The Indian Tax Authorities ‘surveyed’ BBC last week. They wanted a peek into some transactions they found suspicious. And one of the allegations apparently levelled against the British media house is that it flouted something called the ‘transfer pricing’ regulations. So in today’s Finshots, we thought we’d explain a bit about this specific part of the tax world today.

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The Story

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.

Now, this example isn’t a figment of our imagination. It’s based on one of the very first tax disputes in India involving such favouritism or cosy deals between related companies. It’s a case that dates back to 1958. And the company in question was India-based Mazagon Dock Ltd and its then British shareholders.

At the end of the day, the Court ruled that Mazagon’s business should be subject to income tax. All those years in which Mazagon transferred profits to its British parents? Well, Mazagon would have to assume that they’d charged for services appropriately. That they’d received income from its British shareholders. And then pay a tax on that amount in India.

This, folks, is a classic case of the ‘transfer pricing’ problem.

Simply put, it’s the price at which two companies that are related, transfer goods or services to each other. And in an era of globalisation where companies have a sprawling web of subsidiaries peppered across the world, such transactions between related parties are quite common.

And because there are always going to be companies that find loopholes in the law to reduce taxes, the tax authorities step in.

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.

Almost every country has now established regulations around transfer pricing when it comes to these related entities. After all, no country wants to be on the receiving end of losing tax revenue, right?

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.

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).

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.

Seems like a neat idea, no?

But did it actually succeed in bringing down the disputes? We don’t know, to be honest. All we can say is that while over 1,500 companies have applied for APAs, only 420 of them have seen the light of day. Most others are still pending because the agreements are getting more and more complex. And it takes time for an understaffed tax unit to wade through it all.

So yeah, maybe APAs have seen some degree of success. But it’s not that significant.

Anyway, it doesn’t seem like BBC’s Indian subsidiaries were part of any APA. Because the tax authorities decided to pay a visit to the British media firm’s India offices last week. They alleged that “it [BBC India] has been ‘non-compliant under transfer pricing rules’, ‘persistent and deliberately violative of transfer pricing norms’, and ‘deliberately diverted’ a ‘significant amount of the profits’ without following ‘the arm’s length arrangement in the case of allocation of profit’ ”.

But did BBC actually violate these rules?

Well, no one will know till the final decision is made. And that could take years. But until then, you at least know what’s transfer pricing!

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