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CONFIDENTIAL

First Report of the


Committee to Review
Taxation of Development
Centres and the IT Sector

9/14/2012
Foreword

The Committee set-up 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-I), 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
14th September, 2012
Table of Contents
Part 1: Introduction 1- 6
Part 2: Approach to Taxation of Development Centres 7 - 28
Part 3: Income-tax Issues pertaining to the IT Sector 29 - 51
Appendix A: Importance of Development Centres 52 - 55
Annexure-I: Press release of Prime Minister’s Office dated
30th July, 2012 56 - 57
Annexure-II: Office Memorandum of Department of
Revenue, dated 3rd August, 2012 58 - 59
Annexure-III: CBDT order No. 154, dated 7th August, 2012 60
Annexure-IV: Press Note issued by the office of Hon’ble Finance
Minister, Shri P. Chidambaram, on 6th August, 2012 61 - 63
Annexure-V: Office Memorandum dated 8th August, 2012 of
FT &TR Division of CBDT 64
Annexure-VI: Other Transfer Pricing Issues raised by the
Stakeholders in relation to Development Centres 65
Committee to Review Taxation of Development Centres and the IT Sector

PART 1: INTRODUCTION

1.1 Prime Minister’s Office issued a press release on July 30, 2012
(Annexure -I), 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 "onsite 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 -

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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 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 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-II(6),
Mumbai and Shri Sobhan Kar, Addl. Commissioner of Income Tax (APA), Delhi
vide CBDT order No 154 dated 7th August, 2012 (Annexure-III).

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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 alia, 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 )

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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.

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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

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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.

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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 follows1:
Financial year Number of TP Number of % of adjusted Amount of
Audits adjustment cases adjustment
completed cases (INR in crore)
2004-05 1,061 239 23 1,220
2005-06 1,501 337 22 2,287
2006-07 1,768 471 27 3,432
2007-08 218 84 39 1,614
2008-09 1,726 670 39 6,140
2009-10 1,830 813 44 10,908
2010-11 2,301 1,138 49 23,237
2011-12 2,638 1,343 52 44,531

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.”

1
“White paper on Black Money, May 2012” Ministry of Finance, Department of Revenue,
CBDT, New Delhi at page no. 59 and Para 4.7.1

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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

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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.

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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, un-
installation, 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.

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

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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

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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

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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 far 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

2 Comments sent by e-mail on 7th September by JS FT&TR-I, CBDT as agreed by DGIT


(International Taxation)

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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.

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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

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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 same 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 same would be grossly incorrect for most contract
R & D arrangements in India today.

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2.14 Views of Revenue3

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

3 Presentation cum Discussion on 3rd September, 2012 - JS FT&TR-I, CBDT and DGIT
(International Taxation)

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• 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

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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

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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.

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• 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.
• 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 10B (i)(d) (extracted below)
stipulates that transfer of unique intangible requires application of PSM:

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“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

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• 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 far 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 intangible5. 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

4 INTM440160 of HMRC - Transfer pricing: Types of transactions: intangibles


5 INTM440170 of HMRC - Transfer pricing: Types of transactions: intangibles

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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
same 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.

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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

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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 scrutinised
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

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provisions in the Income Tax Act. However, the Committee has, considering its
mandate, not examined those.

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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”

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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 10B.

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% on-
site work defeats the purpose of exports out of India. They also relied on
Circular no. 694 of 1994.

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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

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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, 10AA 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 10A, 10AA or 10B 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,

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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 10AA

3.11 Views of the Industry

3.11.1 The industry explained that tax incentive u/s 10A of the Income-
tax Act came 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.

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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

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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.

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• 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.

3.14 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.

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Committee to Review Taxation of Development Centres and the IT Sector

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.

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• 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 same 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 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. 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.

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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.

3.19.2 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/10AA/10B. 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 10B 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.

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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 & 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.

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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, 10AA 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.

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Committee to Review Taxation of Development Centres and the IT Sector

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)

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Committee to Review Taxation of Development Centres and the IT Sector

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.

3.30 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 same, 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.

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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.

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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

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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(1)(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 same from the total turnover, by incorrect

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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 same 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

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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.

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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 same location where there is an existing

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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.

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• 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.

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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 6.
Export revenue from IT/BPO Industry FY 2012

35%

65%

Indian MNC Center

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.

6 NASSCOM Strategic Review, 2012


7 NASSCOM Strategic Review, 2011 (Page 37)

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• 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 8.
• 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 9.
• 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.

8 NASSCOM - http://www.nasscom.in/global-inhouse-centres
9 NASSCOM - http://www.nasscom.in/global-inhouse-centres

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• 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 10.
• 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 11.
• 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.

10 NASSCOM Strategic Review 2011 – IT-BPO Sector


11 NASSCOM Strategic Review – 2011 (Page 83)

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MNC R&D Centers in India


871
900 780
699
800
700
517
600
500 297
400
300 191

200
100
0
Before '00 01-02 03-04 05-06 07-08 09-11

(Source: Zinnov analysis of MNC R&D ecosystem in India)

A Research paper by IIM-A indicates that other countries with similar growth in
R & D include China, UK, Germany, Brazil, Russia, etc.12.

12
IIMA (2012): Foreign R & D centres in India

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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:

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

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

3) Ms Rashmi 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.

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Annexure II

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Annexure III

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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 foodgrain 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

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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.

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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.”

*******

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Annexure V

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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.

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