• Service: Tax, Global Transfer Pricing Services, Global Compliance Management Services, International Tax
  • Type: Regulatory update
  • Date: 7/1/2013

India - Revised guidance for contract R&D centers  

July 1: India’s income tax authorities on 29 June 2013 announced the withdrawal of Circular 2 (concerning  the Profit Split Method (PSM) as the preferred method for computing tax liability), and the modification of Circular 3 relating to the taxation of software development and other R&D centers.

Circular 2 was withdrawn with the issuance of Circular No. 05/2013 [F. No. 500/139/2012-FTD-I] (29 June 2013).

Read a Finance Ministry release (29 June 2013)


These changes come after the tax authorities considered requests from the IT sector for greater clarity concerning international taxation and transfer pricing of certain R&D center activities in India.

The new guidance reflects representations made by taxpayers in the IT sector that R&D centers in India, when established by foreign companies, can be classified into three broad categories based on functions, assets, and risk assumed:

  • Centers that are entrepreneurial in nature (i.e., those performing significantly important functions and assuming substantial risks)
  • Centers that are based on cost-sharing arrangements
  • Centers that undertake contract R&D (i.e., when the functions, assets, and risks are minimal)

The new guidance continues to classify a development center as a contract R&D service provider with minimal risk. However, it also provides certain clarifications.

The new guidance:

  • Removes a restriction that all guidelines must be satisfied before a development center can be classified as contract R&D service provider with minimal risks
  • Concerning functions to be performed by the foreign principal, expands and elaborates on the meaning of “economically significant functions” to include critical functions—such as conceptualization and design of the product and providing the strategic direction and framework
  • Clarifies that not only the foreign principal but also its associated enterprises (i.e., affiliates overseas and foreign related parties) can provide funds, capital, and other economically significant assets (including intangibles) for research or product development and that the Indian development center can be compensated by any related parties for work performed
  • Removes a condition that the Indian development center could not use any other economically significant assets (including intangibles) in research or product development (thus addressing an issue that “human capital” used by Indian R&D centers could have been treated by the tax authorities as an intangible asset, thus resulting in the Indian R&D center possibly never being classified as being a center performing contract R&D)
  • Clarifies that the term “low tax jurisdiction” means any country or territory listed in a notice issued pursuant to section 94A or Chapter X of the Income-tax Act; however, the new circular retains a rebuttable presumption that if a foreign principal is located in a country / territory widely perceived to be a low or no tax jurisdiction, then the foreign principal is not controlling the risk and that, in such instances, the Indian R&D center may be disqualified from being classified as a contract R&D center
  • Directs the Assessing Officer or Transfer Pricing Officer to be guided by the conduct of the parties, and not merely by the terms of the contract

KPMG observation

Tax professionals have noted that in retaining the “low tax jurisdiction” condition (albeit presumably as an anti-avoidance measure), the guidance may prejudicially affect foreign principals located in “no tax” jurisdictions—for example the UAE free zones—even the foreign principal, otherwise, in reality is an entrepreneurial entity bearing all significant risks. Some tax professionals believe this rule may need to be re-considered in order to avoid hardship in such instances.

It has been observed that the new circular appears to take a more rational approach and is more “business friendly.” Also, it guides the Assessing Officer and Transfer Pricing Officers to select the “most appropriate method.”

For more information, contact a tax professional with KPMG’s Global Transfer Pricing Services practice:

Alpana Saksena

+91 9619888716

Read a July 2013 report [PDF 202 KB] prepared by the KPMG member firm in India: CBDT provides breather to taxpayers in relation to Circulars issued on contract R&D centres and application of Profit Split Method thereto

Contact a tax professional with KPMG's Global Transfer Pricing Services.

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