2 TP Circulars: Less Clarity, More Confusion?

Clarity- this was the single point goal of the Rangachary Committee that was set up last year by the Prime Minister- clarity on how the transfer pricing principles should be applied to over 750 MNC Development Centres in India. The Committee submitted its report in September last year, the contents of which were not made public. Then last week, CBDT issued two circulars on the issue. so after almost an year long wait, we ask, have we achieved any clarity or is industry worse off? Payaswini Upadhyay gets you some answers.
 
GE, Microsoft, IBM, Capgemini and over 750 such MNCs carry out product development, analytical work, software development through captive entities in India. Setting up of Development Centres comes with the benefits of a low-cost labor market for these companies and growth of services sector for India.
 
Manisha Pande
VP- Transfer Pricing, GE India
“Typically, the business model works like this- there is a foreign MNC company that is say headquartered in the United States, Europe – lets take US as an example and it will do its own R&D in US as well. Now with respect to further R&D in the most cost-effective way, it may look at procuring R&D services across the world. So the way the model will work is that it will probably have an R&D Centre in India, in Brazil, In Shanghai or wherever the company finds it most cost effective to do R&D. Now these centres- such as the one set up in India- are actually a contract service provider i.e. a service provider providing its services to a company in the US.”
 
And the point of contention between industry and the tax department has been the remuneration that the Indian development centre receives for the services it provides
 
Dinesh Kanabar
Deputy CEO, KPMG
Member, Rangachary Committee
“There have been cases where the tax authorities have come and said that the Indian multinational- which is being remunerated, for eg, at cost plus 15% -the tax authorities have come and said the correct margin ought not be 15% but ought to be 20%, 25% - and those percentages vary depending upon who is the officer, at what location, how does he perceive risk, functions and assets etc. But there is a set of assessees where the officers have gone ahead and stated that a cost plus is not a right methodology for remunerating and that part of the profits which accrue to the foreign principal overseas ought to be taxed in India because India is developing an intangible and transferring those intangibles and to remunerate India for those intangibles, what you need is a profit split method.”
 
It is to bridge this gap between industry practice and department’s approach that the Prime Minister set up a Committee last year. Chaired by Former CBDT Chairman N Rangachary, the Committee was set up with a view to make India a competitive market for development centres.
 
Vijay Iyer
Partner- Transfer Pricing, EY
“If you have a very large organization outside India which has the head of R&D, may be 500 PhDs sitting there who are conceiving various ideas and those ideas are then converted into algorithms and designs and then sent down to development centres like India and China for an actual execution, then based on the OECD commentary, it would mean that the Indian development centre is only providing routine services, needs to be compensated for the services and nothing more than the services.”
 
Manisha Pande
VP- Transfer Pricing, GE India
“When it comes to the cost of development and the funds that are available for a company, it is a very fungible kind of a capital that is available. A company will decide what is the most cost effective jurisdiction and what is the most cost effective way to apply their capital to get the maximum return on research and development. If the competitiveness of India reduces because of the way we tax our R&D centres, in the short term perhaps there will be some gains that the Revenue will have but in the long term, the competitiveness of the country and its ability to encourage innovation, use our talent pool of engineering- that will suffer.”
 
But what the CBDT issued last week is a far cry from the Committee’s proposals. The department issued two circulars last week. First one provides clarity on profit split method or PSM. The Income Tax Act allows the tax department to use PSM in cases where the arm’s length price cannot be calculated because the transaction involves transfer of unique intangibles or in case of multiple transactions which cannot be evaluated separately. The new Circular now clarifies that the officer will need to record his reasons for not using the PSM method before considering other methods like TNMM
 
Dinesh Kanabar
Deputy CEO, KPMG
Member, Rangachary Committee
“Its paragraph number 1 of Circular 2 which is really critical- it seems to suggest that profit split method is the method which is applicable in the context of R&D and transfer of intangibles. That Circular has absolutely nothing to do with what Rangachary Committee stated because that Circular lays down a proposition of the government. The issue is, the Circular suggests, when you do research, cost plus can never be the basis on how a research is remunerated – it ought to be remunerated for the intangible that is generated and therefore, it mandates, so to say that profit split method is the right method and if an officeer came to a contrary conclusion, he needs to document it and I must say, personally, I don’t agree with this approach at all.”
 
Manisha Pande
VP- Transfer Pricing, GE India
“None of the contract R&D Centres that we know of, there is a profit split being applied at all. Profit split is applied in situations where we are talking about a cost contribution agreement where, say, a bunch of parties get together, pool in their funds and they want a return out of that- you see that in pharma companies or oil and gas companies doing some sort of research together. Also, in full risk, entrepreneurial R&D companies, there could be a possibility of applying profit split.”
 
And that’s where, experts say, the disconnect is. The second Circular deals with development centres engaged in contract R&D services with insignificant risks. It lays down that an R&D Development Centre in India will be characterized as contract R&D only if it complies with all these conditions- that the significant economic functions are performed by foreign entity, economically significant assets for R&D are provided by the foreign partner, core functions, control and risk lies with the foreign partner. But all these factors will not be recognized if they exist purely on paper or if the foreign entity is located in a low or no tax jurisdiction. Having said all of this, the Circular does not conclude what method would be used to determine the arm’s length price.

Vijay Iyer
Partner- Transfer Pricing, EY
“The essence of this whole thing is it concludes that a particular fact pattern will conclude that there is a contract R&D situation but it doesn’t go further to say what is the implication of being a contract R&D- this needs to be closed with a clear clarification that once it is contract R&D, the method used would be a net margin method or to say that in a negative way that it would not be a profit split method.”
 
Dinesh Kanabar
Deputy CEO, KPMG
Member, Rangachary Committee
“The use of terminology within the Circular which are not defined- so what do you mean by significant economic risks- if you use a term like that which is not defined at all, you are again leaving it to the vagaries of interpretation. Is, for eg, the use of human resources something which will qualify as an intangible- you are dealing with employment of assets- whether those assets contain human capital, not contain- so number of things which have been states are so vague that at a practical level, one will find a tendency to say that this Circular does not apply even assuming one could clarify the use of transactional net margin method.”
 
So seems like we took a full circle and came back to right where we started or may be even worse- because as the experts in this story pointed out, the two Circulars do no talk to each other. While one legitimizes profit split to be ‘the’ method to arrive at the arm’s length price, the other gives no clarity on what will be the fate of a taxpayer even if he fulfills all the conditions of a contract R&D service provider. And if that was to be, then why the façade of setting up a committee whose report has not even made public!
 
In Mumbai, Payaswini Upadhyay