CONFIDENTIAL

Fourth Report
of the Committee
to Review
Taxation of Development
Centres and the IT sector

(Safe Harbour for Contract R & D in the IT Sector)

5th April, 2013

 CONTENTS

Page No.

Part -1 Introduction 1

Part -2 Deliberation in the Committee 3

Part -3 Safe Harbour for Contract R & D in IT Sector 6

Part -4 Recommendations 32

Annexure –I Press release of Prime Minister’s Office dated 44

30th July,

Annexure –II Department of Revenue O M dated 13th September, 2012 47

Annexure –III India accounts for a small proportion of the total R&D 48
investments by global companies despite having talent pool
across verticals.

Annexure –IV Data from Office of the Director General of Income Tax, 49
(International Taxation), New Delhi

Annexure –V Margins of major global software product/ services 52

companies

Annexure –VI Analysis of profitability of non-captive Indian companies 53

engaged partly in outsourced software product
development.
 FOREWORD
The Prime Minister had constituted this Committee to Review Taxation of
Development Centres and the IT Sector and to recommend Safe Harbour
provisions for taxpayers doing business in certain sectors. The Committee has
already submitted three reports to the Government and is glad to furnish its
fourth report now. This report is the third on Safe Harbour provisions. The first
report, submitted on 14th September, 2012, had addressed the taxation issues
confronting the IT Sector and the Development Centres. The second report
(first on Safe Harbour provisions), submitted on 13th October, 2012, had laid
down the recommendations for Safe Harbour provisions for the IT-Software
and ITES sectors. The third report, submitted on 18th December, 2012, had
recommended Safe Harbour provisions for two areas of the financial sector,
i.e., Outbound Loans and Corporate Guarantees.

This report, the fourth, contains the Committee’s recommendations for Safe
Harbour provisions in respect of Contract R&D in the IT Services Sector. Two
more reports on Safe Harbour provisions for Contract R&D in the
Pharmaceutical Sector and for Auto Ancilliaries [Original Equipment
Manufacturers], respectively, would be submitted by the Committee in this
month itself.

While furnishing this report, I must duly acknowledge the outstanding

contributions made by its members, namely, Ms. Anita Kapur, Member (A&J),
CBDT, Ms. Rashmi Saxena Sahni, DIT (Transfer Pricing-I), Delhi and Mr. Dinesh
Kanabar, Tax Expert, in examining the issues and finalizing the Committee’s
approach. All of them have displayed an amazing degree of commitment
and conviction. Their invaluable inputs have enabled the Committee to
finalise its recommendations.

I would also like to appreciate the sincere efforts put in by the three senior
officers of the Department, namely Shri Subhakant Sahu, Shri D. Prabhakar
Reddy and Shri Sobhan Kar, Addl. Commissioners of Income-tax, to assist the
Committee in its deliberations and finalization of its recommendations.

Lastly, I would like to place on record the Committee’s appreciation of the

efforts put in by the staff of the Member (A&J), CBDT in providing logistical
assistance to the Committee in finalizing this report.

N. Rangachary,
Chairman
5th, April, 2013
 CONFIDENTIAL

Fourth Report
of the Committee
to Review
Taxation of Development
Centres and the IT sector

(Safe Harbour for Contract R & D in the IT Sector)

5th April, 2013

 CONTENTS

Page No.

Part -1 Introduction 1

Part -2 Deliberation in the Committee 3

Part -3 Safe Harbour for Contract R & D in IT Sector 6

Part -4 Recommendations 32

Annexure –I Press release of Prime Minister’s Office dated 44

30th July,

Annexure –II Department of Revenue O M dated 13th September, 2012 47

Annexure –III India accounts for a small proportion of the total R&D 48
investments by global companies despite having talent pool
across verticals.

Annexure –IV Data from Office of the Director General of Income Tax, 49
(International Taxation), New Delhi

Annexure –V Margins of major global software product/ services 52

companies

Annexure –VI Analysis of profitability of non-captive Indian companies 53

engaged partly in outsourced software product
development.
 FOREWORD
The Prime Minister had constituted this Committee to Review Taxation of
Development Centres and the IT Sector and to recommend Safe Harbour
provisions for taxpayers doing business in certain sectors. The Committee has
already submitted three reports to the Government and is glad to furnish its
fourth report now. This report is the third on Safe Harbour provisions. The first
report, submitted on 14th September, 2012, had addressed the taxation issues
confronting the IT Sector and the Development Centres. The second report
(first on Safe Harbour provisions), submitted on 13th October, 2012, had laid
down the recommendations for Safe Harbour provisions for the IT-Software
and ITES sectors. The third report, submitted on 18th December, 2012, had
recommended Safe Harbour provisions for two areas of the financial sector,
i.e., Outbound Loans and Corporate Guarantees.

This report, the fourth, contains the Committee’s recommendations for Safe
Harbour provisions in respect of Contract R&D in the IT Services Sector. Two
more reports on Safe Harbour provisions for Contract R&D in the
Pharmaceutical Sector and for Auto Ancilliaries [Original Equipment
Manufacturers], respectively, would be submitted by the Committee in this
month itself.

While furnishing this report, I must duly acknowledge the outstanding

contributions made by its members, namely, Ms. Anita Kapur, Member (A&J),
CBDT, Ms. Rashmi Saxena Sahni, DIT (Transfer Pricing-I), Delhi and Mr. Dinesh
Kanabar, Tax Expert, in examining the issues and finalizing the Committee’s
approach. All of them have displayed an amazing degree of commitment
and conviction. Their invaluable inputs have enabled the Committee to
finalise its recommendations.

I would also like to appreciate the sincere efforts put in by the three senior
officers of the Department, namely Shri Subhakant Sahu, Shri D. Prabhakar
Reddy and Shri Sobhan Kar, Addl. Commissioners of Income-tax, to assist the
Committee in its deliberations and finalization of its recommendations.

Lastly, I would like to place on record the Committee’s appreciation of the

efforts put in by the staff of the Member (A&J), CBDT in providing logistical
assistance to the Committee in finalizing this report.

N. Rangachary,
Chairman
5th, April, 2013
 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

PART-1: INTRODUCTION

1.1 Prime Minister’s Office issued a press release on July 30, 2012 (Annexure-I),
stating that the Hon’ble Prime Minister had constituted a Committee to Review
Taxation of Development Centres and the IT Sector under the Chairmanship of
Shri N. Rangachary, former Chairman CBDT & IRDA. The Committee submitted its
first report to the Government on 14th September, 2012 covering issues listed in
the terms of reference of the Committee, except the following:

“Engage in sector-wide consultations and finalise the Safe Harbour provisions

announced in Budget 2010 sector-by-sector.”

1.2 The rationale for entrusting the Committee with the task of finalising Safe
Harbour rules was explained in the Press Release (ibid) as follows:

“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”

1.3 The Committee was advised to suggest Safe Harbour Rules individually,
sector-by-sector, in a staggered manner.

1.4 Vide Office Memorandum dated 13th September, 2012 (Annexure-II), the
Finance Minister has approved that the Committee may finalise the Safe
Harbour Rules in the following sectors / activities:

(a) IT Sector

(b) ITES Sector

(c) Contract R&D in the IT and Pharmaceutical Sector

1

(d) Financial Transactions – Outbound loans

Page

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

(e) Financial Transactions – Corporate Guarantee

(f) Auto Ancillaries – Original Equipment Manufacturers

1.5 The Committee submitted its second report, the first on Safe Harbours, on
13th October, 2012 to the Government. That report contained its
recommendations for Safe Harbour rules for IT and ITES sectors.

1.6 The Committee’s third report, which made recommendations for Safe
Harbour rules for financial transactions of outbound loans and corporate
guarantees, was submitted on 18th December, 2012.

