Advance Pricing Agreements

On March 31, 2014, India signed its first batch of five advance pricing agreements (APAs) with multinational companies. The concept of Advanced Pricing Agreement (APA) was introduced in India via the Finance Act 2012.

The international transactions are complex and involve more than one country. The sole objective of the APA is to bring tax certainty in international transactions and overcome the issues due to transfer pricing between related parties. By related parties, we mean to say that one party is a holding, subsidiary or an associate company of another party.

We understand this by the following example.

Suppose a US resident company US Inc. purchases goods for 100 rupees and sells it to its associated Indian resident company India Inc.  for 200 rupees, who in turn sells in the open market in India for 400 rupees. Had A sold it direct, it would have made a profit of 300 rupees. But by routing it through B, it restricted it to 100 rupees, permitting B to appropriate the balance. The transaction between A and B is intentionally arranged and not governed by market forces. The profit of 200 rupees is, thereby, shifted to the country of B. The goods is transferred on a price (transfer price) which is arbitrary or dictated (200 hundred rupees), but not on the market price (400 rupees).  Thus, the effect of transfer pricing is that the parent company or a specific subsidiary tends to produce insufficient taxable income or excessive loss on a transaction. The Income Tax authorities may object to the low profits or losses incurred by the India arm.  On the other hand, the US tax authories may also raise a question why the US Inc. sold the goods to India Inc for lower profits. It is also possible that against the actual income of Rs. 400; the two related parties may end up paying double taxation on profits. The two companies may also involve in litigations in respective countries.

To avoid uncertainty, a principle of arm’s-length price (ALP) is used to decide what price should be charged by related parties, that is, the price two unrelated parties would charge under similar circumstances. Although there are various methods to determine ALP, yet, there is no scientific way to calculate an exact one. Further, the two countries often take the benefit of a provision in the double taxation avoidance agreements/conventions (DTAAs/DTACs) called mutual agreement procedure (MAP). In the above example, competent authorities of India and the US would negotiate how much of total profit would be taxable in India and how much in the US, so that there is no double taxation.

But the mutual agreement procedure (MAP) is a post-assement process and may take long time. To remove this problems, some countries have advance pricing agreement/arrangement scheme (APA scheme). Under this scheme, which was introduced by India in Finance Act 2002, the two competent authorities will negotiate in advance to determine the ALP of the future international transaction.  Thus, APAs bring tax certainty, reduce litigation expenses and avoid risk of double taxation. An APA brings extra revenue to the tax administration.

The APAs may be bilateral or unilateral. When the competent authorities of two countries negotiate in advance to determine the ALP of the future international transaction, it is called bilateral APA. On the other hand; sometimes, taxpayers may like to go for unilateral APA, to have an agreement only with one government authority to have tax certainty in that country. This is called Unilateral APA and it is generally done when there is no DTAA/DTAC between the two countries or that the taxpayer is only looking for tax certainty in one country.

Recently signed agreements are five unilateral APAs signed by CBDA for five years. The agreements specify the Arm’s Length Price for the Covered International Transactions Entered into by the Taxpayers. These agreements cover a range of international transactions, including interest payments, corporate guarantees, non -binding investment advisory services and contract manufacturing. The agreements pertain to different industrial sectors including pharmaceuticals, telecom, exploration and financial services.

Model Question
  1. In comparison to mutual agreement procedure (MAP), the advance pricing agreement/arrangement (APA) promise more advantages. Discuss.

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