Tax & Accounting Blog

Indian Expert Committee Report on the Software Industry: Analyzing the Impact

ONESOURCE, Transfer Pricing October 2, 2013

By Gaurav Shah, MZSK & Associates, Mumbai

Gaurav Shah is an associate director with MZSK & Associates, a member firm of the International BDO Network, in Mumbai.

Indian captives engaged in software development and software R&D work have long faced transfer pricing challenges, the most important being the margins expected of such captives by the Indian revenue authorities. Additionally, these captives have also been facing transfer pricing challenges on account of denial of various adjustments, including risk adjustments.

Indian IT companies also have been facing a wide range of challenges, especially in claiming the tax holidays made available to the industry. Several representations have been made by the industry from time to time demanding a review of the practices adopted by the Indian revenue authorities regarding several contentious issues faced by the industry.

In July 2012, the Prime Minister’s Office announced the creation of an expert committee “to review taxation of development centers and the IT sector.”1 The committee was directed to:

  • finalize safe harbor provisions; and
  • suggest an approach for taxing development centers.

The committee was formed under the chairmanship of N. Rangachary, former chairman of the Central Board of Direct Taxes and Insurance Regulatory Development Authority, and included officials from the Indian Revenue Department as well as a tax expert. The committee submitted its first report relating to the taxation of development centers in September 2012.

Committee’s Approach—Key Features

At various places in the report, it becomes evident that for framing its recommendations, the committee has considered the operational aspects of functioning of the IT industry. For this purpose, the committee has heavily relied on inputs from the industry body, the National Association of Software and Services Companies (NASSCOM).

As a result of input from NASSCOM, the committee appears to have obtained a deep understanding of the competitive forces operating in the industry, business models prevalent in the industry, as well as the functions, assets and risks analysis in a typical captive development center set-up.
The committee also liberally sought inputs from various industry bodies,2 various government bodies,3 revenue authorities, and tax professionals. In addition, the committee conducted several rounds of consultations with various stakeholders and was enriched with the views of all those concerned. Accordingly, in forming its recommendations, the committee appears to have had the advantage of considering views of all key stakeholders.

Identifying Low-Risk Captives

Identification of low-risk-bearing captives has been the subject of dispute in several cases. In various cases, taxpayers took the position that comparables selected from publicly available databases were full-risk entrepreneurial service providers and therefore were insisting on a risk adjustment or lower net margins under the arm’s-length principle. In some cases, the taxpayers even sought to reject potential comparables on the ground of differential risk profiles.

On the other hand, the revenue authorities had been denying risk adjustments in most cases citing lack of relevant financial information for carrying out such adjustments. In some other cases, the revenue authorities denied risk adjustments on the basis that captives, by virtue of their reliance on only one customer, face significant business risk.

The committee has observed that most software projects follow a “distributed development” model whereby various chunks of work are outsourced (including to offshore captives such as those in India). The committee has observed that the overwhelming majority of captives in India and their principals adopt this operating model. It also has discussed the detailed functional profile of the Indian captives and their respective foreign principals.

Based on the recommendations of the industry as well as the revenue authorities, the committee has recommended that the Indian captives should be considered as limited-risk-bearing entities if all of the following conditions are fulfilled:

  • Critical functions with regard to the overall product life cycle, including conceptualization and design, are performed by the foreign principal, while the Indian captive is merely engaged in implementation of these concepts and designs
  • The principal provides the capital investment for the captive. It bears risk of failure of the research carried out by the captive and owns the outcome of the research. The Indian captive has no right on the outcome of the research.
  • The Indian captive is required to report to the principal on a regular basis.
  • The Indian captive operates in a low-risk environment.
  • The entirety of the product life cycle is not undertaken by the Indian captive.
  • If a patent is registered in India for the work performed by the Indian captive, it cannot be commercially exploited on a stand-alone basis because of its insignificance to the overall value chain.
  • Terms of outsourcing to the Indian captive are similar to the terms of outsourcing the work to a third party.

The committee has emphasized that the contractual arrangement between the Indian captive and the foreign principal would be considered a relevant, but not a conclusive, factor. The committee has laid significant stress on the actual conduct of the parties
being consistent with the contractual terms. Significantly, in cases where the foreign principal is located in a tax-favored jurisdiction, the recommended assumption (rebuttable) is against the Indian captive being a low-risk-bearing entity.

Most Appropriate Method

Regarding the most appropriate method to be adopted in cases involving low-risk-bearing captives, in most cases, the taxpayers as well as revenue authorities have been adopting the cost plus method or the transactional net margin method (TNMM). Profit split has been used in rare cases.

Generally, taxpayers have been claiming that the profit split method requires exceptional circumstances, such as where the research and development is performed by the Indian captive under a cost contribution arrangement or where the foreign principal is located in a tax-favored jurisdiction and has a low level of functions and risks. Taxpayers also have pointed out several difficulties in practically applying profit split.

The revenue authorities, on the other hand, have pointed out the increasing ambit of the R&D performed by Indian captives and claimed that there is a transfer of innovation and intellectual property by these captives to their foreign principals, thereby rejecting straitjacket applicability of TNMM in all cases.

The committee has recommended that TNMM be considered the most appropriate transfer pricing method in cases involving low-risk-bearing captives that fulfill the criteria listed above. The committee also has highlighted the following practical difficulties in applying the profit split method in cases involving Indian captives:

  • Determination of unique contribution in an integrated product is challenging in cases involving R&D services.
  • Identifying profits arising from the controlled transaction is difficult.
  • It is difficult to verify the accuracy of the data across various geographical locations.
  • Availability of data is a significant challenge and profit split invariably involves making various assumptions, which could skew the results of the benchmarking analysis.
  • Use of a profit split based on allocation keys may lead to the claim by Indian captives for splitting of global losses in cases where the foreign principal has incurred losses, even if the R&D activity performed by the Indian captive was successful.
  • Profit split is a highly subjective method and gets more subjective as the number of entities making valuable intangible contributions increases.

The committee also pointed to guidance issued by the United Kingdom’s H.M. Revenue and Customs, which lists further problems with profit split: difficulty in isolating controlled transactions and establishing value-added functions, in estimating the expected profits over a number of years, and in examining intangibles creation potential along with the risk of failure.

This article originally appeared in BNA’s International Tax Monitor.