In his budget speech for the year 2009, the then Finance Minister, Mr. Pranab Mukherjee, stated:

“In order to further improve the investment climate in the country, we need to facilitate the resolution of tax disputes faced by foreign companies within a reasonable time frame.  This is particularly relevant for such companies in the Information Technology (IT) sector. I, therefore, propose to create an alternative dispute resolution mechanism within the Income Tax Department for the resolution of transfer pricing disputes. To reduce the impact of judgemental errors in determining transfer price in international transactions, it is proposed to empower the Central Board of Direct Taxes (CBDT) to formulate ‘safe harbour' rules.” (Emphasis added)

The institution of Dispute Resolution Panel (DRP) was thus created to deal with the first aspect of resolution of tax disputes involving foreign companies. Its composition and functioning have undergone many changes within a short period. Jury is still out about its success or otherwise. As for the safe harbour the following section was inserted in the Income Tax Act by the Finance (No.2) Act, 2009.

“92CB. (1) The determination of arm's length price under section 92C or section 92CA shall be subject to safe harbour rules.

(2) The Board may, for the purposes of sub-section (1), make rules for safe harbour.

Explanation. - For the purposes of this section, "safe harbour" means circumstances in which the income-tax authorities shall accept the transfer price declared by the assessee.”

Days, months and years passed thereafter but there was no sign of the promised safe harbour rule. In the meantime, the transfer pricing adjustments were increasing by the year. It is possible that revenue considerations might have delayed the introduction of any hurried safe harbour rules. Besides, it is always a difficult job to pinpoint the exact circumstances in which the margin of the taxpayer would be acceptable to the tax department.

Then in the year 2012, three years after the introduction of the provision relating to safe harbour, Mr Mukherjee became the President and the PM held the finance portfolio for a time. Within this short period, the PM appointed two committees, the first headed by Dr. Parthasarathy Shome to take care of the GAAR imbroglio and the second, a committee headed by Mr. N. Rangachary, former Chairman CBDT to go into the working of development centres. The Committee was also entrusted with the task of formulating the safe harbour rules.

In a July 30, 2012 press note issued by the PMO, it was, inter-alia, mentioned as follows:

“Many MNCs carry out activities such as product development, analytical work, software development, etc. through captive entities in India. They exist in a wide range of fields including IT software, IT hardware, Pharmaceutical R&D, other automobile R&D and scientific R&D. These are popularly called Development Centres .Over 750 MNCs have such centres at over 1100 locations in India. The reason for this large concentration of Development Centres in India is the worldwide recognition of India as a place for cost competitive, high quality knowledge related work. Such Development Centres provide high quality jobs to our scientists, and indeed make India a global hub for such Knowledge Centres. However, India does not have a monopoly on Development Centres. This is a highly competitive field with other countries wanting to grab a share of the pie. There is need for clarity on their taxation.

5. As far as Safe Harbour provisions are concerned, these were announced in finance bill 2010 but have yet to be operationalised with a wide application. Safe Harbour provisions have the advantage of being a good risk mitigation measure, provide certainty to the taxpayer.”

Subsequently, through an office memorandum dated 13th September, 2012, the Finance Ministry communicated that considering the paucity of adequate data required to draft the rules, the Finance Minister has approved that the Committee may finalise the safe harbour rules in the following sectors/activities: IT Sector, ITES sector, Contract R&D in the IT and Pharmaceutical sector, Financial Transactions-outbound loans, financial transactions-corporate guarantee, auto ancillaries- original equipment manufacturers. The committee was asked to submit its report in 3 tranches-by 15.10.2012, 15.11.2012 and 31.12.2012.

It is interesting to note that this Office Memo acknowledges absence of adequate data. However, it does not state why the above-mentioned sectors were chosen and whether there was adequate data available in respect of these sectors.

The Rangachary Committee however managed to submit the required reports within this incredibly tight time schedule. The reports were confidential. It was only subsequently when the safe harbour rules were actually formulated and public comments were invited that these reports were also made available to the public. The safe harbours suggested by the committee for the various sectors are based on departmental data. Unfortunately, the relevant annexures have not been made available in the public domain, for obvious reasons. However, that does not detract from the merits of the work of the committee.

