in certain unconventional changes in the Transfer pricing (‘TP’) & International taxation regime. After EQL, CBCReporting – BEPS Action Plan 13, Lower tax on patents, now we see thin Capitalisation rules (BEPS AP 4) and Secondary Adjustments.
Let us discuss in detail, one of the most talked about amendment brought by Budget 2017 which is Secondary Adjustments.
Under existing TP regulations if an adjustment is made to arm’s length price (‘ALP’) as computed by Taxpayer there is no further requirement for Taxpayer to give economic effect to the transaction and take it to its logical end. Such an adjustment is done for tax purposes so that Revenue does not suffer due to non-arm’s length pricing. This a Primary Adjustment (‘PA’). This adjustment does not enter the books of accounts, only the resultant tax impact is taken.
However, now a new section 92CE has been inserted in the Income-tax Act, 1961 to provide for secondary adjustments (SAs), to align with OECD TP Guidelines & international best practices. “Secondary adjustment” means an adjustment in books of accounts of Assessee and its associated enterprises (‘AE’) to reflect that the actual allocation of profits between assessee and its AE are consistent with the transfer price determined as a result of primary adjustment (‘PA’), thereby removing the imbalance between cash account and actual profit of the assessee.
Assessee shall be required to make a secondary adjustment in cases where a primary adjustment exceeding INR 1 Crore to transfer price:
- has been made suo motu by the assessee in his return of income; or
- has been made by Assessing Officer (‘AO’) and accepted by assessee; or
- is determined by advance pricing agreement (APA) entered into by assesse u/s 92CC; or;
- is made as per the safe harbour rules framed u/s 92CB; or
- is arising as a result of resolution of an assessment by way of mutual agreement procedure (MAP) under agreement entered into u/s 90 / 90A
Where primary adjustment results in an increase in total income or reduction in loss of assessee, the excess money available with its AE, if not repatriated to India within prescribed time, shall be deemed to be an advance made by assessee to such AE and the interest on such advance shall be computed as income of assessee, in the prescribed manner.
SA Provisions are not to be applied where Primary adjustment is made in respect of period prior to AY 2017-18 (i.e. AY 2016-17 and before).
As per OECD TP Guidelines, Secondary adjustments may take the form of constructive dividends, constructive equity contributions or constructive/ deemed loans. India has chosen to apply SA provisions in the form of constructive/deemed loans by imputing interest on the same. The provisions of secondary adjustment are internationally recognised and are already part of the transfer pricing rules of many leading economies in the world.
To explain the concept of PA and SA, let us take an example of an Indian captive service provider company (I Co) providing services to its foreign AE (F Co) on a cost plus basis:
- Actual transaction price: Cost of 1000 + 10% mark -up = 1100
- Arm’s length price: Cost of 1000 + 15% mark-up = 1150
- Primary adjustment in the hands of I Co. : 1150 – 1100 = 50 on which tax will be paid
- Excess cash in the hands of F Co. : Rs. 50
An SA seeks to address the impact of the excess cash of Rs. 50 in the hands of F Co. Put differently, it seeks to address the impact of cash deficit of 50 in the hands of I Co. Had the transaction been conducted at arm’s length originally, the amount of 50 would have been reported in the books of accounts of I Co, and collected in the ordinary course of business. Eventually, I Co would incur cost related to repatriation of the amount of 50.
Way forward, Practical difficulties, Gray Areas or where clarity is needed
1. Taxpayers presently doinga suo-motu primary adjustment in their return on income (to align their transactions with ALP principle) might get discouraged to do such an adjustment. This may lead to a loss of revenue at self-assessment stage. However, if any adjustment is made in the books itself a benefit of +/-3% range as per proviso to Section 92C is available with the Assessee.
2. Practical difficulties: e.g. the foreign country in which the AE is located may have exchange control provisions that make it difficult to repatriate the excess money to India, or it may have adjusted the transaction as per its own TP provisions and already taxed a portion of the funds Indian tax authorities consider as excess income. The foreign AE may not be willing to repatriate the difference to India (Rs 50 in above example) or may willing to repatriate only the net amount available in their hands after paying taxes in their home country (Example Rs 50*70% – considering 30% tax rate in hands of foreign co.)
