With transfer pricing adjustments rising from R45,000 crore in FY12 to R70,000 crore in FY13, it’s not surprising that investors are spooked about doing business in India. After all, if a global software or a pharma firm has an R&D centre in India and the taxman thinks that this is contributing to the global firm’s profits and asks that a share of this be added to the local firm’s India income, this is a recipe for trouble. The immediate impact, should the taxman keep applying the profit-split-method (PSM), would be to dissuade global firms from doing contract R&D business in India. Given the loss in foreign exchange as well as the fact that, with contract R&D growing, a lot of knowledge/best practices get transferred to India, this would be unfortunate. Which is why the finance ministry did well to get the taxman to withdraw, on Saturday, an earlier circular issued which gave the impression to various tax assessing officers that PSM was the way to go. A more detailed notification, made public on Sunday, spelt this out even further and, to a very large extent, takes care of the problem.
A distinction is now to be made between development centres that are “entrepreneurial in nature”, those that are based on “cost-sharing” and those that undertake “contract research and development”. Since most assesses argue their centres are contract ones, the Sunday circular issued pretty clear guidelines to help the taxman figure out when to use PSM and when not to. The guidelines make it clear, for instance, that when the foreign principal bears the risk and provides the funds/capital for the Indian unit, PSM is not to be applied. This would be the case for most contract development centres since, whether a new molecule is discovered by scientists in the Indian R&D centres, for instance, is never certain—to that extent, the risk is being borne by the global principal. Similarly, in the case of a global auto giant getting work done in the local arm, if the basic product development is done overseas while a part of this is outsourced to India, this will not attract PSM. Indeed, the Rangachary report on this, as FE has reported today, has said that PSM is a very tricky concept to work with, so the taxman will do well to simply ask for a higher mark-up on the costs of the Indian firm—so if a global major gives a 10% mark-up on costs for its development centre, and this is what is taxed as profit, the taxman can insist this be raised to, say, 15%. The finance minister is supposed to be opining on the report over the next few weeks.
There is one grey area, which is understandable, where the Indian centre has ownership rights to the research done—in this case, the patents would be registered in the Indian company’s name. If the taxman chooses to apply PSM here, that is quite understandable. But armed with Sunday’s circular, and the finance ministry would have come out with its view on the Rangachary recommendations by then, the assessee has a better chance of arguing out its case legally.