First Report of The Committee To Review Taxation of Development Centres and The IT Sector

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First Report of the Committee to Review Taxation of Development Centres and the IT Sector
Foreword
The Committee setup by the Government to examine some of the issues relating to taxation of income of
persons engaged in the IT sector is glad to furnish its first report on some of these issues. Its report on the
other issues will follow in due course.
While furnishing this report, I must duly acknowledge the role played by its members, namely, Ms. Anita Kapur,
DGIT (Administration), Delhi, Ms. Rashmi Saxena Sahni. DIT (Transfer Pricing-l), Delhi and Mr. Dinesh Kanabar,
Tax Expert in analyzing the various data and showing a rare commitment and devotion.
I must also acknowledge with gratitude the important role played by the two senior officers of the
Department, namely Shri D. Prabhakar Reddy and Shri Sobhan Kar, Addl. Commissioners of Income Tax, in
assisting the Committee in its deliberations and bringing into consideration relevant issues from time to time.
N. Rangachary,
Chairman
14th September, 2012
PART 1: INTRODUCTION
1.1 Prime Minister's Office issued a press release on July 30, 2012 (Annexure -1), stating that the Hon'ble
Prime Minister had constituted a Committee to Review Taxation of Development Centres and the IT Sector
under the Chairmanship of Mr. N Rangachary, former Chairman CBDT & IRDA. The press release also
underlined the following grounds for seeking resolution of tax issues through an arm's length exercise in the
form of a review by the Committee:
• There is a need to address issues relating to the taxation of the IT Sector such as the approach to taxation
of Development Centres, tax treatment of "onsife services" of domestic software firms, and also the issue of
finalising the Safe Harbour provisions announced in Budget 2010.
• The reason for large concentration of Development Centres in India is the worldwide recognition of India as
a place for cost competitive, high quality knowledge related work. Such Development Centres provide high
quality jobs to our scientists, and indeed make India a global hub for such Knowledge Centres. However, India
does not have a monopoly on Development Centres. This is a highly competitive field with other countries
wanting to grab a share of the pie. There is need for clarity on their taxation.
• Safe Harbour provisions announced in Finance Bill 2010 but yet to be operationalised have the advantage of
being a good risk mitigation measure and provide certainty to the taxpayer.
• A comprehensive approach involving consultations with the Government departments concerned and the
industry bodies is required.
• The overall goal is to have a fair tax system in line with best international practice, which will promote
India's software industry and promote India as a destination for investment and for establishment of
Development Centres.
1.2 The press release indicated the following terms of reference and the time lines for the Committee
Terms of Reference:
i) Engage in consultations with stakeholders and related Government departments to finalise the approach to
Taxation of Development Centres and suggest any circulars that need to be issued.
ii) Engage in sector-wide consultations and finalise the Safe Harbour provisions announced in Budget 2010
sector-by-sector. The Committee will also suggest any necessary circulars that may need to be issued.
iii) Examine issues relating to taxation of the IT sector and suggest any clarifications that may be required.
Time Lines:
i) Finalise the approach to taxation of Development Centres and suggest any necessary clarifications by
31August 2012.
ii) Suggest any necessary clarifications that may be needed to remove ambiguity and improve clarity on
taxation of the IT Sector by 31 August 2012.
iii) Finalise Safe Harbour Rules individually sector-by-sector in a staggered manner and submit draft Safe
Harbour provisions for three sectors/sub- activities each month beginning with the first set of suggestions by
30 September 2012. All Safe Harbour provisions can be finalised by 31 December 2012.
1 .3 The Committee was formally notified through an Office Memorandum of Department of Revenue, dated
03-08-2012 (Annexure-II), with the following members:
i. Shri N. Rangachary, former Chairman, CBDT and IRDA -Chairman
ii. Ms. Anita Kapur, DGIT (Administration), -Delhi - Member
iii. Ms. Rashmi Saxena Sahni, DIT (Transfer Pricing-I), Delhi - Member
iv.Shri Dinesh Kanabar, Tax Expert - Member
1.4 The Committee sought and was provided assistance of two officers, namely, Shri D. Prabhakar Reddy,
Addl. Commissioner of Income Tax, TPO-Il(6), Mumbai and Shri Sobhan Kar, Addl. Commissioner of Income
Tax (APA), Delhi vide CBDT order No 154 dated 7th August, 2012 (Annexure-III).
1.5 The time limit of August 31, 2012 for submission of recommendations of the Committee on issues other
than Safe Harbour was, with the approval of the Finance Minister, extended to 15th Sept. 2012.
1.6 The rationale for setting up the Committee was, inter olio, reiterated in the Press Note issued by the
office of Hon'ble Finance Minister, Shri Chidambaram on August 06, 2012 (Annexure-IV). The relevant part is
extracted below:
"Clarity in tax laws, a stable tax regime, a non-adversarial tax administration, a fair mechanism for dispute
resolution, and an independent judiciary will provide great assurance to investors. We will take corrective
measures wherever necessary. We have recently appointed two Committees, one to examine GAAR legal
provisions and guidelines and the other to review taxation of the IT sector and Development Centres. I have
also directed a review of tax provisions that have a retrospective effect in order to find fair and reasonable
solutions to pending as well as likely disputes between the Tax Departments and the Assessees concerned.
With these measures, and some other measures that we hope to take in the short term, it is our intention to
raise the level of investment to 38% of the GDP that was achieved in 2007-08."
1.7 Further, FT & TR Division of CBDT through Office Memorandum dated 8th August, 2012 (Annexure-V),
advised the Committee that the Hon'ble Finance Minister had approved the suggestion that the issue of
application of Global Profit Method to determine arm's length price of intangibles developed by the R&D
centres of MNEs in India may be considered by the Committee.
1.8 Interaction with the stakeholders
The Committee sought written comments from the following Departments of the Central Government,
industry stakeholders and accounting firms:
i. Department of Electronics & Information Technology (DoE & IT)
ii. 'Department of Commerce (DoC)
iii Department of Economic Affairs (DEA)
iv. Department of Industrial Policy & Promotion (DIPP )
v. Central Board of Direct Taxes (CBDT)
vi. Central Board of Central Excise and Customs (CBEC)
vii. NASSCOM (National Association of Software and Service Companies)
viii. CII (Confederation of Indian Industry)
ix. FICCI (Federation of Indian Chambers of Commerce and Industry)
X. ASSOCHAM (Associated Chambers of Commerce and Industry of India)
xi. PHDCCI (PHD Chamber of Commerce & Industry)
xii. ICAI (Institute of Chartered Accountants of India)
xiii. PWC (Price Waterhouse Coopers)
xiv. E&Y (Ernst & Young)
xv. Deliotte Haskins & Sells
xvi. KPMG
xvii. BMR Advisors
xviii. Khincha and Khincha, Bangalore
xix. T. P. Ostwal & Associates, Mumbai
xx. Vaish & Associates, Delhi
xxi. Vispi T. Patel & Associates, Mumbai
1.9 The Committee received written submissions from most of the above stakeholders. The Department of
Electronics & IT primarily supported the position of NASSCOM on various issues. The Department of
Commerce generally sought uniform, predictable and fair application of the tax laws apart from supporting
some beneficial construction of incentive provisions in respect of certain contentious issues e.g "onsite
service", shifting of employees to new unit and MSA vs. SoW.
1.10 The Department of Economic Affairs informed that they had no comments to offer.
1.11 In addition to that, the Committee also received written suggestions/comments from the following:
i Shri N.R.Narayana Murthy, Chairman Emeritus, Infosys (forwarded by Department of Revenue)
ii. American Chamber of Commerce (Amcham)
iii. Baker & McKenzie representing the Software Coalition
iv. Sonata Software Ltd.
v. Coalition on International Taxation in India
1.12 An interactive session was conducted on 19th August, 2012 with the following business/industry
chambers:
i NASSCOM
ii. FICCI
iii. ASSOCHAM
1.13 An interactive meeting was also held on 3rd September, 2012 with the following officers of the Income-
tax Department/CBDT to ascertain the views of the Revenue:
i Chief Commissioners of Income-tax (CCA), Bengaluru, Chennai, Delhi, Hyderabad and Mumbai.
ii. Director General of Income-tax (International Taxation), Delhi
iii. Joint Secretaries (FT & TR-I and II), CBDT
iv. Commissioner of Income-tax (ITA), CBDT
1.14 Another round of consultations was held by the Committee with the following business/industry
chambers on 12th September, 2012:
i. NASSCOM (including E&Y)
ii. CII (including Microsoft, Yahoo India, Wipro, Deloitte Haskins & Sells and Amarchand Mangaldas)
iii. ASSOCHAM (including PWC)
iv. FICCI
1.15 After going through the representations received from the various stakeholders and giving due
consideration to the perspective of the Revenue, the Committee identified certain critical issues affecting the
industry for its first report on which action can be taken immediately.
1.16 Approach of the Committee:
1.16.1 The approach of the Committee was driven by its commitment to be objective and just. The
Committee has attempted to address the issues posed to it by suggesting clarifications that interpret the
existing legal provisions. When the interpretations canvassed by the Revenue and the other stakeholders were
divergent but equally well argued, the Committee has opted to support an interpretation that is fair to the
taxpayer and provides reasonable resolution of contentious issues.
1.16.2 The Committee has refrained from examining the issues raising questions about the logic and
rationale of the extant provisions of the Income Tax Act and seeking amendments thereto, as the Committee
is not mandated to review the law.
1.17 Thus, this first report covers key concerns, as highlighted by the stakeholders, relating to taxation of
Development Centres (DCs) as well as taxation issues of the IT Sector and completes the response of the
Committee to the first two terms of reference. Finalisation of Safe Harbour rules for certain sectors including
DCs, requires detailed data analysis and the Committee will respond to this matter in its subsequent reports.
PART 2: FIRST TERM OF REFERENCE - APPROACH TO TAXATION OF DEVELOPMENT
CENTRES (DCs)
Background
2.1 Inter-group pricing arrangements between related business entities including transfer of tangible
goods/intangibles/services or lending or borrowing money etc, fall within the ambit of Transfer Pricing.
Comprehensive Transfer Pricing (TP) legislation was introduced in India w.e.f. 01-04-2002.
2.2 Eight TP audit cycles have been completed and the transfer pricing adjustments made are as follows':
Financial year Number of TP Number of % of adjusted Amount of

