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By Craig A. Sharon, Esq.
Bingham McCutchen LLP, Washington, DC
At the end of January, I participated in the Pacific Rim Tax Institute's third annual international tax conference in Silicon Valley (PRTI III), where U.S. Competent Authority Mike Danilack spoke openly about the IRS's relationship with the Indian tax authority. By all accounts, that relationship is hanging by a thread, due primarily to the "controversial" views of India's Competent Authority.2 Mr. Danilack's comments, while more pointed and personal than usual, mostly confirmed what the tax press has been reporting and what taxpayers and their representatives have been experiencing in India for a decade or more, i.e., international tax enforcement in India represents a special challenge for foreign taxpayers and tax authorities alike.
The big question is what tax authorities and taxpayers can or should do to moderate India's behavior. One (unprecedented) IRS response, confirmed by Mr. Danilack at PRTI III, has been to adopt a policy to reject any and all U.S. taxpayer requests for bilateral Advance Pricing Agreements (APAs) with India, until the Indian Competent Authority assumes more reasonable positions in U.S.-India transfer pricing disputes. Citing a backlog of more than 140 Competent Authority cases, Mr. Danilack told attendees at PRTI III that he has no confidence, notwithstanding public representations to the contrary by Indian officials, that U.S. taxpayers will experience better treatment in India's new APA program than they have encountered so far in the Mutual Agreement Procedure (MAP) process. Mr. Danilack also ruled out mandatory treaty arbitration as a potential solution to the situation, contending that arbitration requires a healthy and orderly MAP process as a prerequisite.
The U.S. taxpayer community has not yet challenged the new IRS policy, at least not publicly, despite a seemingly broad interest in pursuing bilateral APAs with India. That acquiescence reflects the depth of taxpayer frustration with India's international tax enforcement and taxpayer empathy with the exceptional nature of the IRS policy. Extreme circumstances often produce extreme policies… .
This commentary addresses whether or not the IRS's "disengagement" policy re U.S.-India bilateral APAs is the "best" policy. It concludes to the contrary - specifically, that the policy is unlikely, on its own, to moderate the views of the Indian Competent Authority. I should confess upfront that as IRS APA Director from 2008 to 2011 - before India adopted its APA program, but after U.S.-India transfer pricing disputes began to explode - I encouraged the Indian tax authority, on the limited occasions when I had the opportunity, to adopt a bilateral APA program. Many of the arguments that I made then in favor of an Indian APA program are applicable to the current IRS policy:
1. Disengagement adversely affects U.S. taxpayers disproportionately.
Roughly 80% of U.S. transfer pricing disputes involve foreign-initiated adjustments. My guess is that, of the 140 pending U.S.-India cases, all but a handful are India-initiated adjustments to U.S. companies operating in India. Until U.S.-India trade flows and tax controversies become more two-way and better balanced, the Indian tax authority will continue to take positions that the IRS will resist and that will expose U.S. companies (but not Indian companies) to significant transfer pricing risk. Given that a bilateral APA process so favors the interests of U.S. taxpayers, why not give it a try?
2. The U.S. policy is not likely to change India's behavior.
As important as U.S. business is to India's economy and notwithstanding statements by the Indian government that it wants the country's APA program to succeed,3 it is hard to see how a solitary U.S. policy rejecting bilateral APAs will force a favorable change in India's international tax enforcement. The evidence to date, albeit limited in time, does not build confidence.4 More likely, to be effective, the policy will require the support of other tax authorities, unrelenting pressure from the global business community, and complementary IRS enforcement measures, including increased examinations of Indian companies operating in the United States, aggressive auditing of U.S. companies with Indian unilateral APAs, and a strong push for mandatory treaty arbitration. It will also require considerable patience and possibly higher-level government-to-government discussions. In the end, it may require significant reductions in foreign direct investment in India (and/or changes in personnel).
3. India is not unique.
The trends do not favor the U.S. position. Like it or not, India's transfer pricing and permanent establishment (PE) positions, while outside the Organisation for Economic Co-operation and Development (OECD) mainstream, are neither unique nor capable of being restricted to India. The other BRICS countries (Brazil, Russia, India, China, and South Africa) either follow India's positions or are sympathetic to them (e.g., location savings, risk allocations),5 while other developing countries have adopted, or are likely to adopt, similar positions. Even though the United States has few tax treaties with developing countries, the IRS cannot ignore these countries any more than it can ignore globalization generally. Regardless, how different is India from Japan in the '90s, from Canada over the past decade, and from China currently? In each case, the IRS continued to accept (or continues to accept in the case of China) bilateral APAs. Increased U.S. engagement (and flexibility) on international tax issues will inevitably be required.
4. The APA process works.
Rejecting bilateral APAs with India will not eliminate U.S.-India transfer pricing controversies. It only eliminates the most effective forum for resolving such disputes. The APA process works because it is mostly prospective and therefore less results-oriented, because it is voluntary and requires more cooperation and transparency, and because, as between tax authorities, it builds trust over time in a controlled environment. As a substantive matter, the APA process accelerates tax authority learning and is more likely to produce timely, principled, and "single-tax" results than the traditional administrative, litigation, and MAP processes that the IRS is now relying on to resolve U.S.-India disputes. Why not test the resolve of the Indian government and use its new APA program, even if on a pilot basis, to "re-set" U.S.-India tax relations?
In sum, U.S.-India tax relations are in disarray. The new India APA program offers an opportunity to change course. Direct engagement has worked with other countries (e.g., Japan), appears to be working with Canada (based on Mr. Danilack's comments at PRTI III), and will be increasingly necessary with other developing countries. The APA process represents the most promising form of engagement, with no greater potential for wasting IRS time and resources than the transfer pricing process, especially if combined with mandatory arbitration - admittedly, a long way off. When all the circumstances are considered, the arguments for IRS engagement with India's new APA program, even if initiated on only a limited basis, seem to outweigh the arguments for disengagement. Indeed, if the IRS tries to make the APA process work, but the Indian tax authority fails to keep its word, the IRS's subsequent rejection of U.S.-India bilateral APAs will surely resonate more with other tax authorities and higher-ups in the Indian government than the current disengagement policy. That approach strikes me as a more promising route for moderating India's behavior.
This commentary also will appear in the April 2013 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, Levey, Carmichael, van Herksen, Patton, Levi, Krupsky, and Kellar, 890 T.M., Transfer Pricing: Alternative Practical Strategies, Chapter 8, "Advance Pricing Agreements, Gleicher, 892 T.M., Transfer Pricing: Competent Authority Considerations, Cole, Kawano, and Schlaman, 940 T.M., U.S. Income Tax Treaties - U.S. Competent Authority Functions and Procedures, and Kotwal and Hansraj, 966 T.M., Business Operations In India, and in Tax Practice Series, see ¶3600, Section 482 - Allocations of Income and Deductions Between Related Taxpayers, and ¶7160, U.S. Income Tax Treaties.
4 See, e.g., the India section in Chapter 10 of the recently updated UN Transfer Pricing Manual; the influence of the BRICS on the OECD draft intangibles report; the letter from the Silicon Valley Tax Directors Group to the U.S. and India Competent Authorities (dated 1/18/13), indicating no observed moderation in India's Competent Authority positions; and other recent India pronouncements (e.g., BRICS' Communique, dated 1/18/13) and proposed transfer pricing adjustments (e.g., value of Shell and Vodafone stock subscriptions).
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