Relief for tech firms as I-T revokes circular on transfer pricing

Clarifies 'profit-split' will not be only method to compute tax

The income-tax department on Saturday revoked its recent circular on adoption of profit-split method as a preferred mode for computing tax liability on multinational companies’ development centres in India. It also clarified that another circular, relating to the parameters defining R&D centres, would be suitably modified.

The two circulars, issued in March this year, had drawn serious concerns, especially from technology and pharma companies.

One of the two circulars was on application of profit-split method for transfer pricing, while the other was for identifying development centres engaged in contract R&D services with insignificant risk. According to the profit-split method, part of parent company’s profit is taken into account while computing the tax liability of its centres. This would have meant a significant jump in tax demand on research & development centres of foreign companies operating in India.

While industry players cheered Saturday’s move, experts said it would avert future trouble in the area of transfer pricing, which is already embroiled in significant litigation.

“The peak assessment season has yet to begin; so, the clarification at this stage is more than welcome,” said S P Singh, senior director, Deloitte Haskins & Sells.

Rough calculations suggest that over $2 billion are stuck in transfer-pricing litigation involving software development centres alone. Nasscom director Bishakha Bhattacharya said the profit-split method’s withdrawal as “the default means of arm’s-length pricing” was welcome.

Also, the promise to “remove the ambiguity involved in the definition of R&D centres will prevent the situation from worsening further”. R&D centres account for a significant portion of Indian software services firms’ export revenues. Most large multi-national firms, including IBM and Microsoft, have been embroiled in transfer pricing litigation in the past.

A panel formed by the government under former CBDT chairman N Rangachary to resolve these issues had in September last year given its report on ‘Taxation of Development Centres and IT Sector’. These and a few other circulars were based on the panel’s report.

The tax department’s circular three listed five conditions to decide whether or not a development centre was a contract R&D service provider with insignificant risk. Singh said, according to the earlier circular, the profit-split method would not be applicable on entities that qualified the five parameters under the definition of contract R&D service provider with insignificant risk.

“However, it was very difficult for companies to meet all the parameters.”

Taking cognizance of this, the government said “the use of the phrase ‘cumulatively complied with’ was perhaps too restrictive”. It has also proposed to define and elaborate on phrases like ‘economically significant functions’ and ‘low or no tax jurisdiction’ to make the definition clear.

So far as circular two is concerned, the department said, since it was giving an impression that “there was a hierarchy among the six methods” of transfer pricing and that the profit-split was the preferred one, it has “rescind” the circular. Bhattacharya said the industry was looking forward to how the government would not expand the definition and it should “hopefully be in industry’s favour”.