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Who Will Bear Covid Costs? Companies Are Staring At A Transfer Pricing Challenge

Bloomberg quint |

23 March 2021

Covid-19 has thrown up a transfer pricing challenge for multinationals with a presence in India and domestic firms with offshore group entities. As the end of the financial year approaches, companies have to take key transfer pricing decisions to ensure tax compliance.

To deter shifting of profits to low-tax jurisdictions, international transactions between group entities are subject to transfer pricing provisions. Simply put, the provisions say that two related parties must transact at arm’s length pricing.

The pandemic has resulted in two specific challenges for companies: Distribution of extraordinary costs incurred on transactions involving an Indian service provider and a foreign group entity. Decision on allocation of intra-group costs incurred to support group entities.

Extraordinary Costs India is a global outsourcing hub for multinational enterprises. It has some of the largest captive, back office and research centres in the world. Transfer pricing comes into play when any such entity provides goods or services to its offshore related party.

To ensure that certain transactions are fairly taxed, the law prescribes that the cost of services must include a pre-determined profit margin—the cost-plus margin model.

The outbreak of Covid-19 last year meant that companies had to incur one-time costs for a variety of reasons.

Businesses incurred various types of extraordinary costs to tide over the lockdown as well as to normalise operations, Arati Amonkar, partner at EY India, explained.

First, there were costs relating to IT infrastructure, reconfiguring office space, etc., she said. At the same time, fixed costs like labor and lease continued without corresponding pre-Covid revenue levels for a substantial part of the year, she said.

Second, employee costs—which varied from sector to sector. The demand for support employees was lower in case a captive centre was providing services to the airline industry which has gone through a significant downturn, Ajay Rotti, partner at Dhruva Advisors, pointed out. This would’ve caused a drop in their utilisation and the associated costs, he said.

"On the other hand, banking and certain other industries saw a spike in activity during the pandemic due to increase in digital transactions and security issues arising from it. Companies serving these sectors may have seen higher employee utilisation."

The question here is who should bear these costs? To be clear, tax authorities may want that all extraordinary expenses be invoiced so that the tax liability in India increases.

Covid-19 related factors will have transfer pricing implications for Indian captive centres providing services on a cost-plus-margin basis, Rotti said, adding that whether costs incurred for such purposes should be considered for the markup or not will be a critical decision.

Such decisions typically depend on factors such as distribution of risk between the transacting parties, the pricing model being followed, and the terms of the outsourcing contract, among others.

The strategy will also vary based on the size of business operations and sector. Rotti explained this through an illustration.

Rotti explained this through an illustration.

Lets say that X is an Indian captive service provider for an overseas associated entity. The cost-plus markup for X is Rs 117, consisting of Rs 70 as cost, Rs 30 as extraordinary expense and a 17% markup. If X excludes extraordinary expenses and raises invoice of Rs 82 (70 + 17% markup), authorities can demand tax on the differential revenue citing that extraordinary costs should also be marked up.

Helping-Hand Costs
The second challenge relates to determination of costs incurred by Indian companies to help foreign group entities. A parent company in India may have incurred significant costs to support an offshore subsidiary or a group entity during the pandemic. While accounting for costs, it would be relevant to segregate them between those incurred for business and those which are in the nature of capital transactions, Jiger Saiya, partner at BDO India, pointed out.

"The decision on whether a cost allocation to a group entity must be done or not will have to be determined from the perspective of its financial viability. A charge on an already impaired business—entity suffering through losses due to Covid-19—can cause more harm than the risk it will try to reduce."

A complete waiver will also require special evaluation as the pandemic has altered several economic equations, he added.

Any decision on allocation of costs may invite scrutiny from the tax department, experts explained.

The department may question the reason of allocation, its benefits and whether the offshore entity had a material role to play in the transaction. On the other hand, a complete waiver will result in additional costs being allocated at the Indian entity level, thus reducing the tax that can be collected in India, as such costs will not be invoiced to the entity abroad.