CBDT’s circular on Transfer pricing issues - Identification of development centre and application of PSM

CBDT has issued two important circulars in relation to identification of development centres engaged in contract ‘R&D Activities’ and application of profit split method

When TPO can prefer TNMM or CUP method over PSM where intangibles are involved, CBDT clarifies

Rule 10B(1)(d) prescribes that the Profit Split Method is applicable mainly in international transaction involving transfer of unique intangibles. However, vide Circular No. 02/2013, the CBDT clarifies that TPO may consider TNMM or CUP method as most appropriate method instead of Profit Split Method for selection of comparables engaged in development of intangibles in same line of business, provided:

1) TPO should be of the view that PSM cannot be applied due to non-availability of information and reliable data required for application of the method;

2) He records reasons for non-applicability of PSM.

(View circular)

How to identify development centres engaged in contract R&D services with insignificant risk, CBDT clarifies

A development centre in India (‘IDC’) may be treated as a contract R&D service provider with insignificant risk if following conditions are satisfied:

1) Foreign principal performs most of the economically significant functions involved in research and development cycle whereas IDC would largely be involved in economically insignificant functions;

2) Economically significant assets including intangibles for R&D activities are provided by principal and IDC would not use any other economically significant assets;

3) IDC works under direct control and supervision of foreign principal;

4) IDC doesn’t assume or has no economically significant realized risks; and

5) IDC has no ownership right (legal or economic) on outcome of research which vests with foreign principal.

Further, the CBDT clarifies that the above conditions should be borne out of the conduct of the parties and not merely by the contractual terms.

(View circular)

Exp. on ‘clinical drug trial’ is deductible even if the impossible “incurred in-house” condition isn’t satisfied

Explanation to Section 35(2AB)(1) does not require that the expenses which are included in this explanation are essentially to be incurred inside an in-house research facility because it is not possible to incur these expenses for in-house research facility

In the instant case, the issue that arose for consideration of HC was as under:
"Whether the expenditure which was not incurred in an in-house research facility could be discarded for weighted deduction under sec. 35(2AB) of IT Act?”

Deliberating on the issue, the HC held in favour of assessee as under:

1) The Explanation to section 35(2AB)(1) provides that expenditure on scientific research in relation to drugs and pharmaceuticals shall include expenditure incurred on clinical drug trials, obtaining approval from any regulatory authority and filing an application for a patent under the Patents Act, 1970. The whole idea thus appears to be to give encouragement to scientific research. By its very nature, clinical trials may not always be possible to be conducted in closed laboratory or in similar in-house facility provided by the assessee and approved by the prescribed authority;

2) Before a pharmaceutical drug could be put in the market, the regulatory authorities would insist on strict tests and research on all possible aspects, such as possible reactions, effect of the drug and so on;

3) Extensive clinical trials, therefore, would be an intrinsic part of development of any such new pharmaceutical drug. It cannot be imagined that such clinical trial can be carried out only in the laboratory of the pharmaceutical company;

4) The activities of obtaining approval of the authority and filing of an application for patent necessarily have to be outside the in-house research facility. Thus, the restricted meaning suggested by the Revenue would completely make the explanation quite meaningless;

5) Segregation of the expenditure by prescribed authority into two parts, namely, those incurred within the in-house facility and outside, by itself would not be sufficient to deny the benefit to the assessee under section35(2AB) of the Act - Cadila Healthcare Ltd. v. CIT [2013] 31 taxmann.com 300 (Gujarat)

Related case:
Exp. on ‘drug trials’ can’t be disallowed even if it isn’t incurred in-house as trials can be carried outside labs only - Cadila Healthcare Ltd. v Addl CIT [2013] 29 taxmann.com 229 (Ahmadabad - Trib.)

Validity of retro amendment made to sec. 115JB by FA, 2009 can’t be challenged as it was made to widen the tax base

The amendment made to Explanation 1 to Section 115JB of the IT Act, by the Finance Act, 2009 by insertion of clause (i) with retrospective effect from 1.4.2001 is not ultra vires or unconstitutional.

In the instant writ petition, the petitioner-company challenged the constitutional validity of retrospective amendment made to Section 115 JB of the IT Act, by the Finance Act, 2009 by insertion of clause (i) in the Explanation 1(requiring addition to book profit of provisions for diminution of asset).

