Economic downturn exposes chinks in the MNC business model
2 min read . Updated: 16 Jul 2020, 06:49 AM ISTCompanies will find it hard to attribute any moderation in their profits or even losses to their Indian units
NEW DELHI : The sharp economic downturn has exposed a weak spot in the business model of multinational corporations (MNCs) with research and development, software production, and other information technology-related businesses in India. Companies such as Microsoft, IBM and Cisco will find it hard to attribute any moderation in their global profits or even losses to their Indian units, which will continue to be taxed at pre-downturn levels by the Indian tax department, tax experts said.
This exposes the downside of a business model that treats Indian units of MNCs as back-end operations with no risk-taking role and are therefore paid a fixed margin on a “cost-plus" basis, said analysts.
Treating Indian units as functionally low or no-risk entities—units without strategic decision-making powers, direct customer interface or assets like intellectual property rights—suited MNCs in limiting the taxable income recognized in India when the global profits were handsome. Changing this characterization of the business function for tax purposes during the pandemic can prove to be a challenge.
Tax consultants said most of their MNC clients are under pressure to drive down margins of their Indian units, something that is set to be challenged by tax officials.
Over the past decade, India has taken many steps to reduce litigation and offered tax certainty to MNCs in an area that is prone to litigation globally—transactions between the MNC parent and their local units.
Officials keen to attribute higher taxable profits to the local unit often make additional tax claims called “transfer pricing adjustments".
But the steps India’s income tax department has offered so far, including negotiation of taxable profit margins and specifying operational profit margins that will not attract audits (safe harbour margins), have helped in reducing the quantum of such tax claims.
Now, the economic downturn has opened a new front for potential litigation. The profit margins agreed in normal times under such negotiated deals—called advanced pricing agreements (APAs)—make it hard for companies to deviate from that while economic realities press them to do so.
“The present scenario is a concern for MNC parents as they do have a lower allocation for R&D in the ensuing year and the same is expected to be passed on to their downstream units," said Divakar Vijayasarathy, founder and managing partner at DVS Advisors LLP, a consultancy having MNC clients facing this dilemma.
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