Taxation, Transfer Pricing and Digitalization
India stands as one of the fastest growing economies of the world today and is expected to sustain the growth rates in the next several years, as per reports of the World Bank and OECD. It has the unique advantage of having a huge market for consumers and at the same time is attracting the global multinationals for selling their products and services. This market in India, like other developing countries, is a market of the future. While it is important to realize the importance of a huge consumer base in India, it is crucial to remain alert and sensitized to the realization of fair taxes due to the government. This is a complex issue in the context of Multinational companies, who only have a related enterprise in India. There are complex issues of PE or permanent establishment in India, necessity of physical presence etc, which makes it imperative to seriously consider the issues of Transfer Pricing relating to the International Transactions, in this country.
Multinational Enterprises have been structuring and planning their business and commercial activities in a fashion to divert their major incomes in tax regimes with lower or no taxes. Mauritius, Switzerland, Ireland and several other nations have been used as tax havens. These multinationals have used methods like thin capitalization to shift capital to enterprises located in these countries and claim deductions for interest, payments for intangibles as methods of shifting profits. There has been large scale tax evasion at a global level and the same is estimated to be around USD 280 Billion in 2015.
In the context of developing economies like India, losing taxes due to loopholes in policies and methods is more hurting, compared to high income countries, since the proportion of Corporate Income taxes, which is effected by transfer pricing, on an average comprises of 16% of their revenue. The share of corporate taxes getting impacted by transfer pricing is only 8% on the average, for the high income countries. There are also important issues of retaining public legitimacy and confidence, for not allowing unfair transfer of profits out of developing countries. It is also estimated that long run losses for developing economies would be 2% of the GDP.
World has become a global market place and is becoming increasingly so, with the rapid strides of digitalization. At the outset, there were issues to determine value creation with economic activity as per principles agreed upon by the OECD and G20 nations. While countries like USA and other developed ones argue that greater value is derived from innovation, research and development that produce advanced technology and other intangibles, countries like India and China argue that access to consumers and markets have great importance for creating value. Due to complex business structures and complicated value chains created by Multinational groups, the determination of the Arms Length Price has become a challenge.
The issues of digitalization are related to the emerging complexities of transfer pricing. Through digitalization and difficulty in locating the value addition becomes more intense and since digitalized net based business transactions do not have always have physical definitions, MNEs will have more sophisticated opportunities to design their business models to avoid taxes. The issue of digitalization will create more opportunities of tax evasion by net based Multinational Enterprises.
Difficulties with ALP
Failure of ALP methods to arrive at fair results due to lack of data on comparables, difficulties of various methods to consider multiple issues of intangibles, thin capitalization, unjustified claims of deductions and inability of the mechanisms to pierce the sophisticated structures and aggressive evasion by Multinational Entities, has initiated a rethink on the existing Transfer Pricing rules.
In the Indian context, some of the specific challenges of the present system can be summarized as (i) Difficulties in finding appropriate comparable data for using the TP methods (ii) Increasing litigation in TP issues (iii) Challenges of administration relating to selection of appropriate cases for audit, shortage of skilled officials, lack of consistency and non availability of coordinated data over time (iv) Progress through MAP and APAs need to be expedited at a faster pace (v) Identification of digital presence and digital presence, for addressing future digitalized and net based transactions (vi) Difficulty in simplifying the methods and procedures to ensure simpler and more efficient implementation of the domestic and international guidelines, resulting in uncertainty and unpredictability of the system.
The complexities of International Taxation based on the ALP, therefore already poses complex challenges. Large scale tax evasion, manipulated capital transfers, valuation of intangibles, generation of Stateless Income are issues denting the credibility of the present global taxation system. The Actions of BEPS project of OECD is a step to address these issues. India and China have huge stakes in getting the reforms expedited with huge potential markets and possibility of evasion of taxes by multinationals. India has been advocating for greater importance to LSAs, or Location Specific Advantages, to emphasize the unique problems in India, though the UN model.
Complexities of Digitalization
India is targeted as one of the biggest consumer markets for all major internet based companies, whether based in India or abroad. However, the difficulty in arriving at a fair system of taxation is a challenge. The characteristics of the internet based business transactions unique and non- traditional (a) No physical boundaries with global reach. Net does not recognize physical tax regimes (b) Multiple models are in operation and constantly changing. The Google model today does not remain the same tomorrow, due to user contributions, new markets and linkages. (c) Multi- sided markets. Amazon may be having various markets through actual item sales, advertisements, sale of data and other sources of revenue from the market. (d) Intangible issues become more important. Youtube gains in value due to contributions of users and the same needs to be evaluated in some manner in its Goodwill account. (e) Non-traditional markets with monopolistic trends and fierce competition. Each moment new entrants challenge existing internet models. The monopoly can come to an end immediately. This is different from traditional markets.
These characteristics of digital markets therefore result in more complexities in addressing transfer pricing issues for capturing various value creation activities. Further, redefining Permanent Establishment, addressing issues like peer to peer transactions along with other rapid changes being made by MNEs in their business models, will need to be anticipated and addressed. Supreme Court, in USA, and some courts in India have accepted PE, without physical presence. With digital internet business, MNEs may be forced to constantly change in face of fierce competition. Perhaps the MNEs may not always be interested in evading taxes and also would like some certainty and predictability with their taxes in different regimes. Vodafone, Nokia, Shell and many other MNEs in India had to face huge tax demands and tax litigation in India, which impacted their functioning for some time.
India has gone ahead by also taking on board the stakeholders in terms of these MNEs in deciding its International Tax guidelines. Even with regard to deciding the economic presence and the digital presence or the implementation and threshold limits, the stakeholders are being kept on board, which is the pragmatic approach for reducing litigation and gaining confidence of business groups at the International level. Digitalization is going to aggravate the problems of transfer pricing and international taxation with more sophisticated methods used by internet platforms. All stakeholders need to be together for resolving the impending challenges.
About the Author: The author is an Indian Revenue Service Officer with over 30 years of experience in the field of taxation and economics, and has been associated with academics including a recent stint at Georgetown University, Washington DC, as a Visiting Researcher in 2018.
Disclaimer: Above expressed are the personal views of the author, and the publisher or the author disclaim all, and any liability and responsibility, to any person on any action taken on reliance of it.
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