HC held in favour of revenue as under:

1) No merit in the contention of assessee that amendment imposes  a new tax or new levy outside the scope of section 115JB
a) The purpose of the Explanation is to broaden the base amount on which tax is payable by the company. The tax-base stands widened by the amendment inasmuch as the amount or amounts set aside as provision for diminution in the value of any asset and debited to the profit and loss account shall be added to the book profit;

b) The tax which was essentially a tax on the book profit and, consequently, a tax on the total income of the petitioner does not cease to be such a tax or become a new or different tax in nature and character merely because one more item is prescribed to be added to the book profit shown in the profit and loss account from a retrospective date;

c)  The tax was always on the book profit and on the total income of the company; it continues to remain so even after the retrospective amendment, the change being not in the nature and character of the tax, but on the quantum of the book profit/total income of the company on which it is charged. Since the amendment does not provide for any new levy of income-tax, there is no question of it being struck down on the ground of retrospectivity.

2) Not sufficient to show that amendment travels beyond section 115JB, but it is necessary to show that it goes beyond the relevant entry in the Constitution
a) In order to successfully challenge the retrospectivity of the amendment it is necessary for the petitioner to show that the retrospective operation so completely alters the character of the tax as to take it outside the limits of the entry which gives the legislature competence to enact the law;

b) The nature of the tax has not undergone any change and it still remains a tax on the book profit of the company. All it does is to widen the base upon which the levy operates by adding one more category of a debit to the profit and loss account by which the book profit of the company can be increase;

c) Explanation 1 to the Section prescribes the manner in which the book profit of a company shall be computed. It is upon the book profit so computed, after giving effect to the said Explanation, that the tax is payable by the company;

d) It is difficult to accept the argument that the insertion of clause (i) with retrospective effect into the Explanation 1 so completely alters the nature and character of the tax that it falls beyond the Entry 82 in the Union List of the Constitution (“Taxes on income other than agricultural income”) and ,consequently, is beyond the competence of the legislature.

3) The retro amendment doesn’t take away with retrospective effect any benefit which is granted by the legislature
a) It would be incorrect to treat the provisions of Section 80J and the provisions of Section 115JB on par and require the same standards to be fulfilled to enact a valid legislative amendment with retrospective effect in both of them;

b) It would be erroneous and inaccurate to consider any deduction allowed while computing the book profit of the company as a benefit or relief granted to it in the same manner in which Section 80J conferred a benefit upon an assessee who set-up an industrial undertaking in a notified backward area. The scheme and purpose are so different that a comparison of both the provisions would be totally off the mark;

c) There is considerable difference between provisions conceived as incentive or relief provisions, (enacted with a view to foster industrial growth and scientific research activities in the country) and those which essentially seek to bring within the purview of the fiscal legislation companies which have not paid any tax, though have been earning substantial profits and also dividends;

d) If this essential difference between the two types of provisions is kept in mind, it will be apparent that there can be no question of the retrospective amendment under challenge not serving the larger public interest. Thus, the writ Petition dismissed but with no order as to costs -  Whirlpool of India Ltd. v. Union of India [2013] 31 taxmann.com 200 (Delhi)

A retro amendment to a tax incentive provision which is merely clarificatory isn’t unconstitutional

Gujarat HC upholds the validity of retro amendment made by way of insertion of an Explanation below sec. 80-IA(13), which clarifies that no deduction is available under 80-IA for execution of work contracts.

In the instant case, the petitioner challenged the vires of Explanation inserted in Sec. 80IA(4) by Finance Act 2009. The case of the petitioner was that it was engaged in the development of infrastructure facility. Till the introduction of impugned amendment, deductions were available to all undertakings and enterprises executing infrastructure development projects and it was not required that the assessee itself must develop such infrastructure facilities by investing its own funds. Such Explanation, therefore, changes the very complexion of the deductions which were available for years together and, thus, creates a levy with retrospective effect. The petitioner challenged such explanation, in particular, on the ground of retrospective operation of such amendment.

