Published Editorial

Revised TP Circulars: Major Relief To India Inc.

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CNBC website (moneycontrol.com)

by

Vijay Iyer
Partner & National Transfer Pricing Leader
EY

Transfer pricing issues relating to Research and Development (R&D) centers have created a fair bit of controversy in the Indian context and a number of such issues are currently under litigation at various appellate levels. In view of the above controversy and having regard to the concerns expressed by various stakeholders, the Hon’ble Prime Minister of India constituted a committee to ‘Review Taxation of Development Centers and the IT Sector’ under the Chairmanship of Mr. N Rangachary, former Chairman of CBDT and IRDA. The committee submitted its first report to the Indian government in September 2012.  Earlier this year, based on the committee’s report, the apex Indian tax administrative authority, the Central Board of Direct Taxes (‘Board’) issued two circulars (‘Circular 2’ & ‘Circular 3‘ dated 26 March 2013) on transfer pricing issues relating to the use of Profit Split Method (‘PSM’) and development centers engaged as contract R&D service providers.

Circular 2 indicated that PSM would be the most appropriate method for determining the arm’s length price for R&D activities resulting in development of intangible. Circular 3 provided the conditions that were to be ‘cumulatively’ satisfied for development centers in India to be treated as contract R&D service providers with insignificant risk. The conditions included were

(i) Performance of economically significant functions only by the overseas Associate Enterprise (‘AE’) 
(ii) Supply of funds and economically significant assets by the overseas AE
(iii) Exercise of strategic and regular direction, supervision, and control over the Indian development center by the overseas AE
(iv) The economic and the legal ownership of intangible arising out of the research to vest with overseas AE
(v) Overseas AE not to be situated in a widely perceived low or no tax jurisdiction and that Indian development center should not assume any economically significant risk.

Subsequent to the issue of the two circulars, the Board received representations from various stakeholders on the contents of the circulars. It has been represented that there is a need for providing more clarity on the principles for distinguishing and appropriately characterizing R&D centers and identifying the most appropriate method for determining the arm’s length price/transfer pricing. The matter has been reviewed in light of the representations received, and accordingly Circulars 5 and 6 have been issued by the Board.

The Board, by Circular 5/2013(Circular 5) dated 29 June 2013, withdrew its earlier Circular 2 by citing that the Circular 2 provided an impression that there is a hierarchy among methods and that PSM is the preferred method in respect of international transaction relating to intangibles, which is contrary to the principle of Most Appropriate Method (‘MAM’) provided in the Indian transfer pricing regulation. The withdrawal of this circular comes as a major relief to India Inc. In the absence of acceptable intangible valuation methodologies, inconsistencies in statutory financial reporting between the AEs, variance in the Generally Accepted Accounting Principles (‘GAAP’) followed by the AE’s, non-availability of adequate and reliable comparable data (overseas entities) would have made the application of PSM a daunting task.

Further, the withdrawn Circular had cited that incase of Transfer Pricing Officers (‘TPO’) not being able to apply the PSM method, the TPO may consider looking at Transactional Net Margin Method (‘TNMM’) and Comparable Unrolled Price (‘CUP’) Method as the MAM and tweak them appropriately by taking into account location savings and location specific advantages. This again could have resulted in a larger disagreement between the revenue department and the taxpayers on the manner of tweaking the methods and the quantification of the location based advantages.

In addition to withdrawing Circular 2, the Board has issued Circular No 6/ 2013 (Circular 6) dated 29 June 2013, amending the conditions listed in Circular 3 for a development center to qualify as a contract R&D center with insignificant risks. The Circular 6 has elaborated the phrase economically significant function to include conceptualization and design of the product and providing the strategic direction and framework. 

Further, the Circular 6 has also elaborated the term low or no tax jurisdiction to mean countries or territories notified under Section 94A of the Income-tax Act, or any other country or territory that may be notified for the purpose of Chapter X of the Act. As a major highlight, the Circular 6 has removed the requirement to satisfy ‘cumulatively’ the conditions specified in the Circular 3. The amendments, while retaining the substance of Circular 3 conditions, appear to provide a relatively greater degree of operational latitude and flexibility to qualify inter-company arrangements as provision of contract R&D services.