Update on the withdrawal / substitution of TP circulars for R&D centres

Background

· The Prime Minister’s office (“PMO”) in a press release on July 30, 2012 stated that a Committee to review taxation of Development Centres and the IT sector was constituted under the chairmanship of Mr N Rangachary (“Rangachary Committee”). The press release in a way defined the term “R&D centres” or “development centres”, which are frequently referred terms in the various CBDT circulars that were issued subsequently. Accordingly, the development centres were Indian captive centres of Multinational companies (“MNCs”) carrying out activities such as product development, analytical work, software development in a variety of fields including IT software, IT hardware, pharmaceutical R&D, other automobile R&D and scientific R&D.

· In March, 2013, the CBDT issued the following two Circulars pertaining to R&D centres.

- Circular 2 of 2013 was issued to clarify on the adoption of Profit Split Method (“PSM”) for R&D centers transferring unique intangibles and suggested application of the PSM as the default method for benchmarking the remuneration of Indian R&D centers. Further, where PSM could not be applied and Comparable Uncontrolled Price (“CUP”) method or Transaction Net Margin Method (“TNMM”) was adopted, the said Circular required upward TP adjustment to be made taking in to account transfer of intangible without additional remuneration, locations savings and location specific advantages.

- Circular 3 of 2013 had laid down five conditions to be cumulatively satisfied to characterize an R&D center as an insignificant risk carrying service provider.

On account of these Circulars, which were binding of the Revenue, it appeared very likely that the Revenue authorities would increasingly seek to characterize Indian centres engaged in variety of sectors such as IT software, manufacturing related R&D etc as R&D centres carrying significant risks and functions and accordingly apply PSM as the default benchmarking method rejecting the other methods as may have been adopted by taxpayers.

Withdrawal of Circular 2

However, the CBDT has after considering several views from the industry rescinded the Circular 2 dealing with PSM acknowledging that the circular appeared to suggest that there was a hierarchy in the methods prescribed (there is no such hierarchy prescribed in law) and that PSM should be the most preferred method while dealing with transfer of unique intangibles.

As a result of the withdrawal, the Transfer Pricing Officers (“TPOs”) cannot rely on the Circular 2 in any TP assessment. Having said that, the application of PSM when there is transfer of unique intangible is sanctioned under the TP law itself. The Circular 2 was worded in such a way that it could be applied to a R&D centre transferring unique intangible as a default method. Though the circular is withdrawn (therefore, TPO cannot apply this circular directly), the TPO could still examine the intercompany services agreement to check if the agreement envisages transfer of unique intangibles and apply the PSM method by relying on the TP law itself, rather than the circular.

Circular 6 issued amending Circular 3 of 2013

Simultaneously, Circular 3 of 2013, which prescribed the conditions relevant for determining if a R&D centre carried insignificant risk has been amended by the issuance of Circular 6 of 2013. The changes and the significant points arising from the revised circular 6 are captured below. Alongside, we have also referred to the relevant recommendations of the Rangachary Committee, which has recently been made public by the Government.

· The CBDT recognizes that the captive R&D centres can be classified into three broad categories based on their functions, assets and risks assumed. Interestingly, the CBDT in this regard appears to have drawn upon the views placed by the Industry before the Rangachary Committee. The categorization is as follows

Categories as per the Circular 6 of 2013	Relevant discussion in the Committee report
1. Centres which are entrepreneurial in nature	The industry view as recorded in the report notes that in these cases, the Indian company would typically undertake R&D on its own account and bears full risk and reward from future R&D; and it bears the costs and owns the resultant IP.
2. Centres which are based on cost sharing arrangements	In this category, the Indian company will typically have an arrangement with another party to pool the IP and share risk and reward from future R&D; jointly own the resultant IP and agree to jointly share costs and profits. It notes that both the above models are prevalent in pharmaceutical, biotech and similar industries.
3. Centres which undertake contract research and development	Under this segment, Indian centre under a contract provides services to associated enterprises (“AEs”) and compensated on a cost plus arrangement . All risks associated with the work product is assumed by the service recipient. Indian centre does not own any IP associated with the work product and does not also contribute any IP. It notes that this is generally the preferred model for the IT software and ITES sector.

· The CBDT has laid out 6 points as guidelines for determining a contract R&D centre with insignificant risk. It will be pertinent to note that the circular 3 of 2013 also similarly prescribed certain guidelines, which were however required to be cumulatively complied with. However, the new Circular 6 of 2013 does not refer to such cumulative compliance. Further, the Press release issued along with the Circular 6, while explaining the background to the amendment notes that “the use of the phrase ‘cumulatively complied with’ was perhaps too restrictive”.

Guidelines for determining a contract R&D centre with insignificant risk

The guidelines prescribed by Circular 6 of 2013 are briefly discussed below. Alongside, we have referred to the Rangachary Committee report, to the extent it would be relevant

Guidelines prescribed by Circular 6	Additional aspects from committee recommendations
1. Foreign principal performs most of the economically significant functions (which would include critical functions such as conceptualization and design of the product, providing strategic direction and framework) involved in the research or product development cycle, while the Indian centre carries out the work assigned to it by the principal.	In this regard, the committee report notes that typically the Indian centre would largely be involved in the actual development, implementation or maintenance of specific features or portions of the product, with limited inputs on design as necessary within the strategic direction / framework provided by the principal. The entire product life cycle or software development life cycle is not undertaken by the Indian centre.
2. Foreign principal provides funds/capital and other economically significant assets including intangibles for research or product development.	The principal bears the risk of failure of the research and will be the owner of IP in case of a successful outcome. The Indian centre will have a guaranteed remuneration irrespective of the outcome.
3. The Indian centre works under the direct supervision of the foreign principal, which has not only the capability to control/supervise but actually does so through its strategic decisions to perform core functions as well as monitor activities on regular basis.	The Indian centre is required to report back to the principal on a regular basis such as predetermined milestones. The principal is expected to be able to assess the outcome of the research. Any suggestion by the Indian centre for modification of the research program is subject to the review and approval by the Principal.
4. The Indian centre does not assume or has not economically significant realized risks. Actual conduct and not merely the contractual terms are important considerations in this regard.	The Indian centre does not assume risks such as market risk, business risk, credit risk, service acceptance risk, capacity risk, IP infringement risk.
5. Where the foreign principal is located in a low or no tax jurisdiction, there will be a rebuttable presumption that the foreign principal does not control the risk. For this purpose, country / territory notified under section 94A or Chapter X of the Act will be treated as low tax jurisdictions (Till date, no such country or territory has been notified)
6. Indian centre has no ownership right (legal or economic) on the outcome of the research, which vests with the foreign principal, which should also be evident from the contact as well as the conduct of the parties.	The rights in the development contractually vest since inception with the foreign principal and any resultant IP is registered in its name. Employees of the Indian centre could get involved to comply with the filing requirements, without any underlying rights in the exploitation by the Indian personnel or the Indian R&D centre, which should be evident from the employment contract and or the R&D service contract. Further, the patent registration is not capable of being commercially exploited on a standalone basis, as its contribution to the overall value chain is insignificant. Further, it should be considered if the terms and conditions regarding ownership of IP would have been similar if the activities carried by the Indian captive centre were or could have been outsourced to a third party R&D centre.

Entity characterization and selection of comparables

In this context, we also wish to highlight that entity characterization and selection of appropriate comparable companies is also hinged on a proper appreciation of the business/functions of the company from a Transfer Pricing perspective. The ruling of the Bangalore Bench of the Tribunal in GE Technology Centre is relevant in this regard. You may refer to the BMR Tax Edge released earlier on this ruling, which is attached herewith for reference.