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CBDT revises guidance on transfer pricing of R&D centres
Based on the recommendations of the Rangachary Committee, the Central Board of Direct Taxes (CBDT) had issued Circulars No. 2 & No. 3, regarding transfer pricing issues of Research & Development (R&D) centres in March 2013. Taxand India discusses why the CBDT has rescinded Circular No. 2, regarding the application of the Profit Split Method (PSM).
The circular regarding the application of PSM had grave implications for Indian R&D centres as it accorded priority to PSM over other methods for the purpose of determining the arm’s length price. This may have entailed Indian R&D centres being required to be compensated on the basis of overall profits of the multinational group rather than on a cost plus basis. Further, there was an apprehension amongst taxpayers that Circular No. 3 could have been misapplied to characterise most captive R&D centres in India as high-risk service providers.
After considering the feedback received from the industry, the CBDT has rescinded the circular on the application of PSM (Circular No. 2). Accordingly, PSM need not be regarded as the preferred transfer pricing methodology for R&D centres, and the most appropriate methodology would be determined based on the functional and risk matrix of the R&D centre.
Infact, the Rangachary Committee report recognised that where the R&D centre assumes insignificant risk (Circular No. 3), Transactional Net Margin Method (TNMM) may be regarded as the most appropriate transfer pricing methodology. Further, the Rangachary Committee report recognised practical difficulties in the application of PSM, such as the determination of the unique contribution by each party, identifying profits arising from controlled transactions and the availability of data. The Rangachary Committee report also observed that a higher cost plus mark-up under TNMM would be more appropriate for factoring in location savings and location advantages rather than an unreliable PSM.
By withdrawing Circular No. 2, the CBDT has re-confirmed that the most appropriate transfer pricing methodology should be determined based on the functions, assets and risks analysis of the R&D centre and not by using a straight jacketed formulaic approach. This is consistent with the guidance provided in the Indian Transfer Pricing Regulations and the OECD Transfer Pricing Guidelines.