Secondary Adjustment and Presumptive Taxation – More Issues than solutions?

superadmin — Fri, 07 Sep 2018 11:39:37 +0000

Secondary Adjustment and Presumptive Taxation – More Issues than solutions? superadmin Fri, 07/09/2018 - 17:09

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The transfer pricing law in India is witnessing a highly dynamic environment owing to a plethora of judicial pronouncements coupled with legislative amendments. One such recent development was introduction of concept of Secondary Adjustment in Finance Act 2016, which provided for levy of interest on the amount of primary adjustment.

As a recap, secondary adjustment implies that where as a result of a primary adjustment to the transfer price, there is an increase in the total income or reduction in the loss of the taxpayer, the excess money (i.e., the difference between the arm s length price determined in the primary adjustment and the price at which the international transaction has actually been undertaken) which is available with its AE, needs to be repatriated into India within the prescribed time. If such sum is not repatriated to India within the prescribed time, shall be deemed to be an advance made by the taxpayer to such AE. Also, interest on such advance shall be computed in the hands of the taxpayer in such manner as may be prescribed.

Whilst the amendment by CBDT is aimed at bringing clarity on operationalization of secondary adjustment, there are still various open issues which are prone to debate. One such issue to ponder upon is whether secondary adjustment would result in application of transfer pricing principles in case of taxpayers opting for presumptive taxation or whether such cases would continue to be outside the purview of transfer pricing?

Non Applicability of Transfer Pricing to Schemes of Presumptive Taxation â€“ Practical Position?

In order to facilitate ease of doing business, and to reduce the compliance burden for certain class of taxpayers, the Income Tax Act provides for various schemes of presumptive taxation. Under such schemes of presumptive taxation, the taxpayers can declare their income at prescribed rates of turnover or on the basis of some other criteria.

The Tonnage Tax Scheme ( TTS ) and Section 44BB (for Oil and Gas) are two of the most popular schemes of presumptive taxation, which are used by MNC s in structuring their business operations in India.

The MNCs offering to pay tax under any of these schemes of presumptive taxation shall have no impact on their tax liability, whatsoever, owing to the quantum of expenses actually incurred by them. This is because the tax would be paid by them on the basis of a fixed percentage of turnover or on tonnage basis.

Based on said reasoning, multinational entities opting for presumptive taxation could have taken a stance that no transfer pricing documentation needs to be maintained in respect of their expense transactions with AEs, as application of transfer pricing provisions to their expense transactions would not have any bearing on their taxable income. However, the introduction of secondary adjustment provisions, could dramatically alter the taxability of companies opting for presumptive taxation schemes, in as much as their inter-company expenditure could be challenged resulting in possible transfer pricing implications.

In the ensuing paragraphs, we have analyzed the interplay of secondary adjustments and transfer pricing provisions qua companies that have opted for presumptive taxation schemes.

Transfer pricing V/s Tonnage taxation scheme

Tonnage taxation scheme, governed by Section 115VA of the Act, is applicable in case of a company, owning at least one qualifying ship. The said scheme provides for payment of tax in accordance with net tonnage owned by the Company. The amount of revenues / expenses of such a company shall have no bearing on its tax liability.

The following illustration shows a glimpse of impact of secondary adjustment in a case where tonnage tax scheme has been opted by the taxpayer:

Scenario 1 This deals with a situation of a Shipping Company who has opted for the tonnage taxation scheme. The taxpayer has made a payment of INR 75 cr. to its AE outside India, for availing intra group services ( IGS ).

Scenario 1: Pre secondary Adjustment Position

Particulars	Amount (INR Cr.)	Action by TPO	Implications of TP adjustment
Revenue from shipping business in India	185	185	Primary Adjustment - IGS payment disallowed by TPO No Secondary Adjustment No impact on the tax payable by the Company as tax would be paid on presumptive basis only
IGS paid / other related party expenditure	(75)	(Disallowance by TPO)
Administrative expenses	(10)	(10)
Other expenses	(25)	(25)
Profit *	75	150
Tax as per Tonnage	10	10

* MAT does not apply to tonnage tax companies.

