In the digitally aided fast paced world of today intangibles have become a very important part of tax planning of Multi National Enterprises (MNE’s). Specifically, research and scientific activities have become a very important of tax base planning at a group level for multinational enterprises. Whether we look at Alphabet, or Meta or Apple or Amazon or Sandoz or Pfizer the ilk. A very important stream of shareholder ’s residual money is from the effective tax rate that is finally applicable to shareholders. Intangibles are invariably the result long periods of research and development, whether it be IP or marketing intangibles or any other, it is a well-known fact that MNE’s today of any significant size are putting in lot of capital in Research and Development.
Although the term “Research and Development”(R&D) has not been specifically defined under the Domestic Tax Laws, yet all entities in India are entitled to deduction for research and development expenses. A definition of the term Research and Development has not been incorporated into the Income Tax Act per se but Scientific Expenditure as defined u/s 43(4) of the Income Tax Act 1961 “Scientific Research’ means any activity for the extension of knowledge in the fields of natural or applied science including agriculture, animal husbandry or fisheries;” (Deputy Commissioner of Income-tax (Asstt.) vs Mastek Ltd. (Gujarat High Court) Tax Appeal No. 242, 243 AND 263 OF 2000), which is more or less analogous with what a definition of R& D could be.
In the domain of International Taxation, it is generally the MNE’s who engage in research and development activities and they generally represent significant elements of cost, which are invariably in the domain of section 92C viz under and arm’s length price.
Explanation(i)(d) to section 92B provides that scientific research would be covered under the ambit of international transactions.
Section 92C inter alia provides for allocation of profits between associated enterprises on the basis of six approved methods
- comparable uncontrolled price method;
- resale price method;
- cost plus method;
- profit split method;
- transactional net margin method;
- such other method as may be prescribed by the Board.
For the sixth portion Rule 10(AB) prescribes as follows “10AB. For the purposes of clause (f) of sub- section (1) of section 92C, the other method for determination of the arm’s length price in relation to an international transaction 91[or a specified domestic transaction] shall be any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts.]”
However, it is interesting to note that neither the rule nor the section provides for any preference to any method or any guidance on how and which criteria to use for an appropriate selection for transfer pricing. Furthermore, there was no clarity on what was the position of the state in matter of risk allocation as such.
The CBDT on its part came out with a circular number 06/2013 [F NO. 500/139/2012], DATED
29-6- 2013 for the purpose. It clarified Inter alia amongst others that
“The Research and Development Centres set up by foreign companies can be classified into three broad categories based on functions, assets and risk assumed by the centre established in India. These are:
- Centres which are entrepreneurial in nature;
- Centres which are based on cost-sharingarrangements; and
- Centres which undertake contract research and development.
While the three categories are not water-tight compartments, it is possible to distinguish them based on functions, assets and risk. It will be obvious that in the first case the Development Centre performs significantly important functions and assumes substantial risks. In the third case, it will be obvious that the functions, assets and risk are minimal. The second case falls between the first and the third cases.”
In particular the circular clearly outlines that there is some leeway between all the three types and in particular the second type will have characteristics of both the first and second types. In the same circular the CBDT has noted the preference of the assessee to perform TP using the Transactional Net Margin Method (TNMM) as opposed to other more simpler traditional methods by classification of the R&D provider as a contract R&D provider with an insignificant risk. The CBDT then delves forward to provide for a guidance on how the same should be tackled in particular with reference to for identification of the Development Centre as a contract R&D service provider with insignificant risk.
The steps are outlined as below
- The Foreign principal assumes most of the risks associated with the research and development and uses the Indian associated enterprise as a toll manufacturer, and the employees or associated companies of the Foreign Principal also remunerate the employees or the associate enterprise to carry out the tasks entrusted by the Foreign Principal.
- The foreign principal or its associated enterprise(s) provides funds/capital and other economically significant assets including intangibles for research or product The personnel and other resources are also remunerated by the foreign Principal or is Associated Enterprises for the work done at the Contract R&D centre.
- The Foreign principal exercises direct control and supervision over the R&D center, not only contractually but functionally too.
- The contract R&D centre doesn’t take over any significant economic risk both contractually and functionally.
- The Foreign Principal of the R&D centre isn’t located in a tax haven or a low tax
- The R&D center doesn’t have any control over the final product and is contractually obligated to pass on the final product and any incidental benefits to the Foreign
It is only if all the criteria above are met that the R&D centre would be considered a low risk entity. The assessing officer shall be free to allocate the TP method considering all the facts and circumstances of the case.
Thus the regime of R&D as a contract toll manufacturer is well defined as per Indian Tax Laws.
GAAR regime will apply in case of R&D centres as well, so anti abuse rules would take an important part in determination of profits to be allocated to R&D centres.
Although, establishing R&D Centers by the way of PE is not illegal, they are generally not established as a PE just owing to the fact that it creates complications in the structure and tax compliance. Furthermore, it is highly likely that the Department of Scientific and Industrial Research would accord any recognition to it, and thus by extension no incentives might be provided to it. Therefore, it would make sense to incorporate and entity for R&D centres.