3. Adjustment in the books of accounts of the AE: Section defines SA to be an adjustment in the books of accounts of the Assessee and the AE.It may not be within the control of the taxpayer to enforce recording of a PA in the books of accounts of the AE. Moreover, it would be beyond the jurisdiction of the Indian regulations to mandate such an action on part of the AE located outside India.
4. Economic Double taxation: in case taxpayer is unable to receive cash for Secondary Adjustment, it would result in a deemed interest charge. Such deemed interest may not be tax deductible in the overseas jurisdiction where the related parties are based.
5. Corresponding Adjustment: As per OECD Model commentary -Article 9(2), any amount subject to tax in hands of the Indian taxpayer in the form of SA, would not be available for set off in the hands of the concerned foreign AE in its foreign jurisdiction, as “corresponding adjustment”, since such benefit is only available for PA, provided there is an enabling provision under the Treaty and countries agree under a Mutual Agreement procedure (‘MAP’).
6. Meaning of PA accepted by Assessee not clear: Where Assessee appeals against a PA made by the AO/TPO, which is ultimately partially sustained in the highest forum; or a forum beyond which either the taxpayer or the Revenue does not wish to agitate, would SA apply in such case; and if yes, there needs to be a proper mechanism formulated in the legislation to subject only such revised amount as a SA, with extended time limits for repatriation thereof by the AE, in order to obtain exoneration from levy of such tax.
7. SA arising in case of overall TNMM: Taxpayers having complex business structures and dealing with multiple overseas AEs, but who follow overall transactional net margin method (TNMM), in their case if the AO makes a PA in Transfer Prices by accepting such application of overall TNMM adopted by the taxpayer, an issue may arise as to which foreign AE needs to repatriate the amount of PA in favour of the Indian taxpayer in order to obtain immunity from SA? One quick fix solution to counter this could be to apportion the PA amongst the various AEs in ratio of the amount of international transactions entered into by the Indian taxpayer with such entities. However, the safer solution would be for such taxpayers to follow the fundamental approaches of TP and adopt a transaction by transaction approach, instead of an overall TNMM.
8. Constructive Loan has the effect of Constructive Dividend: In the earlier e.g. the amount charged from F Co by I Co was Rs. 1,100 whereas it has paid tax on service income of Rs. 1,150 on agreeing that it ought to be the ALP. This practice was widely being used to avoid Dividend Distribution Tax (‘DDT’) on the amount of TP adjustment. Now, as per Section 92CE(1), I Co is required to pass necessary entry in the books of account whereby the profits of I Co are reflected at arm’s length basis. Thus, even for the purpose of books of account the profits would increase to Rs. 1,150 (instead of Rs. 1,100) with corresponding amount shown as receivable from the AE. Accordingly, ‘accumulated profit’ for the purpose of Section 2(22) i.e. dividend would be Rs. 150 [instead of Rs. 100] and in case of distribution of dividend or ultimately at the time of liquidation, DDT would be payable on Rs. 150 (instead of Rs. 100).
Thus, while making a book adjustment does not trigger any constructive dividends, it certainly enhances the value of dividend whenever declared in future. The side effect of SA onthe DDT has neither been publicly discussed but has been simply and silently proposed to be made as part of the law.
Conclusion and reflection:
SA Provisions are present in many countries, including US and a number of European countries. Therefore, the introduction of secondary adjustment is not anomalous to global practices. However, the stringent requirement to record the Primary Adjustment in the books of accounts is quite burdensome. Mobilising cash from related parties, which could be several in number, is extremely difficult. The fact that this would be required much after the close of the relevant financial year significantly adds to the complexity, and pushes the level of difficulty.
Even today, in the area of transfer pricing, the taxpayers’ most significant expectation from the Government continues to be addressing the TP related litigation and to reduce the same in future. With the objective of ease of doing business in India, introduction of Secondary Adjustment provisions, especially in the proposed manner, may add to the woes of the taxpayers.