Audits completed adjustment cases cases adjustment (lNR 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."
2.4 Transfer pricing is not an exact science. It is both fact intensive and fact sensitive and does require
exercise of judgment on the part of tax administration and taxpayer. Administration of TP provisions relating
to transfer pricing documentation, comparability analysis, choosing and, applying most appropriate method to
determine arm's length price, continues to generate litigation.
2.5 Development Centres (DCs) are an important segment in the R&D ecosystem as per the research
findings of the Industry stakeholders summarised in the Appendix A.
2.6 Broad Concerns Flagged by the Industry Stakeholders

i . Clarity in tax laws and stability of the tax profile offered by a country is a significant differentiating factor for
investors to commit investment.
ii. The cost associated with protracted litigation, huge compliance burden, and huge capital being locked up in
tax disputes is forcing MNC centres to revisit their Indian strategy.
iii . In order to ensure that India maintains its competitive advantage over other developing economies, all
vying for Foreign Direct Investment (FDI), tax policies with respect to R&D centres must ensure that the cost
of undertaking R&D in India does not increase to an extent that makes it unviable for MNCs to undertake R&D
work in India.
2.7 Specific Issues
i. Work carried on by the Development Centres (DCs)
ii. Application of Most Appropriate Method
iii General transfer pricing issues which are not specific to the DCs/IT Sector
2.8 Work carried on by the Development Centres (DCs)
2.9 Views of the Industry
2.9.1 The software development life cycle involves various stages like envisioning, planning, designing,
developing, testing and deploying. The software life cycle begins when an application is first conceived and
ends when it is no longer in use. It includes aspects such as initial concept, requirement analysis, functional
design, internal design, documentation planning, test planning, coding, document preparation, integration,
testing, maintenance, updates, retesting, phase-out, and other aspects. Software life cycle models describe
phases of the software cycle and the order in which those phases are executed. The stages of Software
Development Cycle, using the simplest model, which are based on sequential phases, are as follows:
i. Envision & Plan
ii. Design
iii. Develop
iv. Test
v. Deploy & Maintain
i. In the Envision and Plan stage, a clear definition of the customer problem is identified by gathering the
business requirements. This stage is essential to understand the purpose, requirements, required
functionality, system environment, output and such other critical factors. In this stage the functionality of the
software such as what the software should perform, business logic that processes data, what data is stored
and used by the software, and how the user interface should work is decided. Various scenarios to help guide
the development team in developing a solution are framed. Product architecture defining the components of
the offerings, their relationships and dependencies, the overall design strategy, and resource requirements are
finalized in this stage.
ii In the Design phase, a value proposition and a product prototype are developed by a software developer
based on the results of the Envision and Plan stages, customer feedback from the previous product version,
surveys, competitive analysis, the product leader's vision for the future and an overall vision for the product
category. The software design and its architecture (hardware and software) are the deliverables of this stage.
iii. The Develop stage includes working on requirement activities, implementation activities and verification
activities. The entire work project is broken into several modules/ program, each of which is independently
developed and coded based on the requirements and the specifications. This phase of software lifecycle may
be performed simultaneously and may overlap with part of the design and testing phases. Documentation of
the internal design of software for the purpose of future maintenance and enhancement is done throughout
development.
iv. In the Test stage, the products and offerings are integrated and tested before delivering the end
product/service to the customers. Testing such as system testing to validate the software product against
the requirement specification, unit testing to check performance of specific components of the system,
recovery testing, security testing, stress testing, and performance testing etc. are carried out to verify the
integration and performance of all system elements. Any debugging or minor modifications over the product,
if required, are made under this stage. In this stage, the customer may also conduct acceptance testing
according to the acceptance test plan prepared by the customer to determine whether or not the system
satisfies its acceptance criteria.
v. In the Deploy stage, all of the activities that make a software system available for use are undertaken.
Beginning with the installation of a pilot to analyze the initial functioning of the system, the software will then
be completely deployed at the customer site. The deployment activities include activities pertaining to
release, installation, uninstallation, activation, deactivation, adaption, updation and retirement of the offerings.
An integral part of deployment is ensuring smooth functioning of the software by fixing any defects and
providing regular maintenance activities.
2.9.2 NASSCOM has indicated the following three types of contractual structures as being prevalent in India:
CONTRACTUAL STRUCTURES
Contracted Development Cost Sharing/ Contribution Entrepreneur
• Parties of service provider and • Parties agree to form partnership •The company undertakes the R&D
service recipient have contractual to pool respective IP and share on its own account and bears full
agreement risk and reward from future R&D risk and reward from future
• Service provider has no • Both parties contribute IP or R&D
ownership/ rights on IP associated share the costs thereof and have • The company bears the costs of
with work product; does not joint ownership of any IP R&D and has ownership of IP
contribute any IP either. developed going forward developed
• Service recipient assumes all • Parties jointly share the • The company enjoys the profits
risks associated with work product risks, in their cost sharing ratio associated with the IP developed
• Service provider is generally • Parties agree to jointly
compensated on commercial share the profits associated with
basis (hourly/ lump sum for 3rd the IP developed, as per mutually
party, and cost plus for internal) negotiated terms
Generally, preferred model for the Generally, preferred model for Generally, preferred model for
IT industry (software and enabled Pharma, Biotech and similar Pharma, Biotech and similar
services) 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, enhancement, maintenance and
protection of the intangibles are entirely controlled and performed by the principal R&D Company. Risks and
control of the costs relating to development, protection and maintenance of intangibles are also completely
borne by the principal R&D Company.
2.9.5 Some portions of each of these activities are carried on from India (Offshore) and other portions at the
site of the customer or at the headquarters of an MNC (Onsite). The proportion of onsite to offshore work for
each stage may differ from development centre to development centre.
2.9.6 An overwhelming majority of captive R&D Development Centres in India and the Principal R & D
company have the following functional profile, in relation to the IT Development centres rendering contract R
& D services:
a) Principal R & D company is responsible for the overall research programme and funds the entire cost of R &
D including a service fee to Development Centre and allocates budgets to various researchers
b) Principal R & D company designs research programmes, makes decisions as to where R & D activities will
be conducted, and regularly monitor the progress on all R & D projects.
c) Principal R & D Company controls the R & D function for the MNE group and the R & D programme of the
group operates under strategic direction of Principal R & D company senior management.
d) Contracts between the principal R & D Company and Development Centre specify that principal R & D
Company will bear all risks and costs related to R&D undertaken by Development Centre.
e) All patents, designs and other intangibles developed by Development Centre research personnel are
registered by principal R&D Company, pursuant to contracts between the Development Centre and principal
R&D Company.
f) Personnel of Development Centre may be involved in planning and design by virtue of giving suggestions
for modifications to the research programme and such suggestions are required to be reviewed and approved
by the principal R&D Company.
2.9.7 For a member of an MNE group to be entitled to intangible related returns, it should in substance-
i. Perform and control important functions related to the development, enhancement, maintenance and
protection of the intangibles and control other related functions performed by independent enterprises or
associated enterprises that are compensated on an arm's length basis;
ii. Bear and control the risks and costs related to developing and enhancing the intangible; and,
iii. Bear and control risks and costs associated with maintaining and protecting its entitlement to intangible
related returns.
2.9.8 In the cases of captive R&D centres operating in India, it is not only that the legal and economic
ownership lies with the overseas principal R&D Company, but it also has to be appreciated that any work
product, the patent registration, etc. if any, based on contribution by India cannot be commercially exploited
on a standalone basis because its contribution to the overall value chain is insignificant. Such patent
registration is only to safeguard the legal rights of the principal against infringement of IP (by competitors),
however insignificant these rights be. The principal makes decisions with respect to the following:
• Hiring/Terminating services of contract researcher
• Type of research to be carried on and assigning objectives
• Budget to be allocated for research
• Assessing outcome of the research test, review & evaluate results
• Setting stage for decision making
2.10 View of Revenue 2
2.10.1 The DCs in India are engaged in R&D activities for development of new product (including software
development) and services, development of design and development of part of product or services which go
as input to final product/services being developed by parent company.
2.10.2 These research and development activities may be classified into two categories:
✓ Primary function of R&D activity is to develop new product/services or inputs.
✓ Other function is to discover and create new technology, design, methodology, for development of new
product, process and services.
2.10.3 The models of R&D differ significantly. However, R&D is intended to yield immediate profit or
immediate improvement in operations and involves little uncertainty in so for as the return on investment is
concerned. The new product development (services, design and inputs) is a crucial factor in survival of the
group because nowadays products/services are changing so fast that it requires continuous revision or
development of design, products and services. Accordingly, the R&D activities are core to the survival of the
group in the competing market.
2.10.4 Different companies adopt different models and type of R&D activities and ratio of research and
development spending to the revenue varies significantly. High R&D expenses are justified in the light of
consequent high gross margins varying from 60 to 90%.
2.10.5 The categorization of off-shore development centres in India may be on the basis of type, model and
nature of R&D activity and reason and benefit of off-shoring. It may be very difficult to make exact groupings
of R&D development centres because of above parameters which may vary from one industry to another
industry segment in each country.
2.10.6 Analysis of the conduct of the parties is more important than the written contract.
2.10.7 The contract development structure as mentioned in NASSCOM presentation will need further
examination by analyzing actual contract in case of entities engaged in R&D activities, product and services
development, design development etc. It may be seen from presentation that NASSCOM has admitted that
services provider also bears the risk of R&D activities in case of contracted R&D and is not a risk free entity.
Accordingly, the remuneration model will vary from case to case depending upon FAR analysis.
2.10.8 A sample analysis in a 2007 in-house report of the tax department noted significant variations in the
PLI margins of the taxpayers accepted by the Department in the Software/ITES sectors.
2.10.9 Contractual agreements vary with the companies and it may be difficult to construct a homogenous
group on the basis of contractual agreement.
2.10.10 Grouping of off-shore development centre would require a more detailed study and broad
categorization as suggested by NASSCOM on the basis of an assumption that all contracts for R&D activities
are same will generate more litigation.
2.10.11 Decision of creating groups in one industry segment and corresponding margins may be examined in
light of international standard and
practice because if such grouping and margin are not acceptable to a country which is a party to international
transaction, it will increase the cases of double taxation.
2.11 Recommendations of the Committee:
The Committee has responded to the relevant issues in the context of the discussion on the application of
Most Appropriate Method.
2.12 Application of Most Appropriate Method
2.13 Views of the Industry:
The stakeholders highlighted the following position to argue in favour of TNMM/cost plus mark up methods:
2.13.1 Indian R & D Centres of MNCs are entitled only for appropriate cost-plus return for the contract R & D
work performed and not entitled to any intangible related returns.
2.13.2 In a scenario where
• the principal R & D company bears the risk of failure of the research and will be the owner of the outcome;
• the contract researcher is paid a guaranteed remuneration irrespective of the outcome of the research;
• the principal R & D Company makes a number of relevant decisions in order to control its risks,
it would be a typical case for only the principal R & D Company to be entitled to all the intangible related
returns and the Development Centre be compensated on a total cost plus basis. A large majority of R & D
centres operating in India today would be covered under the fact pattern discussed above. Transactional Net
Margin Method would be the only appropriate transfer pricing method to benchmark the transaction of
rendering services by Development Centres to the Principal R & D Company with appropriate mark-up on cost.
2.13.3 Application of PSM requires exceptional circumstances, for example
i. where an MNC undertakes the R & D under a cost contribution arrangement- Under such an arrangement, all
the parties contribute costs and resources and jointly undertake R & D and share the risks and rewards of
such R & D. In this arrangement, the participants in the R & D process get part of the legal and economic
rights in the intangibles and hence the participants would be entitled to intangible related returns. It is a
possibility that some of these arrangements may entail a PSM for compensation to all the participants ;or
ii where the principal is located in tax havens/tax shelters with no significant functions performed or
decisions taken outside India.
2.13.4 Application of PSM by India will increase the overall cost of undertaking R & D work in India though
the quantification for the some would depend on varied factors. Also, the lifecycle of an R & D program tends
to be long (average lifecycle of an R& D program exceeds two years) with new programs starting regularly.
