Budget 2017: Did The Government Think Through The Secondary Adjustment Provision?

In the Union Budget presented on February 1, there were not too many transfer pricing changes—except a major one—a formal introduction of the concept of secondary adjustment in respect of transfer pricing additions. This proposal is in line with the views shared by the Organisation for Economic Co-operation and Development (OECD) and practices adopted by many European Union (EU) countries, the U.S., Canada, China, South Africa and others.

Secondary Adjustment: Applicability

Secondary adjustment means actual adjustment in the books of accounts of the Indian taxpayer and its Associated Entities (AEs), i.e., by passing accounting entries, of the primary adjustment (difference between the transfer price recorded in the books of accounts and the arm’s length price determined). As per the proposal in Budget 2017, such secondary adjustment is now mandated under following scenarios where primary adjustment is made:

• by the taxpayer himself suo-moto;
• by the tax officer which has been accepted by the taxpayer;
• based on an Advance Pricing Agreement (APA) entered into by the taxpayer;
• based on safe-harbour declaration by taxpayer; or
• based on a Mutual Agreement Procedure (MAP) resolution under the tax treaty.

In essence, a secondary adjustment has to be done to ensure that full effect is given, as if the international transaction were originally undertaken at the adjusted value.

It is also proposed that secondary adjustment shall not be carried out if:

• the amount of primary adjustment made in any previous year does not exceed Rs 1 crore; and
• primary adjustment pertains to period prior to financial year (FY) 2016-17.

The amendment will come into effect from 1 April 2017 and will accordingly apply in relation to FY18 and subsequent years.

While the Indian government has stated that it has taken a cue from the OECD transfer pricing guidelines and international best practices, it is worthwhile to note here that as per the OECD’s guidelines as well as regulations of quite a few countries, secondary adjustment may take the form of constructive dividends, constructive equity contributions, or constructive loans.

Countries such as the U.S., Canada, France, Spain and few other EU counties provide for all three mechanisms, whereas South Africa and China have specifically opted for constructive dividend mode of secondary adjustment.

However, the Indian government has proposed to adopt the constructive loan mechanism for effecting the secondary adjustment.

Secondary Adjustment: Implications?

The stated purpose of secondary adjustment is to remove the imbalance between cash account and actual profit of the taxpayer and to reflect that actual allocation of profit is consistent with the arm’s length price (ALP) determined as a result of the primary adjustment.

Thus, taxpayer and its AE would now have to compulsorily pass necessary accounting entries in the books in respect of primary adjustment. This means not only the taxable income increases but even book profits would increase as a result of this secondary adjustment. This would imply that apart from corporate tax implications, there would be additional dividend distribution tax costs eventually as and when dividends are distributed out of such book profits. Also, one would have to evaluate whether there are any other tax implications like service tax, etc., on these amounts being recorded in books.

In case a taxpayer fails to record this secondary adjustment in the books of accounts and repatriate the monies to India within a reasonable time period (to be prescribed), such excess funds which is available with the AE, shall be deemed to be an advance made by the taxpayer to such AE and the interest on such advance, shall be computed as the income of the taxpayer (to be prescribed).

To explain this by way of an example, say, an Indian company is rendering back office services to its AE and is remunerated on cost plus 10 percent basis as per its group policy. In order to avoid litigation in India, the company opts for safe harbour rules and offers to tax the additional 10 percent mark-up as required under safe harbour rules. So far, it would have paid tax on this additional 10 percent mark-up and there were no further consequences.

This would result in significant hardships for the Indian company and following issues could arise:

Recording In Books Of AEs

Enforcing the recording of such adjustment in books of accounts of AE would be difficult for Indian taxpayer, especially in cases where the primary adjustment is on account of unilateral APA, safe harbour option, or suo-moto offering to tax. The AE would not necessarily agree that ALP agreed (after primary adjustment) by Indian taxpayer is actually the ALP, and hence, would not be willing to record or repatriate the same to the Indian taxpayer. Even the tax laws of the AE’s country would not allow for such a deduction if it’s not actually regarded as ALP and would result in double taxation. The government had anyways clarified that the safe harbour’s margins are not necessarily ALP but only option to the tax payer to avoid litigation. In such cases, to mandate the AE to record the adjustment would be unfair.

Typically, it takes two to three years after the end of the financial year to complete the transfer pricing assessment. In such a situation, if the assessment results in primary adjustment, what would be the timing of recording the secondary adjustment—in the year of making the primary adjustment or the year for which it pertains to? Other accounting principles also need to be considered before taking the secondary adjustment in the books of accounts of the taxpayer in India as well as the foreign jurisdiction. Also, the question would arise as to whether the auditors would agree to the accounting treatment for secondary adjustment, although the inter-company agreement may only specify the original basis of transfer pricing.

There is also a question on whether minimum alternate tax (MAT) would be applicable in the year of recording secondary adjustment.

Increase Litigation

The tax payer may be prompted not to accept the primary adjustment in the first place but instead litigate the same.

The provisions provide that secondary adjustment should be made if primary adjustment made by AO is accepted by taxpayer. Thus, one view is that in case the taxpayer appeals against the primary adjustment, irrespective of the outcome of the appeal, the secondary adjustment should not be made. This would tempt the taxpayer to file frivolous appeals. Such provisions would also discourage the tax payer from making suo-moto adjustment or opting for safe harbour provisions. When the government is looking at reducing litigation, these new proposals are not going to help achieve that objective.

Exchange Control Regulations

The question is once such secondary adjustment is recorded in books of tax payer, can the funds be freely received from an exchange control perspective. What kind of documentation would be required to receive such funds?

The issue becomes more intricate when payment of funds is involved—mainly on expense side of transactions. If the primary adjustment is made in respect of excess management fees and royalties which were already remitted, how does one bring back that amount from exchange control perspective?

Reverse Scenarios

It would be interesting to watch as to what would be the position of the Indian government where the foreign jurisdiction requires the similar secondary adjustment to be accounted and remitted for, when the Indian government considers the transactions to be at ALP. Would the Indian government allow tax deduction on such secondary adjustment?

Drafting Error

The use of the word ‘and’ in exclusion clause of the proposed amendment between (a) and (b) (as highlighted above) seems to be a drafting error.

Upon plain reading of the above provisions, one would interpret that both the above conditions should be satisfied simultaneously in order not to apply the secondary adjustment. It means, if the primary adjustment pertains to the FY17 (say for FY13) and the amount of primary adjustment is more than Rs 1 crore, then still the secondary adjustment should be carried out. To take this example further, if the primary adjustment pertains to FY18 and the value of primary adjustment is Rs 70 lakh, then, too, secondary adjustment would need to be carried out. However, reading the notes to the clauses, memorandum to the Finance Bill and the Finance Bill together, it appears that the Finance Minister wants to exclude the application of secondary adjustment provisions if either of the situations arise—the amount of primary adjustment made in any previous year does not exceed Rs 1 crore, or the primary adjustment pertains to period prior to FY17.

This drafting error needs to be taken care of while passing the Finance Bill.

Conclusion

Given the implications and significant impact on litigation and ease of doing business in India, the government can review whether India is ready for such provisions at this time. And if such regulations are to be made, the government must provide appropriate clarifications on these unresolved issues.

Maulik Doshi is a partner at SKP Business Consulting. The views expressed in this article are personal and do not reflect the views of the organization.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.