As per one of the two circulars issued by the Central Board of Direct Taxes (CBDT) on Thursday, firms that do research for their global associate or parent and share the risks with them will have to show their income based on the profit split method. Under this method, the value of the service rendered by the captive unit in India or the transfer price would be assessed taking into account the global profitability of the parent. Depending on up to what extent the parents profit is attributable to the research outcome, the income profile of the Indian firm varies in the tax mans perspective.
If one bears a part of the research risk, then one also participates in the rewards of discoveries. Accordingly, ones income may be reckoned to be high, said Amit Maheshwari, partner, Ashok Maheshwary & Associates, explaining the rationale behind the CBDTs theory.
In another circular, the CBDT laid down a set of conditions to be met for classifying contract R&D service providers with insignificant risk, for whom the profit split method of calculating arms length price may not necessarily be applicable. Such entities are those that work with the capital, assets and intangibles supplied by the global parents that control and supervise the contracted R&D work.
The insignificant risk classification and resultant immunity from the profit split method would not apply if the foreign parent is situated in a low-tax jurisdiction, the board said.
While industry is in full agreement with the classification of development centres with insignificant risks, the reaction is mixed on the circular dealing with the method of calculating the value of services rendered by such captive units. Experts said the circular is broad in nature and does not distinguish between research and contract research. They said that most Indian back offices of multinational firms do not share the risk of the research commissioned by the global parent and hence the ideal way of calculating the value of transactions between the two (transfer price) is the cost plus method without any reference to global profitability. Under this, the tax liability is calculated presuming the operational profit of such work at a particular level, say, cost plus 15-20%.
Circular 2 does not address the issue of transfer pricing in the context of a contract R&D company. Therefore, that issue remains unaddressed and there is room for controversy, said Vijay Iyer, partner, Ernst & Young.