Tax Avoidance and Evasion

This article discussed various methods of Tax avoidances and problem of Transfer pricing and its implications on India’s tax revenues.

Methods of Tax avoidances

• Tax Havens: Route profits through subsidiaries located in tax havens
• No Repatriation of Profits: Companies headquartered in the US give a declaration to the tax a authorities there to not repatriate non-US profits, avoiding tax in their home country
• Transfer Pricing: Use transfer pricing to allocate expenses to high-tax countries and profits to low-tax countries
• Round Tripping: Commonly used for intellectual property rights. For example, US parent sells patent to its subsidiary in Netherlands, a low-tax country. The Dutch subsidiary received royalty payment from the US parent.
• Share Buyback: Parent invests in Indian company through Mauritius. Since dividends are taxed in India, the Indian company buys back the shares. Profits are repatriated to Mauritius, where capital gains tax is zero.

Concept of Transfer Pricing

Before we understand this concept, we need to take an example. In 2009-10, TCS had shown a net profit per employee of Rs 4.3 lakh. At the same time, Capgemini, a foreign IT firm with operations in India, recorded a net profit per employee of Rs 1.5 lakh. Thus, Capgemini showed a net profit per employee which is around one third of TCS.

Despite of similar business, similar in contract pricing and similar in salaries and other expenses, why the foreign IT firms reporting profitability numbers that are a fraction of their Indian peers?

This difference goes on the same lines on other scales such as revenue per employee, operating profit margin, net profit margin. The experts say that this is due to the menace of Transfer pricing.

• Transfer pricing is where a foreign parent company with operations in many countries, including tax havens, prices its transactions with its Indian subsidiary, apparently to reduce its overall tax liability.
• The fundamental principle of these related-party transactions is that the price at which the Indian subsidiary (e.g. Yahoo India) provides a service to its parent (e.g. Yahoo US) should be similar to what it would have charged a client.

Definition

• Commercial transactions between the different parts of the multinational groups may not be subject to the same market forces shaping relations between the two independent firms. One party transfers to another goods or services, for a price. That price is known as “transfer price”.
• This may be arbitrary and dictated, with no relation to cost and added value, diverge from the market forces. Transfer price is, thus, a price which represents the value of good; or services between independently operating units of an organization.
• But, the expression “transfer pricing” generally refers to prices of transactions between associated enterprises which may take place under conditions differing from those taking place between independent enterprises. It refers to the value attached to transfers of goods, services and technology between related entities.
• It also refers to the value attached to transfers between unrelated parties which are controlled by a common entity.
• Example: Suppose a company A purchases goods for 100 rupees and sells it to its associated company B in another country for 200 rupees, who in turn sells in the open market for 400 rupees. Had A sold it direct, it would have made a profit of 300 rupees. But by routing it through B, it restricted it to 100 rupees, permitting B to appropriate the balance. The transaction between A and B is arranged and not governed by market forces. The profit of 200 rupees is, thereby, shifted to the country of B. The goods is transferred on a price (transfer price) which is arbitrary or dictated (200 hundred rupees), but not on the market price (400 rupees).
• Thus, the effect of transfer pricing is that the parent company or a specific subsidiary tends to produce insufficient taxable income or excessive loss on a transaction. For instance, profits accruing to the parent can be increased by setting high transfer prices to siphon profits from subsidiaries domiciled in high tax countries, and low transfer prices to move profits to subsidiaries located in low tax jurisdiction.
• As an example of this, a group which manufacture products in a high tax countries may decide to sell them at a low profit to its affiliate sales company based in a tax haven country. That company would in turn sell the product at an arm’s length price and the resulting (inflated) profit would be subject to little or no tax in that country.
• The result is revenue loss and also a drain on foreign exchange reserves. The Transfer pricing has been a taxing issue for both multinational corporations and tax authorities for a long time. The Transfer Pricing has been under tough scrutiny by the authorities in India, which look for a better share in the tax from the companies.
• Most of the countries in the western world have their own rules regarding the transfer pricing. Indian Government also seels to take some proactive measures to resolve the disputes arising due to the transfer pricing.

Transfer Pricing Rules

• Claiming that foreign IT firms don’t always invoke this principle of pricing, the IT department is showing the transfer-pricing rules — introduced in 2001 –to them.
• The existing transfer pricing provisions which were introduced in the year 2001 do not have detailed provisions as compared to transfer pricing provisions of developed countries such as OECD Rules.
• In India, there is a need to upgrade these transfer pricing provisions to meet the challenges of growing intangible economy and various complex cost sharing arrangements.
• As per directions of FM, DGIT (International Taxation) has constituted a committee to look into the issue of revising the transfer pricing provisions.

Impact on Indian Economy

We read in the financial newspapers that the cases of the department asking foreign IT companies to recalculate revenues are increasing. As is the quantum of adjustments on account of transfer pricing. The overall adjustment figure for all foreign companies operating in India, in both the IT sector and in non-IT sectors, hit a new high of Rs 22,800 crore in 2010-11.

Transfer Pricing audit

• The Government has taken steps to strengthen our Transfer Pricing audit. The TP regulation came into force in India only in 2001.
• It took us some time to gain expertise. Within a short span of time, Indian TP auditors have made adjustments worth Rs.45,000 crore.
• For cases under MAP, quite a substantial part of the additions have also been confirmed in MAP resolution, which speaks highly about the quality of the TP audits.

Dispute Resolution Panel (DRP)

Dispute Resolution Panel (DRP) was constituted under section 144C of the Income Tax Act, 1961 inserted by the Finance Act 2009. DRPs had been constituted at Delhi, Mumbai, Ahmedabad, Kolkata, Chennai, Hyderabad, Bengaluru and Pune. DRP consists of three commissioners or directors of income tax appointed by the Central Board of Direct Taxes (CBDT). Any foreign company, or any domestic company with transfer pricing issues, in whose case the income-tax assessing officer proposes to make any variation in the income or loss returned, may apply within a month of receiving the draft assessment order before the DRP for appropriate remedy by way of direction to the assessing officer. However, by now, it has not been a good idea.