US tightens grip on Indian R&D centres

On August 1, 2006, the Internal Revenue Service of US issued new transfer pricing regulations for transactions involving provision of intra-group services ("service regulations"). The service regulations also cover transactions involving transfer of intangibles. These regulations replaced the 1968 guidelines and shall be effective from
January 2007.

Given the significant cross border trade of services with the US, the service regulations are of particular significance for India. The regulations require US multinationals doing business in India to undertake a thorough review of service contracts with their Indian subsidiaries. Key features of the regulations impacting Indian subsidiaries is discussed below.

Services Cost Method: SCM allows US multinationals to charge their subsidiaries for specified services at cost. "Specified services" cover primarily low-margin services such as back office and administrative services including payroll, HR, accounting, tax compliance, legal and public relations common to most industries.

It does not include executive or managerial services. Multinationals require supporting documentation to demonstrate that transactions involving provision of inter-group services fall under the specified category.

The regulations explicitly recognise "shared services arrangements" involving two or more participants, with at least one participant deriving benefit from the shared service.

Contingent payment for R&D: The regulations separately acknowledge contingent payment agreements under which payment for services is made conditional on achievement of certain results.

For example, an agreement for R&D services could require contingent payment. The service regulations recognise that there can be a range of correct prices for such agreements and as long as the taxpayer falls within that range, no adjustment should be made.

Service transactions involving transfer of intangibles: Under service regulations, ownership of intellectual property shall generally be determined with reference to legal title. However, legal ownership should be consistent with economic ownership (based on development efforts undertaken by each entity). Hence, if a related entity undertakes marketing, it shall be entitled to incremental profit arising from the success of marketing efforts.

The regulations define the circumstances under which a transaction entailing provision of services would involve transfer of intangible. For example, a contract R&D service provider shall not be considered to have transferred know-how or other intangibles unless it has ownership of such intangibles by contract or any other prior arrangement.

Typically, all R&D work undertaken by Indian subsidiaries of US multinationals is contract based and the ownership of intangibles rests with the head office.

Stewardship expenses: Stewardship services are services performed by the parent organisation to serve its interest as a shareholder. For example, services such as emergency management or technical advice (trouble shooting) or in some cases, support in day to day management.

Since, stewardship services primarily benefit the group as a whole and do not provide direct benefit to the recipient, they are of a non-chargeable nature. The regulations have significantly narrowed down the scope of stewardship services by prescribing that the 'sole effect' (rather than the 'primary effect') of the service should be benefit to the group as a whole.

Thus, even if a service benefits the recipient incidentally, it shall not qualify as a stewardship activity. For example, review or oversight activities would be classified as chargeable under the regulations, since it provides direct benefit to the recipient. In summary, the move is going to thrust stricter compliance on US head offices to pass most
costs to their respective subsidiaries.

Implications for Indian subsidiaries: The regulations would clearly affect chargeability of several services already being provided to Indian subsidiaries and impute further charges for services previously considered as non-chargeable.

Prior to the new regulations, multinationals had an option to club several inter-related services and levy a single charge for the entire gamut of services. The new regulations, particularly SCM, would necessitate maintenance of onerous documentation for low margin services. The captive Indian business process outsourcing and the knowledge processing outsourcing units shall be impacted the most.

Similarly, shared services arrangement, contract R&D and contingent payment arrangement shall require separate documentation with description of benefits to Indian subsidiaries resulting from such arrangement.

Given the strict benefits test the Indian revenue has adopted for allowing deduction towards intra-group services, the only concern is that a US corporation should not lose out on deduction (as a result of new US regulations) in both jurisdictions- that would certainly be a double whammy!

The US regulations are at variance to the definition of stewardship services in the OECD transfer pricing guidelines. In determining whether services are of a stewardship nature, Indian Revenue would in all likelihood rely on approach of OECD member countries.

Therefore, there is a possibility that Indian Revenue may disallow expenses for activities considered as chargeable by service regulations. This would throw open the door to double taxation conflicts.

India's numerous R&D centres in pharmaceutical, engineering design and technology sectors catering to US parent would have to review existing contracts for development of intangibles.

Though the service regulations recognise legal ownership, they do not disregard efforts undertaken by entities (other than legal owner) for development of intangibles. This provides flexibility in tax planning to allocate income from intangibles based on developmental efforts.

The possibility of greater income flows to Indian R&D centres seems high.

Whether or not the newly introduced regulations meet IRS's objective of reducing compliance burden for corporations is something that time would tell. However, the regulations would certainly bolster revenue collections for IRS, while making US services costlier for Indian subsidiaries.