Application of Profit Split Method on Research & Development Centres in India

Application of Profit Split Method on Research & Development Centres in India [Circular 2/2013 & 3/2013, issued by Central Board of Direct Taxes, Ministry of Finance, Government of India]

Today, Central Board of Direct Taxes, Ministry of Finance, Government of India (in short ‘CBDT’) has issued two circular in respect of application of Profit Split Method (‘PSM’) for the purposes of determination of arm’s length price in case of Research & Development Centres (in short ‘R&D Centres’) operating in India.

Circular 2/2013 elaborates points that should be kept in mind while applying PSM on R&D Centres, Circular 3/2013 provides conditions wherein R&D Centres in India would be treated as contract R&D Centres with insignificant risk.

In general, guidance in the captioned circulars is on the principles as enumerated in the OECD TP Guidelines, with importance being given to “economically significant function, asset and risk” along with other criteria. In a simple example, economically significant function can be a function which is adding greater value to the R&D in value chain.

As per Circular 2/2013, the preferred method for computing arm’s length price of R&D services provided by India Centre shall be PSM. However, wherein PSM cannot be applied due to non-availability of the comparable data, Transactional Net Margin Method (‘TNMM’) or Comparable Uncontrolled Price Method (‘CUP’) could be considered for the purpose of computing arm’s length price.

Reading of Para 1 & 2 of Circular 2/2013 suggests that the Circular 2/2013 would be applicable wherein R&D Centre in India is not characterized as “Contract R&D Centre with insignificant risk”.  Circular 3/2013 enumerates conditions wherein R&D Centre in India would be considered as Contract R&D Centre with insignificant risk. Such conditions are, wherein

Foreign Principle

•  performs most of the economically significant functions involved in research or product development life cycle, and,
• provides fund/capital and other economically significant asset including intangibles for research or product development and,
• have capabilities to control or supervise research or product development, and,
• control or supervise India Centre through its strategic decisions to perform core functions as well as monitor activities on regular basis, and,
• is not located in a country/ territory widely perceived as a low or no tax jurisdiction (however, in case if India Centre able to satisfy the Indian Tax authorities on the economic significance of Foreign Principle in value chain, then possibly this condition may be relaxed) and,
•  has ownership right of research outcome

And, Indian Centre

•  is largely involved in economically insignificant functions involved in research or product development life cycle, and,
•  is  not using any other economically significant assets including intangibles in research or product development, and,
• does not assumes or has no economically significant realized risk, and,
•  does not have ownership right (legal or economic) on outcome of research.

It is to be noted that the above conditions are required to be satisfied on cumulative basis. Further, purpose of analysis, importance would be given to actual conduct rather than the contractual arrangement between Foreign Principal and India Centre.

Trust the same would find you useful. 

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Regards

CA Gaurav Garg

JGarg Economic Advisors

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(E) gaurav@jgarg.com