HC upholds the retrospective operation of amendment, and held as under:

1. The Explanation merely clarifies that deduction under section 80IA(4) would not be available in case of execution of works contract. Even without the aid of this explanation, it is possible to contend that an enterprise executing a works contract isn’t eligible to sec. 80-IA(4) deduction;
   
   
2. In view of the Gujarat HC verdict’s in the case of CIT v. Radhe Developers [2012] 17 taxmann.com 156 (Guj.), there would certainly be a demarcation between developing the facility and execution of works contract awarded by an agency engaged in developing such facility. From the inception, deduction is envisaged for development of infrastructure facilities with private participation;
   
   
3. The impugned explanation is purely explanatory in nature and doesn’t amend the existing statutory provisions, thus, the question of levying any tax with retrospective effect would not arise;
   
   
4. The explanation doesn’t restrict or aim to restrict the provisions of deduction. If it does so, certainly a question of reasonableness in the context of retrospective operation would arise. The Explanation only supplies clarity where, at best confusion is possible in the unamended provision. The revenue could, therefore, legitimately contend that no such deduction is available for mere execution of works contract. Thus, the present petition is dismissed – Katira Construction Ltd. v. Union of India[2013] 31 taxmann.com 250 (Gujarat)

Lord Shiva and Lord Hanuman are super natural powers and worshipping them isn’t a religion; Sec. 80G liberalized

Expenses incurred on worshipping of Lord Shiva, Hanuman, Goddess Durga and on maintenance of temple cannot be regarded as incurred for religious purpose.

In the instant case, the assessee-trust filed an application seeking approval under section 80G(5)(vi). The Commissioner took the view that the expenses incurred related to the religious object and since expenditure on religious object exceeded 5% of total income, he rejected application for approval under section 80G(5)(vi).

On appeal, the Tribunal held in favour of assessee as under:

1) Lord Shiva, Hanuman, Goddess Durga do not represent any particular religion, they are regarded as super natural powers of the universe;

2) Hindus consist of a number of communities having different Gods who are being worshipped in a different manner, different rituals, and different ethical codes. Even the worship of God is not essential for a person who has adopted Hinduism way of life. Thus, Hinduism holds within its fold men of divergent views and traditions who have very little in common except a vague faith in what may be called as the fundamentals of the Hinduism. Therefore, it cannot be said that Hinduism is a separate community or a separate religion;

3) Technically Hinduism is neither a religion nor a community. Therefore, expenses incurred for worshipping of Lord Shiva, Hanuman, Goddess Durga and for maintenance of temple cannot be regarded to have been incurred for religious purpose. Thus, the Commissioner was not correct, in law, in not allowing the approval to the assessee-trust under section 80G. Accordingly, the order of the Commissioner was to be set aside and the Commissioner was to be directed to grant approval to the assessee-trust under section 80G(5)(vi) - Shiv Mandir Devsttan Panch Committee Sanstan v. CIT [2012] 27 taxmann.com 100 (Nagpur - Trib.)

No embargo on TPO to search for any number of comparables as longs as he selects only relevant one

The provisions of Transfer Pricing do not fix any upper limit on no. of comparables that can be selected by TPO. Further there are no restrictions on the powers of TPO in carrying out fresh search for the relevant comparables 

In the instant case, the assessee was providing Information Technology Enabled Services (ITES) to the Associated Enterprises. TPO accepted 8 out of the 11 comparables of assessee. However, he felt that the number of comparables were insufficient. Consequently, he conducted a fresh search and added 22 comparables to the list of 8 and made TP adjustment. Assessee contended that TPO having accepted 8 comparables selected by assessee, he cannot search for fresh comparables.

On appeal, the Tribunal held as under:

1) Under the TP regulations, there is no embargo on the powers of the TPO in carrying out fresh search for gathering more relevant information, documents etc., while determining the ALP in relation to international transactions;

2) Assessee’s contention that TPO can not search for fresh comparables can’t be accepted as the sufficient number of comparables depends upon the facts and circumstances of the each case .There cannot be a fixed criteria or parameter for number of comparables, which can be universally applied to each and every case for determination of the ALP;

3) To get an adequate result and better representation, the size of sample must be large enough. The same rule is applicable in the case of number of comparables selected for representing the true and correct ALP in relation to the international transaction;

4) Under the Transfer Pricing Regulations, the number of comparables may be one or more than one, but there is no upper limit prescribed under section 92C of the IT Act;

5) However, the first proviso to section 92(2) indicates that more than one price can be considered for determination of ALP and in such a case, the ALP shall be taken to be arithmetic mean of such price. Therefore, the size of number of comparables has not been prescribed under TP Regulations provided under the IT Act; and

6) Where the number of comparables available is large, then it is always better to consider as many as possible number of comparables which can give an adequate and proper representation of the price prevailing in open market in the said industry, business, trade etc., to which the comparables and international transactions belong – Willis Processing Services (I) (P.) Ltd. v. Dy.CIT [2013] 30 taxmann.com 350 (Mumbai - Trib.)

