Software entities in India have gone through some tough times recently. The global economic environment was generally cloudy, Chief Information Officers (CIOs) were not liberal with their IT budgets and there was competition from countries that were attempting to ape our low-cost, good-quality, good-English communication skills formula.
The sharp depreciation of the rupee vis-à-vis the dollar has brought some cheer to them, as it meant more money in the bank. The tax department seems to want to add to their cheer by rescinding a Circular which should never have been issued in the first place, and agreeing to review another that was so worded that interpreting it required enormous effort. In March 2013, the Central Board of Direct Taxes issued Circular No 2/2013 on the use of the Profit Split Method (PSM).
Needless circular
The Circular did nothing spectacular but to quote from the Income-Tax Rules. Rule 10B(1)(d) of Income-tax Rules, 1962 provides that PSM may be applicable mainly in international transactions involving transfer of unique intangibles.
It can also be applied in multiple international transactions which are so interrelated that they cannot be evaluated separately for the purpose of determining the arm’s length price of any one transaction.
The PSM determines appropriate return on intangibles on the basis of relative contributions made by each associated enterprise.
The Circular concluded that where the Transfer Pricing Officer (TPO) is of view that PSM cannot be applied to determine the arm’s length price of international transactions, he must record reasons for non-applicability of PSM before considering another method.
This was already being done since it is expected these days that Transfer Pricing orders are speaking orders. Rule 10B(2) of the Rules provide the necessary guidance and freedom to choose among the various methods. So, why this circular? While rescinding 2/2013 is a good thing, the CBDT should ensure that such needless Circulars don’t keep coming in future.
contract R&D centre
Now for the circular under review. Circular No 3/2013 defined a contract R&D centre to be one where the foreign principal performs most of the economically significant functions, provides funds/capital and other economically significant assets. The Indian development centre works under direct supervision of foreign principal, does not assume or has no economically significant realised risks, and has no ownership right (legal or economic) on the outcome of research.
While the normal rule would have been to state that any one or all of the conditions are complied with, the Circular sent everyone into a tizzy by using the words ‘cumulatively complied with’.
In the eyes of the tax department, it appears that a software entity in India which is an arm of a foreign principal, does not own the intellectual property for the product, has no role to play in pricing decisions and does not share the monetary pain of the product flopping in the market, would be considered a contract R&D centre with insignificant risks.
While it has been promised that ‘cumulatively complied with’ and ‘economically significant’ will be further elaborated on, the tax department would do well to provide illustrative and real-life examples of what constitutes an R&D centre with insignificant risks.
The lack of robust IP and patent laws in India would ensure that contracts are structured in such a manner that the risks are always with the foreign principal.
To prevent devious tax scheming, the Circular states that in the case of foreign principal being located in a country/territory widely perceived as a low or no tax jurisdiction, it will be presumed that the foreign principal is not controlling the risk.
The takeaways from this for the CBDT are that it should not issue Circulars that provide no value-addition and those that provide a 40,000-foot view of the scheme of taxation. And it can publish the recommendations of the Rangachary Committee that was set up explicitly for this purpose.
(The author is Director, Finance, Ellucian.)