In today’s newsletter, we talk about the nifty tax scheme that’s bringing in billions for Indian tax authorities.


The Prelude

Before we get to the actual meat of the story, a quick detour. Everybody knows that India wants to attract the biggest MNCs out there and they want the likes of Google, Amazon and Apple to do business here. However once they do set up shop in India, these companies will have to transact with their parents back home and tax authorities view these transactions with extreme suspicion.

Consider, for instance, a company in the U.S selling AirPods in India. They set up an entity here and make a killing selling these bad boys. Of course, when these profits accrue en masse, you expect the taxman to take his cut. However, these multinational corporations are sneaky little devils. They will do everything in their power to avoid paying their dues. One way they do this is by simply padding their expenses and rerouting the profits back to the US. The company selling the AirPods will simply make royalty payments to the company in the US and bring down its profit margins to 0. This way they won’t have to pay the 25% tax India demands. Instead, they can get away with the much softer 21% tax rate back home.

And this is unacceptable.

However, Indian tax authorities have a workaround. They regularly scrutinize these transactions to see if they are in line with industry standards. I mean, even someone with a preliminary understanding of business transactions will tell you that the margins on selling state of the art AirPods in India can’t be 0. It’s obviously a farce. And so, the taxman can take the company to task.

Unfortunately, this breeds another problem. Imagine the company makes a margin of 8%. Let’s assume this is in fact a very genuine assessment and not an elaborate scheme to cheat the government. What happens if the taxman pegs that the company is still cheating?

Well, they go to court obviously and then the endless legal battles ensue. The company is frustrated. The taxman is frustrated. The courts are….. Well, they are doing their thing. It's a complete travesty. And for a country that is trying to improve on the “ease of doing business” metrics, this doesn’t bode well. So you have to meet these businesses midway.

Enter, advance pricing agreements (APA). It’s a nifty little arrangement where the tax authorities and the MNCs sit down and hash out their differences. For instance, let’s assume the MNC meets the taxman today and decides to enter into one of these agreements.

The MNC goes — “Taxman, I am sorry. I told you I made margins of close to 3% last year and I know you suspect its a sham. How about I revise it upwards to 8% and I pay taxes on the extra 5%. In return, you promise to not take me to court. How about we call it a day, partner?”

The taxman goes — “Sure”

And the deal is signed. So in return for the MNC’s collaboration, the taxman agrees to not scrutinize financial transactions for the previous year. But what happens to the year before that. Well, that’s up for debate. Tax authorities can still take the companies to task. Unless that is, the MNC decides to extend the agreement for past years as well.

If the government thinks it's a fair assessment they’ll sign off on this new deal. And the MNCs get a free pass for all financial transactions conducted during the said period. And this allows breathing space for both parties. The government gets extra cash for its coffers. No endless litigation. And financial certainty for potential MNCs wanting to do business in India.

So the story goes that the government has been signing off on these APA’s like crazy, extending the agreed profit margin for past years and in turn has made a windfall of close to 10,000 crores in the process.

Not bad, eh?

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