In addition to the issue as discussed above, the Tribunal has dealt with following issues as well:

a) Whether merger and demerger of entities can be a ground for their exclusions from the comparables?

b) What should be the tolerable limit of related party transactions in comparables?

c) Whether loss making and high-profit making entities to be excluded from comparables?

d) Whether turnover criteria is relevant for exclusion of comparables?

Even retro amendment can't tax indirect transfer as it doesn't override tax treaties; HC follows Vodafone

Retro amendments made to overcome Vodafone's decision are fruitless exercises as the same do not contain a non-obstante clause to override treaty. Therefore, where a French company acting as an Investment vehicle transferred its interest in Indian concern to another French company, the transferor was not liable to any tax in India as per India-France DTAA

The facts of the case were as under:

a) L, Hyderabad was an Indian company and 80 per cent of its shares were held by French company S;

b) Company S was a JV between two French companies G and M. G and M sold their shares in S to another French company Sanofi;

c) G and M had applied for Advance Rulings to AAR regarding the taxability of capital gains in India arising out of sale of shares in S to Sanofi in terms of Article 14(5) of Indo-France DTAA;

d) AAR held that such deal was chargeable to tax in India. Hence, G and M filed separate writ petitions before the High Court challenging the ruling of AAR;

e) Sanofi was held as 'assessee in default' for non-deduction of TDS under section 195 from payment made to G and M. Hence, present writ petition was filed by Sanofi before the High Court.

The High court held in favour of assessee as under:

1) S is an independent corporate entity registered and resident in France and FDI in SBL is its commercial substance and purpose;

2) S was established as a Special Purpose Vehicle to facilitate FDI and to cushion potential investment risks of M and G on direct investment in L;

3) Uncontested assertion by petitioners that a higher rate of tax on capital gains (in comparison to what would have been chargeable in India) is payable in France and has been remitted to Revenue in France lends further support to the inference that S was not conceived, pursued and persisted with to serve as an Indian tax avoidant device;

4) Since Revenue failed to establish its case that genesis or continuance of S establishes it to be an entity of no commercial substance and/or that S was interposed only as a tax avoidant device, no case made out for piercing or lifting of the corporate veil;

5) Subsequent to the transaction in issue and currently as well, S continues in existence as a registered French resident corporate entity and as the legal and beneficial owner of L shares;

6) The transaction in issue clearly and exclusively is one of transfer of the entire shareholding in S by M/G in favour of Sanofi. Transfer of L shares in favour of S is neither the intent nor the effect of the transaction;

7) The Revenue's contentions that retrospective amendments by Finance Act,2012 would over-ride DTAA provisions deserves to be rejected for the following reasons:

a. The Finance Act, 2012 introduced GAAR provisions (sections 95 to 102) which override treaties in case of abuse of treaty provisions was proposed to be operationalized w.e.f 1-4-2014. Section 90(2A) inserted by Finance Act,2012 enables application of GAAR even if same is not beneficial to assessee;

b. In contra-distinction, retrospective amendments relied upon by Revenue-Explanation 2 to section 2(47) and Explanations 4 and 5 to section 9 are not fortified by a non-obstante clause to override tax treaties - Sanofi Pasteur Holding SA v. Department of Revenue, Ministry of Finance [2013] 30 taxmann.com 222 (Andhra Pradesh)

Testing services through machines are technical services, still not taxable as FTS as human intervention is missing

Merely because certificates have been provided by the humans after a test is carried out in a laboratory by automatic machines, it can’t be held that the services have been provided through the human skills. Such service is not “Fees for Technical Services”

In the instant case, the moot question that came up before the Tribunal was:
“Whether the payment made purely for standard facility provided by the Laboratory which is done automatically by the machines without any human intervention can be covered under the ambit of Fee for Technical Services”?

The Tribunal held in favour of assessee as under:

1) The expression “fees for technical services” has been defined as consideration for rendering managerial, technical or consultancy services. The word “technical” as appearing in the Explanation 2 to section 9(1)(vii)  is preceded by the word “managerial” and succeeded by the word “consultancy”. It can’t be read in isolation as it takes colour from the word “managerial and consultancy” between which it is sandwiched;

2) Managerial and consultancy services have to be rendered by human only and not by any means or equipment. Therefore, the word “technical” has to be construed in the same sense involving direct human involvement, without that technical services can’t be made available;

3) Where simply an equipment or sophisticated machine or standard facility is provided albeit developed or manufactured with the usage of technology, such a user can’t be characterized as providing technical services; and

4) One has to see whether any kind of human interface or human involvement is there for providing technical services. Merely because certificates have been provided by the humans after a test is carried out in a laboratory automatically by the machines, it can’t be held that services have been provided through the human skills - Siemens Ltd. v. CIT [2013] 30 taxmann.com 200 (Mumbai - Trib.)

