With leading MNCs complaining about the taxman’s new-found aggression — transfer pricing adjustments rose from R44,500 crore in FY12 to R70,000 crore in FY13 — the finance ministry issued a circular on Saturday suggesting the taxman not be so aggressive. In doing so, the finance ministry rescinded a March 26 circular and also promised to issue ‘safe harbour’ rules soon — safe harbour rules will have detailed clarifications for different types of work done by MNCs. This is vital for MNCs doing contract work in India, or R&D, among others.
One of the biggest MNCs to get caught in this aggression recently was Microsoft and, as FE first reported on April 20, the taxman added R5,000 crore to Microsoft India’s income between FY06 and FY09 — the adjustments for later years would have been much higher given Microsoft’s increased India work. The taxman used what is called the ‘profit-split method’, or PSM, to argue that since 4.3% of Microsoft’s global R&D was done in India, 4.3% of its profits that were attributable to R&D should be deemed to be the income of the Indian operations.
While the transfer pricing rules prescribed at least five methods of looking at arms-length pricing, which is the crux of transfer pricing cases, the March 26 circular, to quote Saturday’s circular, “appeared to give the impression … that Profit Split Method was the preferred method”. In other words, the taxman looking at MNC R&D centres or India subsidiaries —
Ikea was accused of understating FY09 profits by 85% — don’t have to look at PSM as the first method of calculating arms-length pricing. The taxman could look at profits of similar companies or just look at cost-plus margins for job work.
Under PSM, the tax officer assumes that the Indian captive unit has shared significant business risk in the research work — Microsoft has argued that this doesn’t apply to its Indian operations which are simply contract research — and has contributed materially in decision making, and, therefore, is eligible for a share in the global parent’s profits, not just a margin over the cost of the contracted research. On the other hand, cost-plus method leads to only taxation of the operational profits of the entity doing contract research.
The ministry said it will also amend and reissue a second circular (No. 3 2013) issued on March 26 that listed out the conditions for considering a captive unit