1.7 This report, the Committee’s fourth, contains Safe Harbour

recommendations on Contract R&D in the IT Sector but not in the
Pharmaceutical Sector. As there is an organic linkage between this report on
Contract R&D in the IT Sector and the earlier one on Safe Harbours for IT and ITES
sectors, it is being submitted separately. The reports for the remaining 2 sectors,
namely, contract R&D in Pharmaceutical Sector and Auto Ancillaries – Original
Equipment Manufacturers, would be submitted shortly.

***
2
Page

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

PART-2: DELIBERATIONS IN THE COMMITTEE

2.1 Part 2 of the first report of the Committee on Safe Harbours (second report
of the Committee) for the IT (Software) & ITES sectors included a detailed
analysis of the statutory provisions regarding Safe Harbours [Section 92CB of the
Income-tax Act], the need for having Safe Harbours and the opposition to the
same, types of Safe Harbours, cross country transfer pricing simplification
measures, and existing transfer pricing simplification measures in India.

2.2 Since those concerns, analyses and explanations, in the view of the
Committee, are equally relevant for this report, reference is invited to the said
portion of the first report on Safe Harbours. However, no detailed discussion on
these issues is being incorporated here to avoid repetition.

2.3 Suggestions and data to frame Safe Harbour provisions for contract R&D
in the IT Sector were invited from the following stakeholders:

• Central Board of Direct Taxes;

• NASSCOM (National Association of Software and Service Companies)

• CII (Confederation of Indian Industry)

• FICCI (Federation of Indian Chambers of Commerce and Industry)

• ASSOCHAM (Associated Chambers of Commerce and Industry of India)

• PHDCCI (PHD Chamber of Commerce & Industry)

• ICAI (Institute of Chartered Accountants of India)

• PWC (Price Waterhouse Coopers)

• E&Y (Ernst & Young)

• Deloitte Haskins & Sells

KPMG
3

•
Page

• BMR Advisors

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

• Vaish & Associates, Delhi

• T. P. Ostwal & Associates, Mumbai

2.4 Discussions were also held by the Committee members with Shri Ajay
Choudhary, 1 founder HCL Technologies, to understand the business model
generally prevalent in this sector i.e., contract R&D in IT. Shri Choudhary
explained how concurrent engineering for the product is done by the industry.
According to him, -

• The concept of Concurrent Engineering is of significant importance in

respect of contract R&D.
• Concurrent Engineering generally refers to the process through which an
R&D work to be outsourced is determined.
• All the Divisions of the parent company [other than the R&D Division] like
Sales, Engineering or Manufacturing interact extensively with each other
and then give inputs of their own Division to the R&D Division.
• This helps the R&D Division to arrive at an agreed upon specification of the
R&D to be done.
• This specification is dependent upon the product or process (output) that is
envisioned as a result of the R&D. This whole process is known as
Concurrent Engineering.
• Thereafter, the parent company takes a call to outsource the various
modules of the R&D work to any of its captive R&D centres in the world.
The final product is the result of the integration of all the R&D modules.
• Concurrent Engineering demonstrates that the decision on the R&D to be
done is taken at the level of the parent company.

2.5 To facilitate the Safe Harbour analysis for Contract R&D in the IT Sector,
the Central Board of Direct Taxes (CBDT) and industry stakeholders were asked
4
Page

1He can be contacted at email id: [email protected]. His office telephone no. is 0120-
2544522

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

to provide their comments and data. Data was called for in respect of the value
of international transactions; the margins shown by the assessee; and the
margins adopted by the Transfer Pricing Officers (TPOs) across the country for
Assessment Years 2006-07, 2007-08 and 2008-09. In addition, the Income Tax
Department was requested to furnish data for A.Y 2009-10 too, as Transfer Pricing
audit for the said assessment year concluded recently in January, 2013.

***
5
Page

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

PART-3: SAFE HARBOUR FOR CONTRACT R & D IN INFORMATION TECHNOLOGY

SECTOR

3.1 The Economic Survey 2012-132 acknowledges that, “the IT-ITES industry has
four major sub-components: IT services, Business Process Outsourcing (BPO),
Engineering Services and R&D, and software products.” This report provides
recommendations on Safe Harbour for contract R&D in the IT Sector.

3.2 But what is Research and Development (R&D)? R&D is defined by

Cambridge’s Advanced Learner’s Dictionary as “the part of a business that tries
to find ways to improve existing products and to develop new ones”3.

3.2.1 The UNCTAD’s Investment Report – 2005 defines R&D as follows:

“R&D is only one component of innovation activities, but it represents the most
developed, widely available, and internationally comparable statistical
indicator of industrial innovation activities.”

3.2.1.1 The report refers to an OECD study and states that R&D (also called
research and experimental development) comprises creative work “undertaken
on a systematic basis in order to increase the stock of knowledge, including
knowledge of man, culture and society, and the use of this stock of knowledge
to devise new applications (OECD 2002b, p. 30).

3.2.1.2 The report goes on to say that R&D involves novelty and the resolution of
scientific and technological uncertainty. It includes basic and applied research
along with development (United States, NSB 2004):

2 Paragraph 10.42, page 223 of Economic Survey 2012-13, Ministry of Finance, Government of
6

India
Page

3 Cambridge’s Advanced Learner’s Dictionary -

http://dictionary.cambridge.org/dictionary/british/re-search-and-de-velopment

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

• Basic research. The objective of basic research is to gain a more

comprehensive knowledge or understanding of the subject under study
without specific applications in mind. In industry, basic research is defined
as research that advances scientific knowledge but does not have
specific immediate commercial objectives.

• Applied research. The objective of applied research is to gain the

knowledge or understanding to meet a specific, recognized need. In
industry, applied research includes investigations to discover new scientific
knowledge that has specific commercial objectives with respect to
products, processes, or services.

• Development. Development is the systematic use of the knowledge or

understanding gained from research directed towards the production of
useful materials, devices, systems or methods, including the design and
development of prototypes and processes.

3.2.1.3 It further states that for data collection purposes, the boundary between
R&D and other technological innovation activities can be found in pre-
production development activities (OECD 2002b). In practice, however, it is
difficult to make the distinction. In technology-intensive industries, distinguishing
between “research” and “development” is especially difficult since much of the
R&D work conducted involves close interaction between researchers in both the
private and public sectors, often also including close collaboration with
customers and suppliers (BIAC2005, Amsden and Tschang 2003).

3.2.2 As is well known, R&D off-shoring started in India in 1984 with Texas
Instruments setting up its first R&D centre in Bangalore and there has been no
looking back since then. The Committee has noted that there is a growing
perception that India must have a place in the top league and paragraph
7
Page

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

10.22 of the Economic Survey identifies R&D as an important service in the Indian
economy. The survey4 goes on to state further as follows:

Quote:

10.45 Among business services, R&D occupies the second position in

India’s GDP with growth being consistently high at near 20 per cent in the
last few year with growth in 2011-12 at 20.5 per cent. Until recently, the
competitive advantage in R&D was almost exclusively with the
developed economies. Of late, emerging countries are increasingly
involved in R&D and innovation, with active involvement of both public
and private sectors. Factors such as low cost, access to new markets,
availability of knowledge-oriented manpower, favorable regulatory
environment, and fiscal benefits play a major role in driving R&D
investments toward emerging economies. These countries are also
encouraging innovation through legal, regulatory, and policy support.

10.46 The US $ 1.5 trillion global gross expenditure on R&D (GERD) for
2013 projected by Battelle and R&D magazine is expected to grow by
more than US$ 50 billion over the previous year. In this enormous activity,
India’s share is 3 per cent with GERD in PPP (purchasing power parity)
terms projected at US $ 45.2 billion which is around five times lower than
that of China. As a percentage of GDP also it is low at 0.9 per cent. This is
partly because the size of the R&D base and absorption capacity is not
commensurate with requirements. As per the report, the share of basic
research in India’s R&D is estimated to be 26 per cent, applied research
36 per cent, development research 32 per cent, and other research 6
percent. Government funding of R&D accounts for two–thirds of the total
8

4 Paragraphs 10.45 and 10.46, page no. 225 of Economic Survey 2012-13, Ministry of Finance,
Page

Government of India.