Thus, an MNC looking to setting-up an R & D centre would seek a greater degree of certainty of the tax policy
applicable in order to meet its long-term objectives. It is therefore imperative that transfer pricing policies for
R & D centres in India are carefully and pragmatically implemented keeping in view that India would like to
retain its competitive edge.
2.13.5 The complex transfer pricing issues need better understanding of the larger R & D program of an MNC
and a careful study of the functional analysis in most cases would reveal that cost plus method would be
applicable. Both taxpayers and tax authorities need to work together to ensure that this understanding
increases quickly. In the meantime, the tax authorities need to resist the temptation of using PSM on a
generalized basis to drive revenue collection when indeed the some would be grossly incorrect for most
contract R & D arrangements in India today.
2.14 Views of Revenue
2.14.1 The position of Revenue as per the presentation made by JS, FT & TR-I, CBDT during the meeting on
3rd September, 2012 before the Committee, is summarised below:
• Off-shoring is no longer limited to standardized information and technology but increasingly involve
product development function (engineering, R&D) and product design;
• Distinction between home-based and foreign-based development centres has disappeared;
• These DCs are transferring labour, skill and innovation to another country;
• There is transfer of intellectual property and these DCs are unaware of the value they are exporting;
• The FAR i.e. Function, Asset and Risk Profile of a DC will depend on nature, business model, reasons and
benefits of off shoring;
• Functions, Assets and Risks are equally important;
• Since risk is a by-product of functions performed and usage of assets, it should be considered together with
functions and assets;
2.14.2 During discussions, JS (FT & TR-I) emphasised that-
• the difference between controllable and un-controllable risks needs to be distinguished;
• business model, nature, reasons and benefits of off-shoring are important factors in determining allocation
of risks;
• various factors that are to be seen while determining the entity controlling a risk are core functions, key
decisions, level of individual responsibility, etc;
• the most appropriate method will vary with the functional profile of the Development Centre and there
cannot be any straitjacket formula for applying cost plus method / TNMM
• undue emphasis on risk, without realizing that the risk is a by-product of function and asset, may give wrong
results;
• risk is located where the functions and assets are located. However control over risk may be divided
between parties. Location savings and location rents also need to be considered.
2.14.3 Further, he asserted, that Offshore Development Centres in India are developing significant intangibles,
known by the application for patents filed from India in US and other countries. These are valuable and unique
as it can be seen from Indian Patent Act, 1972 that only those inventions, which are valuable and unique, can
be patented. Further Indian TP regulations justify the application of PSM when intangibles are involved. The
example of patent battle between Samsung and Apple in which Apple won the legal battle in USA for a $1
billion payout from Samsung demonstrates the value of patents.
2.14.4 Thereafter, in his comments sent by e-mail, he emphasised that the Issue of attribution of global profit
under profit split method needs a careful scrutiny in order to understand extent of the problem. The number of
adjustment under profit split method will give some idea about this problem. If problem were confined
restricted to one or two companies, then it would be easier to examine reasons of such adjustment and to
suggest a solution.
2.15 Recommendations of the Committee
2.15.1 The Committee has noted that
TNMM is the methodology adopted by the Revenue for benchmarking for Contract DCs, till date, except
in two cases in Delhi, where PSM (Profit Split Method) was applied. In one case, DRP deleted the
application of PSM for the AY 2007-08 and reserved the right to apply PSM, if the facts and
circumstances so warrant in future. In this case for the AY 2008-09, the TP adjustment was arrived at
by adopting TNMM as the most appropriate method due to data inadequacy. In the second case, the
TPO adopted PSM for determining ALP, for the AYs 2007-08 & 2008-09, on the ground that unique
intangibles were transferred. In this case, DRP confirmed the approach of the TPO for the AY 2007-08
as the taxpayer was not able to produce data and supporting evidence, within the time available to the
DRP, to demonstrate that any method other than PSM should be applied on the facts and
circumstances. In respect of AY 2008-09, the proceedings are pending as on date.
In one case for A.Y. 2008-09 the taxpayer has applied PSM as the activities performed by the taxpayer
and its affiliate were claimed to be inextricably linked with both entities contributing significantly to the
value chain. However, considering the facts of the case, the TPO applied TNMM.
Whenever industry refers to cost-plus or appropriate mark-up on cost, reference is to profit margin
under Transactional Net Margin Method on cost. While applying TNMM on captives, the profit margin is
computed on the cost, excluding interest and tax. As most of the captives follow cost plus business
model, all the costs (before interest and tax) are reimbursed by the principal, with certain agreed mark-
up. The costs that are considered (before interest and tax) for applying TNMM for the captive and the
comparables also form the cost base for reimbursement by the principal. Thus, as per industry,
appropriate mark-up on costs, in effect refers to the appropriate operating margin under TNMM and
cost plus method referred by the industry, in effect is TNMM under the Income Tax Act.
The characterisation of Research and Development function can broadly be in three baskets, i.e., -
Full risk bearing developer
Limited risk bearing developer
Contract R & D service provider with no significant risks
2.15.2 The Committee acknowledges that the Industry stakeholders have unanimously agreed that most of
the captive DCs in India were Contract R & D service providers with no significant risks. The Committee has,
therefore, focussed on suggesting approach to taxation of such DCs only. The full risk bearing Developers
(who are Entrepreneurs) and limited risk bearing Developers (who follow cost sharing/contribution models)
need a case specific FAR and no general guidance can be given for such cases.
2.15.3 The Committee recommends that if the activities carried on by a DC in India meet the following
parameters (cumulatively), it will be treated as Contract R&D service provider with insignificant risk and
TNMM supported by appropriate cost plus mark up may be the most appropriate method for arriving at
the arm's length price for the services rendered by such DC:
The critical functions with regard to overall product development lifecycle, including particularly
conceptualization and design for the product is driven by the foreign principal. The Indian DC would
largely be involved in the actual development, implementation or maintenance of specific features or
portions of the product, with limited inputs on design as necessary, within the strategic direction /
framework provided by the foreign principal.
The principal provides funds/capital for research. The principal bears the risk of failure of the research
and will be the owner of the outcome of the research in case of success, while the contract researcher
is allocated a guaranteed remuneration irrespective of whether the research is a success or a failure.
The DC is required to report back to the principal on a regular basis, e.g. at predetermined milestones.
The principal is expected to be able to assess the outcome of the research activities. Any suggestion to
the modification of the research programme by the DC is subject to the review and approval by the
foreign principal who makes the relevant decisions to control the risks.
The DC does not assume risks or has Insignificant realised risk such as market risk, business risks,
economic conditions risk, credit & collection risk, capacity utilisation risk, quality risk product / service
acceptance risk, product development risk, infrastructure utilisation risk, intellectual property
infringement risk.
The entirety of the product life cycle and / or software development life cycle is not undertaken by the
Indian DC.
The contract researcher DC has no right to ownership on the outcome of the research. The rights in the
developments contractually vest since inception with the foreign principal and the registration of any IP
arising from such development is made by the foreign principal. Involvement of the Indian personnel to
comply with filing requirements, without any underlying rights in the exploitation by the Indian
personnel and / or by the Indian DC, is evident from the employee contract and / or contract between
DC and its foreign principal.
The patent registration cannot be commercially exploited on a standalone basis because its
contribution to the overall value chain is insignificant. R.t
The terms and conditions regarding ownership of intangibles would have been similar if the activities
carried on by a DC were or could have been outsourced to a third party DC.
2.15.4 Contract between the principal and the DC is a relevant factor but not the determinant factor. Conduct
of the affiliate DC should be consistent with the contractual terms with the Principal. For example, if a
contract shows the principal to be controlling the risk but conduct shows that affiliate is doing so, then the
contractual terms are not the final determinant of actual activities. In the case of foreign principal being
located in a country /territory widely perceived as a tax haven, it will be presumed that the foreign principal
was not controlling the risk. However, the taxpayer may rebut this presumption to the satisfaction of the
revenue authorities.
2.16 Additional Term of Reference:
"The issue of application of Global Profit Method to determine arm's length price of intangibles developed by
the R&D centres of MNEs in India may be considered by the Committee"
2.16.1 The Income Tax Act read with Rule lOB (i) (d) (extracted below) stipulates that transfer of unique
intangible requires application of PSM:
"Profit split method which may be applicable mainly in international transactions involving transfer of unique
intangibles or in multiple international transactions which are so inter-related that they cannot be evaluated
separately "
2.16.2 The Committee recognises the following practical difficulties in the application of a profit split method
(PSM) in cases of DCs engaged in contract R&D services:
Determination of unique contribution in an integrated product is a major challenge in R&D services.
The main problem is faced in identifying the profits arising from the controlled transactions. The
foreign principal determines the product in which the outcome of the research is to be used and knows
as to how and to what extent that research will add value to the product. This information is important
as valuation of intangibles is highly volatile and every R&D activity may not lead to creation of an
intangible For example, in respect of captive R&D centres in India, the data on the combined profit
earned by MNC arising out of the products sold, which are arising out of the R&D activities carried on
India or for that matter any other DC anywhere in the world, is difficult to obtain.
Also, one would need a cross border functional analysis and an ability to verify the accuracy of the data
sitting across various locations.
The availability of data is thus a significant challenge and one therefore has to apply PSM making
various assumptions, which could skew the results and lead to incongruous results. For example
assumptions underlying the choice of an allocation key can bring in subjectivity and vitiate the results.
As getting relevant data to determine profit from the controlled transactions is not easy, use of PSM on
some allocation key may lead to claims for splitting the global loss also if the R&D effort globally does
not yield desired results. This can cause attribution of losses to the activities by the DC even in
situation where the research done by DC is successful
PSM is a highly subjective method, as it requires a subjective analysis of the contributions made by the
controlled parties to an intangible asset and its implementation is often not measurable by specific
reference to objective data. The contribution analysis can sometimes be hard as the more integrated
the company group structure is, the harder it can be to disentangle the underlying contributions and
identify the actual performer. Moreover, if different valuable intangible assets are contributed by more
than one associated company, it gets even more difficult to attribute values.
2.16.3 The Committee has also taken note of the fact that HMRC, UK has recognised the following problems
in application of PSM while issuing the guidance in applying PSM4
i. There is a difficulty in isolating the controlled transactions and establishing what functions add value along
the product chain.
ii. The profits that are to be split should be based as for as possible on projected figures for sales and costs
that were available at that time (replicating the probable negotiation process between two independent
parties). This can potentially involve trying to estimate how a product is going to perform over a number of
years.
iii. The potential for affiliates to produce any valuable intangibles has to be carefully examined, along with
risks of the R & D producing nothing.
2.16.4 HMRC has also discussed how the cost of developing the intangible has only an indirect link to the
value of intangibles. The relevant portion of the guidance is as follows:
"The expense of discovering and developing valuable intangibles has no direct relation to the price of
products manufactured and sold using that technology. If the R & D programme cost £100 million, the
products will rarely be priced directly to try and recoup those costs over say the next 5 years. There is of
course an indirect link; a business will bear in mind the costs of its current R & D programmes for future
products, and what it would like to spend on that R & D in the future, but the pricing of goods and services is
subject to a very complex interaction of many commercial factors. While a revolutionary new product will no
doubt attract a premium price in some markets, there is generally a limit on what people are prepared to pay".
2.17 Recommendation of the Committee:
A proper application of PSM would necessitate the availability of adequate and reliable data with regard to
profits attributable to various functions, risks, geographies etc. As a result, one has to apply PSM with
extreme care and caution and the lack of data at present makes it impracticable to apply PSM. Thus
application of PSM, where appropriate technically given the general facts of a case, may become inaccurate
due to lack of availability or supply of complete data. In these circumstances, it may be appropriate for India
to seek for a higher mark-up under TNMM, possibly also factoring in locational savings and locational
advantage, with proper comparability analysis rather than depend on an unreliable application of PSM,'(Mr
Kanabar, Member of the Committee, has reservations about location savings and location advantage for
arriving at a mark-up because he believes that an appropriate comparability analysis is with respect to
comparables which also have the some locational savings and advantage and no further adjustments are
necessary).
2.18 General Transfer pricing issues which are not specific to the IT Sector
The stakeholders have identified some other transfer pricing issues affecting the DCs including those which
are not engaged in R&D. These issues are listed in Annexure-VI.
2.19 Response and Recommendations of the Committee

