Government withdraws guidelines on identifying and taxing captive R&D centers in India

The government of India has withdrawn its three month old circular on how to calculate taxes payable by captive research & development (R&D) units of foreign companies in India.

The circular, which would impact tax rates of companies like IBM, Microsoft, Samsung, GE, Google and others in India, was issued on March 26. While the move to bring uniformity into the taxation of foreign companies’ R&D operations was welcomed, the circular was considered far less illuminating than the industry had hoped for.

In addition, the software industry worried that the circular included even software ‘development centers’ in its definition of ‘R&D’ centers.

The government was trying to prevent foreign companies from making products, such as software, in their R&D labs in India, and not paying tax in India when those products are sold globally.

So it issued two circulars (clarifications) in March. One dealt with the application of the “profit split method” to calculate transfer pricing – or the price that the parent multinational was paying to the Indian unit for the services rendered to the parent company. The government worried that the ‘price’ showed was much less than what it should be, and as such the Indian unit showed a lower revenue than it should. As a result, the profit, and therefore the tax liability, of the Indian unit would also be less.

The other circular was on “conditions relevant to identify development centres engaged in contract R&D services with insignificant risk”.

Both have now been withdrawn, and a new one on identifying R&D centers has been issued.

“The Central Board of Direct Taxes’ move to withdraw circular No 2 (dt. March 26 2013) with immediate effect and amend circular No 3, issuing a new set of guidelines for identifying the Development Centres as a contract R&D service provider, is clear indication of the fact that the Government has appreciated IT industry’s viewpoint. The Government has also reiterated its position to issue safe harbor guidelines, thus clearing up the issues on transfer pricing,” Nasscom said.

While most of India’s IT engineers do not work on products, but only on services such as maintenance and testing, big product companies such as Microsoft and Google do have large ‘labs’ teams in India. These teams help the companies come up with new products, or implement product ideas by writing code, testing it etc.