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

funding. Industry contribution to R&D has been steadily increasing over

the years but is still less than third of the total. Government support for R&D
in India tends to focus on classical objectives for public R&D funding such
as nuclear energy, defence, space, health, and agriculture.

Unquote

3.2.3 Jose Guimon,5 in his paper ‘Global trends in R&D–intensive FDI and policy
implications for developing countries’, states as follows:

Quote:

R&D-intensive FDI was formerly a triadic rather than global phenomenon,

with both inflows and outflows heavily concentrated in the US, Western
Europe and (to a lesser extent) Japan. However, during the last decade
the relevance of developing countries in global innovation networks has
increased substantially. This can be ascribed largely to the sharp increase
in new R&D investments by MNCs in China and India during the last
decade, although starting from a very low base: the number of R&D
centres owned by foreign MNCs rose from only 100 in each of the two
countries in 2001 to 1100 in China and 780 in India by the end of 2008
(Bruche, 2009). According to Jaruzelski and Dehoff (2008) eighty-three
percent of all new R&D sites opened between 2004 and 2007 by the
largest 1000 MNCs by R&D expenditure were located in China or India.

Unquote

3.3 The NASSCOM has acknowledged that new software product companies
are enrolling as its members. About 30 software product firms, who are also
members of software body NASSCOM, have formed a policy think tank called
9
Page

5Guimon, Jose, PhD, Global trends in R&D–intensive FDI and policy implications for developing
countries, page 6.

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

Indian software product Industry Round Table or 'iSpirit' to share expertise and
further develop the software products industry in the country.

3.3.1 This phenomena has also been highlighted by Nirmalya Kumar6/ Panish
Puranam in their book, ‘India Inside’, wherein they have stated as follows:

Quote:

In many of the captive units we researched for this book, we found

instance of truly novel and unique technology developments for global
market. Yet global consumers rarely recognize India as the country of
origin, because most of this innovation takes place in the B2B context.
When we refer to the B2B context, we do not necessarily mean only
product or service markets in which the customers are firms, rather than
individual consumers. Instead we mean that the innovation occurring in
these Indian captive units is visible only to other business units, whether
within or outside the MNC, regardless of who purchases the final product.

To understand the nature of this invisibility, consider the idea of

segmenting R&D activities that is, breaking activities down into smaller
parts that can be performed in different geographies. An obvious
segmentation of R&D is vertical, into processes that capture customers,
requirements, generate product specifications, search out technological
solutions to meet the desired specifications, prototype the results, and
then manufacture and sell the results of the process. This type of
segmentation creates a strong sense to sequence: one process requires
the preceding processes to have been conducted, if not completed.
Another method is horizontal – a kind of segmentation that often arises
10

6Kumar, Nirmalya and Panish Puranam, India Inside, Ed. 2012, Harvard Business Review Press,
Boston, Massachusetts, Pages 31-32.
Page

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

from complex, multi component technologies, such as engines, IT

hardware, or even complex software. The various components involved,
in principle, could be developed in parallel, as long as the component
interfaces support eventual assembly and interoperability.

Unquote

3.3.2 Jose Guimon,7 (ibid), quoting Velde, states:

Quote:

According to Velde (2001), pro-active and strategic FDI policy

interventions affecting the dynamic pattern of national comparative
advantages become necessary in order to avoid the risk of low-skill, low-
income trap. Lall (2004) also argues that the need for policy intervention
has become stronger given the fast pace of globalization and
technological change. Attracting R&D–intensive FDI requires a more
proactive kind of intervention, unlike generic FDI policies which can rely
largely on investment liberalisation along with marketing and promotion.

Unquote

3.3.3 R & D is being increasingly undertaken in developing countries due to

various factors called ‘push and pull’ or ‘demand and supply’. As Rakesh
Basant and Sunil Mani state in their working paper for IIM Ahmedabad,8 -

Quote:

Push (or demand) factors include increasing competitive pressure that firms
in developed countries have to face. These include increase in
11

7 Guimon, Jose, PhD, Global trends in R&D–intensive FDI and policy implications for developing
countries, page 9.
Page

8 Basant, Rakesh and Sunil Mani, Foreign R&D Centres in India: An Analysis of their Size, Structure

and Implications, W.P. No. 2012-01-06, January 2012, IIM Ahmedabad, pages 24-25.

Page 11 of 53
 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

international competition and increased importance of product

performance and quality based competition. There are also pressures to
shorten international product penetration of new products and need to
launch products in different markets simultaneously. Such competition
seems to be accompanied by simultaneous processes that not only
increase product differentiation but also homogenize markets globally.
Such changes require firms to innovate rapidly and at lower costs but the
cost of R&D in developed nations are on the rise and at times relevant
scientific manpower is simply not available. With the increase in technology
intensity and complexity of innovative products, process and services and
the multi-disciplinary nature of R&D activity, firms find (internal capabilities
to be either inadequate or too expensive. The sharp declines in product
(Services) life cycles also enhance the need to reduce cost and increase
the speed to market. Decentralization of R&D is seen as a response to these
competitive and associated pressures. The emergence of ICT that
facilitates rapid and meaningful interaction across geographies has also
enhanced the potential of decentralization. Change in technologies and
use of ICT also create opportunities for increasing modularity of innovation
and different modules can potentially be developed in different locations.
Given the ‘push’ factors, availability of R&D skills at competitive wages, a
well-developed nation innovation system, globalization of production
requiring R&D in proximate regions, market demand for R&D based
products can act pull factors for R&D activity in a specific region. For
example, Mitra (2007) argues that that salaries of researchers account for
about 45 percent of total R&D expenditure in the US and if the same is
undertaken in India, the costs can much lower. Based on the information
available to him for the year 2005, his estimates suggest significant cost
12

savings.
Page

Unquote

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

3.3.4 The above view is also supported by Jose Guimon,9 (ibid) as follows:

• R&D-intensive FDI may be demand-driven, supply-driven or efficiency-

seeking.

• Demand-driven R&D is associated with knowledge-exploiting motivations

and primarily oriented towards the adaptation of products, services or
processes to overseas markets. Demand-driven and efficiency-seeking
R&D subsidiaries tend to focus initially in lower-end and routine R&D
activities (Manning et al., 2008).

• Demand-driven R&D is often closely connected to the internationalization

of manufacturing operations and attracted by large and dynamic
markets.

• Whereas supply driven R&D is related to knowledge-augmenting

motivations, i.e. to tapping into foreign sources of knowledge. In this case
the location decision is driven by the quality of local universities, human
capital, research infrastructure and the presence of specialized clusters,
rather than by the size or dynamism of the domestic market.

• In other circumstances the international allocation of R&D is driven mainly

by efficiency-seeking motivations, where certain segments of the R&D
value chain are relocated to lower cost locations.

• These different strategic motivations are closely related to the distinction

between competence creating and competence exploiting mandates of
MNC subsidiaries (Cantwell and Mudambi, 2005).
13
Page

9
Guimon, Jose, PhD, Global trends in R&D–intensive FDI and policy implications for developing
countries, page 7.

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

• In practice, the different R&D motivations are often hard to differentiate,

and a single subsidiary may undertake different R&D projects, some of
them demand-driven, others supply-driven, etc.

• The strategic content of international R&D mandates evolves through time

in response to changes in corporate strategies and subsidiary
competencies.

3.3.5 He further highlights conclusions by others in this regard as follows10,-

Quote :

Puga and Trefler (2010) suggest that developing economies normally

engage initially only in incremental (rather than radical) R&D, related to
addressing production-line bugs and suggesting minor product
improvements. But these lower-end R&D activities may act as a seed in the
sense that, with time, they may enable a shift towards higher value adding
R&D activities following learning and competence building in the
subsidiaries (Chaminade and Yang, 2008; Medcof, 2007; Puga and Trefler,
2010). Indeed, the developmental impact of demand-driven and
efficiency-seeking R&D should not be neglected. Rather, such R&D
activities should be seen as an invaluable opportunity for an evolutionary
upgrading of technological capabilities.