2.19.1 The Committee recognises that these Transfer Pricing (TP) issues impact all sectors and are not
peculiar to DCs or IT sector and considers their review beyond its mandate. The Committee acknowledges
that these issues do create tax uncertainty but is of the view that most of these arise due to lack of
consistency and proper FAR analysis in the application of transfer pricing provisions. Hence, there is certainly
an urgent need to have internal clarity and consistency on these issues.
2.19.2 The Committee has noted that following significant recommendations for conducting FAR
analysis were made by an earlier committee set up by the then DGIT (International Tax) in 2007 under the then
DIT(TP) Delhi:
• The Functional analysis is the key for determination of arm's length price of controlled transactions.
• The functional analysis helps in:
Selection of most appropriate method
Selection of comparable uncontrolled transactions
Determination of relative value of contribution for application of Profit Split Method.
The functional analysis aims to identify functions performed in controlled transactions by each
associated enterprise, taking into account the assets employed or to be employed and risks assumed
by respective associated enterprises. The, emphasis should be on economic significance of functions
and not on the number of functions performed by parties.
Identification of functions performed to consider the assets -tangible and intangible that are
employed or to be employed in actual conduct of controlled transactions
The economic substance and commercial realities of transactions need to be examined to find out the
true nature and terms of controlled transactions so as to ascertain the actual functions performed,
assets used and risks assumed by respective associated enterprises.
The allocation of risks should be consistent with the economic substance of the transactions.
The functions carried out (taking into account the assets used and the risks assumed) by respective
enterprises will determine to some extent the allocation of risks between them and the return each
enterprises would expect in arm's length dealings.
Each critical process involved in actual conduct of controlled transactions should be examined so as to
ascertain actual functions performed, assets utilized and risks assumed by respective parties.
Level of expenses and types of expenses should also be scrutinized to identify functions associated
with main function, additional function, assets used -intangibles and intangibles - and the risk
assumed.
Economic characterisation can be illustrated as follows:
■ Research & Development function
✓ Full risk bearing developer of intangibles
✓ Limited risk bearing developer of intangibles
✓ Contract R & D service provider with no significant risks
• Service Provider(Software)

✓ Software product developer with all risks
✓ Contract software service provider with limited risks ✓ Manpower service provider with no significant risks
2.19.3 The Committee recommends that CBDT must issue an updated guidance note on FAR analysis taking
the recommendations of the earlier committee into account. Further, a circular clarifying the position on other
administrative issues listed in Annexure VI should be issued so that there is uniformity in application of
provisions across the country, which will also
reduce disputes and grievances. A few of these issues listed in Annexure VI raise question about the
appropriateness of some of the Transfer Pricing provisions in the Income Tax Act. However, the Committee
has, considering its mandate, not examined those.
PART 3: SECOND TERM OF REFERENCE - INCOME-TAX ISSUES PERTAINING TO THE IT SECTOR
3.1 The Committee has, after long deliberations and careful consideration of all the issues, arrived at a set
of recommendations consistent with its approach summarized in paragraph 1.16. The issues and
recommendations are detailed in the following paragraphs:
3.2 Issue -1: Whether "on-site" development of computer software qualifies as an export activity for tax
benefits
3.3.1 Industry representatives have asserted that the Indian software export industry is the child of the
concept of globalization. They have explained globalization as something that is about sourcing capital from
where it is the cheapest; sourcing talent from where it is best available; producing where it is most cost-
effective; and selling where the markets are, without being constrained by the national boundaries. According
to them, the Global Delivery Model, which has become the de-facto standard for the Indian software industry,
splits a large software development of maintenance project into two classes of activities:
the first set of activities, called "on-site activities, has a very high level of interaction between the client
officers and the staff of the Indian software company; and
the second set of activities, called "off-shore" activities, includes activities like functional design,
detailed technical design, architecture, database design, programming, testing, etc.
3.3.2 Their submission is that the second set of activities is taken up by scalable, talent-rich, technology-
enabled, process-driven and cost-competitive development centres in India. They further claim that,
sometimes, the customer may insist that the entire set of activities including both "on-site" and "off-shore" be
taken up "on-site" at his premises due to exigencies of speed, uncertainty arising from new technologies and
confidentiality.
3.3.3 It is also claimed that sometimes, the talent required for "on-site" tasks may be requisitioned by a
company from any of its offices anywhere in the world based on the need of the expertise and this is what the
Global Delivery Model is all about. Another assertion is that sometimes, a pilot project may have to be done
exclusively "on-site" to establish the credibility of the Indian software export. Therefore, the contention is that
"on-site" activities are also export activities generating hard currency revenue for India.
3.3.4 Industry emphatically argued that denial of tax holiday to several units by the tax authorities deriving
profits from "on-site" services, on the ground that no export has been made out of the unit is also contrary to
the express provisions of the statute, as no such restrictive condition is found in the substantive provisions of
Section 10A, 10AA and 10B of the Act. They draw support from, Explanation 3 to Section 10A, Explanation 2
to Section 10AA and Explanation 3 to Section I0B.
3.3.5 Additionally, they have contended that CBDT's circular no. 694 of 1994 creates uncertainty since it
provides that the "on-site" software development will be considered as export only if the software is 'actually'
the product of the unit.
The officers of CBDT were of the view that the "on-site" services should have some nexus with the unit
claiming the deduction. They opined that 100% onsite work defeats the purpose of exports out of India. They
also relied on Circular no. 694 of 1994.
• Explanation 3 to Section 10A and Explanation 3 to Section 10B of the Income-tax Act inserted vide the
Finance Act, 2001 and Explanation 2 to Section 10AA inserted vide SEZ Act, 2005 read as follows:
"For the removal of doubts, it is hereby declared that the profits and gains derived from on site development
of computer software (including services for development of software) outside India shall be deemed to be
the profits and gains derived from the export of computer software outside India."
• These Explanations create a fiction that even when the activities are carried "on site" i.e., outside India, the
income there from is deemed to be derived from export. The Committee recommends that deeming fiction
created by these Explanations. must be given effect to and income from "on site" development pursuant to
contract between the Indian entity and the overseas client for the development of software, should be
considered as derived from export.
• Circular no. 694 of 1994 has been partially rendered otiose after the insertion of the deeming fiction in the
above stated Explanations and should be modified immediately by deleting the portion relating to
"development of programmes on-site".
• In cases where deduction has been denied and the taxpayer is before the CIT (A) or DRP, the issue may be
allowed to be decided by the CIT(A) or DRP in accordance with the law and the Assessing Officers should be
directed to either concede the issue or not contest the same further.
• In cases where the CIT(A) or ITAT or High Court has decided this issue in favour of the taxpayer, no further
appeal should be filed by Revenue. Wherever Revenue has already filed further appeal on this issue before the
ITAT, High Court or Supreme Court, as the case may be, the relevant ground of appeal may be withdrawn
immediately.
3.6 Issue 2: Whether business receipts from Deputation of Technical Manpower (DTM) are eligible for
deduction under Section 10A, I0AA and 10B?
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.

