CBDT revamp the Safe Harbour Rules Safe harbour rules were introduced in 2013 as a dispute prevention measures for transfer pricing cases which otherwise had suffered considerable litigation.

SHR

provides certain profit margins and circumstances for different businesses which, if adopted by the tax payers, would allow the arm‟s length prices declared by tax payers to be automatically accepted, and the tax payers would not suffer any transfer pricing adjustments. However, the safe harbour program has received what is described as a “lukewarm response” from taxpayers in India. The reasons were very obvious – the safe harbour margins were very high and there is ambiguity in the classification of services. Taking a cue from the above, the Central Board of Direct Taxes (CBDT) vide notification dated 7 June 2017 has revised the Safe Harbour Rules by relaxing the margins and making few other prominent changes, which would make it an attractive option, especially for Small and Medium Enterprises („SME‟).

Key highlight of the revised Safe Harbour Rules: The revised rules are applicable for Assessment Year ("AY") 2017-18 and two immediately following assessment years. Since the existing and revised rule overlap for the AY 2007-08, the taxpayers have an option to exercise either of the two safe harbour rules depending upon whichever is most beneficial to them. The revised rules lower the minimum operating profits to be declared by MNC units to avoid an audit. Further, the revised rules have reduced the minimum operational profits to be declared by IT-enabled services to avoid an audit to 17-18% depending on previous years‟ turnover, down from 20-22% earlier. In the case of knowledge process outsourcing, the safe habour margins have been set at 18%, 21% and 24% depending on employee cost, compared to a flat 25% earlier. A new category of international transaction for “receipt of low value-adding intra-group services” has been inserted under the revised rules.

“Low value-adding intra-group services” has been defined to mean services that are performed by one or more members of a multinational enterprise group on behalf of one or more other members of the same multinational enterprise group and which:  Are in the nature of support services  Are not part of the core business of the multinational enterprise group, i.e., such

services neither constitute the profit-earning activities nor contribute to the economically significant activities of the multinational enterprise group  Are not in the nature of shareholder services or duplicate services  Neither require the use of unique and valuable intangibles nor lead to the creation

of unique and valuable intangibles  Neither involve the assumption or control of significant risk by the service

provider nor give rise to the creation of significant risk for the service provider  Do not have reliable external comparable services that can be used for

determining their arm‟s length price. Low value-adding intra-group services exclude the prescribed list of ten services which include IT (Software services), Knowledge Process Outsourcing services („KPO‟) and Business process outsourcing services („BPO‟) among other excluded services. The definition of 'contract research & development services' in the context of software development has been amended to exclude routine functions like debugging of software carried out by taxpayer, and where the source code has been made available to carry out such routine functions. Employee cost has been defined to include all costs that are generally grouped under the head employee cost in the profit and loss account and it also includes outsourcing expenses to the extent of employee cost are on actuals or 80% of total outsourcing expenses, if bifurcation into employee cost and other outsourcing cost is not available. The definition of the operating cost („OC‟)has been amended to include costs relating to Employee Stock Option Plan ('ESOP') or similar stock based compensation by the AE to the employees of the taxpayer, reimbursement of expenses by the taxpayer to its AE and

recovery of expenses by the taxpayer from its AE relating to the normal operations of the taxpayer. The definition of the operating revenue has been amended to include costs relating to ESOP or similar stock based compensation by the AE to the employees of the taxpayer.

A comparison of the erstwhile and revised SHR is as follows:

Eligible International Transaction Software Development services and IT enabled service

Knowledge Process Outsourcing services

Erstwhile Safe Harbour Rules Threshold

Safe Harbour Margin

Up to Rs 500 Not less than Crore 20% on total operating costs

Revised Safe Harbour Rules Threshold

Safe Harbour Margin

Up to Rs. 100 Crores

Not less than 17% on total operating costs

Above Rs 500 Not less than 22% Above Rs Crore on total operating 100 Crores costs up to Rs 200 crores

Not less than 18% on total operating costs

NA

Not less than 25% Up to Rs on operating 200 Crores costs

- Not less than 24%, and Employee cost at least 60% of OC - Not less than 21%, and Employee cost is 40% or more but less than 60% of OC - Not less than 18%, and Employee cost up to 40% of OC

Advancing of Up to Rs 50 intra-group Crores loans where loan is denominated in Indian currency

Base rate of State Bank of India + 150 basis points

None

One year marginal cost of funds lending rate of SBI as on 1st April of relevant previous year plus: 175 basis points , where CRISIL rating between AAA to A or its equivalent 325 basis points, where CRISIL rating of BBB-,BBB, BBB+ or its equivalent

Above 50 Crores

Base rate of State Bank of India + 300 Basis points

475 basis points where CRISIL rating of BB to B or its equivalent 625 basis points , where CRISIL rating between C to D or its equivalent 425 basis points where credit rating is not available, and Amount of loan does not exceed Rs. 100 crores as on 31st March of relevant previous year

Advancing of intra-group loans where loan is denominated in foreign currency

NA

NA

6 month LIBOR interest rate as on 30th September of relevant previous year plus: 150 basis points where CRISIL rating between AAA to A 300 basis points CRISIL rating of BBB-,BBB, BBB+ 450 basis points where CRISIL rating of BB to B 600 basis points where CRISIL rating between C to D 400 basis points where Credit rating is not available and amount of loan does not exceed equivalent of Rs.100 crores as on 31st March of relevant previous year

Providing corporate guarantee

Up to Rs 100 Crore

Not less than 2% p.a.

