First Report of the Committee to Review Taxation of Development Centres and the IT Sector

Foreword

The Committee setup by the Government to examine some of the issues relating to taxation of income of persons engaged in the IT sector is glad to furnish its first report on some of these issues. Its report on the other issues will follow in due course.

While furnishing this report, I must duly acknowledge the role played by its members, namely, Ms. Anita Kapur, DGIT (Administration), Delhi, Ms. Rashmi Saxena Sahni. DIT (Transfer Pricing-l), Delhi and Mr. Dinesh Kanabar, Tax Expert in analyzing the various data and showing a rare commitment and devotion.

I must also acknowledge with gratitude the important role played by the two senior officers of the Department, namely Shri D. Prabhakar Reddy and Shri Sobhan Kar, Addl. Commissioners of Income Tax, in assisting the Committee in its deliberations and bringing into consideration relevant issues from time to time.

N. Rangachary,

Chairman

14^th September, 2012

PART 1: INTRODUCTION

1.1 Prime Minister's Office issued a press release on July 30,   2012 (Annexure  -1), stating that the Hon'ble Prime Minister had constituted a Committee to Review Taxation of Development Centres and the IT Sector under the Chairmanship of Mr. N Rangachary, former Chairman CBDT & IRDA. The press release also underlined the following grounds for seeking resolution of tax issues through an arm's length exercise in the form of a review by the Committee:

•  There is a need to address issues relating to the taxation of the IT Sector such as the approach to taxation of Development Centres, tax treatment of "onsife services" of domestic software firms, and also the issue of    finalising the Safe Harbour provisions announced in Budget 2010.

• The reason for large concentration of Development Centres in India is the worldwide recognition of India as a place for cost competitive, high quality knowledge related work. Such Development Centres provide high quality jobs to our scientists, and indeed make India a global hub for such Knowledge Centres. However, India does not have a monopoly on Development Centres. This is a highly competitive field with other countries wanting to grab a share of the pie. There is need for clarity on their taxation.

•  Safe Harbour provisions announced in Finance Bill 2010 but yet to be operationalised have the advantage of being a good risk mitigation measure and provide certainty to the taxpayer.

•  A comprehensive approach involving consultations with the Government departments concerned and the industry bodies is required.

•  The overall goal is to have a fair tax system in line with best international practice, which will promote India's software industry and promote India as a destination for investment and for establishment of Development Centres.

1.2  The press release indicated the following terms of reference and the time lines for the Committee

Terms of Reference:

i)  Engage in consultations with stakeholders and related Government departments to finalise the approach to Taxation of Development Centres and suggest any circulars that need to be issued.

ii) Engage in sector-wide consultations and finalise the Safe Harbour provisions announced in Budget 2010 sector-by-sector. The Committee will also suggest any necessary circulars that may need to be issued.

iii) Examine issues relating to taxation of the IT sector and suggest any clarifications that may be required.

Time Lines:

i)  Finalise the approach to taxation of Development Centres and suggest any necessary clarifications by 31August 2012.

ii)  Suggest any necessary clarifications that may be needed to remove ambiguity and improve clarity on taxation of the IT Sector by 31 August 2012.

iii)  Finalise Safe Harbour Rules individually sector-by-sector in a staggered manner and submit draft Safe Harbour provisions for three sectors/sub- activities each month beginning with the first set of suggestions by 30 September 2012. All Safe Harbour provisions can be finalised by 31  December 2012.

1 .3   The Committee was formally notified through an Office Memorandum of Department of Revenue, dated 03-08-2012   (Annexure-II), with the following members:

i. Shri N. Rangachary, former Chairman, CBDT and IRDA  -Chairman

ii. Ms. Anita Kapur, DGIT (Administration), -Delhi - Member

iii. Ms. Rashmi Saxena Sahni, DIT (Transfer Pricing-I), Delhi - Member

iv.Shri Dinesh Kanabar, Tax Expert  -  Member

1.4  The Committee sought and was provided assistance of two officers, namely, Shri D. Prabhakar Reddy, Addl. Commissioner of Income Tax, TPO-Il(6), Mumbai and Shri Sobhan Kar, Addl. Commissioner of Income Tax (APA), Delhi vide CBDT order No  154 dated 7th August, 2012 (Annexure-III).

1.5  The time limit of August 31, 2012 for submission of recommendations of the Committee on issues other than Safe Harbour was, with the approval of the Finance Minister, extended to 15th Sept.  2012.

1.6   The rationale for setting up the Committee was, inter olio, reiterated in the Press Note issued by the office of Hon'ble Finance Minister, Shri Chidambaram on August 06, 2012 (Annexure-IV). The relevant part is extracted below:

"Clarity in tax laws, a stable tax regime, a non-adversarial tax administration, a fair mechanism for dispute resolution, and an independent judiciary will provide great assurance to investors. We will take corrective measures wherever necessary. We have recently appointed two Committees, one to examine GAAR legal provisions and guidelines and the other to review taxation of the IT sector and Development Centres. I have also directed a review of tax provisions that have a retrospective effect in order to find fair and reasonable solutions to pending as well as likely disputes between the Tax Departments and the Assessees concerned. With these measures, and some other measures that we hope to take in the short term, it is our intention to raise the level of investment to 38% of the GDP that was achieved in 2007-08."

1.7  Further, FT & TR Division of CBDT through Office Memorandum dated 8th August, 2012 (Annexure-V), advised the Committee that the Hon'ble Finance Minister had approved the suggestion that the issue of application of Global Profit Method to determine arm's length price of intangibles developed by the R&D centres of MNEs in India may be considered by the Committee.

1.8   Interaction with the stakeholders

The Committee sought written comments from the following Departments of the Central Government, industry stakeholders and accounting firms:

i.      Department of Electronics & Information Technology (DoE & IT)

ii.     'Department of Commerce (DoC)

iii     Department of Economic Affairs (DEA)

iv.    Department of Industrial Policy & Promotion (DIPP )

v.     Central Board of Direct Taxes (CBDT)

vi.    Central Board of Central Excise and Customs (CBEC)

vii.    NASSCOM (National   Association of Software and Service Companies)

viii.    CII (Confederation of Indian Industry)

ix.      FICCI (Federation of Indian Chambers of Commerce and Industry)

X.      ASSOCHAM (Associated Chambers of Commerce and Industry of India)

xi.      PHDCCI (PHD Chamber of Commerce & Industry)

xii.     ICAI   (Institute of Chartered Accountants of India)

xiii.    PWC (Price Waterhouse Coopers)

xiv.    E&Y (Ernst & Young)

xv.     Deliotte Haskins & Sells

xvi.    KPMG

xvii.   BMR Advisors

xviii.  Khincha and Khincha, Bangalore

xix.    T. P. Ostwal & Associates, Mumbai

xx.     Vaish & Associates, Delhi

xxi.    Vispi T. Patel & Associates, Mumbai

1.9  The Committee received written submissions from most of the above stakeholders. The Department of Electronics & IT primarily supported the position of NASSCOM on various issues. The Department of Commerce generally sought uniform, predictable and fair application of the tax laws apart from supporting some beneficial construction of incentive provisions in respect of certain contentious issues e.g "onsite service", shifting of employees to new unit and MSA vs. SoW.

1.10  The Department of Economic Affairs informed that they had no comments to offer.

1.11  In addition   to   that,   the Committee also received written suggestions/comments from the following:

i     Shri N.R.Narayana Murthy, Chairman Emeritus, Infosys  (forwarded by Department of Revenue)

ii.    American Chamber of Commerce (Amcham)

iii.  Baker & McKenzie representing the Software Coalition

iv.  Sonata Software Ltd.

v.   Coalition on International Taxation in India

1.12    An interactive session was conducted on 19th August, 2012 with the following business/industry chambers:

i     NASSCOM

ii.   FICCI

iii.  ASSOCHAM

1.13  An interactive meeting was also held on 3rd September, 2012 with the following officers of the Income-tax Department/CBDT to ascertain the views of the Revenue:

i    Chief Commissioners of Income-tax (CCA), Bengaluru, Chennai, Delhi, Hyderabad and Mumbai.

ii.  Director General of Income-tax (International Taxation), Delhi

iii. Joint Secretaries (FT & TR-I and II), CBDT

iv. Commissioner of Income-tax (ITA), CBDT

1.14    Another round of consultations was held by the Committee with the following business/industry chambers on 12th September, 2012:

i.  NASSCOM (including E&Y)

ii. CII (including Microsoft, Yahoo India, Wipro, Deloitte Haskins & Sells and Amarchand Mangaldas)

iii.  ASSOCHAM (including PWC)

iv. FICCI

1.15    After going through the representations received from the various stakeholders and giving due consideration to the perspective of the Revenue, the Committee identified certain critical issues affecting the industry for its first report on which action can be taken immediately.

1.16 Approach of the Committee:

1.16.1   The approach of the Committee was driven by its commitment to be objective and just. The Committee has attempted to address the issues posed to it by suggesting clarifications that interpret the existing legal provisions. When the interpretations canvassed by the Revenue and the other stakeholders were divergent but equally well argued, the Committee has opted to support an interpretation that is fair to the taxpayer and provides reasonable resolution of contentious issues.

1.16.2  The Committee has refrained from examining the issues raising questions about the logic and rationale of the extant provisions of the Income Tax Act and seeking amendments thereto, as the Committee is not mandated to review the law.

1.17   Thus, this first report covers key concerns, as highlighted by the stakeholders, relating to taxation of Development Centres (DCs) as well as taxation issues of the IT Sector and completes the response of the Committee to the first two terms of reference. Finalisation of Safe Harbour rules for certain sectors including DCs, requires detailed data analysis and the Committee will respond to this matter in its subsequent reports.

PART 2: FIRST TERM OF REFERENCE - APPROACH TO TAXATION OF DEVELOPMENT

CENTRES (DCs)

Background

2.1    Inter-group pricing arrangements between related business entities including transfer of tangible goods/intangibles/services or lending or borrowing money etc, fall within the ambit of Transfer Pricing. Comprehensive Transfer Pricing (TP) legislation was introduced in India w.e.f. 01-04-2002.

2.2    Eight TP audit cycles have been completed and the transfer pricing adjustments made are as follows':

2.3    Transfer pricing disputes are a major cause of concern for captive DCs in India. The PMO's Press Note dated July 30, 2012 defines captive DCs as under: "Many MNCs carry out activities such as product development, analytical work, software development, etc. through captive entities in India. They exist in wide variety of fields including IT software, IT hardware, Pharmaceutical R&D, other automobile R&D and scientific R&D. These are popularly called Development Centres."

2.4    Transfer pricing is not an exact science. It is both fact intensive and fact sensitive and does require exercise of judgment on the part of tax administration and taxpayer. Administration of TP provisions relating to transfer pricing documentation, comparability analysis, choosing and, applying most appropriate method to determine arm's length price, continues to generate litigation.

2.5    Development Centres  (DCs) are an important segment in the R&D ecosystem as per the research findings of the Industry stakeholders summarised in the Appendix   A.