Revenue has contended that Deployment of Technical Manpower [DTM] is not an eligible activity u/s I0A,
I0AA or I0B as the taxpayer companies were not contracted for software development and were responsible
only for sending trained manpower abroad. Therefore, the receipts arising from such DTM activity are being
held as not being eligible for tax incentives under these Sections.
• The Committee, while interpreting Explanations to Sections 10A, 10AA and 10B (ibid) in the context of
industry practice and particularly the words in parenthesis i.e., (including services for development of
software), agrees with the view that the Deployment of Technical Manpower [DTM] which has any connection
with software development work - which would include up-gradation, testing, maintenance, modification,
etc of the software - contracted to the eligible unit should be considered as an eligible activity under Sections
10A, 10AA and 10B.
• However, if the DTM is unrelated to the above activities of the eligible unit, then it would not be an eligible
activity and would not be eligible for tax benefits under Sections 10A, 10AA and 10B as "on-site" activities.
• The contract governing such deployment would be one of the crucial documentary evidence to establish the
connection between DTM and software development activities.
• In cases where deduction has been denied and the taxpayer is before the CIT(A) or DRP, the issue may be
immediately.
3.10 Issue 3: Taxation of new SEZ units whether hiring of new employees is a condition for eligibility to claim
deduction under Section I0AA
3.11 .1 The industry explained that tax incentive u/s 10A of the Income-tax Act come to an end on
31/3/2011. Thus, STPI units are no longer eligible to claim any tax benefit. On the other hand, SEZ units in the
software development segment have a 15 year tax holiday available to them u/s 10AA of the Act.
3.11 .2 The stakeholders from the industry do agree that tax authorities rightly deny the benefit when
taxpayers move all their business to the SEZ unit from their existing STPI unit to claim the tax incentives.
However, industry has emphatically stated that the movement of personnel from STPI units is necessary as
every project needs experienced project managers, analysts, programmers, etc, and it was impossible for a
software company to do projects only with freshers. Further, the submission was that re-skilling of
employees, addresses underemployment and results in incremental activity which generates economic
rewards in the system The view of the industry is that since there is no requirement of the law as contained in
Section 10AA to have only new employees in the SEZ unit, tax authorities should not deny the tax benefits on
this ground. They have also relied upon Instruction No. 70, dated 9th November, 2010, issued by the
Department of Commerce in which the latter has clarified that there was no limitation on the movement of
manpower from STPI/DTA units to SEZ units.