Above Rs 100 Not less than Crore 1.75% p.a.

None

Not less than 1% p.a. on the amount guaranteed

Provision of contract research and development (R&D)services relating to Software development

None

Not less than 30% on OC

Up to Rs. 200 Crores

Generic Pharma Drugs

None

Not less than 29% Up to Rs. on OC 200 Crores

Not less than 24 % on OC Not less than 24 % on OC

Manufacture and export of core auto components

None

Not less than 12% on OC

None

Not less than 12% on OC

non-core auto components

None

Not less than 8.5% on OC

None

Not less than 8.5% on OC

Low value adding intra group services

N.A

Up to Rs. 10 Crore including markup

- 5% markup; and - Cost pooling method, exclusion of shareholders cost, duplicate costs and reasonableness of allocation keys is certified by an accountant

N.A

Implications The revised safe harbour rules provide a definitive advantage to SME since there is a cap on the value of transactions, keeping out larger companies. While these margins may not yet reflect arm‟s length mark-ups, paying taxes at a rate that's higher by a few percentage points would still be a good idea to avoid litigation. Another interesting feature of the revised safe harbour rules is the gradation of the safe harbour margin thresholds for the KPO sector based on the percentage of employee cost incurred. This means that higher the ratio of employee cost to operating expenses, higher the safe harbour margins. Based on experience, the employee cost ratio trend in the KPO industry tends to be upwards of 50% and most KPO companies are likely to fall in the 21% or 24% bracket. Hence the benefit of the revised SHR will be marginal.

Further, there is ambiguity around the definition of IT enabled services and KPO services. Some clarity on this front would have been welcomed by taxpayers. Further, Identification of cost relating to ESOP provided by Associated Enterprises („AE‟) to employee of taxpayer and recovery of expenses relating to business operations of taxpayer for the purpose of calculation of mark-up requires a careful consideration. The revised rule has segregated the safe harbour interest margins for inter-company loans denominated in foreign as well as domestic currencies and the rate of interest on loans has been streamlined on the basis of credit rating of the AE. This is a more practical approach. However, this could pose to be an additional burden for them and the cost involved in obtaining the rating may not be feasible as compared to the benefit obtained from the safe harbour. Further, the factors such as security, tenor, seniority, etc that also influence on pricing of loans seem to be missing in setting such safe harbour margins. Further, reduction in the margins for corporate guarantee irrespective of the amount involved is also a favourable move. However, the obligation of having the credit rating of the overseas borrower being approved by CRISIL will dissuade the taxpayers. However, considering the recent trends, many taxpayers who have extended huge amounts of corporate guarantee might like to face the potential litigation where they may in addition to contest for lower commission rates can also take the plea of nil commission rate on the ground that it is not an international transaction but a shareholder activity. The introduction of low value-adding intra-group services within the ambit of the safe harbour rules is a positive development for taxpayers. This was the biggest source of litigation, and it was extremely burdensome and difficult for SMEs to provide sufficient evidence to support the benefits derived by them from the intra-group services. Inclusion of this transaction under SHR will help the taxpayers to get certainty. The definition of low value-added intra-group services in SHR is in line with BEPS Action Plan 10 except herein, it also includes services for which there are no reliable external comparable services to determine the arm's length price excluding few specified services. The revised SHR vis-à-vis low value –adding intra group services

prescribe for a

maximum mark-up of 5% and require certification by an Accountant. This could pose to be an additional documentation requirement for the taxpayer. Further, shareholder

costs and duplicate costs have not been defined anywhere in the Act or the Rules and some clarity on that front would have been welcome. CBDT has not made any amendments in the safe harbour margin in respect of for manufacture of auto and non-core auto components though the erstwhile rule received the lukewarm response. CBDT has not done away with the transfer pricing documentation for safe harbour applicants which was widely expected and it‟s being recommended in the Rangachary committee report. Though, minimising the documentation requirements could have helped in achieving the objectives of 'simplification' and 'ease of doing business' and also would have more contributed to administrative convenience and low cost for the tax payers as well as tax authorities. Thus, overall, barring the exceptions referred to above, the CBDT‟s attempt to revise the safe harbour margins and regime, needs to be appreciated and eyed positively.