Super deductions u/s 35 are generally not available to PE’s , it might be made available for in case if some contribution is made to an approved scientific research association being an Indian Entity. Such a super-deduction would generally not be available to the PE if the contribution is made to a non-resident.
In India, certain R&D incentives are available to products manufactured through use of IP owned or leased by Indian owned companies. Thus, accordingly any transfer of an IP to a low tax jurisdiction or a tax haven would lead to a denial of benfits. Further, transfer pricing regulations apply in the case of transfer of IP or the right to use IP between associated enterprises. There are no specific statutory anti- avoidance rules with respect to such transfer. Indian law has introduced GAAR applicable from 1 April 2015.
It might be also noted that India does not have any “patent-box” regimes existing.
Thus in the case of MNE’s in the Indian context it appears that Taxation for Research and Development centers is more about transfer pricing and proper allocation of method rather than other factors.
In case of Intra group facilities the OECD Transfer Pricing Guidelines accept the same as in para 7.41 “Research is similarly an example of an activity that may involve intra-group services. The terms of the activity can be set out in a detailed contract with the party commissioning the service, commonly known as contract research. The activity can involve highly skilled personnel and vary considerably both in its nature and in its importance to the success of the group. The actual arrangements can take a variety of forms from the undertaking of detailed programmes laid down by the principal party, extending to agreements where the research company has discretion to work within broadly defined categories. In the latter instance, the additional functions of identifying commercially valuable areas and assessing the risk of unsuccessful research can be a critical factor in the performance of the group as a while. It is therefore crucial to undertake a detailed functional analysis and to obtain a clear understanding of the precise nature of the research, and of how the activities are being carried out by the company, prior to consideration of the appropriate transfer pricing methodology. The consideration of options realistically available to the party commissioning the research may also prove useful in selecting the most appropriate transfer pricing method.”
Courts in India have on various occasions stepped in to determine what an arms length could be in matters of allocation of research and development costs, either intra group or intra company and that comparables in such cases should be strict. Some of which are enumerated below:
- DCIT  137 taxmann.com 246 (Bangalore – Trib.)[29-03-2022]
- Where selected company performed research and development activities, said company was not functionally comparable to assessee, manufacturer Continental Automotive Components India (P.)
- Where under Parent Subsidiary Agreement, assessee subsidiary Microsoft- India acted as a R&D service provider and parent Microsoft-USA supplied related intangibles and ownership right on outcome of research, vested with Microsoft-USA, assessee was a contract R&D service provider to Microsoft-USA – Microsoft India (R&D) (P.) Ltd. v. Deputy Commissioner of Income-tax, Circle-16(2), New Delhi –  97 taxmann.com 360 (Delhi – Trib.)[14-09-2018]
- Where a company, engaged in carrying out research and development activities, had created large intangibles and earned revenue from different verticals, same was to be excluded from list of comparables to assessee-company, a captive service provider – Huawei Technologies India (P.) Ltd. v. ACIT ( 133 taxmann.com 486 (Bangalore – Trib.)[22-07-2021])
- A)Where comparable company was engaged in product engineering, acquisition and development, consultancy and solutions and also undertook significant research and development operations, approved by government, it would not be comparable to assessee company engaged in provision of software development services. b) Where comparable company engaged in diverse range of activities, owned high brand value and had also incurred significant expenses in foreign currency, it would not be comparable to assessee company engaged in provision of software development services – Finastra Software Solutions (India) (P.) Ltd. v. ACIT –  135 com 308 (Bangalore – Trib.)[21-12-2021]
- A company engaged in pharmaceutical industry, having own intangibles, could be compared with assessee, rendering contract research and development service – Deputy Commissioner of Income tax, Circle-1(1) v. Akzo Noble Car Refinishes India (P.) Ltd ( 90 taxmann.com 15 (Delhi – Trib.)[08-01-2018])
- Where assessee was providing software research and development services to its AEs, a company engaged in diversified activities of software development, consultancy, engineering services, web development and hosting, was incomparable to assessee b) Where assessee was providing software research and development services to its AEs, a company engaged in business of software products was incomparable to assessee c) Where assessee had two divisions viz, software R&D division and marketing support division, TPO was justified in apportioning unallocated cost between both segments of assessee while making segmental analysis of both divisions – Trident Microsystems India (P.) Ltd –  111 com 100 (Bangalore – Trib.)[26-07-2019]
- A company in business of clinical trial services is comparable to a company providing contract manufacture, contract research and development of drugs to its Associated Enterprises b) Where both comparables as well as assessee are situated in India, no adjustment of ALP on account of locational advantage is called for – PCIT vs. Watson Pharma (P.) Ltd. ( 95 taxmann.com 281 (Bombay)/257 Taxman 65 (Bombay)[20-06-2018])
- SLP dismissed against High Court ruling that where services rendered by assessee were specialized and required specific skill based analysis and research that was beyond rudimentary nature of services rendered by a BPO, it was to be held services provided by assessee constituted functions of a KPO MC Kinsey Knowledge Centre India (P.) Ltd. v. Principal Commissioner of Income-tax, Delhi-6 102 taxmann.com 439 (SC)/ 261Taxman 451 (SC)[04-02-2019]