Unquote

3.4 Size and Characteristics of the sector

3.4.1 Rakesh Basant and Sunil Mani, in their W.P,11 have referred to a 2006 study
by TIFAC and summarized the main findings of the study with regard to FDI in
R&D as follows:
14
Page

10
Ibid, page 8.

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

• R&D Services has emerged as the third segment in Export of IT Services - it

occupies a share of 18.4% of software exports accounting for an annual
value of $2.3 billion (during 1998-2003).

• R&D investment worth of $1.13 billion has flowed into India during the five
year period 1998-2003.

• US is the largest investor followed by Germany, Korea, France and Japan.

China too has established centres in India.

• The study identified 100 R&D centres employing 22980 scientists and
engineers.

• Lower costs and availability of scientists and engineers are the main
determinants.

• IT and Telecom, followed by pharmaceutical, auto and chemicals in

general are the major industries attracting FDI in R&D.

• Nearly half the FDI companies are cases of relocation of in-house R&D in
home country to offshore location in India.

• Partnerships with local companies are good at the start but partnerships
are not forever – 56 percent of FDI companies prefer to work alone in
India, with 100% foreign equity without local partners in equity.

Source: TIFAC (2006)

3.4.2 A study12 by Zinnov Management Consulting shows that India accounts

for a small proportion of the total R&D investments by global companies
despite having a strong talent pool across verticals (Annexure-III).
15

11
Basant, Rakesh and Sunil Mani, Foreign R&D Centres in India: An Analysis of their Size, Structure
Page

and Implications, W.P. No. 2012-01-06, January 2012, IIM Ahmedabad, page 29.
12 Zinnov Management Consulting, Global R&D Benchmarking Study – F.Y 2011, June, 2012.

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

3.4.3 Rakesh Basant and Sunil Mani13 have also stated in their paper;

Quote:

Further, we compared the list of centres arrived at by Zinnov with those

arrived at by the original 2006 TIFAC study. So the total number of foreign
R&D centres operating from India is reckoned to about 639 as on January
2010 although according to Zinnov (2011) this is about 871 by December
2010. A recent TIFAC sponsored study (Mrinalini, et al, 2010) arrives at a
total number of 700 although even in this study the criteria for identifying
the R&D centres is not spelt out in explicit terms. In sum, all estimates of the
number of foreign R&D centres are mere guesstimates and its exactness
may not be taken for granted but only as a broad approximation.

Unquote

3.4.4 Jose Guimon,14 (ibid) has also observed that,-

Quote:

R&D-intensive FDI is expected to bring significant benefits to host countries

by enabling an upgrading of technological capabilities as well as a better
access to international markets (Cantwell and Piscitello, 2000; Carlsson,
2006; Santangelo, 2005). In view of the potential benefits, attracting (and
embedding) R&D-intensive FDI is becoming a critical concern for
policymakers across developed and developing countries alike. But the
benefits associated with R&D-intensive FDI do not accrue automatically; a
threshold level of absorptive capacity is required in order to tap into the
16

13
Basant, Rakesh and Sunil Mani, Foreign R&D Centres in India: An Analysis of their Size, Structure
and Implications, W.P. No. 2012-01-06, January 2012, IIM Ahmedabad, page 31.
Page

14 Guimon, Jose, PhD, Global trends in R&D–intensive FDI and policy implications for developing

countries, page 2.

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potential externalities. The impact of R&D-intensive FDI on host countries

comprises direct and indirect effects (Gorg and Strobl 2001; Narula and
Dunning, 2010).

Unquote

Absorptive capacity has been defined in his paper as the firm’s or country’s
ability to acquire, assimilate and exploit knowledge developed elsewhere.

3.4.5 As stated in the first report of the Committee, NASSCOM has given three
types of contractual structures prevalent in India in this sector. This is reiterated
below for the purpose of easy reference.

CONTRACTUAL STRUCTURES
Contracted Cost Sharing/ Entrepreneur
Development Contribution
• Parties of service • Parties agree to form • The company
provider and service partnership to pool undertakes the R&D
recipient have respective on its own account
contractual IP, and share risk and and bears full risk and
agreement. reward from future R&D reward from future
• Service provider • Both parties R&D.
has no ownership/ rights contribute IP, or share the • The company
on IP associated with costs thereof and have bears the costs of
work Product: does not joint ownership of any IP R&D and has
contribute any IP either. developed going ownership of IP
• Service recipient forward. developed.
assumes all risk • Parties jointly share • The company
associated with work the risks, in their cost enjoys the profits
product. sharing ratio. associated with the IP
• Service provider is • Parties agree to developed.
generally compensated jointly share the profits
on commercial basis associated with the IP
17

(hourly/ lump sum for developed, as per

3rd party, and cost plus mutually negotiated
Page

for internal) terms.

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3.5 In this context, the position of NASSCOM, as stated at Para 2.9.3 of the First
Report of the Committee is relevant and, thus, is reproduced below for the sake
of clarity:

“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
Centres in India and their Principal R&D Company fit in the above profile.”

3.5.1 Typical features of such a model, as described by NASSCOM and already

included in the first report of the Committee, are as follows:

• 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.

• 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 HQs of
an MNC (Onsite). The proportion of onsite to offshore work for each stage
may differ from Development Centre to Development Centre.
18
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• 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:

1. 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.

2. Principal R&D Company designs research programmes, makes

decisions as to where R&D activities will be conducted, and regularly
monitors the progress on all R & D projects.

3. 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 the senior management of the principal R & D Company.

4. 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.

5. All patents, designs and other intangibles developed by Development

Centre research personnel are registered by principal R&D Company,
19

pursuant to contracts between the Development Centre and principal

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R&D Company.

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6. 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.

• In a scenario such as the above, 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; and 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 to be
compensated on a total cost plus basis.

• 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.

• 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
20

Company but it also has to be appreciated that any patent registration,

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based on contribution by India, cannot be commercially exploited on a

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standalone basis. Such Patent registration is only to safeguard the legal

rights of the principal against infringement of IP (by competitors), however
insignificant these rights may be. The Principal has rights to make 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

3.6 In this context, para 2.10 of the first report of the Committee, wherein the
view of the Revenue 15 is mentioned, may be referred to. The important
contentions contained therein are summarised as follows:

• 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.

• 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.
• Different companies adopt different models and type of R&D activities
and ratio of research and development of the revenue varies significantly.
• The categorization of off-shore development centre in India may be on the
basis of type, model and nature of R&D activity and reason and benefit of
21
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15 JS FT&TR, CBDT and agreed by DGIT (International Taxation)

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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.
• 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.
• Contractual agreements vary with the companies and it may be difficult
to construct a homogenous group on the basis of contractual agreement.

3.7 As regards the compensation model, the Indian industry, as quoted in the
first report of the Committee, is of the view that,-

Quote:

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 outcome;

the contract researcher is paid a guaranteed remuneration irrespective

of the outcome of the research;
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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
to 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.

Unquote

3.8 As regards methodology for benchmarking, industry is of the view

(reference paragraphs 2.13.3 - 2.13.5 of the first report of the Committee) that,-

Quote

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 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
23

(ii) where the Principal is located in tax havens/tax shelters with no

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significant functions performed or decisions taken outside of India.

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Application of PSM by India will increase the overall cost of undertaking

R&D work in India, though the quantification for the same would depend
on varied factors. Also, 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 position.

The complex transfer pricing issues need better understanding of the

larger R & D program of an MNC and a careful study of the functional
analysis in most cases would reveal that cost plus method would be
applicable. Both taxpayers and tax authorities need to work together to
ensure that this understanding increases quickly. In the meantime, the tax
authorities need to resist the temptation of using PSM on a generalized
basis to drive revenue collection when indeed the same would be grossly
incorrect for most contract R & D arrangements in India today.

