Volume 6, Issue 1

3rd April, 2013

Tax Alert
CBDT Releases Circulars on Application of Profit Split Method and the Conditions to Identify Contract R&D Service Providers with Insignificant Risk


Central Board of Direct Taxes (CBDT) has recently released two circulars - Circular No. 02/2013, pertaining to selection and application of the profit split method (PSM) and Circular No. 03/2013, relating to the conditions relevant to identify development centres engaged in contract R&D services with insignificant risk. The guidance encompassed in the said circulars is explained in this tax alert.

Circular on application of profit split method

In this circular, the CBDT has provided the following points with regards to the selection of PSM as the most appropriate method (MAM).

(i) The use of transfer pricing methods such as Transactional Net Margin Method (TNMM) is discouraged for valuation of intangibles due to lack of correlation between cost incurred on R&D activities and return on the intangible developed through those R&D activities.

(ii) The circular refers to Rule 10B (1)(d) regarding the applicability of PSM mainly in international transactions involving the transfer of unique intangibles or highly interrelated international transactions.

(iii) Various factors mentioned under Rule 10C(2) for selection and application of PSM have been reiterated, including:

  1. the nature and class of the international transaction
  2. the availability, coverage and reliability of data necessary for application of the method
  3. the degree of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions
  4. the nature, extent and reliability of assumptions required to be made in application of the method

(iv) In cases where PSM cannot be applied for international transactions involving intangibles, the reasons for non-applicability of PSM should be recorded by the transfer pricing officer (TPO) before considering TNMM or Comparable Uncontrolled Price Method (CUP) as the MAM.

(v) Further, the taxpayer should have all the information necessary for application of PSM.

(v) CUP or TNMM may be used by selecting comparables engaged in developing intangibles in the same line of business, and upward adjustments can be made considering transfer of intangibles without additional remuneration, location saving and location specific advantages.

Circular on conditions relevant to identify development centres engaged in contract R&D services with insignificant risk

The circular lays down the conditions that need to be cumulatively fulfilled for a development centre to be classified as a contract R&D service provider with insignificant risk. The conditions are as follows:

(i) The economically significant functions involved in research or product development should be conducted by the foreign principal, with the Indian entity restricted to insignificant functions.

(ii) The foreign principal provides capital and other economically significant assets such as intangibles and know-how for the R&D.

(iii) The foreign principal controls, directs and supervises the research and development undertaken by the Indian development centre.

(iv) The Indian development centre should not assume economically significant risks. If the actual conduct is not in tandem with the contractual terms, the contractual terms shall not be the final determinant of actual activities. Further, if the foreign principal is in a low or no tax jurisdiction, it will be presumed that the foreign principal is not controlling the risk.

(v) The ownership rights (legal or economic) to the outcome of the research should rest with the foreign principal, and this should be evident from the conduct of the parties as well as the contractual agreement.

SKP’s Comments

Circular No. 02 /2013

  • The latest clarification on use of PSM is more of a reiteration of the rules already in place and does not specify its application. In that sense it does not provide any additional guidance.

  • CBDT has further clarified that in case PSM is otherwise applicable with respect to a transaction involving development of intangibles, the TPO should not discard the same merely on the grounds of non-availability of information/data, since such information/data should otherwise be available with the taxpayers; and if the TPO were to finally discard PSM, he should record reasons for doing so.

    One hopes that this is not an implicit admission of applicability of PSM in cases where it is not otherwise applicable with respect to transactions involving development of intangibles, say in the case of a risk mitigated ring fenced contract R&D services provider, as explained by the CBDT in Circular No. 03/2013. We feel that such an interpretation by the TPO would be in contradiction to the Circular No. 03/2013 and thus against both the legal and economic principles of transfer pricing.

  • Though TNMM or CUP could be used, searching for comparables engaged in developing similar intangibles is a daunting task assigned by CBDT to the taxpayer. In case PSM is applied to transfer of intangibles, adjustments on account of additional remuneration/location savings/specific advantages are not required as these aspects are taken into account during the working of the methodology. However, valuation of the intangibles transferred remains a very subjective exercise, and a matter for endless litigation.

Circular No. 03 /2013

  • The classification and categorization of the Indian development centre as contract R&D service provider undertaking insignificant risks may help the centre claim the benefit of the much awaited safe harbour rules. The circular reiterates that FAR (Functions/Assets/ Risks) of the entities involved, coupled with control and ownership of the intangibles developed would be crucial for classification as a contract service provider. Further, it stipulates that FAR must be followed in substance and not in the form of written agreement only.

  • The tax department appears to continue to view low tax/no tax jurisdictions suspiciously with a presumption that the foreign principal in such a jurisdiction bears no risk, unless it is established that the significant FAR and other criteria are met in substance thus demonstrating that the Indian entity is merely a risk insulated contract service provider. This is an extension of the reiteration by the tax authorities that the foreign principal should have substance in its existence and should have the capability of controlling and supervising the operations of the Indian contract R & D service provider. The entity undertaking significant risks should be determined based on the exposure to possible losses and not on the basis of taxability in the host country.

These circulars, instead of providing much needed clarity and certainty, raise doubts in the minds of the investors regarding the approach of the government towards the ever growing transfer pricing disputes.