Readers are well aware that the transaction of IGS is subject to intense scrutiny by the Indian TP authorities which typically insists on the 4 pronged tests to substantiate the need, evidence and the arm s length pricing of such IGS. However, in the instant case, the payment of 75 Cr. as IGS by the company shall not have any transfer pricing implications, as even if the amount of IGS is held to be Nil through the application of transfer pricing provisions, the same would not alter the tax liability of the company. Only the book profits of the company will change due to the disallowance*. Accordingly, the Company can plan its cash repatriation strategy through IGS and avoid payment of dividend distribution tax (if funds are repatriated by dividend payment). (*The MAT is not applicable on companies opting for Tonnage Tax Scheme so no additional income tax liability due to disallowance.)

Scenario 2: Post secondary Adjustment Position

Particulars	Amount (INR Cr.)	Implications of TP adjustment
Revenue from shipping business in India	185	Primary Adjustment - IGS payment disallowed by TPO. Impact On Tax Liability owing to primary adjustment â€“ NIL as tax would be paid on presumptive basis only. Secondary Adjustment Impact - Excess funds i.e. 75cr to be repatriated to India in 90 days from the prescribed date. If 75 CR. is not repatriated to India within 90 days of prescribed date, interest would be levied. If in above case, funds are remitted back to India, and the same are repatriated back by way of Dividend payment, there shall beadditional liability of DDT on 75cr. on repatriation of INR 75cr. back to the AE.
IGS paid / other related party expenditure	(75)
Administrative expenses	(10)
Other expenses	(25)
Profit	75
Tax as per Tonnage	10
*Dividend due to repatriation of excess profits	75

Scenario 2 illustrates the post-secondary adjustment situation â€“ wherein the TPO would question the payment of IGS to its AE. This adjustment would be labeled as primary adjustment. Further, with secondary adjustment in force, a timeline of 90 days is allowed to repatriate excess funds in India. If not duly repatriated within 90 days, interest would be levied on the amounts not so repatriated. Such interest would increase the total income for income tax purposes of the Indian company on a notional basis, which shall be outside the ambit of tonnage tax scheme.

In the event there is actual remittance of funds back to India, the same will attract Dividend Distribution Tax ( DDT ), if funds are repatriated back by way of payment of dividend. In such a scenario, the taxpayers would need to re-strategize and get back to the drawing board to alternative cash repatriation strategies or allow cash accumulation in India at the cost of global treasury.

With Income Tax department using the stick of secondary adjustment, to restrict cash flows of presumptive taxation companies, the heat could turn back on the MNCs as they would be require to prepare and maintain comprehensive transfer pricing documentation to demonstrate that their related party expenditure, including IGS, is in compliance with the arm s length principle.

Thus, from a compliance perspective, the presumptive taxpayers would be required to prepare and maintain robust and comprehensive documentation to justify the payment of IGS to its AEs to prevent the primary adjustment of disallowance of IGS.

Conclusion

Basis above it can be inferred that secondary adjustment could be used as a tool to challenge the established transfer pricing cum cash repatriation structures. In summary, maintenance of a robust transfer pricing documentation is the key and could serve as the only defense mechanism before the tax authorities in order to mitigate any plausible tax and transfer pricing risk.

The primary objective of introduction of provisions on secondary adjustments was to align Indian TP provisions with Organization for Economic Co-operation and Development TP Guidelines and promote international best practices with respect to transfer pricing policies. However, on the contrary, secondary adjustment might lead to a plethora of multifarious issues, as discussed, in absence of any proper clarifications. One of them is the applicability of secondary adjustments in presumptive taxation cases.

Practically, in situations when secondary adjustments is imputed on a taxpayer, mobilizing funds from related parties (which could be several in number) is extremely difficult apart from the complete absence of clarity on the mode of infusion of such funds from a regulatory / FEMA perspective and the accounting treatment thereof. The fact that the fund infusion would be required much after the close of the relevant financial year significantly adds to the complexity, and pushes the level of difficulty into the realm of impossibility of performance, at least from a practical perspective.

Post introduction of secondary adjustment provisions, it clearly emerges that taxpayers would need to be more cautious in pricing their intra-group dealings, and failure to do so may additionally expose them to secondary adjustments (in addition to primary adjustment). It is also the need of the hour that the CBDT issues appropriate clarifications to ensure that this does not emerge as another significant transfer pricing issue in the time to come.

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