Transfer pricing circulars may lead to more litigation

The recent circulars issued clarifying the government's position on taxation of development centres maintained by multi-national companies (MNCs) are likely to lead to an increase in disputes and litigation rather than resolving them, some tax experts have said.

Earlier this week, the Central Board of Direct taxes (CBDT) issued two circulars on transfer pricing issues. Circular no.2/2013 dealt with Application of Profit Split Method (PSM), while Circular no. 3 dealt with the conditions relevant to identify development centres engaged in "contract R & D (research and development) services with insignificant risk."

In case of the first circular, though the subject mentions the application of profit split method, the circular implicitly in some places and explicitly at other places concludes that in case of R & D activities, use of Cost Plus/Transactional Net Margin Method (TNMM) is not the appropriate. For example, it mentions that there is no correlation on cost incurred on R & D activities and return on an intangible developed through R & D activities.

The circular clearly states PSM has to be applied to estimate the value of intangibles. Application of PSM requires information about the tax payer and the associated enterprises (AEs). The circular requires the taxpayer to furnish the good and sufficient reason for non-availability of such information. It means that tax payer will be required to furnish the detailed information/documents of the AEs.

Even if transfer pricing officer (TPO) considers other methods such as TNMM as an appropriate one, he will be required to make an upward adjustment taking into account transfer of intangibles, location savings & location-specific advantages, according to the provisions.

Samir Gandhi, tax partner, Deloitte, "Though the CBDT is of the view that the circular will help in providing certainty on transfer pricing issues relating to development centre, it seems this may not be exactly true. The circular in fact lays down that PSM is the most appropriate method for R & D centre and not the Cost Plus method. It is possible that this will increase the litigation rather than resolving/preventing the disputes and may lead to India may not considered as a preferred location to set up development centres."

Similarly, the second circular lays down five conditions to be cumulatively complied with. The important being that foreign principals perform most of the economically significant functions involved in development cycle and provides economically significant assets including intangibles. The Indian development centre will work under direct supervision of the principal through strategic decisions and monitoring of activities on regular basis. The Indian development centre will have no legal or economic ownership right on outcome of research. The satisfaction of the above conditions should be evidenced by the conduct of the parties and not merely by the contractual term, according to the circular.

Experts said though the emphasis is on the risk in the subject matter of the circular, a lot of weightage is given to the function performed by the foreign principal and the Indian development centre. The only reference to risk is that mere bearing of contractual risk will not be the final determinant.

"Further, if the foreign principal is located in widely perceived as low or no tax jurisdiction such as Mauritius or Cayman Islands, it will be presumed that foreign principal is not contracting the risk," added Gandhi of Deloitte.