Royalty paid by an NR to other NR can't be taxed in India if it arises from patent exploited outside India

The royalty in respect of license granted by a non-resident to another non-resident for manufacturing of CDMA handsets cannot be taxed in India even if these handsets are sold to Indian parties. The source of royalty would be deemed as the place where patent is exploited, viz, where the manufacturing activity takes place, which is outside India.

In the instant case, the appellant was a company incorporated in the USA and was engaged in development and licensing of CDMA technology. The appellant granted license to 'use and sell CDMA technology' to the unrelated Original Equipment Manufacturers ('the OEMs'), who were non-resident and were located outside India, in consideration for royalty. The licenses granted by the appellant to the OEMs were used for manufacturing of handsets and network equipments, which, in turn were sold to various parties located outside India and in India. In respect of taxability of its income in India, the appellant contended that the royalty income earned by it from the OEMs of CDMA mobile handsets and network equipments sold in India was not taxable in India either under Section 9(1)(vi)(c) of the Act or under Article 12(7)(b) of the India-USA DTAA.

Deliberating on the issue, the Tribunal held in favour of assessee as under:

1) The license to manufacture products by using the patented intellectual property of the appellant had not been used in India as the products were manufactured outside India and when such products were sold to parties in India it couldn't be said that OEMs had done business in India;

2) Sale in India without any operations being carried out in India would amount to business with India and not business in India;

3) No patents of the appellant had been used for customization of handsets;

4) The role of appellant ended when it licensed its CDMA technology for manufacturing handsets and when it collected royalty from OEMs on these products;

5) There was no finding that the OEMs had carried on business in India or a part of the sale consideration was attributable to any sale or licensing of software carried out in India. When OEM's itself were not brought to tax, to hold that the appellant was taxable was not correct;

6) The source of royalty was the place where patent was exploited, viz, where the manufacturing activity took place, which was outside India. Hence, the Indian parties would not constitute source of income for the OEMs; and

7) The software was only used with the hardware and was not independent of the equipment or the chipset. Since no separate consideration was paid by Indian parties for licensing of the software and the consideration was paid only for the equipment which had numerous patented technologies, the sale couldn't be bifurcated or broken down into different components.

Thus, the royalty earned by the appellant couldn't be brought to tax in India under Section 9 of the Act or Article 12 of the India-USA DTAA - QUALCOMM INCORPORATED v. ADIT [2013] 30 taxmann.com 30 (Delhi - Trib.)   

Commission as envisaged under Section 194H doesn’t require principal-agent relationship, ITAT rules

TDS under section 194H attracted so long as payment is in the nature of brokerage or commission; Section 194H does not require that relationship between the payer and the payee be necessarily of a principal and agent

Depreciation is not an outgoing expenditure but a statutory deduction.  Therefore, the provisions of section 40(a)(i) are not attracted on such deduction

In the instant case, the moot questions raised before the Tribunal were as follows:
1) Whether Sec. 194H can be invoked in a situation where principal-agent relationship amongst parties is missing?

2) If payment to NR is capitalized in books of accounts and depreciation thereon is being claimed by assessee, whether the depreciation can be disallowed by invoking Sec. 40(a)(ia)?

On first Issue, the Tribunal held in favour of revenue as under:

1) Section 194H talks about the payment to a recipient which is the income by way of commission or brokerage.

2) It does not require that the relationship between the payer and the payee should be of a principal and agent.

3) The Explanation to section 194 elaborates on the terms ‘commission or brokerage’ by including any payment received or receivable directly or indirectly by a person acting on behalf of another person.

4) Thus, it is clear that the provisions of section 194H do not require any formal contract of agency.

On Second issue, the Tribunal held in favour of assessee as under:

1) The deduction under section 32 is not in respect of the amount paid or payable which is subjected to TDS;

2) Depreciation is a statutory deduction on an asset which is not an outgoing expenditure.  Therefore, the provisions of section 40(a)(i) are not attracted on such deduction;

3) Therefore, where payment, which has been made without deduction of TDS, has been capitalized as part of cost of asset, depreciation in respect of such payment can’t be disallowed by invoking section 40(a)(i) - SKOL Breweries Ltd. v. ACIT [2013] 29 taxmann.com 111