Formulating a fair tax system for captive R&D

Global corporations have in increasing numbers set up captive research and development centres in India, drawn by its scientific and engineering talent, and top-class research universities. This, in turn, has led to jobs, large-scale investments in world-class facilities, and exposure to cutting-edge technologies.

Over the last few years, tax and transfer pricing have become key areas of concern and uncertainty for these captive R&D centres. Specifically, tax authorities are seeking to challenge their existing business model and attribute a larger compensation for their activities.

Given the potential for high-stake litigation and the likely impact of the uncertainty on the country’s competitiveness vis-à-vis other countries, the Government set up the Rangachary Committee to look into the transfer pricing issues faced by the R&D centres. The panel’s report was promptly followed by two circulars that aimed to provide certainty on the issues.

The Central Board of Direct Taxes issued Circular No. 2, which reiterated that the Profit Split Method would be appropriate in determining the profits attributable to R&D centres that engage in transactions involving the transfer of unique intangibles, or in multiple international transactions that are so interrelated that it is not feasible to evaluate the arm’s length price of any one transaction.

Circular No. 3 dealt with the nature of activities undertaken by the R&D centres — that is, whether they were mere contract centres with minimal risk or bearing full risk. The circulars led to apprehension among taxpayers on the taxability of the centres.

Based on discussions and various representations, the CBDT recently issued Circular No. 6, which puts to rest many of the apprehensions. Circular No. 3 has been amended and R&D centres in India have been classified broadly as

entrepreneurial in nature — that is, bearing full risk;

based on cost-sharing arrangements; and

undertaking contract R&D activities — that is, with minimal insignificant risks.

Circular No. 6 also laid down broad guidelines for identifying the development centre as a contract R&D service provider with insignificant risk:

Foreign principal performs most of the economically significant functions in the research or product development cycle, either through its employees or its associated enterprises, while the Indian development centre carries out work assigned to it by the foreign principal. Economically significant functions would include conceptualisation and design of product and providing strategic direction and framework.

The foreign principal or its associated enterprise(s) provides funds/ capital and other economically significant assets including intangibles for research or product development. The foreign principal or its associated enterprise(s) also provides remuneration to the Indian development centre.

The Indian development centre works under the direct supervision of the foreign principal or its associated enterprise, which not only has the capability to control or supervise, but also actually controls or supervises the research or product development through its strategic decisions to regularly perform core functions and monitor activities.

The Indian development centre does not assume, nor has economically significant realised risks. If a contract shows that the foreign principal is obligated to control the risk but the conduct shows that the Indian centre is doing so, then the contractual terms are not the final determinant of activities.

In the case of a foreign principal located in a country/ territory widely perceived as low- or no-tax jurisdiction, the foreign principal will be presumed to not control the risk. However, the Indian development centre may rebut this presumption to the satisfaction of the revenue authorities. Low-tax jurisdiction shall mean any country or territory notified as such under section 94A of the income tax law.

The Indian development centre has no ownership right (legal or economic) over the outcome of the research, which vests with the foreign principal, and this is evident from the contract as well as the conduct of the parties.

The combined reading of all three circulars indicates that the Profit Split Method is not the most appropriate for contract R&D centres with insignificant risks, and that the taxpayer can adopt the Transactional Net Margin Method for determining the arm’s length price for remuneration.

This is a welcome move that would reduce litigation and create a fair tax system in line with leading international practice, thereby promoting India as a destination of choice for development centres. The Government’s prompt action is indeed commendable and will go a long way in ensuring the future growth of this important sector through a sophisticated, competitive and business-friendly tax framework.

(The author is Tax Partner, KPMG India)

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