The Committee took views of industry associations, some prominent companies of the relevant sectors, and the big accounting firms as also from the tax department itself. From the reports of the Committee, it appears that there was some resistance from the revenue in respect of safe harbour for the following groups- contract R&D in the IT sector; contract R&D in the pharma sector, and auto ancillaries. Considering the lack of homogeneity, PwC India also recommended that no safe harbour may be introduced with respect to transactions of guarantees.The committee however went ahead with its recommendations for all the sectors referred to it albeit with a number of caveats. The final recommendations of the committee in respect of the acceptable margins of the different sectors were as follows:

The reaction to the recommendations has been mixed. While the move to have a safe harbour has generally been welcomed by all, there were grumblings that the threshold has been put at a very high level and that the validity of the safe harbour limits was for a limited number of years. Many also complained of the margins being unrealistically high. Responding to the reactions, the CBDT has finally notified the rules, which further liberalized the norms – monetary threshold proposed by the committee in respect of IT, ITES and KPO services has been removed. IT and ITES transactions up to Rs. 500 crores have been provided safe harbour margin of 20% and transactions above Rs.500 crores have been provided safe harbour margin of 22%. Safe harbour for KPO has been reduced from 30% to 25%. The ceiling of Rs. 100 crores for corporate guarantee has been removed but in case of transactions above Rs 100 crores, safe harbour will now be available if the WOS has been rated to be of adequate to highest safety by a rating agency. The margin for such transactions above Rs 100 crores has been reduced to 1.75%.Procedurally, it has been provided that the taxpayer may opt for safe harbour for up to five years in a go. In case of doubts, the AO has to refer the matter to TPO who then has to pass an order within two months. The taxpayer can then again object to the CIT who has to pass an order within two months.

The US position on safe harbour:

Since the loudest whiners against the alleged high handedness of the Indian tax administration are the US MNCs, it is interesting to note that another and more important trade and investment partner of the USA - China, has no safe harbour rule at all. It will also be instructive to note the reaction of the USA treasury and the IRS to the concept of safe harbour. It is fairly well known that the concept of transfer pricing adjustment itself was invented by the USA, initially to prevent profit shifting by its domestic companies, which were subsequently extended to other multinationals.

In 1988, the Treasury Department and the Internal Revenue Service jointly conducted a study of the intercompany pricing rules under IRC Section 482, which is the basic transfer pricing legislation. The study was done in the context of the 1986 Tax Reform Act. Chapter 9 of the study examined the issue of safe harbours under the caption: “The need for certainty: Are safe harbours the solution?”

The study noted: “One of the most consistent criticisms of the section 482 regulations is that they do not provide taxpayers with enough certainty to establish intercompany prices that will satisfy the Service without overpaying taxes. Based on the government's experience in litigation, the current section 482 regulations also fail to provide the Service and the courts with sufficiently precise rules to make appropriate section 482 adjustments, especially when third party comparables are not available. One of the most common suggestions for solving these problems is to amend the section 482 regulations to adopt safe harbors, or simple, mechanical, bright-line tests that may be used in lieu of the fact-specific arm's length inquiry under section 482.”

“Although various types of safe harbors are available, theyall have one common element that makes them both attractive to the taxpayer and potentially troublesome to the government: they generally would serve only to reduce tax liability. Taxpayers for which a safe harbor would produce a lower tax liability than the appropriate normative rule would use it. Those for which a safe harbor would produce a higher tax liability than the appropriate normative rule generally would not seek the protection of the safe harbor but would apply the normative rule. Reducing administrative costs, or the need for certainty, may encourage some taxpayers to use a safe harbor in marginal situations even if application of the normal rule would result in a tax savings. In general, however, the only benefit a safe harbor offers from the Service's perspective is a saving of administrative costs.” (Emphasis added)

…

“The government's experience in the section 482 regulations area has been that safe harbors have generally treated amounts as arm's length that were usually different from market rates. This result is even more likely to occur in the transfer pricing area because of the inherent difficulty of constructing valuation safe harbors for the types of intangible and tangible property that have created transfer pricing problems under section 482.”

“Furthermore, because of the complexity of the regulatory process and the difficulty in obtaining reliable data, adjustments or corrections to safe harbor standards would be slow. In any event, the fundamental deficiencies of safe harbors are not resolved by continually reviewing and revising the rates, or by intentionally setting the safe harbor on the conservative side for protection of the revenue. If safe harbors are set at nonmarket rates, they will be used only by taxpayers that will benefit by making or receiving payments at those rates.”

The study therefore concluded:

“1. Historical experience with safe harbors indicates that they generally result in unwarranted windfalls for taxpayers, without significant benefits for the government.

2. In the highly factual section 482 context, no one safeharbor or combination of safe harbors has yet been proposed that would be useful but not potentially abusive

3. While the possibility that useful safe harbors could be developed is not categorically rejected, additional section 482 safe harbors are not recommended at the present time.”

Even now, as pointed out by the Rangachary committee itself, safe harbour is available in the USA in respect of loans and low value added intragroup services.

The OECD view:

The OECD was also initially against the use of safe harbour provisions, which were considered to be at odds with the arm's length principle. However, based on a country survey of practices of several countries done in the year 2011, it has modified its opposition to some extent and has released a discussion draft in 2012. The concluding recommendation of the OECD in this regard is as follows:

“E.5 Recommendations on use of safe harbours

4.125 Transfer pricing compliance and administration is often complex, time consuming and costly. Properly designed safe harbour provisions, applied in appropriate circumstances, can help to relieve some of these burdens and provide taxpayers with greater certainty.

4.126 Safe harbour provisions may raise issues such as potentially having perverse effects on the pricing decisions of enterprises engaged in controlled transactions and a negative impact on the tax revenues of the country implementing the safe harbour as well as on the countries whose associated enterprises engage in controlled transactions with taxpayers electing a safe harbour. Further, unilateral safe harbours may lead to the potential for double taxation or double non-taxation.

4.127 However, in cases involving smaller taxpayers or less complex transactions, the benefits of safe harbours may outweigh the problems raised by such provisions. Making such safe harbours elective to taxpayers can further limit the divergence from arm's length pricing. Where countries adopt safe harbours, willingness to modify safe-harbour outcomes in mutual agreement proceedings to limit the potential risk of double taxation is advisable.

4.128 Where safe harbours can be negotiated on a bilateral or multilateral basis, they may provide significant relief from compliance burdens and administrative complexity without creating problems of double taxation or double non-taxation. Therefore, the use of bilateral or multilateral safe harbours under the right circumstances should be encouraged.

4.129 It should be clearly recognised that a safe harbour, whether adopted on a unilateral or bilateral basis, is in no way binding on or precedential for countries which have not themselves adopted the safe harbour.

4.130 For more complex and higher risk transfer pricing matters, it is unlikely that safe harbours will provide a workable alternative to a rigorous, case by case application of the arm's length principle under the provisions of these Guidelines.

4.131 Country tax administrations should carefully weigh the benefits of and concerns regarding safe harbours, making use of such provisions where they deem it appropriate.”

Thus even now the OECD does not favour unilateral safe harbours but suggests bilateral or multilateral ones. The OECD also thinks that safe harbour rules may be appropriate only in cases involving small taxpayers or less complex transactions.

The UN view on safe harbour

The recently released UN practical manual on transfer pricing also takes a cautious approach to safe harbours and posits that such rules may be used in the case of SMEs and advocates its use in the case of MNEs involving only low value-added services, interest rates in respect of short-term inter-company “plain vanilla” loans of moderate value, etc.

The UN manual also points out the possibility of misuse of safe harbours in the following words:

“There are possible down-sides to safe harbours, including the possibility of abuse. An example of such abuse is breaking down what is in reality a large transaction into several smaller ones. There is also a risk that taxpayer lobbying efforts will make it hard to remove safe harbours when capabilities have improved and they are no longer needed, or when conditions have changed so that they are no longer appropriate. There is also the possible risk that safe harbour rules are too generous; this, can possibly result in revenue unnecessarily foregone. Or there may be a distortionary impact in that such a regime may encourage and perpetuate an economy based on small scale or low profit transactions rather than higher risk/higher reward transactions to which the safe harbours will not apply. Safe harbours may thus even be a discouragement of investment in high margin activity as compared to low margin activities.” (Emphasis added)

Transfer pricing rules are put in place by countries to deal with the problem of profit shifting and base erosion. It is true that such rules are complex and they generate a lot of litigation. But, at the end of the day these rules also generate revenue, either directly or by being a preventive measure. Therefore a call has to be taken as to how the rules should be implemented. It is possible for the government to sacrifice some revenue in the interest of foreign investment. However, if the idea is to keep marginal cases out, suitable adjustments can be done in the threshold limit.

One more aspect needs to be taken into account. In India, we have now expanded transfer pricing rules to even ‘specified domestic transactions'. The same set of rules applies to such cases as well. It is quite likely that there will be an explosion in the workload of transfer pricing officers (Section 92CA covers specified domestic transactions also). Naturally there will also be litigations. It will be necessary to restrict the cases of such domestic transfer pricing to a manageable level. In course of time there may be demand for suitable safe harbour for domestic cases as well. It may be noted that in domestic cases, there is no provision of Advance Pricing Arrangements or MAP that are available to MNCs. It will be interesting to see how the government responds to such demands in times to come.