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.
• As per the provisions of Section 10AA there is no requirement with regard to the employment of new
employees in the eligible undertaking in order to claim deduction. Employment of existing employees cannot
be considered as splitting up or reconstruction of a business already in existence. Accordingly, the condition
of new employees cannot be imposed while examining the eligibility of the taxpayer for the deduction under
Section 10AA. If the legislative intent was to impose such a condition, then specific clauses for employment
of new and regular employees would have been inserted. In the absence of a specific condition of employing
new employees and considering the business model of the industry, denial of deduction under this Section by
insisting upon the employment of new employees is unwarranted.
• The Committee, however, is of the view that in the absence of an express provision in the statute requiring
units in SEZs to have only new employees or a certain percentage of new employees, one of the crucial
objectives for providing tax incentives i.e., to generate employment in the Country, is not met. Accordingly, if
the Government intends to link tax foregone to the positive externality of employment generation and also to
address the present concerns of the industry, then the Income-tax Act may be amended prospectively to
provide that 50% of the billable employees in an SEZ unit in its first year should be new employees and also
provide that this condition would be deemed to have been satisfied if the taxpayer is able to demonstrate that
the net addition of new billable employees at the enterprise level is at least equal to the number that
represents 50% of the total billable employees of the new SEZ unit. For example, let us assume that Company
ABC has 10,000 billable employees as on 31/3/2013 and it sets up a SEZ unit in June 2013 with 2,000 billable
employees. As per the proposed new condition, if Company ABC either shows 1000 new billable employees in
the SEZ unit or is able to demonstrate that it had at least 11,000 billable employees as on 31 /3/2014 for the
company as a whole, then it would be considered to have successfully met the proposed new condition. This
50% ratio is being suggested recognising the business environment wherein some shifting of experienced
employees may be necessary to maintain the competitive advantage offered by the Indian entity.
• In cases where the CIT(A) or [TAT or High Court has decided this issue in favour of the taxpayer, no further
appeal should be filed by Revenue. Wherever Revenue has already filed further appeal on this issue
before the ITAT, High Court or Supreme Court, as the case may be, the relevant ground of appeal may be
withdrawn immediately.
3.14 Issue 4: Hierarchy of documents - Whether the Master Services Agreement (MSA or by whatever name
called ) or the Statement of Work (SoW or by whatever name called ) should be the deciding document for
enabling software exporting units to claim deduction under Sections 10A, 10B and 10AA of the Income-tax
Act
3.15.1 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.
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.
• The Committee understands that there is a Master Contract or Agreement (hereinafter referred to as Master
Services Agreement or MSA) which lays down the rules of business and a Subordinate Contract (hereinafter
referred to as Statement of Work or SoW), which lays down the actual scope of work.
• The Committee is of the view that the SoW should be above the MSA in the hierarchy of legal/commercial
documents for the purposes of determining the actual work being done.
• Since the SoW lays down the actual scope of work and the software development is carried out in
accordance with the terms of the SoW, it is the SoW that should be given primary importance and not the
MSA for the purposes of tax incentives under Sections 10A, 10AA and 10B. The fact that an SoW has been
issued under an existing MSA would not be detrimental to the claim of deduction by an taxpayer.
• Thus, the Committee recommends that if the work of software development is governed by a new SoW, the
taxpayer should be eligible for the tax benefits available under these Sections irrespective of the date of
signing of the MSA.
• However, to address the concerns of the Revenue, if an existing SoW is prematurely terminated in a non-
eligible undertaking and the same work is covered under a new SoW in an eligible undertaking, this fact would
need to be taken into account by the Assessing Officer as a relevant factor in determining whether the
undertaking is new or is formed by splitting up or reconstruction of a business already in existence. Besides,
to facilitate the Assessing Officer, the Committee also recommends that a requirement be provided through
legislative change that a Chartered Accountant's certificate should be obtained by the taxpayer confirming
that the new SoW has not been brought into existence by prematurely terminating an old SoW covering the
same work.
• In cases where deduction has been denied and the taxpayer is before the CIT (A) or DRP, the Issue may be
directed to either concede the issue or not contest the some further subject to the taxpayer furnishing a
certificate from the management to the effect that the new SoW has not been brought into existence by
prematurely terminating an old SoW covering the same work.
• In cases where the CIT(A) or [TAT or High Court has decided this issue in favour of the taxpayer, no further
]TAT, High Court or Supreme Court, as the case may be, the relevant ground of appeal may be withdrawn
immediately. However, these actions by the Revenue would be subject to the taxpayer furnishing a certificate
from the management to the effect that the new SoW has not been brought into existence by prematurely
terminating an old SoW covering the same work.
3.18 Issue - 5: Tax incentives not available to R&D activities in STPIs, SEZs and EOUs, as it is not an eligible
activity - Denial of tax holiday under Sections 10A, 10AA and 10B, respectively, in mid-course on the
eligibility criterion on this issue.
3.19.1 The stakeholders from industry pointed out that tax holidays, once given, should not be denied mid-
course on the ground that R & D activities were not eligible, as it created uncertainty and sent out negative
signals. Their argument is that R & D activities are IT enabled services covered under the term 'customised
electronic data' and also under the products and services notified by the CBDT in Notification No. 890(E),
dated 26/9/2000.
3.1 9.2 They requested that it should be clarified that R&D centres set-up as STPs, SEZs or EOUs should be
allowed deduction u/s 10A/I0AA/I0B. Further, wherever additions have been made or cases have been re-
opened, all such actions should be withdrawn and relief granted to the taxpayers by means of a circular.
Sections 10A, 10AA and I0B provide tax benefit for export of articles or things or computer software.
Scientific R & D does not come within the IT enabled services notified by the CBDT expanding the scope of
"customized electronic data or any product or service of similar nature". Besides, original research and
development is not included as a part of customized electronic data or services of similar nature. If scientific
research and development had been notified as a service similar to export of customized electronic data, it
would have been a different matter.
• The Committee is of the view that the services covered by the Notification, namely, Engineering and Design
services, could potentially include R & D activities. However, in order to set at rest any controversy, the
Committee recommends that R 8 D services should be notified as being eligible to claim this deduction and
should be deemed to have been notified from the original date of notification i.e., 26/9/2000.
• Pursuant to the amendment to the Notification, in cases where deduction has been denied and the taxpayer
is before the CIT (A) or DRP, the issue may be allowed to be decided by the CIT(A) or DRP in accordance with
the law and the Assessing Officers should be directed to either concede the issue or not contest the same
further.
• Pursuant to the amendment to the Notification, in cases where the CIT(A) or ITAT or High Court has
decided this issue in favour of the taxpayer, no further appeal should be filed by Revenue. Wherever Revenue
has already filed further appeal on this issue before the ITAT, High Court or Supreme Court, as the case may
be, the relevant ground of appeal may be withdrawn immediately.
3.22 Issue - 6: Deduction under Section 35(2AB) of the Income-tax Act should be extended to computer
software
The industry asserted that since a lot of R & D activity was carried out in the software segment, it may be
clarified that beneficial provisions of Section 35 (2AB) allowing a weighted deduction to the eligible entities,
should be extended to the IT sector.
3.24 View of Revenue
The deduction under Section 35(2AB) is given to bio-technology companies or manufacturing companies,
which have incurred expenditure for scientific research or for creation of R & D facilities. The segregation of R
& D expenses from regular manufacturing expenses can be made clearly in the case of these companies.
Software development is specifically not provided in these provisions. Moreover, the segregation of R & D
expenses from other expenses is near impossible in the case of software development companies. The
software development companies have already been given sufficient incentives and there is no justification of
extending the provisions of Section 35(2AB) to the IT sector.
3.25 Recommendation of the Committee:
The Committee notes that Section 35(2AB) of the Act refers to manufacture or production of any article or
thing and the term "computer software" is missing. The Committee is of the view that if the legislative intent
was to cover computer software also, the language would have been similar to the language used in Sections
10A, I0AA i.e "articles or things or computer software". The Committee, therefore, recommends that having
regard to the provisions as currently worded, no clarification is necessary.
3.26 Issue - 7: Tax holiday under Sections 10A / 10B denied to the transferee on transfer of undertaking under
slump sale
3.27.1 The representatives of industry pointed out that tax holiday under Sections 10A/10AA/10B is
undertaking specific and hence any business reorganisation which results in the transfer of the entire
undertaking should entitle the purchaser to claim tax holiday benefits for the unexpired period of tax holiday
claim.
3.27.2 They recommend a clarification stipulating that an eligible undertaking, which is transferred as a
going concern by way of a slump sale, would be eligible for the tax holiday for the remainder period under the
relevant Sections. They seek that clarification should clearly bring out the fact that change in ownership of
business/undertaking would not constitute splitting up/reconstruction of an existing business and, therefore,
a transfer by way of a slump sale of an eligible undertaking would not disentitle the purchaser of the
undertaking to claim the tax holiday.
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.
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.
appeal should be filed by Revenue. Wherever Revenue has already filed further appeal on this issue
before the [TAT, High Court or Supreme Court, as the case may be, the relevant ground of appeal may be
withdrawn immediately.
3.30 Issue - 8: Tax holiday benefits denied for non-maintenance of separate books of account of the tax
holiday eligible unit
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.
The deduction under Sections 10A/10B is given "eligible undertaking" wise, and not 'eligible business' wise.
The profits of the "eligible undertaking" will also have to be certified by a Chartered Accountant as per
specified audit form. In view of the some, the "eligible undertaking" has to necessarily maintain separate
books of account for the profits of the eligible unit to be determined and for the accountant to certify the said
profits. Besides, under the STPI rules, separate books of account are required to be maintained.
The Committee is of the view that the Revenue cannot deny deductions under Sections 10A, 10AA or
10B on the ground of non-maintenance of separate books of account for the eligible unit, as there is no
requirement in law to maintain separate books of account. The Committee also took note of the
provisions of Section 11 of the Act, wherein there is a specific requirement in sub-section (4A) for
maintenance of separate books of account by a trust or institution in respect of profits and gains of
business, which is incidental to the attainment of the objectives of such trust or institution.
The Committee is of the view that in the absence of specific requirements for maintaining separate
books of accounts, STPI rules cannot be relied upon to impose any obligations of compliance for
claiming tax benefit under the Income Tax Act.
The Government may amend the Income-tax Act prospectively if it considers necessary that the
"eligible undertaking" should maintain separate books of account.
In cases where deduction has been denied and the taxpayer is before the CIT (A) or DRP, the issue may
be allowed to be decided by the CIT(A) or DRP in accordance with the law and the Assessing Officers
should be directed to either concede the issue or not contest the same further.
In cases where the CIT(A) or ITAT or High Court has decided this issue in favour of the taxpayer, no
further appeal should be filed by Revenue. Wherever Revenue has already filed further appeal on this
issue before the ITAT, High Court or Supreme Court, as the case may be, the relevant ground of appeal
may be withdrawn immediately.
3.34 Issue 9: Secondment Arrangements Tax Issues
3.35.1 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.
The Revenue's contention is that the overseas affiliates are the real employers of the secondees under the
secondment agreements and that the Indian entities only assumed the role of intermediaries who were
authorized by the real employers to exercise supervision and control over the seconded employees during the
period of secondment. Further, the Revenue claims that since the secondees were employees of overseas
affiliates and were providing managerial services to the Indian entities, the payment made by the latter to the
former under the secondment agreements constituted 'Fees for technical services' under Section 9(l) (vii) of
the Act. The Revenue, therefore, believes that the Indian entities are liable to deduct tax under Section 195 of
the Act in respect of reimbursements made to the overseas affiliates under the secondment agreements and
where no tax is deducted, the entire payment made by the Indian entities is liable to be disallowed under
Section40(a) (i) of the Act.
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"
3.39.1 Industry has pointed out that in the absence of a definition to the term 'total turnover', the Revenue has
been ignoring the legal intent of the provisions and does not provide parity of treatment between the term
export turnover and total turnover and the items which are excluded from the export turnover are not being
excluded from the total turnover. This results in the reduction of the tax holiday available to the IT companies.
3.39.2 As an illustration, if an eligible unit had no domestic turnover, its entire profits ought to be eligible for
relief under Section 10A/10B/10AA of the Act. However, on account of the fact that the Revenue removed
some elements (such as say telecommunication expenses) only from the export turnover without removing
the some from the total turnover, by incorrect application of the said formula, the extent of profit eligible for
the relief gets artificially reduced.
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.
• The Committee is of the view that the formula for computation of the profits eligible for deduction under
Sections 10A, 10AA and 10B cannot be altered without explicit provision in law in such a manner so as to
artificially reduce such eligible profits. Therefore, the Committee recommends that whenever certain items of
expenses or receipts are removed from the export turnover, the some items of expenses or receipts should
also be removed from the total turnover to ensure parity between the numerator and the denominator.
• In cases where the quantum of deduction has been reduced due to an erroneous application of the formula
by Revenue and the taxpayer is before the CIT(A) or DRP, the issue may be allowed to be decided by the
CIT(A) or DRP in accordance with the law and the Assessing Officers should be directed to either concede the
issue or not contest the same further.
immediately.
3.42 Issue - 11: Denial of tax holiday on transfer of an eligible SEZ unit from one SEZ to another SEZ
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.
Revenue denies the tax holiday on the ground that the undertaking is formed by splitting up as the assets
have been used earlier.
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
Industry representatives have pointed out that if a new STP/EHTP/SEZ undertaking is set up at the some
location where there is an existing STP/EHTP/SEZ undertaking, the Revenue regards it as an expansion of an
existing undertaking and grants tax holiday only for the residual period commencing from the setting up of
the existing undertaking. It has been submitted that whether an undertaking is new or an expansion of an
existing undertaking should be determined having regard to the facts of the case and judicial precedents and
the mere fact that a new undertaking is covered by an existing STP/SEZ approval should not result in treating
the new undertaking as an expansion.
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.
Committee is of the view that there is no presumption in law that only one undertaking can be set up in
one STP/EHTP/SEZ or only one undertaking can claim benefits under Sections 10A and 10AA or only
one undertaking can operate under one license. The issue as to whether an undertaking is new or
expansion or is set up by splitting-up or reconstruction of an earlier business is a matter of fact which
must be examined by the assessing officer on the facts of each case to determine eligibility for
deduction of the new undertaking.
In cases where deduction has been denied by adopting the above presumption and the taxpayer Is
before the CIT (A) or DRP, the issue may be allowed to be decided by the CIT(A) or DRP in accordance
with the law after ascertaining from the Assessing Officers whether after ignoring the above
presumption the taxpayer is eligible for deduction. If the AO is satisfied that taxpayer is eligible he
should either concede the issue or not contest the same further.
In cases where the CIT(A) or ITAT or High Court has decided this issue in favour of the taxpayer, after
examining the eligibility of the taxpayer for these deductions, no further appeal should be filed by
Revenue. Wherever Revenue has already filed further appeal on this issue before the ITAT, High Court
or Supreme Court, as the case may be, the relevant ground of appeal may be withdrawn immediately.
3.50 Issue 13: Retrospective amendment of the definition of royalty with
regard to taxation of software and transmission charges
3.51 Views of the industry
Detailed representations have been made on this matter by the Industry questioning the retrospective
operation and scope of the amendment.
3.52 Response of the Committee:
The Committee, as presently constituted, is, in accordance with its approach mentioned in paragraph 1.16,
constrained from looking at this subject in the absence of specific mention of this issue in its terms of
reference.
APPENDIX A
IMPORTANCE OF DEVELOPMENT CENTRES
NASSCOM data shows that at present more than 750 DCs are working from India, 28 per cent of them with
multiple locations and DCs contributed around 1 /3rd of total IT export revenues of $68 billion in the fiscal
2012. They account for 22 per cent of IT-BPO export revenues and 21 per cent of employees
NASSCOM research indicates the following :
Over 152 new delivery centres were set up in 2011 in global sourcing destinations. India accounted for
the largest share, 25 percent (38 centres), followed by Eastern Europe at 20 percent and Philippines
and Rest of Asia at 17 percent each.
India's strong value proposition and leadership status in the captive industry is ensuring that it gets a
substantial share of first time outsourcers. While in 2009, over 15 new captives were established in
India and over 25 captives increased their presence / scale of work in India, 2010 has seen 10 new
captives open up in India 7.
DCs have played a key role in the IT-BPO sectors phenomenal growth story, establishing 'proof of
concept' and branding India as a global sourcing destination. The segment, miniscule till 2003, has
witnessed tremendous development in the last 7 years - growing at a CAGR of 22 per cent, employing
close to 4 lakh people and contributing to 1 per cent of India GDP.
Impact of DCs on India extends beyond revenues and employment- playing a leading role in
developing an R&D and product culture, spearheading initiatives to develop affordable products for
emerging markets and creating entrepreneurship opportunities.
ER&D/SPD segment is the largest segment within the Indian captive landscape with over 200+ ER&D
captives established in the last 3 years. MNC Development centres accounted for over 1 per cent of
India's GDP in FY2010, support indirect employment of 1.4 million people and have played a key role in
creating an innovation ecosystem in India.
The industry has significantly grown over the last 5 years and currently has representation from most
of the verticals like Aerospace & Defence, Automotive, BFSI, Bio-Technology, Chemicals, Computer
Hardware, Education, Electronic/Electrical Equipment, Energy, Healthcare, Industrial,
Semiconductors, Software/Internet, and Telecommunications, etc.
Manufacturing focussed verticals such as Automotive and Construction / Heavy Machinery were
some of the first industries to engage in ER&D off shoring and now have a mature supply base in
India.
Cost pressure, access to flexible capacity, local market access for growth and decreasing time-to-
market were some of the key reasons driving off shoring in those industries. But the most important
factor is the availability of large pool of skilled manpower in terms of scientists, engineer etc.
Consumer Electronics is an industry mired with products that have very short life cycles and where
time-to-market is very critical. The product (customer) requirements and features vary by geography
and region. Hence, offshoring in this vertical veers towards tapping the emerging markets and
delivering products with features and content more in line with the local market's needs. Similarly,
Medical Devices is another where the market needs and affordability of products vary widely across
regions. Here too, accessing emerging markets is the primary driver over providing low-cost solutions,
which comes a distant second.
The IT services industry is dominated by India / India-centric providers who constitute more than two-
thirds of the market. Large integrated players dominate this segment, providing services across a
number of verticals and geographies. Foreign providers like IBM contribute around 10-15 percent of
revenues, while IT captives constitute the remaining 10-15 percent. Software products and ER&D
(Engineering Research and Development) have a high proportion of captive players around 50-55
percent, taking advantage of India's engineering design and development capabilities. The BPO
industry is evenly split between Indian and foreign players.
Some of the R&D Centres in India include that of Veritas, Synopsis, Adobe, Ericsson, Texas
Instruments, Cisco, NetApp, BMC, Google, Microsoft, SAP, Yahoo, EMC, McAfee, Honeywell, Dell, Intel,
IBM, Alcatel, Symantec, Sony and Huawei.
NASSCOM findings are supported by other studies. As per Zinnov Consulting analysis of MNC R&D Centers in
India, MNC R&D landscape is rapidly growing with a current base 871 MNCs with their R&D Centers in India.
India currently
boasts an installed R&D talent pool base of over 2,00,000 engineers growing at an average of 9% a year for
the last 5 years.
A Research paper by IIM-A indicates that other countries with similar growth in R & D include China, UK,
Germany, Brazil, Russia, etc.
Annexure I
PM sets up committee to review Taxation of Development Centres and the IT Sector, Safe Harbour
Provisions to be Finalised soon
July 30.2012
New Delhi
The Prime Minister has constituted a Committee to Review Taxation of Development Centres and the IT
Sector. The Committee will engage in consultations with stakeholders and related government departments
to finalise the Safe Harbour provisions announced in Budget 2010 sector-by-sector. It will also suggest the
approach to taxation of Development Centres.
2. The Prime Minister had earlier set up an Expert Committee on GAAR under the Chairmanship of Dr. Partho
Shome to engage in a widespread consultation process and finalise the GAAR Guidelines. The response has
been overwhelmingly positive.
3. While this committee would address concerns on GAAR provisions and would reassure investors about the
predictability and fairness of our tax regime, it was felt that there is still a need to address some other issues
relating to the taxation of the IT Sector such as the approach to taxation of Development Centres, tax
treatment of "onsite services" of domestic software firms, and also the issue of finalising the Safe Harbour
provisions announced in Budget 2010.
4. Many MNCs carry out activities such as product development, analytical work, software development, etc.
through captive entities in India. They exist in a wide range of fields including IT software, IT hardware,
Pharmaceutical R&D, other automobile R&D and scientific R&D. These are popularly called Development
Centres. Over 750 MNCs have such centres at over 1100 locations in India. The reason for this large
concentration of Development Centres in India is the worldwide recognition of India as a place for cost
competitive, high quality knowledge related work. Such Development Centres provide high quality jobs to our
scientists, and indeed make India a global hub for such Knowledge Centres. However, India does not have a
monopoly on Development Centres. This is a highly competitive field with other countries wanting to grab a
share of the pie. There is need for clarity on their taxation.
5. As far as Safe Harbour provisions are concerned, these were announced in Finance Bill 2010 but have yet
to be operationalised with a wide application. Safe Harbour provisions have the advantage of being a good
risk mitigation measure, provide certainty to the taxpayer.
6. The resolution of the above tax issues requires a comprehensive approach in which other government
departments are consulted and industry bodies are taken on board. The overall goal is to have a fair tax
system in line with best international practice which will promote India's software industry and promote India
as a destination for investment and for establishment of Development Centres. Therefore, the Prime Minister
has constituted a Committee consisting of experts from the Income Tax Department, both serving and retired,
who will examine the issues in detail and submit proposals in a short time. An arm's length exercise of this
nature will allay a lot of concerns in addition to the immediate resolution of issues that is
necessary.
7. For this purpose, a Committee on Taxation of Development Centres and the IT sector has been constituted
consisting of:
1) Shri N. Rangachary, former Chairman CBDT & IRDA - Chairman
2) Ms Anita Kapur, Director General (IT) - Member
3) Ms Rashrni Sahani Saxena, DIT (TP) - Member
4) Any other officer from the Income Tax Department to be co-opted by the Chairman
8. The Terms of Reference of the Committee will be to:

i) Engage in consultations with stakeholders and related government departments to finalise the approach to
Taxation of Development Centres and suggest any circulars that need to be issued.
ii) Engage in sector-wide consultations and finalise the Safe Harbour provisions announced in Budget 2010
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
iii) Finalise Safe Harbour Rules individually sector-by-sector in a staggered manner and submitting draft Safe
Harbour provisions for three sectors/sub-activities each month beginning with the first set of suggestions by
30 September 2012. All Safe Harbour provisions can be finalised by 31 December 2012.
10. The Department of Revenue will provide all necessary support to the Committee to facilitate its work
including office assistance and assistance to facilitate consultations.
Annexure II
F. No. A. 50050/ 103/2012-Ad.l
Government of India
Ministry of Finance
Department of Revenue
New Delhi, dated the 3rd August, 2012
OFFICE MEMORANDUM
Subject: Constitution of a Committee to Review Taxation of Development Centres and the IT Sector- Reg.
A Committee has been constituted with the approval of the Prime Minister to review the Taxation of-
Development Centres and the IT Sector. This Committee shall consist of:
(i) Shri N. Rangachary, former Chairman, CBDT & IRDA - Chairman
(ii) Ms. Anita Kapur, Director General (IT) - Member
(iii) Ms. Rashmi -Saxena Sahni, DIT(TP) - Member
(iv) Shri Dinesh Kamabar, Tax-Expert - Member
The terms of Reference of the Committee will be to:
(i) Engage in Cons Rations with stakeholders and related government departments:to finalise the.approach-
to Taxation of Development Centres and suggest any circulars that need to be issued.
(ii) Engage in sector-wide consultations and finalise the Safe Harbour provisions announced In Budget 2010
(iii) Examine issues relating to taxation of the IT sector and suggest any clarifications that may be required.
The committee will work to the following time schedule:
(i) Finalise the approach to taxation of Development Centres and suggest any necessary clarifications by 31
August 2012.
(ii) Suggest any necessary clarifications that may be needed to remove ambiguity and Improve clarity on
(iii) Finalise Safe Harbour Rules individually sector-by-sector in a staggered manner and submit draft Safe
Harbour provisions for three sectors/sub-activities each month beginning with the first set of suggestions by
30 September 2012. All Safe Harbour provisions are to be finalised by 31 December 2012.
2 The Department Revenue will Provide all necessary support to the committee to facilitate its work including
office assistance and assistance to facilitate consultations.
(M. L. Meena)
Joint Secretary to the Government of India
Copy to:
I. Shri N. Rangachary, former Chairman, CBDT & IRDA.
2. Ms. Anita Kapur, Director General (IT).
3. Ms. Rashmi Saxena Sahni, DIT(TP).
4. Shri.Dinesh Kanabar, Tax Expert.
5. Shri. B.V:R. Subrahmanyam, Joint Secretary to PM.
6..PS to FM
7. PPS to secretary(Revenue).
8. Chairman,CBDT
9. DS(Admn), Department of Revenue with the request to provide all
Necessary support to the Committee to facilitate its work including office_
assistance and assistance to facilitate consultations.
Annexure III
F. No. A 35915 29/2012-Ad.VI
Government of India
Ministry of Finance
Central Board of Direct Taxes
New Delhi, Dated 7th August 2012

ORDER No. 154 of 2012
With the approval of the Competent Authority, the services of the following officers are placed at the disposal
of the Committee to Review Taxation of Department Centre and the IT Sector under the Chairmanship of Shri
N. Rangachary former Chairman. CBDT & IRDA with immediate effect and until further orders.
S. No. Name of Officer / Post (S/ Shri) Civil Code
1. Sobhan Kar, Additional Commissioner APA, Delhi 99018
2. D. Prabhakar Reddy, Additional Director of Income Tax, TPO2(6), 99011

Mumbai
(A. K. Chaturvedi)
Director Ad. VI
Copy to:
1. Office Concerned
2. Shri N. Rangachary Chairman of the Committee to Review Taxation of Development Centres and the IT
Sector
3. DGIT (IT), Delhi/CCIT(CCA), Mumbai/JS(FT&TR-I)
4. All Chief Commissioner Directors General of Income Tax
5. Principle Chief Controllers of Accounts New Delhi
6. Zonal Accounts Officers CBDT C/o CCIT (CCA)concerned
7. PPSs to FM /MOS (R)/ Finance Secretary Chairman, CBDT/ Members CBDT/ Addl. Secy (R)/JS (Admn)
CBDT/JS(R).
8. Adviser to FM
9. Ad. Section Department of Revenue
10. Hindi Section for Hindi version
11. Secretary General IRS Association ITGOA/ All India Income Tax SC & ST Employees Welfare Association.
(A. K. Chaturvedi)
Director Ad. VI
Annexure IV
FINANCE MINISTER CONFIDENT OF BRINGING ECONOMY BACK ON DESIRED TRACK; GIVES AN OVERVIEW
OF MAP FOR RECOVERY
New Delhi: Shravana 15, 1934
August 06, 2012