2.6    Broad Concerns Flagged by the Industry Stakeholders

i . Clarity in tax laws and stability of the tax profile offered by a country is a significant differentiating factor for investors to commit investment.

ii. The cost associated with protracted litigation, huge compliance burden, and huge capital being locked up in tax disputes is forcing MNC centres to revisit their Indian strategy.

iii . In order to ensure that India maintains its competitive advantage over other developing economies, all vying for Foreign Direct Investment (FDI), tax policies with respect to R&D centres must ensure that the cost   of undertaking R&D in India does not increase to an extent that makes it unviable for MNCs to undertake R&D work in India.

2.7    Specific Issues

i.   Work carried on by the Development Centres (DCs)

ii.   Application of Most Appropriate Method      

iii  General transfer pricing issues which are not specific to the DCs/IT Sector

2.8    Work carried on by the Development Centres (DCs)

2.9    Views of the Industry

2.9.1 The software development life cycle involves various stages like envisioning, planning, designing, developing, testing and deploying. The software life cycle begins when an application is first conceived and ends when it is no longer in use. It includes aspects such as initial concept, requirement analysis, functional design, internal design, documentation planning, test planning, coding, document preparation, integration, testing, maintenance, updates, retesting, phase-out, and other aspects. Software life cycle models describe phases of the software cycle and the order in which those phases are executed. The stages of Software Development Cycle, using the simplest model, which are based on sequential phases, are as follows:

i.  Envision & Plan

ii. Design

iii. Develop

iv. Test

v. Deploy & Maintain

i.   In the Envision and Plan stage, a clear definition of the customer problem is identified by gathering the business requirements. This stage is essential to understand the purpose, requirements, required functionality, system environment, output and such other critical factors. In this stage the functionality of the software such as what the software should perform, business logic that processes data, what data is stored and used by the software, and how the user interface should work is decided. Various scenarios to help guide the development team in developing a solution are framed. Product architecture defining the components of the offerings, their relationships and dependencies, the overall design strategy, and resource requirements are finalized in this stage.

ii  In the Design phase, a value proposition and a product prototype are developed by a software developer based on the results of the Envision and Plan stages, customer feedback from the previous product version, surveys, competitive analysis, the product leader's vision for the future and an overall vision for the product category. The software design and its architecture (hardware and software) are the deliverables of this stage.

iii.  The Develop stage includes working on requirement activities, implementation activities and verification activities. The entire work project is broken into several modules/ program, each of which is independently developed and coded based on the requirements and the specifications. This phase of software lifecycle may be performed simultaneously and may overlap with part of the design and testing phases. Documentation of the internal design of software for the purpose of future maintenance and enhancement is done throughout development.

iv.  In the Test stage, the products and offerings are integrated and tested before delivering the end product/service to the customers. Testing such as system testing to validate the software product against the requirement specification, unit testing to check performance of specific components of the system, recovery testing, security testing, stress testing, and performance testing etc. are carried out to verify the integration and performance of all system elements. Any debugging or minor modifications over the product, if required, are made under this stage. In this stage, the customer may also conduct acceptance testing according to the acceptance test plan prepared by the customer to determine whether or not the system satisfies its acceptance criteria.

v.  In the Deploy stage, all of the activities that make a software system available for use are undertaken. Beginning with the installation of a pilot to analyze the initial functioning of the system, the software will then be completely deployed at the customer site. The deployment activities include activities pertaining to release, installation, uninstallation, activation, deactivation, adaption, updation and retirement of the offerings. An integral part of deployment is ensuring smooth functioning of the software by fixing any defects and providing regular maintenance activities.

2.9.2 NASSCOM has indicated the following three types of contractual structures as being prevalent in India:

CONTRACTUAL STRUCTURES

Contracted Development	Cost Sharing/ Contribution	Entrepreneur
• Parties of service provider and service recipient have contractual agreement • Service provider has no ownership/ rights on IP associated with work product; does not contribute any IP either. • Service recipient assumes all risks associated with work product • Service provider is           generally compensated on commercial basis (hourly/ lump sum for 3rd party, and cost plus for internal)	• Parties agree to form partnership to pool respective IP and share risk and reward from future R&D • Both parties contribute IP or share the costs thereof and have joint ownership of any IP developed going forward • Parties jointly share the           risks, in their cost sharing ratio • Parties agree to jointly           share the profits associated with the IP developed, as per mutually negotiated terms	•The company undertakes the R&D on its own account and bears full risk and reward from future         R&D • The company bears the costs of R&D and has ownership of IP developed • The company enjoys the    profits associated with the IP developed
Generally, preferred model for the IT industry (software and enabled services)	Generally, preferred model for Pharma, Biotech and similar Industries.	Generally, preferred model for Pharma, Biotech and similar Industries.

2.9.3   Most software projects follow a "distributed development" model with phases and parts of the projects performed across different sites or departments, with work packages delegated to external vendors (i.e., outsourcing) or transferred to offshore captive service providers, for instance in India. The overwhelming majority of captive IT Development Centers in India and their Principal R&D Company fit in the above profile.

2.9.4   In the Indian context, captive Development Centres do not operate with any autonomy; any work, suggestions and inputs of the captive Development Centres in India are always subject to review, modification and approval of the principal R&D Company. The functions of development, enhancement, maintenance and protection of the intangibles are entirely controlled and performed by the principal R&D Company. Risks and control of the costs relating to development, protection and maintenance of intangibles are also completely borne by the principal R&D Company.

2.9.5   Some portions of each of these activities are carried on from India (Offshore) and other portions at the site of the customer or at the headquarters of an MNC (Onsite). The proportion of onsite to offshore work for each stage may differ from development centre to development centre.

 

2.9.6   An overwhelming majority of captive R&D Development Centres in India and the Principal R & D company have the following functional profile, in relation to the IT Development centres rendering contract R & D services:

a) Principal R & D company is responsible for the overall research programme and funds the entire cost of R & D including a service fee to Development Centre and allocates budgets to various researchers

b) Principal R & D company designs research programmes, makes    decisions as to where R & D activities will be conducted, and  regularly monitor the progress on all R & D projects.

c) Principal R & D Company controls the R & D function for the MNE group and the R & D programme of the group operates under strategic direction of Principal R & D company senior management.

d) Contracts between the principal R & D Company and Development Centre specify that principal R & D Company will bear all risks and costs related to R&D undertaken by Development Centre.

e) All  patents,   designs   and   other intangibles   developed by Development Centre research personnel are registered by principal R&D Company, pursuant to contracts between the Development Centre and principal R&D Company.

f)  Personnel of Development Centre may be involved in planning and design by virtue of giving suggestions for modifications to the research programme and such suggestions are required to be reviewed and approved by the principal R&D Company.

2.9.7  For a member of an MNE group to be entitled to intangible related returns, it should in substance-

i. Perform and control important functions related to the  development, enhancement, maintenance and protection of the intangibles and control other related functions performed by independent enterprises or associated enterprises that are compensated on an arm's length basis;

ii. Bear and control the risks and costs related to developing  and enhancing the intangible; and,

iii. Bear and control risks and costs associated with maintaining and protecting its entitlement to intangible related returns.

2.9.8   In the cases of captive R&D centres operating in India, it is not only that the legal and economic ownership lies with the overseas principal R&D Company, but it also has to be appreciated that any work product, the patent registration, etc. if any, based on contribution by India cannot be commercially exploited on a standalone basis because its contribution to the overall value chain is insignificant. Such patent registration is only to safeguard the legal rights of the principal against infringement of IP (by competitors), however insignificant these rights be. The principal makes decisions with respect to the following:

• Hiring/Terminating services of contract researcher

• Type of research to be carried on and assigning objectives

• Budget to be allocated for research

• Assessing outcome of the research  test, review & evaluate results

• Setting stage for decision making

2.10  View of Revenue 2

2.10.1    The DCs in India are engaged in R&D activities for development of new product  (including software development) and services, development of design and development of part of product or services which go as input to final product/services being developed by parent company.

2.10.2   These research and development activities may be classified into two categories:

✓ Primary function of R&D activity is to develop new product/services or inputs.

✓Other function is to discover and create new technology, design, methodology, for development of new product, process and services.

2.10.3  The models of R&D differ significantly. However, R&D is intended to yield immediate profit or immediate improvement in operations and involves little uncertainty in so for as the return on investment is concerned. The new product development (services, design and inputs) is a crucial factor in survival of the group because nowadays products/services are changing so fast that it requires continuous revision or development of design, products and services. Accordingly, the R&D activities are core to the survival of the group in the competing market.

2.10.4  Different companies adopt different models and type of R&D activities and ratio of research and development spending to the revenue varies significantly. High R&D expenses are justified in the light of consequent high gross margins varying from 60 to 90%.

2.10.5  The categorization of off-shore development centres in India may be on the basis of type, model and nature of R&D activity and reason and benefit of off-shoring. It may be very difficult to make exact groupings of R&D development centres because of above parameters which may vary from one industry to another industry segment in each country.

2.10.6   Analysis of the conduct of the parties is more important than the written contract.

2.10.7   The contract development structure as mentioned in NASSCOM presentation will need further examination by analyzing actual contract in case of entities engaged in R&D activities, product and services development, design development etc. It may be seen from presentation that NASSCOM has admitted that services provider also bears the risk of R&D activities in case of contracted R&D and is not a risk free entity. Accordingly, the remuneration model will vary from case to case depending upon FAR analysis.

2.10.8   A sample analysis in a 2007 in-house report of the tax department noted significant variations in the PLI margins of the taxpayers accepted by the Department in the Software/ITES sectors.

2.10.9  Contractual agreements vary with the companies and it may be difficult to construct a homogenous group on the basis of contractual agreement.

2.10.10  Grouping of off-shore development centre would require a more detailed study and broad categorization as suggested by NASSCOM on the basis of an assumption that all contracts for R&D activities are same will generate more litigation.

2.10.11 Decision of creating groups in one industry segment and corresponding margins may be examined in light of international standard and

practice because if such grouping and margin are not acceptable to a country which is a party to international transaction, it will increase the cases of double taxation.

2.11  Recommendations of the Committee:

The Committee has responded to the relevant issues in the context of the discussion on the application of Most Appropriate Method.

2.12  Application of Most Appropriate Method

2.13  Views of the Industry:

The stakeholders highlighted the following position to argue in favour of TNMM/cost plus mark up methods:

2.13.1  Indian R & D Centres of MNCs are entitled only for appropriate cost-plus return for the contract R & D work performed and not entitled to any intangible related returns.

2.13.2  In a scenario where

• the principal R & D company bears the risk of failure of the research and  will be the owner of the outcome;

• the contract researcher is paid a guaranteed remuneration irrespective of the outcome of the research;

• the principal R & D Company makes a number of relevant decisions in order to control its risks,

it would be a typical case for only the principal R & D Company to be entitled to all the intangible related returns and the Development Centre be compensated on a total cost plus basis. A large majority of R & D centres operating in India today would be covered under the fact pattern discussed above. Transactional Net Margin Method would be the only appropriate transfer pricing method to benchmark the transaction of rendering services by Development Centres to the Principal R & D Company with appropriate mark-up on cost.

2.13.3    Application of PSM requires exceptional circumstances, for example

i. where an MNC undertakes the R & D under a cost contribution arrangement- Under such an arrangement, all the parties contribute costs and resources and jointly undertake R & D and share the risks and rewards of such R & D. In this arrangement, the participants in the R & D process get part of the legal and economic rights in the intangibles and hence the participants would be entitled to intangible related returns. It is a possibility that some of these arrangements may entail a PSM for compensation to all the participants ;or

ii  where the principal is located in tax havens/tax shelters with no significant functions performed or decisions taken outside India.