Unquote

3.9 As mentioned in paragraph 2.9.2 of the first report of the Committee, the
views of Revenue on profile of a Development Centre and methodology for
benchmarking are as summarised below:

• Development Centres are no longer limited to standardized information

and technology but increasingly involve product development function
(engineering, R&D) and product design. Also distinction between home
24

based and foreign-based development centres has disappeared. These

Page

DCs are transferring intellectual property, the value of which is not known

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to the DCs. The FAR i.e. Function, Asset and Risk Profile of a DC will depend
on nature, business model, reasons and benefits of off-shoring, etc. In this
regard, 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.

• 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. The various factors
that are to be seen while determining the entity controlling a risk are such
as 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
result. The 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. For intangible
related returns, in situations where the R&D Centre is an entrepreneur or is
working under a cost contribution arrangement, Profit Split Method (PSM)
may be a more appropriate method but the current methods being
followed by the Department for applying PSM, such as those based on
R&D head count, may not be appropriate.

• The Offshore Development Centres in India are developing significant

intangibles, known by the patents being 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
25

unique, can be patented. Further Indian TP regulations justify the

Page

application of PSM when intangibles are involved. The example of patent

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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.

• The Issue of attribution of global profits under profit split method needs a
careful scrutiny in order to understand the extent of the problem.

3.10 As mentioned in the first report (para 2.15.1), the Committee

acknowledges that Research and Development function can be broadly
categorised in the following three baskets, 16 i.e.,-

• Full risk bearing developer viz. an entrepreneur

• Limited risk bearing developer viz. one who works under a cost
contribution arrangement

• Contract R & D service provider with no significant risks viz. one who works
under an assured return basis

3.10.1 Further, whenever industry refers to cost-plus or appropriate mark-up on

cost, the reference is to profit margin under Transactional Net Margin Method on
cost. The profit margin is computed on cost, excluding interest and tax. As most
of the captives follow cost plus business model, the principal reimburses all the
costs (before interest and tax) 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.
26
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16Report of Committee on Transfer Pricing Audits headed by B.D Bishnoi, DIT TP-Delhi, August,
2007, Paragraph 6.48, page 48.

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3.11 In Para 2.19.2 of the first report, the Committee has already
acknowledged the recommendations made by an earlier Committee17 set up
by the then DGIT (International Taxation) in 2007 under the then DIT(TP), Delhi,
which stated that Economic characterisation of R&D function can be illustrated
as follows:
• Full risk bearing developer of intangibles
• Limited risk bearing developer of intangibles
• Contract R & D service provider with insignificant risks

3.12 The Committee, in this report, is suggesting Safe Harbour for such R&D
service providers who act as contract R&D service providers with insignificant
risks. The Committee is of the view that R&D centres which bear full risk as
developers of intangibles (viz. who are Entrepreneurs) and limited risk bearing
Developer of intangibles (viz. who follow cost sharing /contribution models)
need a case specific FAR analysis and no general Safe Harbour can be
designed for such cases.

3.13 In its second report (first on Safe Harbour), the Committee had
emphasised that, “There should be a clear definition of what constitutes IT -
Software Services and IT Enabled Services. Besides, the definition of R&D in IT
Services is also required.” Consequently in para 3.5.1 of the Safe Harbour report
on IT and ITES, the activities covered in the two sectors were defined. It had also
been stated therein that R&D Services within IT Sector would have a separate
set of Safe Harbour rules.

3.13.1 To recapitulate, Para 3.5.1.1 of the second report of the Committee on

safe harbour for IT/ITES, provides a list of activities constituting Information
Technology (Software Sector). These activities are of a routine nature, such as
business application software and information system development using known
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17 Para 6.48 supra

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methods and existing software tools; support for existing systems; converting
and/or translating computer languages; adding user functionality to application
programmes; debugging of systems; adaptation of existing software; and
preparation of user documentation, that do not involve scientific and/or
technological advances or resolution of technological uncertainties;

3.13.2 Para 3.5.1.2 of the report referred supra, lists the services constituting
Information Technology Enabled Service (ITES) i.e., any service provided mainly
with the assistance or use of Information Technology such as back office
operations, call centres or contact centre services; data processing and data
mining; clinical database management services, etc.

3.14 In view of the above discussion, what is the definition of R&D in software is
a key question. In an article,18 Avron Barr and Shirley Tessler have stated,-
Quote:
Software R&D spans a set of tasks including conception, design,
specification, code development testing, and documentation. In the past
decade, most software outsourcing projects have focused primarily on
development and testing from clearly –defined and well-specified
requirements provided by the outsourcing organization. In the more
cutting-edge outsourcing endeavours, which have begun appearing more
regularly in recent year all parties to the project are involved with all stages,
including the design, since it necessarily evolves iteratively with
development, and is therefore much less amenable to formal specification.
Software R&D culminates in a finished program or systems, not in an input
that gets combined with other inputs in some proprietary way, and
certainly, not a discovery or invention whose commercial impact then
28
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18 Barr, Avron and Shirley Tessler, The Globalisation of Software R&D: The Search for Talent,

Stanford Computer Industry Project.

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depends on a secret process or methodology in the manufacture of the

final product.
Unquote
3.15 OECD’s Frascati Manual, 2002 defines the phrase research and
development 19 as,-
Quote:
Research and Experimental Development (R&D) comprise creative work
undertaken on systematic basis in order to increase the stock of
knowledge, including knowledge of man, culture and society, and the
use of this stock of knowledge to devise new application.
Unquote
3.16 Discussion within the Committee as to what constitutes IT Research and
Development services also considered the categorisation of the IT industry itself
as given in the Economic Survey. Besides, as already articulated in the first Safe
Harbour report for IT and ITES sectors, some activities were excluded from routine
ITS and ITES activities, as in the view of the Committee they constituted R&D
(reference para 3.5.1.1 of the said report). The same have been detailed in the
recommendations of the Committee contained in Part – 4 of this report.

3.16.1 Those activities are considered as distinct from software-related

activities of a routine nature because they do not involve scientific and/or
technological advances or resolution of technological uncertainties. Further,
even though Avron Barr and Shirley Tessler state that, “Software R&D culminates
in a finished program or systems, not in an input that gets combined with other
inputs in some proprietary way,” the Committee is of the view that though the
captive DCs may not be participating in the complete research for a finished
product, they are definitely engaged in developing a component of some
29

19http://www.oecd-ilibrary.org/science-and-technology/frascati-manual-2002_9789264199040-
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en

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value for the said product. The research may be multi-locational and this must
be taken cognisance of.

3.17 Methodology

3.17.1 At this stage, it is important to consider the relevance of the 4 Cs of

outsourcing i.e. Credibility, Capability, Capacity and (right) Costs. They must be
factored in while finalising the margins for comparability analysis for Safe
Harbours.

3.17.2 The Committee has taken note of Country Practice – India (Para
10.3.8.11) appearing as part of Chapter 10 in UN’s Practical Manual on Transfer
Pricing for Developing Countries, 2012 of the UN TP Manual, wherein the position
of India has been that in cases where the India-based R&D centre is engaged in
the creation of unique intangibles, additional compensation must be allocated
for transfer of intangibles in addition to the arm’s length compensation for the
R&D activities.

3.17.3 There is a view within the Committee that Safe Harbour margins must
recognise the following factors, which support outsourcing of R&D activities to
India:

• The captive DC conducting research provides a competitive advantage

to its parent in terms of costs and professional competence arising due to
locational advantage. India has unique location-specific intangibles such
as skilled workforce, connectivity facilities, lower costs and global delivery
model, which is, as claimed by NASSCOM, an Indian innovation.

