The Most Aggressive Tax Authorities in the World?

Earlier this week there was a court ruling in India related to transfer pricing. As reported by Business Standard:

The Bombay High Court on Tuesday ruled in favour of Shell in a transfer-pricing order that sought to tax the energy giant’s 2009 investment in its Indian subsidiary. The order will have an impact on other multinationals fighting the tax department on similar grounds.

The income-tax department had sought to add Rs 15,220 crore to Shell India’s taxable income after Shell Gas invested in its local arm at Rs 10 a share. The tax department valued Shell India’s shares at Rs 180 apiece in January 2013 and charged it with undervaluing those to evade tax… The court rejected the tax department’s argument that the Shell case was distinguishable from Vodafone’s case, which won a similar reprieve in October.

In a narrow technical sense this verdict matters simply because it means that the tax authorities in India can no longer try to apply Indian transfer pricing regulations to capital transactions such as the issuance of new shares. This will make life a bit simpler for many companies in India (including some of my clients) that have recently felt obliged to prepare transfer pricing documentation to support balance sheet transactions.

But the broader implications are more interesting. To my knowledge, India was the only country in the world that even attempted to apply transfer pricing rules to capital transactions. And that is just one of many ways in which the Indian tax authorities have very aggressively interpreted and applied transfer pricing rules to multinationals doing business in India. In transfer pricing circles, India has a reputation. This ruling is the latest in a string of court decisions that indicate that the Indian judicial system thinks that the Indian tax authorities have been overstepping their bounds.

This is a good illustration of how subjective transfer pricing can be. The fundamental principle behind every transfer pricing analysis – whether conducted on behalf of a company or a tax authority – is clear enough: transactions must be consistent with the arm’s length standard, meaning that the prices applied to intra-group transactions should be the same as market (or arm’s length) prices. But in practice, it’s often impossible to determine exactly what prices or rates of compensation would be agreed upon between unrelated parties, because such transactions are never actually observed in the real world.

As a result, there’s frequently no obviously correct arm’s length price to apply, and multinationals as well as tax authorities often have substantial latitude in how they interpret and apply the arm’s length standard to intra-group transactions. And just as some multinationals are particularly aggressive in how they approach transfer pricing, so are certain tax authorities, like those in India.

What effect does the behavior of the Indian tax authorities have on the business climate in India? Many companies (as well as some politicians in India) would argue that they effectively view the Indian tax authorities’ harshly aggressive transfer pricing enforcement as an extra tax that companies must pay to do business in India. Many are willing to pay that tax in order to reap the advantages that they get from being in India, but it is a real effect nonetheless, as it probably does dissuade some firms at the margin from undertaking certain economic activity in India.

And I find that very interesting. As a student of economics one learns a lot about how to analyze the effect of explicit taxes on behavior. Some students even learn about the importance of institutions and organizations in facilitating or hindering economic transactions (though generally I think such subjects are woefully under-taught in most economics programs). But relatively little emphasis is paid to qualitative, subjective phenomena such as differential enforcement of transfer pricing regulations from country to county, or the broader category of “business climate”. To me this serves as a useful reminder that even such hard-to-measure economic forces or behaviors can have very real economic effects.

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