2.13.4   Application of PSM by India will increase the overall cost of undertaking R & D work in India though the quantification for the some would depend on varied factors. Also, the lifecycle of an R & D program tends to be long (average lifecycle of an R& D program exceeds two years) with new programs starting regularly. Thus, an MNC looking to setting-up an R & D centre would seek a greater degree of certainty of the tax policy applicable in order to meet its long-term objectives. It is therefore imperative that transfer pricing policies for R & D centres in India are carefully and pragmatically implemented keeping in view that India would like to retain its competitive edge.

2.13.5  The complex transfer pricing issues need better understanding of the larger R & D program of an MNC and a careful study of the functional analysis in most cases would reveal that cost plus method would be applicable. Both taxpayers and tax authorities need to work together to ensure that this understanding increases quickly. In the meantime, the tax authorities need to resist the temptation of using PSM on a generalized basis to drive revenue collection when indeed the some would be grossly incorrect for most contract R & D arrangements in India today.

2.14  Views of Revenue

2.14.1  The position of Revenue as per the presentation made by JS, FT & TR-I, CBDT during the meeting on 3rd September, 2012 before the Committee, is summarised below:

•   Off-shoring is no longer limited to standardized information and   technology but increasingly involve product development function (engineering, R&D) and product design;

• Distinction between home-based and foreign-based development centres has disappeared;

• These DCs are transferring labour, skill and innovation to another country;

• There is transfer of intellectual property and these DCs are unaware of the value they are exporting;

• The FAR i.e. Function, Asset and Risk Profile of a DC will depend on nature, business model, reasons and benefits of off shoring;

•   Functions, Assets and Risks are equally important;

• Since risk is a by-product of functions performed and usage of assets, it  should be considered together with functions and assets;

2.14.2    During discussions, JS (FT & TR-I) emphasised that-

• the difference between controllable and un-controllable risks needs to be distinguished;

• business model, nature, reasons and benefits of off-shoring are important factors in determining allocation of risks;

•   various factors that are to be seen while determining the entity controlling a risk are core functions, key decisions, level of individual responsibility, etc;

• the most appropriate method will vary with the functional profile of the Development Centre and there cannot be any straitjacket formula for applying cost plus method / TNMM

• undue emphasis on risk, without realizing that the risk is a by-product of  function and asset, may give wrong results;

•   risk is located where the functions and assets are located. However control over risk may be divided between parties. Location savings and location rents also need to be considered.

2.14.3  Further, he asserted, that Offshore Development Centres in India are developing significant intangibles, known by the application for patents filed from India in US and other countries. These are valuable and unique as it can be seen from Indian Patent Act, 1972 that only those inventions, which are valuable and unique, can be patented. Further Indian TP regulations justify the application of PSM when intangibles are involved. The example of patent battle between Samsung and Apple in which Apple won the legal battle in USA for a $1 billion payout from Samsung demonstrates the value of patents.

2.14.4  Thereafter, in his comments sent by e-mail, he emphasised that the Issue of attribution of global profit under profit split method needs a careful scrutiny in order to understand extent of the problem. The number of adjustment under profit split method will give some idea about this problem. If problem were confined restricted to one or two companies, then it would be easier to examine reasons of such adjustment and to suggest a solution.

2.15  Recommendations of the Committee

2.15.1  The Committee has noted that

• TNMM is the methodology adopted by the Revenue for benchmarking for Contract DCs, till date, except in two cases in Delhi, where PSM (Profit Split Method) was applied. In one case, DRP deleted the application of PSM for the AY 2007-08 and reserved the right to apply PSM, if the facts and circumstances so warrant in future. In this case for the AY 2008-09, the TP adjustment was arrived at by adopting TNMM as the most appropriate method due to data inadequacy. In the second case, the TPO adopted PSM for determining ALP, for the AYs 2007-08 & 2008-09, on the ground that unique intangibles were transferred. In this case, DRP confirmed the approach of the TPO for the AY 2007-08 as the taxpayer was not able to produce data and supporting evidence, within the time available to the DRP, to demonstrate that any method other than PSM should be applied on the facts and circumstances. In respect of AY 2008-09, the proceedings are pending as on date.
• In one case for A.Y.  2008-09 the taxpayer has applied PSM as the activities performed by the taxpayer and its affiliate were claimed to be inextricably linked with both entities contributing significantly to the value chain. However, considering the facts of the case, the TPO applied TNMM.
• Whenever industry refers to cost-plus or appropriate mark-up on cost, reference is to profit margin under Transactional Net Margin Method on cost. While applying TNMM on captives, the profit margin is computed on the cost, excluding interest and tax. As most of the captives follow cost plus business model, all the costs  (before interest and tax) are reimbursed by the principal, with certain agreed mark-up. The costs that are considered (before interest and tax) for applying TNMM for the captive and the comparables also form the cost base for reimbursement by the principal. Thus, as per industry, appropriate mark-up on costs, in effect refers to the appropriate operating margin under TNMM and cost plus method referred by the industry, in effect is TNMM under the Income Tax Act.
• The characterisation of Research and Development function can broadly be in three baskets, i.e., -

• Full risk bearing developer
• Limited risk bearing developer
• Contract R & D service provider with no significant risks

2.15.2  The Committee acknowledges that the Industry stakeholders have unanimously agreed that most of the captive DCs in India were Contract R & D service providers with no significant risks. The Committee has, therefore, focussed on suggesting approach to taxation of such DCs only. The full risk bearing Developers (who are Entrepreneurs) and limited risk bearing Developers  (who follow cost sharing/contribution models) need a case specific FAR and no general guidance can be given for such cases.

2.15.3  The Committee recommends that if the activities carried on by a    DC in India meet the following parameters (cumulatively), it will be treated as Contract R&D service provider with insignificant risk and TNMM supported by appropriate cost plus mark up may be the most appropriate method for          arriving at the arm's length price for the services rendered by such DC:

• The critical functions with regard to overall product development lifecycle, including particularly conceptualization and design for the product is driven by the foreign principal. The Indian DC would largely be involved in the actual development, implementation or maintenance of specific features or  portions of the product, with limited inputs on design as necessary, within    the strategic direction / framework provided by the foreign principal.
• The principal provides funds/capital for research. The principal bears the risk of failure of the research and will be the owner of the outcome of the research in case of success, while the contract researcher is allocated a guaranteed remuneration irrespective of whether the research is a success or a failure.
• The DC is required to report back to the principal on a regular basis, e.g. at predetermined milestones. The principal is expected to be able to assess the outcome of the research activities. Any suggestion to the modification of the research programme by the DC is subject to the review and approval by the foreign principal who makes the relevant decisions to control the risks.
• The DC does not assume risks or has Insignificant realised risk such as market risk, business risks, economic conditions risk, credit & collection risk, capacity utilisation risk, quality risk product / service acceptance risk, product development risk, infrastructure utilisation risk, intellectual property infringement risk.
• The entirety of the product life cycle and / or software development life cycle is not undertaken by the Indian DC.
• The contract researcher DC has no right to ownership on the outcome of the research. The rights in the developments contractually vest since inception with the foreign principal and the registration of any IP arising from such development is made by the foreign principal. Involvement of the Indian personnel to comply with filing requirements, without any underlying rights in the exploitation by the Indian personnel and / or by the Indian DC, is evident from the employee contract and / or contract between DC and its foreign principal.
• The patent registration cannot be commercially exploited on a standalone basis because its contribution to the overall value chain is insignificant. R.t
• The terms and conditions regarding ownership of intangibles would have been similar if the activities carried on by a DC were or could have been   outsourced to a third party DC.

2.15.4  Contract between the principal and the DC is a relevant factor but not the determinant factor. Conduct of the affiliate DC should be consistent with the contractual terms with the Principal. For example, if a contract shows the principal to be controlling the risk but conduct shows that affiliate is doing so, then the contractual terms are not the final determinant of actual activities. In the case of foreign principal being located in a country /territory widely perceived as a tax haven, it will be presumed that the foreign principal was not controlling the risk. However, the taxpayer may rebut this presumption to the satisfaction of the revenue authorities.

2.16 Additional Term of Reference:

"The issue of application of Global Profit Method to determine arm's length price of intangibles developed by the R&D centres of MNEs in India may be considered by the Committee"

2.16.1  The Income Tax Act read with Rule lOB (i) (d) (extracted below) stipulates that transfer of unique intangible requires application of PSM:

"Profit split method which may be applicable mainly in international transactions involving transfer of unique intangibles or in multiple international transactions which are so inter-related that they cannot be evaluated separately   "

2.16.2 The Committee recognises the following practical difficulties in the application of a profit split method (PSM) in cases of DCs engaged in contract R&D services:

• Determination of   unique contribution in an integrated product is a major challenge in R&D services.
• The main problem is faced in identifying the profits arising from the controlled transactions. The foreign principal determines the product in which the outcome of the research is to be used and knows as to how and to what extent that research will add value to the product. This information is important as valuation of intangibles is highly volatile and every R&D activity may not lead to creation of an intangible For example, in respect of captive R&D centres in India, the data on the combined profit earned by MNC arising out of the products sold, which are arising out of the R&D activities carried on India or for that matter   any other DC anywhere in the world, is difficult to obtain.
• Also, one would need a cross border functional analysis and an ability to verify the accuracy of the data sitting across various locations.
• The availability of data is thus a significant challenge and one therefore has to apply PSM making various assumptions, which could skew the results and lead to incongruous results. For example assumptions underlying the choice of an allocation key can bring in subjectivity and vitiate the results.
• As getting relevant data to determine profit from the controlled transactions is not easy, use of PSM on some allocation key may lead to claims for splitting the global loss also if the R&D effort globally does not yield desired results. This can cause attribution of losses to the activities by the DC even in situation where the research done by DC is successful
•  PSM is a highly subjective method, as it requires a subjective analysis of the contributions made by the controlled parties to an intangible asset and its implementation is often not measurable by specific reference to objective data. The contribution analysis can sometimes be hard as the more integrated the company group structure is, the harder it can be to disentangle the underlying contributions and identify the actual performer. Moreover, if different valuable intangible assets are contributed by more than one associated company, it gets even more difficult to attribute values.

2.16.3  The Committee has also taken note of the fact that HMRC, UK has recognised the following problems in application of PSM while issuing the guidance in applying PSM4

i.  There is a difficulty in isolating the controlled transactions and establishing what functions add value along the product chain.

ii. The profits that are to be split should be based as for as possible on projected figures for sales and costs that were available at that time (replicating the probable negotiation process between two independent parties). This can potentially involve trying to estimate how a product is going to perform over a number of years.

iii. The potential for affiliates to produce any valuable intangibles has  to be carefully examined, along with risks of the R & D producing nothing.

2.16.4  HMRC has also discussed how the cost of developing the intangible has only an indirect link to the value of intangibles. The relevant portion of the guidance is as follows:

"The expense of discovering and developing valuable intangibles has no direct relation to the price of products manufactured and sold using that technology. If the R & D programme cost £100 million, the products will rarely be priced directly to try and recoup those costs over say the next 5 years. There is of course an indirect link; a business will bear in mind the costs of its current R & D programmes for future products, and what it would like to spend on that R & D in the future, but the pricing of goods and services is subject to a very complex interaction of many commercial factors. While a revolutionary new product will no doubt attract a premium price in some markets, there is generally a limit on what people are prepared to pay".

2.17 Recommendation of the Committee:

A proper application of PSM would necessitate the availability of adequate and reliable data with regard to profits attributable to various functions, risks, geographies etc. As a result, one has to apply PSM with extreme care and caution and the lack of data at present makes it impracticable to apply PSM. Thus application of PSM, where appropriate technically given the general facts of a case, may become inaccurate due to lack of availability or supply of complete data. In these circumstances, it may be appropriate for India to seek for a higher mark-up under TNMM, possibly also factoring in locational savings and locational advantage, with proper comparability analysis rather than depend on an unreliable      application of PSM,'(Mr Kanabar, Member of the Committee, has reservations about location savings and location advantage for arriving at a mark-up because he believes that an appropriate comparability analysis is with respect to comparables which also have the some locational savings and advantage and no further adjustments are necessary).

2.18 General Transfer pricing issues which are not specific to the IT Sector

The stakeholders have identified some other transfer pricing issues affecting the DCs including those which are not engaged in R&D. These issues are listed in Annexure-VI.

2.19  Response and Recommendations of the Committee

2.19.1 The Committee recognises that these Transfer Pricing (TP) issues impact all sectors and are not peculiar to DCs or IT sector and considers their review beyond its mandate. The Committee acknowledges that these issues do create tax uncertainty but is of the view that most of these arise due to lack of consistency and proper FAR analysis in the application of transfer pricing provisions. Hence, there is certainly an urgent need to have internal clarity and consistency on these issues.

2.19.2   The   Committee   has   noted   that   following   significant recommendations for conducting FAR analysis were made by an earlier committee set up by the then DGIT (International Tax) in 2007 under the then DIT(TP) Delhi:

•   The Functional analysis is the key for determination of arm's length price of controlled transactions.

•   The functional analysis helps in:

• Selection of most appropriate method
• Selection of comparable uncontrolled transactions
• Determination of relative value of contribution for application of Profit Split Method.
• The functional analysis aims to identify functions performed in controlled transactions by each associated enterprise, taking into account the assets employed or to be employed and risks assumed by respective associated enterprises. The, emphasis should be on economic significance of functions and not on the number of functions performed by parties.
• Identification of functions performed to consider the assets   -tangible and intangible that are employed or to be employed in actual conduct of controlled transactions
• The economic substance and commercial realities of transactions need to be examined to find out the true nature and terms of controlled transactions so as to ascertain the actual functions performed, assets used and risks assumed by respective associated enterprises.
• The allocation of risks should be consistent with the economic substance of the transactions.
• The functions carried out (taking into account the assets used and the risks assumed) by respective enterprises will determine to some extent the allocation of risks between them and the return each enterprises would expect in arm's length dealings.
• Each critical process involved in actual conduct of controlled transactions should be examined so as to ascertain actual functions performed, assets utilized and risks assumed by respective parties.
• Level of expenses and types of expenses should also be scrutinized to identify functions associated with main function, additional function, assets used -intangibles and intangibles  - and the risk assumed.
• Economic characterisation can be illustrated as follows:

■   Research & Development function

✓ Full risk bearing developer of intangibles

✓ Limited risk bearing developer of intangibles

✓ Contract R & D service provider with no significant risks

•   Service Provider(Software)

✓ Software product developer with all risks

✓ Contract software service provider with limited risks ✓ Manpower service provider with no significant risks

2.19.3   The Committee recommends that CBDT must issue an updated guidance note on FAR analysis taking the recommendations of the earlier committee into account. Further, a circular clarifying the position on other administrative issues listed in Annexure VI should be issued so that there is uniformity in application of provisions across the country, which will also

reduce disputes and grievances. A few of these issues listed in Annexure VI raise question about the appropriateness of some of the Transfer Pricing provisions in the Income Tax Act. However, the Committee has, considering its mandate, not examined those.

PART 3: SECOND TERM OF REFERENCE - INCOME-TAX ISSUES PERTAINING TO THE IT SECTOR

3.1    The Committee has, after long deliberations and careful consideration of all the issues, arrived at a set of recommendations consistent with its approach summarized in paragraph 1.16. The issues and recommendations are detailed in the following paragraphs:

3.2    Issue -1: Whether "on-site" development of computer software qualifies as an export activity for tax benefits

3.3    Views of the Industry

3.3.1   Industry representatives have asserted that the Indian software export industry is the child of the concept of globalization. They have explained globalization as something that is about sourcing capital from where it is the cheapest; sourcing talent from where it is best available; producing where it is most cost-effective; and selling where the markets are, without being constrained by the national boundaries. According to them, the Global Delivery Model, which has become the de-facto standard for the Indian software industry, splits a large software development of maintenance project into two classes of activities:

•  the first set of activities, called "on-site activities, has a very high level of interaction between the client officers and the staff of the Indian software company; and
•  the second set of activities, called "off-shore" activities, includes activities like functional design, detailed technical design, architecture, database design, programming, testing, etc.

3.3.2 Their submission is that the second set of activities is taken up by scalable,  talent-rich, technology-enabled,   process-driven   and cost-competitive development centres in India. They further claim that, sometimes, the customer may insist that the entire set of activities including both "on-site" and "off-shore" be taken up "on-site" at his premises due to exigencies of speed, uncertainty arising from new technologies and confidentiality.

3.3.3  It is also claimed that sometimes, the talent required for "on-site" tasks may be requisitioned by a company from any of its offices anywhere in the world based on the need of the expertise and this is what the Global Delivery Model is all about. Another assertion is that sometimes, a pilot project may have to be done exclusively "on-site" to establish the credibility of the Indian software export. Therefore, the contention is that "on-site" activities are also export activities generating hard currency revenue for India.

3.3.4  Industry emphatically argued that denial of tax holiday to several units by the tax authorities deriving profits from "on-site" services, on the ground that no export has been made out of the unit is also contrary to the express provisions of the statute, as no such restrictive condition is found in the substantive provisions of Section 10A, 10AA and 10B of the Act. They draw support from, Explanation 3 to Section 10A, Explanation 2 to Section 10AA and Explanation 3 to Section I0B.

3.3.5   Additionally, they have contended that CBDT's circular no. 694 of 1994 creates uncertainty since it provides that the "on-site" software development will be considered as export only if the software is 'actually' the product of the unit.

3.4    Views of Revenue

The officers of CBDT were of the view that the "on-site" services should have some nexus with the unit claiming the deduction. They opined that 100% onsite work defeats the purpose of exports out of India. They also relied on Circular no. 694 of 1994.

3.5    Recommendations of the Committee:

•   Explanation 3  to Section 10A and Explanation  3 to Section 10B of the Income-tax Act inserted vide the Finance Act,  2001 and Explanation 2 to Section 10AA inserted vide SEZ Act, 2005 read as follows:

"For the removal of doubts, it is hereby declared that the profits and gains derived from on site development of computer software (including services for development of software) outside India shall be deemed to be the profits and gains derived from the export of computer software outside India."

•   These Explanations create a fiction that even when the activities are carried "on site" i.e., outside India, the income there from is deemed to be derived from export. The Committee recommends that deeming fiction created by these Explanations. must be given effect to and income from "on site" development pursuant to contract between the Indian entity and the overseas client for the development of software, should be considered as derived from export.

•   Circular no. 694 of 1994 has been partially rendered otiose after the insertion of the deeming fiction in the above stated Explanations and should be modified immediately by deleting the portion relating to "development of programmes on-site".

•  In cases where deduction has been denied and the taxpayer is before the CIT (A) or DRP, the issue may be allowed to be decided by the CIT(A) or DRP in accordance with the law and the Assessing Officers should be directed to either concede the issue or not contest the same further.

•  In cases where the CIT(A) or ITAT or High Court has decided this issue in favour of the taxpayer, no further appeal should be filed by Revenue. Wherever Revenue has already filed further appeal on this issue before the ITAT, High Court or Supreme Court, as the case may be, the relevant ground of appeal may be withdrawn immediately.

3.6    Issue 2: Whether business receipts from Deputation of Technical Manpower (DTM) are eligible for deduction under Section 10A, I0AA and 10B?

3.7    Views of the Industry

The Industry representatives have stated that the tax authorities have denied tax holiday to several units by alleging that deployment of manpower to "on-site" locations is a case of "body shopping" and no benefits can be given for such activities. The stakeholders have asserted that Deployment of Technical Manpower [DTM] is for the purpose of software development abroad and receipts from such activities are eligible for deduction under the Income-tax Act.

3.8    Views of Revenue

Revenue has contended that Deployment of Technical Manpower [DTM] is not an eligible activity u/s I0A, I0AA or I0B as the taxpayer companies were not contracted for software development and were responsible only for sending trained manpower abroad. Therefore, the receipts arising from such DTM activity are being held as not being eligible for tax incentives under these Sections.

3.9    Recommendations of the Committee:

•   The Committee, while interpreting Explanations to Sections   10A, 10AA and 10B (ibid) in the context of industry practice and particularly the words in parenthesis i.e., (including services for development of software), agrees with the view that the Deployment of Technical Manpower [DTM] which has any connection with software development work      - which would include up-gradation, testing, maintenance, modification, etc of the software - contracted to the eligible unit should be considered as an eligible activity under Sections 10A, 10AA and 10B.

•  However, if the DTM is unrelated to the above activities of the eligible unit, then it would not be an eligible activity and would not be eligible for tax benefits under Sections 10A, 10AA and 10B as "on-site" activities.

•  The contract governing such deployment would be one of the crucial documentary evidence to establish the connection between DTM and software development activities.

•  In cases where deduction has been denied and the taxpayer is before the CIT(A) or DRP, the issue may be allowed to be decided by the CIT(A) or DRP in accordance with the law and the Assessing Officers should be directed to either concede the issue or not contest the same further.

•   In cases where the CIT(A) or ITAT or High Court has decided this issue in favour of the taxpayer, no further appeal should be filed by Revenue. Wherever Revenue has already filed further appeal on this issue before the ITAT, High Court or Supreme Court, as the case may be, the relevant ground of appeal may be withdrawn immediately.

3.10  Issue 3: Taxation of new SEZ units whether hiring of new employees is a condition for eligibility to claim deduction under Section I0AA

3.11  Views of the Industry

3.11 .1   The industry explained that tax incentive u/s 10A of the Income-tax Act come to an end on 31/3/2011. Thus, STPI units are no longer eligible to claim any tax benefit. On the other hand, SEZ units in the software development segment have a 15 year tax holiday available to them u/s 10AA of the Act.

3.11 .2   The stakeholders from the industry do agree that tax authorities rightly deny the benefit when taxpayers move all their business to the SEZ unit from their existing STPI unit to claim the tax incentives. However, industry has emphatically stated that the movement of personnel from STPI units is necessary as every project needs experienced project managers, analysts, programmers, etc, and it was impossible for a software company to do projects only with freshers.   Further, the submission was that re-skilling of employees, addresses underemployment and results in incremental activity which generates economic rewards in the system The view of the industry is that since there is no requirement of the law as contained in Section 10AA to have only new employees in the SEZ unit, tax authorities should not deny the tax benefits on this ground. They have also relied upon Instruction No. 70, dated 9th November, 2010, issued by the Department of Commerce in which the latter has clarified that there was no limitation on the movement of manpower from STPI/DTA units to SEZ units.

3.12  Views of Revenue

The officers of CBDT were of the view that there should be a certain percentage of new employees in the new SEZ units to make those units eligible for claiming this deduction. However, they also appreciated that there was no such explicit requirement in the current provisions of Section 10AA.

3.13 Recommendations of the Committee:

•   As per the provisions of Section 10AA there is no requirement with regard    to the employment of new employees in the eligible undertaking in order to claim deduction. Employment of existing employees cannot be considered as splitting up or reconstruction of a business already in existence. Accordingly, the condition of new employees cannot be imposed while examining the eligibility of the taxpayer for the deduction under Section 10AA. If the legislative intent was to impose such a condition, then specific clauses for employment of new and regular employees would have been inserted. In the absence of a specific condition of employing new employees and considering the business model of the industry, denial of deduction under this Section by insisting upon the employment of new employees is unwarranted.

•  The Committee, however, is of the view that in the absence of an express provision in the statute requiring units in SEZs to have only new employees or a certain percentage of new employees, one of the crucial objectives for providing tax incentives i.e., to generate employment in the Country, is not met. Accordingly, if the Government intends to link tax foregone to the positive externality of employment generation and also to address the present concerns of the industry, then the Income-tax Act may be amended prospectively to provide that 50% of the billable employees in an SEZ unit in its first year should be new employees and also provide that this condition would be deemed to have been satisfied if the taxpayer is able to demonstrate that the net addition of new billable employees at the enterprise level is at least equal to the number that represents 50% of the total billable employees of the new SEZ unit. For example, let us assume that Company ABC has 10,000 billable employees as on 31/3/2013 and it sets up a SEZ unit in June 2013 with 2,000 billable employees. As per the proposed new condition, if Company ABC either shows 1000 new billable employees in the SEZ unit or is able to demonstrate that it had at least 11,000 billable employees as on 31 /3/2014 for the company as a whole, then it would be considered to have successfully met the proposed new condition. This 50% ratio is being suggested recognising the business environment wherein some shifting of experienced employees may be necessary to maintain the competitive advantage offered by the Indian entity.

•    In cases where deduction has been denied and the taxpayer is before the CIT (A) or DRP, the issue may be allowed to be decided by the CIT(A) or DRP in accordance with the law and the Assessing Officers should be directed to either concede the issue or not contest the same further.

•   In cases where the CIT(A) or [TAT or High Court has decided this issue in favour of the taxpayer, no further appeal should be filed by Revenue.          Wherever Revenue has already filed further appeal on this issue before  the ITAT, High Court or Supreme Court, as the case may be, the relevant    ground of appeal may be withdrawn immediately.

3.14  Issue  4: Hierarchy of documents - Whether the Master Services Agreement (MSA or by whatever name called ) or the Statement of Work (SoW or by whatever name called ) should be the deciding document for enabling software exporting units to claim deduction under Sections 10A, 10B and 10AA of the Income-tax Act

3.15  Views of the Industry

3.15.1  The representatives of the industry in the IT sector have stated that when an Indian software exporter is empanelled by a foreign client for developing software from time to time, the first activity that happens is the negotiation of a Master contract between the client and the Indian software exporter. This is known as a Master Service Agreement [MSA]. Generally, this MSA covers issues like duration of the master contract, the rate per hour of work, liability clauses, agreement not to poach each other's staff, loaning of technology, IP protection, etc. This process is a long-drawn process and could take anywhere between two months to one year. Once this MSA is signed, the client informs the business groups that they are now free to issue a Statement of Work [SoW] for a specific piece of software development.

3.15.2  The stakeholders have pointed out that some tax officials are not accepting the SoW and are insisting that the client must issue a fresh MSA for every assignment taken up by an eligible Indian software exporter for a foreign client. They argue that this is not feasible because clients do not see any value in doing this since all clauses of the MSA have already been agreed upon after lengthy negotiations involving purchase and legal people from either side.

3.16  Views of Revenue

The officers of the CBDT were of the view that the SoW should not be the deciding factor but the MSA should be. They contended that if the MSA was old then the deduction should not be allowed, as the SoW could be prematurely terminated and the business transferred to the eligible unit through a new SoW, thereby defeating the legislative intent of encouraging incremental export activity.

3.17 Recommendations of the Committee:

• The Committee understands that there is a Master Contract or Agreement (hereinafter referred to as Master Services Agreement or  MSA) which lays down the rules of business and a Subordinate Contract (hereinafter referred to as Statement of Work or SoW), which lays down the actual scope of work.

•   The Committee is of the view that the SoW should be above the MSA in the hierarchy of legal/commercial documents for the purposes of determining the actual work being done.

•    Since the SoW lays down the actual scope of work and the software development is carried out in accordance with the terms of the SoW, it is the SoW that should be given primary importance and not the MSA for the purposes of tax incentives under Sections 10A, 10AA and 10B. The fact that an SoW has been issued under an existing MSA would not be detrimental to the claim of deduction by an taxpayer.

•   Thus, the Committee recommends that if the work of software development is governed by a new SoW, the taxpayer should be eligible for the tax benefits available under these Sections irrespective of the date of signing of the MSA.

•   However, to address the concerns of the Revenue, if an existing SoW is prematurely terminated in a non-eligible undertaking and the same work is covered under a new SoW in an eligible undertaking, this fact would need to be taken into account by the Assessing Officer as a relevant factor in determining whether the undertaking is new or is formed by splitting up or   reconstruction of a business already in existence. Besides, to facilitate the Assessing Officer, the Committee also recommends that a requirement be provided through legislative change that a Chartered Accountant's certificate should be obtained by the taxpayer confirming that the new SoW has not been brought into existence by prematurely terminating an old SoW covering the same work.

•   In cases where deduction has been denied and the taxpayer is before the CIT (A) or DRP, the Issue may be allowed to be decided by the CIT(A) or DRP in accordance with the law and the Assessing Officers should be directed to either concede the issue or not contest the some further subject to the taxpayer furnishing a certificate from the management to the effect that the new SoW has not been brought into existence by prematurely terminating an old SoW covering the same work.

•   In cases where the CIT(A) or [TAT or High Court has decided this issue in favour of the taxpayer, no further appeal should be filed by Revenue. Wherever Revenue has already filed further appeal on this issue before the ]TAT, High Court or Supreme Court, as the case may be, the relevant ground of appeal may be withdrawn immediately. However, these actions by the Revenue would be subject to the taxpayer furnishing a certificate from the management to the effect that the new SoW has not been brought into existence by prematurely terminating an old SoW covering the same work.

3.18 Issue - 5: Tax incentives not available to R&D activities in STPIs, SEZs and EOUs, as it is not an eligible activity - Denial of tax holiday under Sections 10A, 10AA and 10B, respectively, in mid-course on the eligibility criterion on this issue.

3.19  Views of the Industry

3.19.1 The stakeholders from industry pointed out that tax holidays, once given, should not be denied mid-course on the ground that R & D activities were not eligible, as it created uncertainty and sent out negative signals. Their argument is that R & D activities are IT enabled services covered under the term 'customised electronic data' and also under the products and services notified by the CBDT in Notification No. 890(E), dated 26/9/2000.

3.1 9.2   They requested that it should be clarified that R&D centres set-up as STPs, SEZs or EOUs should be allowed deduction u/s 10A/I0AA/I0B. Further, wherever additions have been made or cases have been re-opened, all such actions should be withdrawn and relief granted to the taxpayers by means of a circular.

3.20  Views of Revenue

Sections 10A, 10AA and I0B provide tax benefit for export of articles or things or computer software. Scientific R & D does not come within the IT enabled services notified by the CBDT expanding the scope of "customized electronic data or any product or service of similar nature". Besides, original research and development is not included as a part of customized electronic data or services of similar nature. If scientific research and development had been notified as a service similar to export of customized electronic data, it would have been a different matter.

3.21  Recommendations of the Committee:

•   The Committee is of the view that the services covered by the Notification, namely, Engineering and Design services, could potentially include R & D activities. However, in order to set at rest any controversy, the Committee recommends that R 8 D services should be notified as being eligible to claim this deduction and should be deemed to have been notified from the original date of notification i.e., 26/9/2000.

•   Pursuant to the amendment to the Notification, in cases where deduction has been denied and the taxpayer is before the CIT (A) or DRP, the issue may be allowed to be decided by the CIT(A) or DRP in accordance with the law and the Assessing Officers should be directed to either concede the issue or not contest the same further.

•   Pursuant to the amendment to the Notification, in cases where the CIT(A) or ITAT or High Court has decided this issue in favour of the taxpayer, no further appeal should be filed by Revenue. Wherever Revenue has already filed further appeal on this issue before the ITAT, High Court or Supreme Court, as the case may be, the relevant ground of appeal may be withdrawn immediately.

3.22 Issue - 6: Deduction under Section 35(2AB) of the Income-tax Act should be extended to computer software

3.23 Views of the Industry

The industry asserted that since a lot of R & D activity was carried out in the software segment, it may be clarified that beneficial provisions of Section 35 (2AB) allowing a weighted deduction to the eligible entities, should be extended to the IT sector.

3.24  View of Revenue

The deduction under Section 35(2AB) is given to bio-technology companies or manufacturing companies, which have incurred expenditure for scientific research or for creation of R & D facilities. The segregation of R & D expenses from regular manufacturing expenses can be made clearly in the case of these companies. Software development is specifically not provided in these provisions. Moreover, the segregation of R & D expenses from other expenses is near impossible in the case of software development companies. The software development companies have already been given sufficient incentives and there is no justification of extending the provisions of Section 35(2AB) to the IT sector.

3.25 Recommendation of the Committee:

The Committee notes that Section 35(2AB) of the Act refers to manufacture or production of any article or thing and the term "computer software" is missing. The Committee is of the view that if the legislative intent was to cover computer software also, the language would have been similar to the language used in Sections 10A, I0AA i.e "articles or things or computer software". The Committee, therefore, recommends that having regard to the provisions as currently worded, no clarification is necessary.

3.26 Issue - 7: Tax holiday under Sections 10A / 10B denied to the transferee on transfer of undertaking under slump sale

3.27  Views of the Industry

3.27.1  The representatives of industry pointed out that tax holiday under Sections 10A/10AA/10B is undertaking specific and hence any business reorganisation which results in the transfer of the entire undertaking should entitle the purchaser to claim tax holiday benefits for the unexpired period of tax holiday claim.

3.27.2   They recommend a clarification stipulating that an eligible undertaking, which is transferred as a going concern by way of a slump sale, would be eligible for the tax holiday for the remainder period under the relevant Sections. They seek that clarification should clearly bring out the fact that change in ownership of business/undertaking would not constitute splitting up/reconstruction of an existing business and, therefore, a transfer by way of a slump sale of an eligible undertaking would not disentitle the purchaser of the undertaking to claim the tax holiday.

3.28  Views of Revenue

Revenue denies the tax holiday on the grounds that the undertaking is formed by splitting up of an existing business or that the assets had been used earlier. They also argue that there is no specific provision in Sections 10A, 10AA or 10B which allows the deduction to be given for the unexpired period post such slump sale, while such a provision is there for amalgamation and demerger.

3.29 Recommendations of the Committee:

The Committee is of the view that the tax benefit is attached to the undertaking and not the taxpayer (owner of the undertaking) and is also of the view that the undertaking post slump sale is not one that has been formed by splitting up or reconstruction of an existing business. Several judicial decisions have also upheld these views and disagreed with the Revenue's stance of disallowing the tax benefit to the owner of the eligible undertaking post such slump sale. Therefore, the Committee recommends that in case of a slump sale of an eligible undertaking as a going concern, the tax holiday for the unexpired period should be available to the owner of the eligible undertaking post such slump sale.

• In cases where deduction has been denied and the taxpayer is before the CIT (A) or DRP, the issue may be allowed to be decided by the CIT(A) or DRP in accordance with the law and the Assessing Officers should be directed to either concede the issue or not contest the same further.

•   In cases where the CIT(A) or ITAT or High Court has decided this issue in favour of the taxpayer, no further appeal should be filed by Revenue.          Wherever Revenue has already filed further appeal on this issue before the [TAT, High Court or Supreme Court, as the case may be, the relevant  ground of appeal may be withdrawn immediately.

3.30 Issue - 8: Tax holiday benefits denied for non-maintenance of separate books of account of the tax holiday eligible unit

3.31  Views of the Industry

The industry has pointed out that there being no such requirement in the Act, taxpayers have been computing profits derived by undertakings from exports on the basis of profit/cost centre data culled out from their respective ERP systems. Accordingly, they requested, it may be clarified that there is no such requirement and tax incentives cannot be denied on this ground.

3.32  Views of Revenue

The deduction under Sections 10A/10B is given "eligible undertaking" wise, and not 'eligible business' wise. The profits of the "eligible undertaking" will also have to be certified by a Chartered Accountant as per specified audit form. In view of the some, the "eligible undertaking" has to necessarily maintain separate books of account for the profits of the eligible unit to be determined and for the accountant to certify the said profits. Besides, under the STPI rules, separate books of account are required to be maintained.

3.33  Recommendations of the Committee:

•  The Committee is of the view that the Revenue cannot deny deductions under Sections 10A, 10AA or 10B on the ground of non-maintenance of separate books of account for the eligible unit, as there is no requirement in law to maintain separate books of account. The Committee also took note of the provisions of Section  11  of the Act, wherein there is a specific requirement in sub-section  (4A) for maintenance of separate books of account by a trust or institution in respect of profits and gains of business, which is incidental to the attainment of the objectives of such trust or institution.
•  The Committee is of the view that in the absence of specific requirements for maintaining separate books of accounts, STPI rules cannot be relied upon to   impose any obligations of compliance for claiming tax benefit under the Income Tax Act.
•  The Government may amend the Income-tax Act prospectively if it considers necessary that the "eligible undertaking" should maintain separate books of account.
•  In cases where deduction has been denied and the taxpayer is before the CIT (A) or DRP, the issue may be allowed to be decided by the CIT(A) or DRP in accordance with the law and the Assessing Officers should be directed to either concede the issue or not contest the same further.
•  In cases where the CIT(A) or ITAT or High Court has decided this issue in favour of the taxpayer, no further appeal should be filed by Revenue. Wherever Revenue has already filed further appeal on this issue before the ITAT, High Court or Supreme Court, as the case may be, the relevant ground of appeal may be withdrawn immediately.

3.34  Issue 9: Secondment Arrangements   Tax Issues

3.35  Views of the Industry

3.35.1   The industry has represented that the Revenue has been contending that

•  the reimbursement by the Indian company of the salaries of the employees deputed to it by the overseas affiliate is in the nature of Fees for Technical Services    ('FTS') and is liable for TDS under Section       195 of the Act;
•  the overseas affiliate seconding the employees to the Indian company is the real employer and that the overseas affiliate provides services to the Indian company through its employees and hence, the payments are chargeable as FTS in India.

3.35.2  The other worry for the industry is that such a contention by the Revenue might lead to potential disallowance under Section 40(a) of the Act in the hands of the Indian company for non-deduction of tax at source.

3.35.3  They have requested that suitable clarifications should be introduced which provide for non-withholding of tax by Indian companies on the reimbursement of salary and related expenses to overseas affiliates in respect of employees deputed to render services to the Indian companies under the supervision and control of the Indian companies.

3.36  Views of Revenue

The Revenue's contention is that the overseas affiliates are the real employers of the secondees under the secondment agreements and that the Indian entities only assumed the role of intermediaries who were authorized by the real employers to exercise supervision and control over the seconded employees during the period of secondment. Further, the Revenue claims that since the secondees were employees of overseas affiliates and were providing managerial services to the Indian entities, the payment made by the latter to the former under the secondment agreements constituted 'Fees for technical services' under Section 9(l) (vii) of the Act. The Revenue, therefore, believes that the Indian entities are liable to deduct tax under Section 195 of the Act in respect of reimbursements made to the overseas affiliates under the secondment agreements and where no tax is deducted, the entire payment made by the Indian entities is liable to be disallowed under Section40(a) (i) of the Act.

3.37  Recommendations of the Committee:

Each contract governing secondment arrangement is fact specific and the Committee is of the view that no general guidance can be suggested in this matter.

3.38  Issue - 10: Reduction in tax holiday owing to absence of parity in treatment of the terms "export turnover" and "total turnover"

3.39  Views of the Industry

3.39.1  Industry has pointed out that in the absence of a definition to the term 'total turnover', the Revenue has been ignoring the legal intent of the provisions and does not provide parity of treatment between the term export turnover and total turnover and the items which are excluded from the export turnover are not being excluded from the total turnover. This results in the reduction of the tax holiday available to the IT companies.

3.39.2   As an illustration, if an eligible unit had no domestic turnover, its entire profits ought to be eligible for relief under Section 10A/10B/10AA of the Act.   However, on account of the fact that the Revenue removed some elements     (such as say telecommunication expenses) only from the export turnover without removing the some from the total turnover, by incorrect application of the said formula, the extent of profit eligible for the relief gets artificially reduced.

3.40  Views of Revenue

The contention of the Revenue is that while freight and insurance charges are to be excluded in computing export turnover because export turnover has been defined in the Income Tax Act and there is a specific exclusion of freight and insurance, a similar exclusion has not been provided in regard to total turnover.

3.41 Recommendations of the Committee:

•  The Committee is of the view that the formula for computation of the profits eligible for deduction under Sections 10A,  10AA and 10B cannot be altered without explicit provision in law in such a manner so as to artificially reduce such eligible profits. Therefore, the Committee recommends that whenever certain items of expenses or receipts are removed from the export turnover, the some items of expenses or receipts should also be removed from the total turnover to ensure parity between the numerator and the denominator.

•  In cases where the quantum of deduction has been reduced due to an erroneous application of the formula by Revenue and the taxpayer is before the CIT(A) or DRP, the issue may be allowed to be decided by the CIT(A) or DRP in accordance with the law and the Assessing Officers should be directed to either concede the issue or not contest the same further.

•  In cases where the CIT(A) or ITAT or High Court has decided this issue in favour of the taxpayer, no further appeal should be filed by Revenue. Wherever Revenue has already filed further appeal on this issue before the ITAT, High Court or Supreme Court, as the case may be, the relevant ground of appeal may be withdrawn immediately.

3.42  Issue - 11: Denial of tax holiday on transfer of an eligible SEZ unit from one SEZ to another SEZ

3.43  Views of the Industry

3.43.1  Industry representatives have pointed out that SEZ regulations, in principle, permit the transfer of a unit from one SEZ to another SEZ. In this regard, Instruction Number 59 issued by the Ministry of Commerce and Industry (SEZ Division) provides that shifting of units from one SEZ to another SEZ for various commercial reasons is permitted, provided an approval from the Board of Approvals is obtained.

3.43.2  However, Revenue authorities are construing that the newly shifted unit would be understood to have been formed by way of splitting up or reconstruction of the existing SEZ unit and hence questioning the allowability of the tax holiday claim in such cases.

3.43.3  Industry has requested that it needs to be appreciated that the formation criteria  (i.e. whether a unit is formed by way of splitting up or reconstruction of an existing business) should be tested in the initial year of a unit and once this is satisfied, mere shifting of a unit from one SEZ to another should not be a ground for denial of income tax benefits.

3.43.4  Industry has asserted that a unit may intend to shift from one SEZ to another due to certain operational difficulties faced by it such as, availability of people, space, desired location, etc.

3.44  Views of Revenue

Revenue denies the tax holiday on the ground that the undertaking is formed by splitting up as the assets have been used earlier.

3.45 Recommendations of the Committee:

•  The Committee is of the view that the tax benefit is attached to the undertaking and, therefore, movement of an eligible SEZ unit from one SEZ to another should not be to the detriment of the unit.
•  Therefore, the Committee is of the view that such physical movement of an SEZ unit should be accepted and the unit should continue to get the benefit of Section 10AA for the unexpired period in the new or other SEZ.
•  In cases where deduction has been denied and the taxpayer is before the CIT (A) or DRP, the issue may be allowed to be decided by the CIT(A) or DRP in accordance with the law and the Assessing Officers should be directed to either concede the issue or not contest the same further.
•  In cases where the CIT(A) or ITAT or High Court has decided this issue in favour of the taxpayer, no further appeal should be filed by Revenue. Wherever Revenue has already filed further appeal on this issue before the ITAT, High Court or Supreme Court, as the case may be, the relevant ground of appeal may be withdrawn Immediately.

3.46 Issue - 12: Setting up of a new undertaking in an STP, EHTP or an SEZ regarded as an expansion of an existing undertaking

3.47 Views of the Industry

Industry representatives have pointed out that if a new STP/EHTP/SEZ undertaking is set up at the some location where there is an existing STP/EHTP/SEZ undertaking, the Revenue regards it as an expansion of an existing undertaking and grants tax holiday only for the residual period commencing from the setting up of the existing undertaking. It has been submitted that whether an undertaking is new or an expansion of an existing undertaking should be determined having regard to the facts of the case and judicial precedents and the mere fact that a new undertaking is covered by an existing STP/SEZ approval should not result in treating the new undertaking as an expansion.

3.48  Views of Revenue

New units are expansion of the existing undertaking and therefore are eligible for tax deduction only for the balance period available for the existing undertaking.

3.49  Recommendations of the Committee:

•  Committee is of the view that there is no presumption in law that only one undertaking can be set up in one STP/EHTP/SEZ or only one undertaking can claim benefits under Sections 10A and 10AA or only one undertaking can operate under one license. The issue as to whether an undertaking is new or expansion or is set up by splitting-up or reconstruction of an earlier business is a matter of fact which must be examined by the assessing officer on the facts of each case to determine eligibility for deduction of the new undertaking.
•  In cases where deduction has been denied by adopting the above presumption and the taxpayer Is before the CIT (A) or DRP, the issue may be allowed to be decided by the CIT(A) or DRP in accordance with the law after ascertaining from the Assessing Officers whether after ignoring the above presumption the taxpayer is eligible for deduction. If the AO is satisfied that taxpayer is eligible he should either concede the issue or not contest the same further.
•  In cases where the CIT(A) or ITAT or High Court has decided this issue in favour of the taxpayer, after examining the eligibility of the taxpayer for    these deductions,   no further appeal should be filed by Revenue. Wherever Revenue has already filed further appeal on this issue before   the ITAT, High Court or Supreme Court, as the case may be, the relevant    ground of appeal may be withdrawn immediately.