• In addition to the above, the issue of market premium also needs to be

factored in.
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3.17.4 An alternate view within the Committee is that market premium or

location savings need not be factored in. The comparables chosen for the
purposes of evaluation of whether the pricing is at arm’s length operate in the
same location and enjoy the same market premium or location savings as are
enjoyed by the Indian captive service providers. As such, once an arm’s length
price is worked out and is factored in, evolving a safe harbour, there is no
question of incremental factoring in of market premium or location savings.

3.17.5 After considerable discussion, the Committee decided to consider an all

inclusive premium amount over and above the basic rate for this sector. In the
view of the Committee, Safe Harbours may be considered only for enterprises
carrying out contract R&D with insignificant risks. In other cases, where there is a
cost sharing or cost contribution arrangement (CCA) or entrepreneurial activity,
appropriate FAR analysis needs to be done on case specific basis, and hence
no Safe Harbours are recommended for these situations.

***
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PART 4 - RECOMMENDATIONS

4.1 Keeping in view the existing provisions of the Act and the directives as
contained in the press release of the PMO, dated 30.07.2012, the Committee
recommends that Safe Harbour provisions should be applicable to enterprises in
contract R&D in the IT sector. An enterprise eligible for Safe Harbour may be
called an ‘Eligible Enterprise’ and all the transactions that are eligible for Safe
Harbour may be called ‘Eligible International Transactions’.

4.2 The Committee recommends that the Government may consider the
following while framing Safe Harbour Rules for Eligible Enterprises opting for Safe
Harbour in contract R&D in the IT sector.

4.3 General Recommendations

• The taxpayer should have the option of whether to go in for Safe Harbour
or not and it should not be mandatory. However, Safe Harbour should not
become a rebuttable presumption for a taxpayer who opts not to go for it
and has an ALP below the Safe Harbour. There has to be a directive to the
Assessing Officer/TPO in this regard that they can get the international
transactions bench-marked but cannot force the taxpayer to rebut the
presumed ALP.

• Safe Harbour would not be available to a taxpayer whose profits are

higher than the Safe Harbour margins on account of its contracted price
and such a taxpayer cannot be assessed at the lower presumptive ALP
corresponding to the Safe Harbour.

• Safe Harbour margins recommended may be made applicable from A.Y

2013-2014, for a period of two years.
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• Further, an institutional mechanism needs to be evolved so that every two

to three years, the Safe Harbour rules/margins/rates are reviewed and
notified in advance so that the taxpayers can comply with such provisions
with ease.

• If any other international transaction is otherwise eligible for Safe Harbours,

such as, loan, etc., it will continue to be an Eligible International
Transaction for the purposes of Safe Harbour.

• Safe Harbour provisions may not be applicable if the Eligible Enterprise

renders services in the nature of Eligible International Transactions to any
Associated Enterprises (AE) located in jurisdiction as notified under section
94A of the Income-tax Act or any other country/territory widely perceived
as a tax haven.

4.4 Recommendations on threshold

4.4.1 The existing limit of Rs. 1 crore provided under sub-rule 2 of Rule 10D was
fixed more than a decade ago. NASSCOM has strongly demanded an upward
revision. This upward revision is also justified to adjust for inflation. It may be
mentioned that change in monetary parameters on account of inflation factor
is part of our tax policy as is evident from the fact that the monetary limit for
audit of accounts of certain persons engaged in business, as provided in section
44AB of Income Tax itself, has been revised upwards from Rs. 40 lakhs to Rs. 1
crore during the corresponding period.

4.4.2 Accordingly, the Committee recommends that the exemption from

maintaining information and documentation for international transactions
specified at Rs. 1 crore under sub-rule 2 of Rule 10D of the Income-tax Rules be
raised to Rs 5 crore as it will reduce compliance cost for small tax payers. Tax
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administration will have a smaller basket for picking up cases for scrutiny
facilitating optimum use of its resources.

4.4.3 The present practice of authorising the Assessing Officer (AO) to do

transfer pricing audit in select number of cases, where the aggregate value of
international transactions is less than the threshold limit (Rs. 15 crore), has
reduced the applicability of the threshold limit as a Safe Harbour while
simultaneously diluting the effectiveness of transfer pricing audit. The Committee,
therefore, recommends that the threshold of Rs.15 crore as an administrative
Safe Harbour should be specified as a statutory Safe Harbour rule itself.

4.5 Specific Recommendations

4.5.1 In the view of the Committee, the following activities undertaken partly or
fully constitute R&D:

• R&D producing new theorems and algorithms in the field of theoretical

computer science.

• Development of information technology at the level of operating systems,

programming languages, data management, communications software
and software development tools.

• Development of Internet technology.

• Research into methods of designing, developing, deploying or

maintaining software.

• Software development that produces advances in generic approaches

for capturing, transmitting, storing, retrieving, manipulating or displaying
34

information.
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• Experimental development aimed at filling technology knowledge gaps

as necessary to develop a software programme or system.

• R&D on software tools or technologies in specialised areas of computing

(image processing, geographic data presentation, character recognition,
artificial intelligence and other areas).

4.5.1.1 In addition, the Committee clarifies that the following activity may also
constitute R&D:

• Upgrades of existing products even where the source code has been
made available by the parent/principal.

4.5.1.2 The ‘Eligible International Transaction’ shall be the rendering of contract

R&D services, partly or fully, in the IT Sector by the ‘Eligible Enterprise’.

4.5.1.3 The Safe Harbours recommended in this report would be applicable to

an Eligible Enterprise that meets the following conditions (to be met
cumulatively) so as to be treated as a Contract R&D service provider with
insignificant risk and the most appropriate method in such cases would be the
Transactional Net Margin Method (TNMM) with an applicable mark-up as
suggested by the Committee (the conditions mentioned below are in
accordance with the broad principles enunciated by the Committee in Para
2.15.3 of its First Report):

• The critical functions with regard to R&D Services, including particularly

conceptualization and design i.e., concurrent engineering, for the
product or component of a product, are driven by the foreign principal.

• The principal provides funds/capital for such Services. The principal bears
the risk of failure of the research and development and will be the owner
35

of the outcome of such R&D and also any intangible generated in

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rendering such R&D services, while the Eligible Enterprise is allocated a

guaranteed remuneration on services pertaining to Eligible International
Transactions, irrespective of whether the outcome of such R&D is a
success or a failure.

• The Eligible Enterprise is required to report back to the principal on a

regular basis, e.g. at pre-determined milestones. The principal is expected
to be able to assess the outcome of the R&D activities. Any suggestion to
the modification of R&D programme by the Eligible Enterprise is subject to
the review and approval by the foreign principal who makes the relevant
decisions to control the risks.

• The Eligible Enterprise, in respect of R&D services pertaining to Eligible

International Transactions, 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 Eligible Enterprise.

• The Eligible Enterprise, as contract R&D service provider, has no right to

ownership on the outcome of any intangible generated or arising during
the course of rendering such R&D services. 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
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Indian personnel and / or by the Eligible Enterprise, is evident from the

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employee contract and / or contract between Eligible Enterprise and its

foreign principal.

• The patent registration, if any, cannot be commercially exploited on a

standalone basis and its value is indeterminate.

• The terms and conditions regarding ownership of intangibles would have

been similar if the R&D activities carried on by the Eligible Enterprise were
or could have been outsourced to a third party.