The Union Finance Minister, Shri P. Chidambaram has said that uppermost in his mind is the duty to re-gain
the confidence of all stakeholders. Assuring that inflation can be moderated in the medium term, he said that
the Government will work with RBI in this regard. In a statement, the Finance Minister said that a path of
financial consolidation will be unveiled shortly. He made it clear that the burden of fiscal correction must be
shared, fairly and equitably, by different classes of stakeholders. The Finance Minister said that the poor must
be protected and others must bear their fair share of the burden. He further said that wherever required, the
corrective measures will be taken in bringing clarity in tax laws, to have a stable tax regime, a non-adversarial
tax administration and a fair mechanism for dispute resolution.
Following is the full text of the Finance Minister's statement:-
"I assumed the office of Finance Minister on Wednesday, August 1, 2012. It is a position of great honour, it is
also a position of great responsibility. In the last few days, I have been briefed by senior officials of the
Ministry of Finance on the state of the economy. It is true that the economy is challenged by a number of
factors, but it is also true that with sound policies, good governance and effective implementation, we would
be able to overcome these challenges.
Uppermost in my mind is the duty to re-gain the confidence of all stakeholders. Obviously, where necessary,
our policies have to be modified or fine-tuned in order to meet the expectations of different stakeholders.
We intend to unveil, shortly, a path of fiscal consolidation. I would like to make it clear that the burden of fiscal
correction must be shared, fairly and equitably, by different classes of stakeholders. The poor must be
protected and others must bear their fair share of the burden. Obviously, adjustments must be made both on
the revenue side and on the expenditure side. We have asked Dr. Vijay Kelkar, Dr. Indira Rajaraman and Dr.
Sanjiv Misra to assist the Government in formulating the path of fiscal consolidation and we expect that the
work will be completed in a few weeks.
Price stability is an important objective. In fact, it is more important for the poor. There has been pressure on
prices, and inflation - especially food inflation - is high. The causes are well known: some are beyond our
control, such as prices of crude oil and imported commodities, but some others can be addressed by
determined action. We will take steps to remove the constraints on the supply side. We will also use our
stocks of food grain to moderate prices. Where necessary, we will enhance the import of items in short
supply. Non-food inflation is already declining. We are confident that inflation can be moderated in the
medium term. Fiscal policy and monetary policy must point to the same direction and must move in tandem.
Government will work with the Reserve Bank of India to ensure that inflation is moderated in the medium
term. We are conscious that current interest rates are high. High interest rates inhibit the investor and are a
burden on every class of borrowers, be it a manufacturer of goods or a purchaser of a home or a two wheeler
or a student who takes an education loan. Sometimes it is necessary to take carefully calibrated risks in order
to stimulate investment and to ease the burden on consumers. We will take appropriate steps in this regard.
The key to restart the growth engine is to attract more investment, both from domestic investors and foreign
investors. Since investment is an act of faith, we must remove any apprehension or distrust in the minds of
investors. We will improve communication of our policies to potential investors. The aim will be to remove the
perceived difficulties in "doing business in India", including fears about undue regulatory burden or regulatory
over-reach. Indian companies, especially public sector enterprises, which have large cash balances will be
encouraged to restart investment. Proposals pending with the Foreign Investment Promotion Board will be
processed and decisions taken expeditiously.
Clarity in tax laws, a stable tax regime, a non-adversarial tax administration, a fair mechanism for dispute
resolution, and an independent judiciary will provide great assurance to investors. We will take corrective
measures wherever necessary. We have recently appointed two Committees, one to examine GAAR legal
provisions and guidelines and the other to review taxation of the IT sector and Development Centres. I have
also directed a review of tax provisions that have a retrospective effect in order to find fair and reasonable
solutions to pending as well as likely disputes between the Tax Departments and the Assessees concerned.
With these measures, and some other measures that we hope to take in the short term, it is our intention to
raise the level of investment to 38% of the GDP that was achieved in 2007-08.
I believe that, around the world, there is enormous goodwill for India and most people continue to keep faith
with the India growth story. It is natural that they look closely at certain economic indicators, one of them
being the exchange rate. Volatility of the exchange rate has reduced in recent weeks. A reassurance on the
investment climate, continued inflow of remittances, and a rise in capital flows -both FDI and FII - will bring
further stability to the exchange rate. We intend to fine tune policies and procedures that will facilitate capital
flows into India.
A high level of savings is a pre-condition to a high level of investment. In 2007-08, savings touched 36% of
GDP. It is now down to 32% of GDP. One of the reasons may be a perceived lack of attractive investment
opportunities and instruments. Hence the attraction of gold, but gold is not a productive asset and the
demand for gold worsens the current account deficit. Both the mutual fund industry and the insurance sector
have turned sluggish. In the next few weeks, we will announce a number of decisions to attract more people
to invest in mutual funds, insurance policies and other well-designed instruments.
Manufacturing and exports are two key drivers of the economy. Both have registered low or negative growth
in recent months. It is imperative that we reverse this trend. Supply side constraints upon manufacturing and
exports must be removed in double quick time. We intend to work with manufacturers and exporters and
implement appropriate short term and medium term measures.
While greenfield investments are important, it is equally important that we implement the projects that are
under construction. We need to focus more closely on large projects as well as infrastructure projects. An
Investment Tracking System for projects with an outlay of Rs.1,000 crore or more has been put in place. The
Prime Minister has set specific targets for key infrastructure sectors. We will review the progress of each of
these projects, periodically, in the Cabinet Committee on Economic Affairs and remove the bottlenecks to
quicker implementation of the projects.
Some sectors are under stress, for example, petroleum, electricity and textiles. We intend to find practical
solutions to the problems that impede higher production or output in the coal, mining, petroleum, power, road
transport, railway and port sectors. The Cabinet Committee on Economic Affairs will examine the issues
affecting each sector and take decisions that will lead to quantitative growth in these sectors.
Unfortunately, the south west monsoon has been below expectations. Drought like conditions have been
reported from several States. It is the duty of the Government to provide relief to the people living in drought
affected districts, protect wage employment and save agricultural production to the extent possible.
MGNREGA and other schemes will be converged to meet the challenge of drought. Contingency plans are in
place to supply drinking water and fodder and to help farmers replant alternative crops. We must seize the
opportunity to build durable assets that will provide employment to the poor as well as help in drought-
proofing agriculture in the affected districts.
As I said at the outset, the Indian economy faces many challenges. We are challenged by the global economy.
We are challenged by the crisis that has afflicted several leading banks of the world. We are challenged by
natural calamities such as floods in one part of the country and drought in other parts of the country. Above
all, we are challenged by our own record of fiscal consolidation, high growth, moderate inflation and rise in
human development indicators that we achieved during 2004-08. Let us remember that we had faced similar
challenges in 1991, 1997 and 2008 and we overcame them. It is widely acknowledged that, today, the Indian
economy is stronger and better prepared to face the challenges. Moderate growth in two out of eight years
should not dent our confidence.
Several legislative proposals have gone through the full deliberative process and are ripe for debate and
passing in Parliament. I seek the cooperation of all political parties represented in Parliament to pass these
Bills. With the cooperation of political parties, civil society, farmers and workers, service providers, producers
and consumers, and scientists and technologists, I am confident that we will prevail and we will return to the
path of high growth, inclusive development, and economic and social justice for all."
Annexure V
Government of India
Ministry of Finance
(foreign Tax and Tax Research Division)
Dated 08.08.2012
Office Memorandum
A concern has been raised regarding the application of global profit method in taxation of companies
engaged in R&D activities in software development in India.
Most of these R&D centres In India have employed highly skilled manpower and generate intangibles,
However, Issues have been raised by the Industry on allocation of profit to such intangibles. Internationally
agreed practices :refer paragraph 2.109 of the OECD Transfer Pricing Guidelines for multinational enterprises
and Tax Administration edition 2012 which suggests use of Profit Split Method in cases Involving intangibles)
and the existing provisions of transfer pricing regulations in India (refer paragraph (d) of rule 109(1) of the
Income-tax Rules,1962), suggest use of profit split method in cases involving development of Intangibles,
The Hon'ble Finance Minister has approved the suggestion that the issue of application of Global Profit
Method to determine arm's length price of intangibles developed by the R&D centres of MNEs In India may be
considered by the Committee constituted by the Hon'ble PM.
(Batsala Jha Yadav)
Director (APA)
FT & TR-l, CBDT
Ms Anita Kapoor,
Director General of Income-tax (Admn),
Member,
Committee to Review Taxation of
Development Centre and the IT Sector

Annexure VI
OTHER TRANSFER PRICING ISSUES
A. Administrative Issues:
i. Higher margins adopted by the TPOs based on cherry picking of comparables.
ii. Not applying a turnover range while choosing comparables.
iii. Conducting fresh search of comparables by the TPOs including use of secret comparables by getting
information under Section 133(6).
iv. Application of some additional filters like different accounting year ending filter, employee cost filter,
diminishing revenue filter and significant activity (>75%) filter while searching for suitable comparables in
public databases like Prowess and Capital Line.
v. Rejection of filters applied by the assessee such as marketing expenses to sales >3% and R&D expenses to
sale >3%.
vi. Issue of risk adjustment, working capital adjustment and capacity utilisation adjustments.
vii. Accounting issues of bank charges, foreign exchange fluctuation, provision for bad & doubtful debts, etc.
B. Legal Issues:
i. Rejection of use of multiple year data and earlier data.
ii. Use of current year data and also use of data, which was not available to the assessee at the time of TP
documentation.
iii. Use of inter-quartile range instead of arithmetic mean.

First Report of The Committee To Review Taxation of Development Centres and The IT Sector

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First Report of The Committee To Review Taxation of Development Centres and The IT Sector

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14th September, 2012

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

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

iv.Shri Dinesh Kanabar, Tax Expert - Member

1.8 Interaction with the stakeholders

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

ii. 'Department of Commerce (DoC)

iii Department of Economic Affairs (DEA)

iv. Department of Industrial Policy & Promotion (DIPP )

v. Central Board of Direct Taxes (CBDT)

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

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

viii. CII (Confederation of Indian Industry)

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

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

xi. PHDCCI (PHD Chamber of Commerce & Industry)

xii. ICAI (Institute of Chartered Accountants of India)

xiii. PWC (Price Waterhouse Coopers)

xiv. E&Y (Ernst & Young)

xv. Deliotte Haskins & Sells

xvii. BMR Advisors

xviii. Khincha and Khincha, Bangalore

xix. T. P. Ostwal & Associates, Mumbai

xx. Vaish & Associates, Delhi

xxi. Vispi T. Patel & Associates, Mumbai

ii. American Chamber of Commerce (Amcham)

iii. Baker & McKenzie representing the Software Coalition

iv. Sonata Software Ltd.

v. Coalition on International Taxation in India

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

i. NASSCOM (including E&Y)

iii. ASSOCHAM (including PWC)

1.16 Approach of the Committee:

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

Financial year Number of TP Number of % of adjusted Amount of

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

2.6 Broad Concerns Flagged by the Industry Stakeholders

2.7 Specific Issues

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

ii. Application of Most Appropriate Method

2.8 Work carried on by the Development Centres (DCs)

2.9 Views of the Industry

i. Envision & Plan

v. Deploy & Maintain

Contracted Development Cost Sharing/ Contribution Entrepreneur

• Hiring/Terminating services of contract researcher

• Type of research to be carried on and assigning objectives

• Budget to be allocated for research

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

• Setting stage for decision making

2.10 View of Revenue 2

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

2.11 Recommendations of the Committee: