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The government on Wednesday announced rules giving conditional exemption to global MNCs’ transactions with their Indian units from being questioned for suppression of income here. The new ‘safe harbour’ rules cover 10 specified types of transactions, the value of which will not be audited to verify whether they are at arm’s length, if the rules are followed. The move could bring relief to a lot of companies in the IT and ITeS sectors and those engaged in contract research in IT and pharmaceutical sectors as well as in production of auto ancilliaries.

Some of the safe harbour norms also cover the entire corporate sector in areas like outbound loans and corporate guaranties.

MNCs have been complaining about Indian tax authorities’ “aggressive stance” on transfer pricing adjustments. The I-T department attributed an additional taxable income of over R70,000 crore on this front to the MNC arms in the 2012-13 audit, up 58% over such claims in the 2011-12 audit.

The rules will be notified after receiving industry feedback till August 26 and will be applicable for FY13 and FY14.

As per the proposed norms, tax officials will not question the income of a captive software developing unit in India executing a work contract for its parent if the profit from the assignment is less than 20%.

Assessment officers had been issuing tax demands to some captive software companies earlier if the declared profit was less than about 30-35%. The industry wanted a lower safe harbour threshold because many South East Asian economies had come up in a big way in the IT sector, depressing the profit margins of Indian units.

While welcoming the move, some experts said the rules will would benefit only small businesses and not IT bigwigs. Mukesh Butani, chairman, BMR Advisors said the scope of safe harbour norms are restrictive in the case of software, IT and ITES as it covers only companies who earn an operating margin up to Rs 100 crore, meaning it will not benefit most captives who have been engaged in disputes on adjustments.

For information technology enabled services (ITES) other than contract R&D, the safe harbour profit margin is 20%, while the same for knowledge process outsourcing (KPO) firms is 30%. The norms also bar tax officials from questioning a loan extended to a wholly-owned subsidiary in India of a global MNC if the interest rate declared is equal to or greater than the base rate of SBI as on 30th June plus 150 basis points. The idea is to avoid questioning of loans for tax purposes if these are actually not meant for shifting of income by way of charging interest rate below market rates. For loans above Rs 50 crore, the safe harbor threshold is SBI base rate plus 300 basis points. The norms also cover corporate guarantees, contract research in software and generic pharmaceuticals and manufacture and export of core and non-core auto components.

The proposed safe harbour rules are not going to appease MNCs in view of the high margins required, said Amit Maheshwari, partner, Ashok Maheshwary & Associates. “Companies will have to approach this risk mitigation tool with caution since once exercised, Mutual Agreement Procedure (MAP), another effective dispute resolution, is ruled out and may result in double taxation,” said Maheshwari.

Vijay Iyer, partner & national leader – transfer pricing, EY described the draft rules as a positive step to reduce litigation. “In order to positively impact dispute resolution, the margins or safe harbours proposed in the draft rules may need to be recalibrated to a more acceptable zone. The exclusion of companies with turnover in excess of Rs 100 crore would limit the number of takers for the safe harbour,” said Iyer.

“An assumption that all players in software and IT earn such margins (20%) is flawed as the arm’s length margin is a function of assets, risks and functions. Hence, industry players who work on this margins and adjustments have been above 20% will not benefit and would have to continue litigating the matter,” said Butani.

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