4.5.2 Margin for Safe Harbour and Most appropriate method

4.5.2.1 Various reports in public domain indicate that India is moving towards
high-end R & D activities in the IT sector. Further, there would be some additional
return expected for economic value addition generated through R&D
intangibles, which physically manifest as patents, as well as for locational
advantages offered by a low cost economy like India which has a large trained
pool of engineers and scientists with comparative lower costs and higher
capabilities. The Data received from the Department [office of DGIT
(International Taxation)] (Annexure IV) revealed that the average margins
considered by the TPOs for A.Y 06-07 is 22.57% while that for A.Y 09-10 is 61.32%.
The data received from the Department was examined but was not relied upon
by the Committee for the following reasons:

• The Department has been adopting two broad categories of IT Services

and ITEs as opposed to greater vertical segmentation made by the
industry body NASSCOM, as well as, in the Economic Survey of India for
2012-13 (reference para 3.1of this report.)
• The sample size is very small with only about 4 to 5 companies being
categorised as entities doing contract R&D in the IT sector though there
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are many R&D centres in India in the IT sector and no reliable inference
could be made from such a small sample;
• High variations in the margins declared by these companies [16.28% being
the highest and 4% being the lowest] and also in the margins determined
by the TPOs [108.02% 20 being the highest and 5.67% being the lowest]
indicate extreme volatility, which is not conducive for any statistical
inference; and
• There are hardly any comparable companies doing R&D in IT sector as
significant R&D is outsourced to captive in India.

4.5.2.2 The potential of third-party vendors in software R&D is still

unexploited. Zinnov's study21 on Software R&D Globalization indicates that only
5% of R&D budgets are currently being spent on outsourced partnerships (third-
party vendors), which means about 95% of the R&D is conducted by companies
in-house (HQ, Captive models). Further, for many of the large sized companies
that participated in the Zinnov survey, mature/ existing products accounted for
more than 75-80% of their total revenues, and hence they have to invest heavily
on maintaining and enhancing these products to suit requirements.

4.5.2.3 Amitava Roy, COO, Symphony Services22, says,-

Quote:

Most software companies are looking to maximize ROI from their software
products, while extending their output from their R&D teams on newer
products. Over 80% of total software R&D spend goes towards activities to
support the products that are in maintenance mode. Yet margins on new
20 This margin was arrived at by doing a corroborative TNMM analysis to the main PSM done in

the order. The margin is inclusive of comparables margins (52.78%), location savings and
additional return on R&D.
38

21 Zinnov Management Consulting, Global R&D Benchmarking Study – F.Y 2011, June, 2012.
Page

22 Source: Third-party Partnerships Hold the Future in Software

R&D http://www.chinasourcingguide.com/?q=en/node/10036

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

products are significantly higher than on maintenance contracts. This

presents two major challenges to software product companies today -
freeing up resources to work on new products and maintaining margins for
legacy products.

Unquote

4.5.2.4 As per the Zinnov analysis, most of the routine software development
services rendered from India are under maintenance contracts or popularly
known as software development services, on which the margins for the MNCs
are lower when compared to margins of software product MNC companies to
whom R&D services are rendered from India which are utilised in the products of
such MNCs (Annexure-V).

4.5.2.5 Since the Committee had earlier recommended Safe Harbour margins
of 20% and 22% for the IT and ITES sectors, and contract R&D in the IT sector is
intrinsically linked to both and in view of the limited data availability, the
Committee has decided to use the 20% margin as the base rate on which the
final recommended margin would be built upon. As stated elsewhere in this
report, contract R&D involves work requiring higher skill sets. For doing such work,
companies may incur higher expenses on employees and equipments and may
also expect to earn higher profits than routine IT/ITES providers.

4.5.2.6 Since there are hardly any comparable domestic companies doing
R&D in the IT sector, as significant R&D is outsourced to captive DCs in India, the
issue of location savings needs to be considered. However, as noted in
paragraphs 3.17.3 and 3.17.4, the views of the members of the Committee are
divided on the issue.

4.5.2.7 Besides, a higher margin is also justified because market premium needs
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to be compensated as well.
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4.5.2.8 Further, the Committee did look at some Indian companies doing R&D
work in the IT sector. They are not captive entities like the Development Centres
of MNEs but are entrepreneurs engaged in outsourced software product
development services, product engineering, analytics, etc. The segment of R&D
work could not be determined and analysed separately for lack of segmental
details. Notwithstanding the fact that these companies are not doing only R&D
work, the profits earned by them do indicate a trend of high earnings. The
Committee found that these companies earn profits in excess of 30% on many
occasions (Annexure VI). Though this sample is also very small in size (6
companies), the high earnings of these companies were noted. Further, though
the profits earned by some of the companies were as high as 50 to 60%, the
Committee recognises the fact that they are not solely into R&D areas of work
but are engaged in other activities too like product development, analytics, etc.

The Committee is of the view that reasonableness demands that the Safe
Harbour margin ought to be between the base rate of 20% and the high
margins of 50 to 60% discussed above.

4.5.2.9 Another independent analysis done by the Committee of well known

MNCs corroborates this conclusion (Annexure-V). Thus, it is clear that there is a
higher profit to be earned by companies by doing R&D work. The Committee,
therefore, is of the view that the Safe Harbour margins for contract R&D in the IT
sector ought to be higher than the 20% and 22% recommended for the ITS/ITES
sectors earlier.

4.5.2.10 Considering all the above factors, the Committee is of the view that an
additional 10 percentage points [on the base rate of 20%] of profits would be
justified. Accordingly, the Committee recommends a Safe Harbour margin of
30% for entities doing contract R&D in the IT sector. The Committee believes that
40

the twin impact of a higher margin and a larger cost base would adequately
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capture the tax base for such activities.

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4.6 The Committee understands that for computing the above-recommended

30% margin, the method of computing the Profit Level Indicator (PLI) is of critical
importance. Operating Profit Margin is the most crucial aspect for calculating
the PLI. Accordingly, the Committee recommends that “Operating Expense”,
“Operating Revenue” and “Operating Profit” for the purposes of calculating PLI
should be defined as follows:

• "Operating Expense” is the expense of the Eligible Enterprise incurred during

the course of its normal operations and in connection with Eligible
International Transactions for the previous year, including depreciation /
amortization expenses relating to assets used by the Eligible Enterprise but
excluding interest expense, provisions for unascertained liabilities, pre-
operative expenses, the loss arising out of translations of foreign currency
items, extraordinary and other items not relating to the operating activities of
the Eligible Enterprise for the previous year, the loss on sale of assets /
investments of the company, and the effects relating to the income tax
expense of the company.

• “Operating Revenue” is the revenue of the Eligible Enterprise earned in

connection with Eligible International Transactions and during the course of
its normal operations for the previous year, but excluding interest income, the
income arising out of translations of foreign currency items, the income on
sale of assets or investments of the company, the refunds relating to the
income tax expense of the company, provisions no longer required written
back and extraordinary and other items not relating to the operating
activities of the Eligible Enterprise for the previous year.
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• “Operating Profit” is the profit earned from normal operations of the Eligible
Enterprise. It is computed as the operating revenue of the Eligible Enterprise
less the operating cost incurred for an accounting period.

4.6.1 If an Eligible Enterprise is into multiple activities other than the Eligible
International Transaction (contract R&D in IT), then a certificate from the auditor
may be prescribed to audit and certify the profitability arising under TNMM on
account of the Eligible International Transaction.

4.6.2 Accounting terms used in these Rules shall be defined in accordance with
generally accepted financial accounting principles in India.

4.6.3 The Committee recommends that once Safe Harbour rules are opted for
by a taxpayer, no margin variation benefit under section 92C(2) or any other
comparability adjustment such as, capacity, risk, working capital, etc. would be
permitted.

4.6.4 To reduce compliance costs for the taxpayers, it is imperative that the
documentation burden on the taxpayers opting for Safe Harbour is made less
stringent, as compared to an assessee choosing regular TP documentation and
scrutiny by the Department. Accordingly, the Committee recommends that such
an enterprise need not maintain information and documents specified in clauses
(g) to (m) of Rule 10D(1) in respect of the Eligible International Transactions.

4.6.5 The Committee clarifies that Safe Harbour rules would not give immunity
from scrutiny of any international transaction other than the Eligible International
Transactions that have been opted by the Eligible Enterprise to be covered
under Safe Harbour.
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4.7 Recommendations on Procedural /Administrative Issues.