3.50  Issue 13: Retrospective amendment of the definition of royalty with

regard to taxation of software and transmission charges

3.51  Views of the industry

Detailed representations have been made on this matter by the Industry questioning the retrospective operation and scope of the amendment.

3.52 Response of the Committee:

The Committee, as presently constituted, is, in accordance with its approach mentioned in paragraph 1.16, constrained from looking at this subject in the absence of specific mention of this issue in its terms of reference.

APPENDIX   A

IMPORTANCE OF DEVELOPMENT CENTRES

NASSCOM data shows that at present more than 750 DCs are working from India, 28 per cent of them with multiple locations and DCs contributed around 1 /3rd of total IT export revenues of $68 billion in the fiscal 2012. They account for 22 per cent of IT-BPO export revenues and 21 per cent of employees

NASSCOM research indicates the following :

•  Over  152 new delivery centres were set up in 2011 in global sourcing destinations. India accounted for the largest share, 25  percent  (38 centres), followed by Eastern Europe at 20 percent and Philippines and Rest of Asia at 17 percent each.
•  India's strong value proposition and leadership status in the captive industry is ensuring that it gets a substantial share of first time outsourcers. While in 2009, over 15 new captives were established in India and over 25 captives increased their presence / scale of work in India, 2010 has seen 10 new captives open up in India 7.
•  DCs have played a key role in the IT-BPO sectors phenomenal growth story, establishing 'proof of concept' and branding India as a global sourcing destination. The segment, miniscule till   2003, has witnessed tremendous development in the last 7 years - growing at a CAGR of 22 per cent, employing close to 4 lakh people and contributing to  1  per cent of India GDP.
•  Impact of DCs on India extends beyond revenues and employment-         playing a leading role in developing an R&D and product culture,         spearheading initiatives to develop affordable products for emerging markets and creating entrepreneurship opportunities.
•  ER&D/SPD segment is the largest segment within the Indian captive landscape with over 200+ ER&D captives established in the last 3 years. MNC Development centres accounted for over 1 per cent of India's GDP in FY2010, support indirect employment of 1.4 million people and have played a key role in creating an innovation ecosystem in India.

• The industry has significantly grown over the last 5 years and currently has representation from most of the verticals like Aerospace & Defence, Automotive, BFSI, Bio-Technology, Chemicals, Computer Hardware, Education,   Electronic/Electrical     Equipment,   Energy,   Healthcare, Industrial, Semiconductors, Software/Internet, and Telecommunications, etc.
•  Manufacturing focussed verticals such as Automotive and Construction / Heavy Machinery were some of the first industries to engage in ER&D     off shoring and now have a mature supply base in India.
•  Cost pressure, access to flexible capacity, local market access for growth and decreasing time-to-market were some of the key reasons driving off shoring in those industries. But the most important factor is the availability of large pool of skilled manpower in terms of scientists, engineer etc.
•  Consumer Electronics is an industry mired with products that have very short life cycles and where time-to-market is very critical. The product (customer) requirements and features vary by geography and region. Hence, offshoring in this vertical veers towards tapping the emerging markets and delivering products with features and content more in line with the local market's needs. Similarly, Medical Devices is another where the market needs and affordability of products vary widely across regions. Here too, accessing emerging markets is the primary driver over providing low-cost solutions, which comes a distant second.
•  The IT services industry is dominated by India / India-centric providers who constitute more than two-thirds of the market. Large integrated players dominate this segment, providing services across a number of verticals and geographies. Foreign providers like IBM contribute around 10-15 percent of revenues, while IT captives constitute the remaining 10-15 percent. Software products and ER&D (Engineering Research and Development) have a high proportion of captive players   around 50-55 percent, taking advantage of India's engineering design and development capabilities. The BPO industry is evenly split between Indian and foreign players.
•  Some of the R&D Centres in India include that of Veritas, Synopsis, Adobe, Ericsson, Texas Instruments, Cisco, NetApp, BMC, Google, Microsoft, SAP, Yahoo, EMC, McAfee, Honeywell, Dell, Intel, IBM, Alcatel, Symantec, Sony and Huawei.

NASSCOM findings are supported by other studies. As per Zinnov Consulting analysis of MNC R&D Centers in India, MNC R&D landscape is rapidly growing with a current base 871 MNCs with their R&D Centers in India. India currently

boasts an installed R&D talent pool base of over 2,00,000 engineers growing at an average of 9% a year for the last 5 years.

A Research paper by IIM-A indicates that other countries with similar growth in R & D include China, UK, Germany, Brazil, Russia, etc.

Annexure I

PM sets up committee to review Taxation of Development Centres and the IT Sector, Safe Harbour Provisions to be Finalised soon

July 30.2012

New Delhi

The Prime Minister has constituted a Committee to Review Taxation of Development Centres and the IT Sector. The Committee will engage in consultations with stakeholders and related government departments to finalise the Safe Harbour provisions announced in Budget 2010 sector-by-sector. It will also suggest the approach to taxation of Development Centres.

2. The Prime Minister had earlier set up an Expert Committee on GAAR under the Chairmanship of Dr. Partho Shome to engage in a widespread consultation process and finalise the GAAR Guidelines. The response has been overwhelmingly positive.

3. While this committee would address concerns on GAAR provisions and would reassure investors about the predictability and fairness of our tax regime, it was felt that there is still a need to address some other issues relating to the taxation of the IT Sector such as the approach to taxation of Development Centres, tax treatment of "onsite services" of domestic software firms, and also the issue of finalising the Safe Harbour provisions announced in Budget 2010.

4. Many MNCs carry out activities such as product development, analytical work, software development, etc. through captive entities in India. They exist in a wide range of fields including IT software, IT hardware, Pharmaceutical R&D, other automobile R&D and scientific R&D. These are popularly called Development Centres. Over 750 MNCs have such centres at over 1100 locations in India. The reason for this large concentration of Development Centres in India is the worldwide recognition of India as a place for cost competitive, high quality knowledge related work. Such Development Centres provide high quality jobs to our scientists, and indeed make India a global hub for such Knowledge Centres. However, India does not have a monopoly on Development Centres. This is a highly competitive field with other countries wanting to grab a share of the pie. There is need for clarity on their taxation.

5. As far as Safe Harbour provisions are concerned, these were announced in Finance Bill 2010 but have yet to be operationalised with a wide application. Safe Harbour provisions have the advantage of being a good risk mitigation measure, provide certainty to the taxpayer.

6. The resolution of the above tax issues requires a comprehensive approach in which other government departments are consulted and industry bodies are taken on board. The overall goal is to have a fair tax system in line with best international practice which will promote India's software industry and promote India as a destination for investment and for establishment of Development Centres. Therefore, the Prime Minister has constituted a Committee consisting of experts from the Income Tax Department, both serving and retired, who will examine the issues in detail and submit proposals in a short time. An arm's length exercise of this nature will allay a lot of concerns in addition   to      the    immediate resolution  of      issues         that   is          necessary.

7. For this purpose, a Committee on Taxation of Development Centres and the IT sector has been constituted consisting of:

1) Shri N. Rangachary, former Chairman CBDT & IRDA - Chairman

2) Ms Anita Kapur, Director General (IT) - Member

3) Ms Rashrni Sahani Saxena, DIT (TP) - Member

4) Any other officer from the Income Tax Department to be co-opted by the Chairman

8. The Terms of Reference of the Committee will be to:

i) Engage in consultations with stakeholders and related government departments to finalise the approach to Taxation of Development Centres and suggest any circulars that need to be issued.

ii) Engage in sector-wide consultations and finalise the Safe Harbour provisions announced in Budget 2010 sector-by-sector. The Committee will also suggest any necessary circulars that may need to be issued.

iii) Examine issues relating to taxation of the IT sector and suggest any clarifications that may be required.

9. The Committee will work to the following time schedule:

i) Finalise the approach to taxation of Development Centres and suggest any necessary clarifications by 31 August 2012.

ii) Suggest any necessary clarifications that may be needed to remove ambiguity and improve clarity on taxation of the IT Sector by 31 August 2012.

iii) Finalise Safe Harbour Rules individually sector-by-sector in a staggered manner and submitting draft Safe Harbour provisions for three sectors/sub-activities each month beginning with the first set of suggestions by 30 September 2012. All Safe Harbour provisions can be finalised by 31 December 2012.

10. The Department of Revenue will provide all necessary support to the Committee to facilitate its work including office assistance and assistance to facilitate consultations.

Annexure II

F. No. A.    50050/ 103/2012-Ad.l

Government of India

Ministry of Finance

Department of Revenue

New Delhi, dated the 3^rd August, 2012

OFFICE MEMORANDUM

Subject: Constitution of a Committee to Review Taxation of Development Centres and the IT Sector- Reg.

A Committee has been constituted with the approval of the Prime Minister to review the Taxation of-Development Centres and the IT Sector. This Committee shall consist of:

(i)      Shri N. Rangachary, former Chairman, CBDT & IRDA   -  Chairman

(ii)     Ms. Anita Kapur, Director General (IT) - Member

(iii)    Ms. Rashmi -Saxena Sahni, DIT(TP) -  Member

(iv)    Shri Dinesh Kamabar, Tax-Expert  - Member

The terms of Reference of the Committee will be to:

(i)  Engage in Cons Rations with stakeholders and related government departments:to finalise the.approach-to Taxation of Development Centres and suggest any circulars that need to be issued.

(ii) Engage in sector-wide consultations and finalise the Safe Harbour provisions announced In Budget 2010 sector-by-sector. The Committee will also suggest any necessary circulars that may need to be issued.

(iii) Examine issues relating to taxation of the IT sector and suggest any clarifications that may be required.

The committee will work to the following time schedule:

(i)  Finalise the approach to taxation of Development Centres and suggest any necessary clarifications by 31 August 2012.

(ii) Suggest any necessary clarifications that may be needed to remove ambiguity and Improve clarity on taxation of the IT Sector by 31 August 2012.

(iii) Finalise Safe Harbour Rules individually sector-by-sector in a staggered manner and submit draft Safe Harbour provisions for three sectors/sub-activities each month beginning with the first set of suggestions by 30 September 2012. All Safe Harbour provisions are to be finalised by 31 December 2012.

2  The Department Revenue will Provide all necessary support to the committee to facilitate its work including office assistance and assistance to facilitate consultations.

(M. L. Meena)

Joint Secretary to the Government of India

Copy to:

I. Shri N. Rangachary, former Chairman, CBDT & IRDA.

2. Ms. Anita Kapur, Director General (IT).

3. Ms. Rashmi Saxena Sahni, DIT(TP).

4. Shri.Dinesh Kanabar, Tax Expert.

5.      Shri. B.V:R. Subrahmanyam, Joint Secretary to PM.

6..PS to FM

7. PPS to secretary(Revenue).

8. Chairman,CBDT

9. DS(Admn), Department of Revenue with the request to provide all

          Necessary support to the Committee to facilitate its work including office_

          assistance and assistance to facilitate consultations.

