Tax clarity on R&D contracts

Globalisation, coupled with the cost arbitrage proposition, saw the setting up of various forms of development centres here. Propelling the India growth story, the captives scaled up from their low-cost outsourcing status to providing high-value innovation and transformation services. However, although the sector has been the beneficiary of various tax incentives, levies in the form of minimum alternate tax, dividend distribution tax, challenges surrounding service-tax refunds coupled with high-pitched tax holiday scrutiny and transfer pricing adjustments have dampened the spirit of the sector.

Abreast with the challenges faced by the sector, the Government set up the Rangachary Committee to come up with recommendations, based on inputs from various stakeholders. Based on the Committee’s recommendations, the Government has issued clarificatory circulars providing guidance on litigative matters.

Although the first of the three such circulars deals with various issues, a notable one relates to development centres engaged in providing research and development (R&D) services. It has been clarified that any R&D activity embedded in engineering and design would be eligible for tax holiday — a welcome move that would act as a breather to companies in this field. However, the circular is concisely worded and leaves ample scope for interpretation. Given the vast span of ‘engineering and design’, it would have been apt to lay specific guidelines on what constitutes this category, and the research related to this field.

Similarly, the functional profile of the development centres has led to transfer pricing disputes. While the taxpayers insist that they are contract R&D service providers with insignificant risk, the administrative position of the Revenue authorities is to treat them as full or significant risk-bearing entities and subject to transfer pricing adjustments accordingly.

The second and third circulars lay down the conditions for identification of development centres engaged in contract R&D assuming insignificant risk, and parameters for applying the Profit Split Method (PSM). The intention is to provide finality to the impending litigation.

The circulars provide specific guidelines on when an Indian development centre can be treated as ‘contract R&D’ thereby entitling it to operate on a cost-plus model of compensation, and not the PSM methodology. This is a positive move in terms of guiding the Revenue authorities objectively and resolving/mitigating long-standing disputes. It highlights the need for economically significant functions to be carried out by the foreign principal and legal ownership of the research to be vested with the principal to categorise the Indian service provider as “contract R&D”.

It is asserted that the Indian development centres should work under the control and supervision of — and should be economically dependent on — the foreign principal. One, however, needs to be conscious of the tax risks faced by the principals in such models.

Further, the circular emphasises the need for “substance” in the conduct of parties, not necessarily governed by the contractual obligations, to determine the parties’ true conduct. In the case of a foreign principal located in a country/ territory widely perceived as a low-tax jurisdiction, it will be presumed that the foreign principal is not controlling the risk, and the onus is on the taxpayer to prove otherwise. Thus, there is a clear requirement that the conduct of the parties should be consistent with the purported risk contractually assigned.

The above principles are in line with the OECD guidelines and are a step in the right direction. However, the guidelines lay down the various factual/ legal propositions (on functionality, demonstration of economic substance, laying out the risk control framework, and so on), and would involve subjectivity at operational levels.

It is desired that the legal principles are applied in true spirit both by the taxpayers and the Revenue authorities to avoid unwarranted litigation.

Vikash Dhariwal, Manager – TRS, PwC India contributed to the article.

The author is Associate Director — Tax and Regulatory Services, PwC India

COMMENT NOW