Budget impact: New arm's length norms, interest restrictions will hit India Inc

MUMBAI: Indian companies transacting with related parties such as foreign parents or group companies may find themselves badly hit with the proposed transfer pricing provisions and also those relating to thin capitalisation, as it would result in a higher income tax (I-T) outgo. A fresh slew of litigation arising from these issues cannot be ruled out.

In simple words, if there is an upward transfer pricing adjustment made to the income of an Indian company that has earned such revenue through transactions with its parent or group companies (known as related parties), then the quantum of such addition needs to be brought back to India within a stipulated time. Else, it will be treated as a loan given by the Indian company , which will attract a notional interest charge and a tax on such interest income. Proposed thin capitalisation rules have restricted the amount of interest that can be claimed if loans are taken from related parties. This is because interest is allowed to be deducted from profits resulting in an I-T arbitrage.

The proposed transfer pricing rules can be illustrated.For example, Company A, based in Bengaluru, provides software development services to its US parent. It operates on a cost plus 10% margin (say Rs 110 is reimbursed by parent for its services). The transfer pricing officer says the profit margin should be higher at 20%. Company A, if it accepts this upward adjustment, currently has to pay tax on the additional Rs 20. This adjustment is called primary adjustment.


The Budget proposals provide that Company A and US parent will need to record this primary adjustment if it exceeds Rs 1 crore in respective books of accounts. This recording is called a secondary ad justment. However, if the Indian company does not accept the adjustment made by transfer pricing authorities and opts for litigation, secondary adjustment does not apply . Vijay Iyer, transfer pricing leader at EY says: “If the amount relating to the primary adjustment is not repatriated to India by the foreign related party within the time limit (yet to be prescribed), it shall be treated as a loan given by the Indian company . A notional interest on such loan will be computed. If the taxpayer does not invoice and collect the sum, interest may continue to accrue.“ Hitesh Gajaria, chartered accountant and transfer pricing specialist, points out that the unintended adverse consequences and the possibility of double taxation.

“Such notional interest will be taxable income in the hands of the Indian company , on which it would pay tax at 30% plus surcharge and cess. The US parent may not face any deduction, either for the upward adjustment (Rs 20 in the illustration) or the notional interest -both of which it would record in its books. It is not clear how the Indian company or the transfer pricing official would be able to influence what the US parent would record in books of account. The proposed income tax amendment may need to be harmonised with India's foreign exchange regulations, under which cross-border loans are tightly governed.“

Transfer pricing, thin capitalisation decoded
Transfer pricing in essence calls for an arm's length pricing between related parties. Thus, if Company A, which is a captive in India, provides software development to its parent in the US, the price it charges needs to be at arm's length (the same price it would charge to third parties). Transfer pricing provisions ensure that revenue is properly captured in the source country (which in this case is India). Thin capitalisation rules by limiting the amount of interest that can be claimed as a tax deduction if loans are from related parties deter income tax arbitrage. This is because interest is allowed as a deduction for computing taxable profits. A company is said to be thinly capitalised when the level of its debt is much greater than its equity capital. TNN