Imagine there are two companies X and Y that are related to each other. Company X is based in India and is in the business of repairing ships. Company Y, which owns the majority of shares in X is based in Britain. Y’s also in a similar line of work. It owns a massive fleet of ships and it hires them out to freight companies to transport goods.
But because of this relationship between X and Y, they decide to enter into an agreement. Whenever Y’s ships need repair, it’ll go to X. And X doesn’t charge an exorbitant fee. In fact, X only charges the minimum — that is, the exact value for materials and labour or whatever is needed to cover the cost of repair. The end result is that X makes no profits.
But wait… how does the company grow if it can’t make profits, you ask? After all, without profits, it can’t really invest in new technology and upgrade its capabilities, no?
Absolutely. But maybe X doesn’t just conduct business with Company Y. Maybe it repairs ships for other companies too. And it charges quite a hefty fee from everyone else. It’s just Y who gets preferential treatment because they’re related to each other.
It’s quite a clever plan, no?
But tax authorities hate such cosy relationships. Because such a business deal means that X is artificially suppressing profits in India. If it charged a regular fee from Y for services, X would make more money. And more money means that it would have to shell out more taxes. Which would eventually land in the Indian government’s coffers.
So this deal means that India is losing out on tax revenue. And if you think about it, such a deal also means that the ‘profits’ are being transferred to Britain. Company Y makes more money and profits since it gets free services from X. And if Britain has a lower tax rate than India, Y pays less tax overall too. It’s a big win for Y. (View Highlight)
Note: Transfer pricing is a business arrangement between two related companies, in which one company (Company X) charges the other (Company Y) less than the market value for services. The goal of transfer pricing is to artificially suppress profits in the country of the first company (India in this case), as it would otherwise have to pay taxes on those profits. This results in profits being “transferred” to the second company (Britain in this case), which may benefit from lower taxes.
Their ask is simple — these related companies need to follow an ‘arm’s length pricing’ when it comes to the sale of goods and services to each other. And there are 6 methods prescribed to calculate the pricing. But we won’t get into that now. It’s complicated. So let’s just say that this simply means that the buyer and seller should assume they’re not related to each other. And shake hands on a price that they would’ve agreed to in the open market. No preferences. They can’t over-invoice or under-invoice just to duck taxes. (View Highlight)
India too has an official transfer pricing rule that came into effect in 2001. And by 2012, there were 3,500 transfer pricing cases stuck in a dispute. In fact, we actually had the 3rd highest number of transfer pricing cases in the world back then. Our tax authorities were going through transactions with a fine-toothed comb. (View Highlight)
But they also realized that these disputes were a waste of everyone’s time. It didn’t inspire confidence. Multinational companies could hesitate to set up operations in India. It would affect employment. It would hurt tax revenues. So, in July 2012, the Indian tax authorities introduced something called an ‘Advance Pricing Agreement’ (APA). (View Highlight)
Under this, a company could sit down with the tax authority and say, “Look, we’re going to have a lot of international transactions. And we don’t want any confusion later. So let’s decide what methodology to use in advance. We’ll use this for say the next 5 years. And please don’t question us during that time.” Of course, Terms & Conditions apply. But that’s the gist of it. Companies avoid the threat of an audit. They save on compliance costs. And tax authorities save time because they don’t need to waste a lot of effort on extensive scrutiny. (View Highlight)
