IRS' Contract R&D, PSM concerns in draft Safe Harbour Rules

CBDT recently issued draft Safe Harbour Rules to reduce TP litigation and provide certainty to the taxpayers. The draft Rules prescribe safe harbour in respect of IT/ITeS industry, contract Research and Development activities, auto ancillary sector and intra-group loans and guarantees.


While the draft Safe Harbour Rules have been welcomed in IRS circles as well, Taxsutra learns that IRS officers have concerns regarding couple of points. They point out that one of the main objectives is providing certainty to small taxpayers. Accordingly, for application of safe harbour rules for software development service as well as ITeS and KPO, transaction value limit of Rs.100 Cr is proposed. But, surprisingly no such limit is prescribed for contract R&D services.


Further, Safe Harbour Rules prescribe use of Transaction Net Margin Method (TNMM) for benchmarking contract R&D services. Does this mean that Profit Split Method (PSM) has been discarded forever for contract R&D activities, even in those cases, where taxpayers do not opt for Safe Harbour Rules?


The Rules talk about application of safe harbour rules only if the assessee qualifies as assessee with "insignificant risk". Further, Rules prescribes guidance regarding relevant factors to be considered in this respect. A couple of months ago, CBDT had rescinded Circular No. 2 on Profit Split Method (PSM) on the ground that circular appeared to give impression that PSM was most preferred method in cases involving unique intangibles. CBDT also amended Circular No. 3 to lay down conditions relevant to identify development centres engaged in contract R&D services with insignificant risk.


IRS officers point out that invariably all the assessee engaged in R&D services claim that they bear insignificant risks. In this respect, it is interesting to note that India practices as included in Chapter on Country Practices in UN Practical Manual on Transfer Pricing for Developing Countries state that "Most of these R&D centres in India were actually found to be engaged in the creation of unique intangibles, legal ownership of which was transferred to their parent MNEs under agreement. Such transfer took place
without any appropriate compensation and patents for these intangibles were registered in the name of the parent MNE. In these cases the Indian transfer pricing administration allocated additional arm’s length compensation for transfer of such intangibles in addition to arm’s length compensation for
R&D activities."