 

Annexure III

F. No. A 35915 29/2012-Ad.VI

Government of India

Ministry of Finance

Department of Revenue

Central Board of Direct Taxes

 

New Delhi, Dated 7^th August 2012

ORDER No. 154 of 2012

With the approval of the Competent Authority, the services of the following officers are placed at the disposal of the Committee to Review Taxation of Department Centre and the IT Sector under the Chairmanship of Shri N. Rangachary former Chairman. CBDT & IRDA with immediate effect and until further orders.

S. No.	Name of Officer / Post (S/ Shri)	Civil Code
1.	Sobhan Kar, Additional Commissioner APA, Delhi	99018
2.	D. Prabhakar Reddy, Additional Director   of Income Tax, TPO2(6), Mumbai	99011

 

(A. K. Chaturvedi)

Director Ad. VI

Copy to:

1.      Office Concerned

2.      Shri N. Rangachary Chairman of the Committee to Review Taxation of Development Centres and the IT Sector

3.      DGIT (IT), Delhi/CCIT(CCA)­­, Mumbai/JS(FT&TR-I)

4.      All Chief Commissioner Directors General of Income Tax

5.      Principle Chief Controllers of Accounts New Delhi

6.      Zonal Accounts Officers CBDT C/o CCIT (CCA)concerned

7.      PPSs to FM /MOS (R)/ Finance Secretary Chairman, CBDT/ Members CBDT/ Addl. Secy (R)/JS (Admn) CBDT/JS(R).

8.      Adviser to FM

9.      Ad. Section Department of Revenue

10.    Hindi Section for Hindi version

11.    Secretary General IRS Association ITGOA/ All India Income Tax SC & ST Employees Welfare Association.

(A. K. Chaturvedi)

Director Ad. VI

Annexure IV

FINANCE MINISTER CONFIDENT OF BRINGING ECONOMY BACK ON DESIRED TRACK; GIVES AN OVERVIEW OF MAP FOR RECOVERY

New Delhi: Shravana 15, 1934

          August 06, 2012

The Union Finance Minister, Shri P. Chidambaram has said that uppermost in his mind is the duty to re-gain the confidence of all stakeholders. Assuring that inflation can be moderated in the medium term, he said that the Government will work with RBI in this regard. In a statement, the Finance Minister said that a path of financial consolidation will be unveiled shortly. He made it clear that the burden of fiscal correction must be shared, fairly and equitably, by different classes of stakeholders. The Finance Minister said that the poor must be protected and others must bear their fair share of the burden. He further said that wherever required, the corrective measures will be taken in bringing clarity in tax laws, to have a stable tax regime, a non-adversarial tax administration and a fair mechanism for dispute resolution.

Following is the full text of the Finance Minister's statement:-

"I assumed the office of Finance Minister on Wednesday, August 1, 2012. It is a position of great honour, it is also a position of great responsibility. In the last few days, I have been briefed by senior officials of the Ministry of Finance on the state of the economy. It is true that the economy is challenged by a number of factors, but it is also true that with sound policies, good governance and effective implementation, we would be able to overcome these challenges.

Uppermost in my mind is the duty to re-gain the confidence of all stakeholders. Obviously, where necessary, our policies have to be modified or fine-tuned in order to meet the expectations of different stakeholders.

We intend to unveil, shortly, a path of fiscal consolidation. I would like to make it clear that the burden of fiscal correction must be shared, fairly and equitably, by different classes of stakeholders. The poor must be protected and others must bear their fair share of the burden. Obviously, adjustments must be made both on the revenue side and on the expenditure side. We have asked Dr. Vijay Kelkar, Dr. Indira Rajaraman and Dr. Sanjiv Misra to assist the Government in formulating the path of fiscal consolidation and we expect that the work will be completed in a few weeks.

Price stability is an important objective. In fact, it is more important for the poor. There has been pressure on prices, and inflation - especially food inflation - is high. The causes are well known: some are beyond our control, such as prices of crude oil and imported commodities, but some others can be addressed by determined action. We will take steps to remove the constraints on the supply side. We will also use our stocks of food grain to moderate prices. Where necessary, we will enhance the import of items in short supply. Non-food inflation is already declining. We are confident that inflation can be moderated in the medium term. Fiscal policy and monetary policy must point to the same direction and must move in tandem. Government will work with the Reserve Bank of India to ensure that inflation is moderated in the medium term. We are conscious that current interest rates are high. High interest rates inhibit the investor and are a burden on every class of borrowers, be it a manufacturer of goods or a purchaser of a home or a two wheeler or a student who takes an education loan. Sometimes it is necessary to take carefully calibrated risks in order to stimulate investment and to ease the burden on consumers. We will take appropriate steps in this regard.

The key to restart the growth engine is to attract more investment, both from domestic investors and foreign investors. Since investment is an act of faith, we must remove any apprehension or distrust in the minds of investors. We will improve communication of our policies to potential investors. The aim will be to remove the perceived difficulties in "doing business in India", including fears about undue regulatory burden or regulatory over-reach. Indian companies, especially public sector enterprises, which have large cash balances will be encouraged to restart investment. Proposals pending with the Foreign Investment Promotion Board will be processed and decisions taken expeditiously.

Clarity in tax laws, a stable tax regime, a non-adversarial tax administration, a fair mechanism for dispute resolution, and an independent judiciary will provide great assurance to investors. We will take corrective measures wherever necessary. We have recently appointed two Committees, one to examine GAAR legal provisions and guidelines and the other to review taxation of the IT sector and Development Centres. I have also directed a review of tax provisions that have a retrospective effect in order to find fair and reasonable solutions to pending as well as likely disputes between the Tax Departments and the Assessees concerned. With these measures, and some other measures that we hope to take in the short term, it is our intention to raise the level of investment to 38% of the GDP that was achieved in 2007-08.

I believe that, around the world, there is enormous goodwill for India and most people continue to keep faith with the India growth story. It is natural that they look closely at certain economic indicators, one of them being the exchange rate. Volatility of the exchange rate has reduced in recent weeks. A reassurance on the investment climate, continued inflow of remittances, and a rise in capital flows -both FDI and FII - will bring further stability to the exchange rate. We intend to fine tune policies and procedures that will facilitate capital flows into India.

A high level of savings is a pre-condition to a high level of investment. In 2007-08, savings touched 36% of GDP. It is now down to 32% of GDP. One of the reasons may be a perceived lack of attractive investment opportunities and instruments. Hence the attraction of gold, but gold is not a productive asset and the demand for gold worsens the current account deficit. Both the mutual fund industry and the insurance sector have turned sluggish. In the next few weeks, we will announce a number of decisions to attract more people to invest in mutual funds, insurance policies and other well-designed instruments.

Manufacturing and exports are two key drivers of the economy. Both have registered low or negative growth in recent months. It is imperative that we reverse this trend. Supply side constraints upon manufacturing and exports must be removed in double quick time. We intend to work with manufacturers and exporters and implement appropriate short term and medium term measures.

While greenfield investments are important, it is equally important that we implement the projects that are under construction. We need to focus more closely on large projects as well as infrastructure projects. An Investment Tracking System for projects with an outlay of Rs.1,000 crore or more has been put in place. The Prime Minister has set specific targets for key infrastructure sectors. We will review the progress of each of these projects, periodically, in the Cabinet Committee on Economic Affairs and remove the bottlenecks to quicker implementation of the projects.

Some sectors are under stress, for example, petroleum, electricity and textiles. We intend to find practical solutions to the problems that impede higher production or output in the coal, mining, petroleum, power, road transport, railway and port sectors. The Cabinet Committee on Economic Affairs will examine the issues affecting each sector and take decisions that will lead to quantitative growth in these sectors.

Unfortunately, the south west monsoon has been below expectations. Drought like conditions have been reported from several States. It is the duty of the Government to provide relief to the people living in drought affected districts, protect wage employment and save agricultural production to the extent possible. MGNREGA and other schemes will be converged to meet the challenge of drought. Contingency plans are in place to supply drinking water and fodder and to help farmers replant alternative crops. We must seize the opportunity to build durable assets that will provide employment to the poor as well as help in drought-proofing agriculture in the affected districts.

As I said at the outset, the Indian economy faces many challenges. We are challenged by the global economy. We are challenged by the crisis that has afflicted several leading banks of the world. We are challenged by natural calamities such as floods in one part of the country and drought in other parts of the country. Above all, we are challenged by our own record of fiscal consolidation, high growth, moderate inflation and rise in human development indicators that we achieved during 2004-08. Let us remember that we had faced similar challenges in 1991, 1997 and 2008 and we overcame them. It is widely acknowledged that, today, the Indian economy is stronger and better prepared to face the challenges. Moderate growth in two out of eight years should not dent our confidence.

Several legislative proposals have gone through the full deliberative process and are ripe for debate and passing in Parliament. I seek the cooperation of all political parties represented in Parliament to pass these Bills. With the cooperation of political parties, civil society, farmers and workers, service providers, producers and consumers, and scientists and technologists, I am confident that we will prevail and we will return to the path of high growth, inclusive development, and economic and social justice for all."

Annexure V

Government of India

Ministry of Finance

Department of Revenue

(foreign Tax and Tax Research Division)

Dated 08.08.2012

Office Memorandum

A concern has been raised regarding the application of global profit method in taxation of companies engaged in R&D activities in software development in India.

Most of these R&D centres In India have employed highly skilled manpower and generate intangibles, However, Issues have been raised by the Industry on allocation of profit to such intangibles. Internationally agreed practices :refer paragraph 2.109 of the OECD Transfer Pricing Guidelines for multinational enterprises and Tax Administration edition 2012 which suggests use of Profit Split Method in cases Involving intangibles) and the existing provisions of transfer pricing regulations in India (refer paragraph (d) of rule 109(1) of the Income-tax Rules,1962), suggest use of profit split method in cases involving development of Intangibles,

The Hon'ble Finance Minister has approved the suggestion that the issue of application of Global Profit Method to determine arm's length price of intangibles developed by the R&D centres of MNEs In India may be considered by the Committee constituted by the Hon'ble PM.

(Batsala Jha Yadav)

Director (APA)

FT & TR-l, CBDT

Ms Anita Kapoor,

Director General of Income-tax (Admn),

Member,

Committee to Review Taxation of

Development Centre and the IT Sector

 

Annexure VI

OTHER TRANSFER PRICING ISSUES

A. Administrative Issues:

i. Higher margins adopted by the TPOs based on cherry picking of comparables.

ii. Not applying a turnover range while choosing comparables.

iii. Conducting fresh search of comparables by the TPOs including use of secret comparables by getting information under Section 133(6).

iv. Application of some additional filters like different accounting year ending filter, employee cost filter, diminishing revenue filter and significant activity (>75%) filter while searching for suitable comparables in public databases like Prowess and Capital Line.

v. Rejection of filters applied by the assessee such as marketing expenses to sales >3% and R&D expenses to sale >3%.

vi. Issue of risk adjustment, working capital adjustment and capacity utilisation adjustments.

vii. Accounting issues of bank charges, foreign exchange fluctuation, provision for bad & doubtful debts, etc.

B. Legal Issues:

i. Rejection of use of multiple year data and earlier data.

ii. Use of current year data and also use of data, which was not available to the assessee at the time of TP documentation.

iii. Use of inter-quartile range instead of arithmetic mean.