Globalisation has led many multinational enterprises (MNEs) to establish research and development centres in India. While the initial attraction was the low-cost labour, the focus has shifted to higher value-added services, innovation and transformation. Transfer pricing (TP) issues related to R&D services have generated significant controversy. Generally operating as “contract service providers”, the Indian affiliates are assumed to offer routine services, not employ valuable assets and not bear significant risks. So, typically, the Indian affiliate is remunerated through traditional TP approaches such as a mark-up on total costs, and the foreign associated enterprise (AE) is entitled to the intangible related returns and a large part of the location savings, if any. While audits have largely focused on the mark-ups, in some instances the tax authority has classified the services as “high value” and applied the profit split method (PSM) for TP adjustment.

In response to concerns over recent tax enforcement efforts, the Central Board of Direct Taxes had through circulars in March 2013 spelt out the conditions for identifying contract R&D service providers with insignificant risk and the application of PSM for R&D activities. However, stakeholders were worried over the subjective application of the circular as well as unintended consequences when an R&D arrangement substantively, but not completely, fulfils the prescribed conditions. The circulars also created challenges in application given the diverse models MNEs use to undertake R&D activities. The conditions could bring under pressure the fundamentals of a limited-risk contract R&D structure, as commonly understood.

Following representations from stakeholders, the CBDT issued revised circulars. Circular 5 rescinds Circular 2, and Circular 6 amends the conditions listed in Circular 3 for a development centre to qualify as contract R&D centre with insignificant risks. The amendments, while retaining the substance of the Circular 3 conditions, appear to provide more operational latitude and flexibility to qualify inter-company arrangements as contract R&D services. The withdrawal of Circular 2 should help clear the presumption that PSM may be the preferred method for arrangements that do not qualify as contract R&D with insignificant risks. The revised circular broadly retains the requirement that the foreign principal (or its AEs) should perform the core functions, has the necessary “control functions”, and actually controls and supervises the R&D activity of the Indian affiliate by undertaking strategic decisions. It also reiterates that satisfaction of conditions would be evaluated based on the actual conduct of the parties and not just the contractual terms.

Recent global developments have raised the profile of economic substance in taxation. The judicial doctrine that “substance” must prevail over “form” and transactions should have “business purpose” to be respected for tax purposes has not often played a direct role in transfer pricing cases in India. However, the circulars appear to introduce this concept while determining risk allocation. It appears that references to economic substance in transfer pricing most often question whether the respective related persons in fact conduct their affairs in the manner described in the agreements.

Thus, if an entity with no R&D capability contends that it retained a related party to conduct research services on its behalf on a limited risk, cost-plus basis, the tax authority may challenge the substance of the limited risk characterisation.

Similarly, if a taxpayer contends that a low-tax principal company bears the risk of commercialising its products, but in fact has no personnel capable of strategy-related decisions, the risk allocation on business substance grounds could be challenged.

The revised circular continues to emphasise the importance of “risk control functions” in analysing and documenting the functional analysis.

It is therefore critical to identify the functional ownership of risks and assets. This would ensure that the taxpayer’s analysis of the “risk control functions”, with regard to the managerial or operational control exercised over the risks, is properly analysed and documented. This approach may better support the risk control analysis framework that the circular expects a taxpayer to present. It therefore becomes important for taxpayers to enhance their documentation to support the characterisation of their arrangements as contract R&D.

Recent global developments have turned the spotlight on the ‘substance over form’ debate.

The author is Tax Partner, EY

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