4.7.1 An Eligible Enterprise may exercise its option for accepting the Safe
Harbour for the year by filing an option form with the Assessing Officer not later
than the due date for filing the Income-tax return. If necessary a new Statutory
Form for exercising Safe Harbour option to be filed along with return of income
may be prescribed. Alternately, the 3CEB Report should be modified to provide
for indication of election of Safe Harbour option for the year along with
identification of Eligible International Transactions.

4.7.2 The Committee recommends that the AO must compulsorily refer such
cases to the TPO who will conduct the functional analysis to determine the
Eligible Enterprise as well as the Eligible International Transaction before
accepting the results of the taxpayer under Safe Harbour. Besides, there should
be strict penalties if any of the eligible conditions laid down for Safe Harbour are
violated by the taxpayer.

***
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Annexure-I
PM sets up Committee to review Taxation of Development Centres and the IT
Sector, Safe Harbour Provisions to be Finalised soon

July 30, 2012

New Delhi

The Prime Minister has constituted a Committee to Review Taxation of

Development Centres and the IT Sector. The Committee will engage in
consultations with stakeholders and related government departments to
finalise the Safe Harbour provisions announced in Budget 2010 sector-
by-sector. It will also suggest the approach to taxation of Development
Centres.
2. The Prime Minister had earlier set up an Expert Committee on GAAR
under the Chairmanship of Dr. Partho Shome to engage in a widespread
consultation process and finalise the GAAR Guidelines. The response has
been overwhelmingly positive.
3. While this Committee would address concerns on GAAR provisions and
would reassure investors about the predictability and fairness of our tax
regime, it was felt that there is still a need to address some other issues
relating to the taxation of the IT Sector such as the approach to taxation of
Development Centres, tax treatment of "onsite services" of domestic
software firms, and also the issue of finalising the Safe Harbour provisions
announced in Budget 2010.
4. Many MNCs carry out activities such as product development, analytical
work, software development, etc. through captive entities in India. They
exist in a wide range of fields including IT software, IT hardware,
Pharmaceutical R&D, other automobile R&D and scientific R&D. These are
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popularly called Development Centres. Over 750 MNCs have such centres
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at over 1100 locations in India. The reason for this large concentration of

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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

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3) Ms Rashmi Sahani Saxena, DIT (TP) - Member

4) Any other officer from the Income Tax Department to be co-opted by the
Chairman
8. The Terms of Reference of the Committee will be to:
i) Engage in consultations with stakeholders and related government
departments to finalise the approach to Taxation of Development Centres
and suggest any circulars that need to be issued.
ii) Engage in sector-wide consultations and finalise the Safe Harbour
provisions announced in Budget 2010 sector-by-sector. The Committee will
also suggest any necessary circulars that may need to be issued.
iii) Examine issues relating to taxation of the IT sector and suggest any
clarifications that may be required.
9. The Committee will work to the following time schedule:
i) Finalise the approach to taxation of Development Centres and suggest any
necessary clarifications by 31 August 2012.

ii) Suggest any necessary clarifications that may be needed to remove

ambiguity and improve clarity on taxation of the IT Sector by 31 August
2012.

iii) Finalise Safe Harbour Rules individually sector-by-sector in a staggered

manner and submitting draft Safe Harbour provisions for three sectors/sub-
activities each month beginning with the first set of suggestions by 30
September 2012. All Safe Harbour provisions can be finalised by 31
December 2012.
10. The Department of Revenue will provide all necessary support to the
Committee to facilitate its work including office assistance and assistance to
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facilitate consultations.
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Annexure-II
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Annexure-III

** Electrical and Electronic equipment

Source: Zinnov analysis of R&D Landscape in India.

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Annexure-IV
Data from Office of the Director General of Income Tax, (International Taxation),
New Delhi
R&D in IT - A.Y 2006-07
S.No Name of the assessee Value of Margins Margins Charge
International shown adopted
Transactions by the by the
(Rs In Crore) assessee TPO (PLI in
(PLI in %) %)
1 GE India Technology 306.44 N.A 5.67 Bangalore
Centre Pvt Ltd
2 Microsoft India 712.23 15.14 39.47 Delhi-I

Mean Margin 15.14 22.57

R&D in IT - A.Y 2007-08

S.No Name of the assessee Value of Margins Margins Charge
International shown adopted
Transactions by the by the
(Rs In Crore) assessee TPO (PLI
(PLI in %) in %)
1 GE India Technology 395.00 37.43 Bangalore
Centre Pvt Ltd
Mean Margin N.A 37.43
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R&D in IT - A.Y 2008-09

S.No Name of the assessee Value of Margins Margins Charge
International shown adopted
Transactions by the by the
(Rs In Crore) assessee TPO (PLI
(PLI in %) in %)
1 Teradata Ltd 23.70 10.00 32.07 Mumbai-II
GE India Technology
2 Centre Pvt Ltd 466.00 16.28 32.66 Bangalore
3 Celetronix India P. Ltd. 39.00 4.00 9.72 Mumbai-I
Mean Margin 10.09 24.82

R&D in IT - A.Y 2009-10

S.No Name of the assessee Value of Margins Margins Charge
International shown adopted
Transactions (Rs by the by the
In Crore) assessee TPO (PLI
(PLI in %) in %)
1 Microsoft India (R & D) 1067.95 15.10 108.02* Delhi-I
Pvt. Ltd.
2 Polycom Technology 16.41 15.11 53.68 Mumbai-I
(R&D) Centre Pvt. Ltd.
3 Teradata Ltd 130.25 13.00 22.25 Mumbai-II
Mean Margin 14.40 61.32
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* The margin is inclusive of comparables margins (52.78%), location savings and

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additional return on R&D.

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 Fourth Report of the Committee to Review Taxation of Development Centres and the IT Sector

SUMMARY

Assessment year Average Margins shown Average Margins adopted

by the assessee (PLI in %) by the TPO (PLI in %)
2006-07 15.14 22.57
2007-08 N.A 37.43
2008-09 10.09 24.82
2009-10 14.40 61.32
Average 13.21 36.53

Source: Data from DGIT, New Delhi

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Annexure-V

Margins of major global software product/ services companies

Margins of major software product companies - Global:

Sl. Name of the Country Currency Year Operating Operating Operating OP to
No. Company Revenues Cost Profit OC
(OC) (OP) %
1 Microsoft Inc. USA USD (Mn.) 201206 73723 51960 21763 41.88%
2 SAP AG Germany Euro (Mn.) 201112 14233 9352 4881 52.19%
3 Oracle Corp USA USD (Mn) 201205 37121 13706 9981 72.82%
4 Software AG Germany Euro (‘000) 201112 1098334 835522 262812 31.45%
5 Adobe Systems USA USD (‘000) 201112 4216258 3383411 832847 24.62%
Inc
Arithmetical Mean 44.59%

Margins of major software service companies – Global

Sl. Name of the Country Currency Year Operating Operating Operating OP to
No. Company Revenues Cost Profit OC
(OC) (OP) %
1 Microsoft Inc. USA USD (Mn.) 201206 Segmental not available
2 SAP AG Germany Euro (Mn.) 201112 2955 2091 864 41.32%
3 Oracle Corp USA USD (Mn) 201205 4721 3662 1059 28.92%
4 Software AG Germany Euro (‘000) 201112 189198 188355 843 0.45%
Arithmetical Mean 23.56%

Source: The Annual Reports of above companies downloaded from Security

Exchange Commission of USA.
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Annexure-VI

Analysis of profitability of non-captive Indian companies engaged partly in

outsourced software product development.

Sl. Name of the Company OP/OC

No F.Y. 2009-10 F.Y. 2010-11 F.Y. 2011-12
Acropetal Technologies
1 Ltd.(Segment) 32.24 22.06 4.66
2 Aricent Technology Limited 25.67 23.51 N.A.
3 E-zest Solutions Limited 6.88 36.42 N.A.
4 Persistent Systems Limited 24.27 21.82 20.58
5 Infosys Technologies Limited 45.44 44.17 42.84
6 Cybermate Infotek Limited 17.66 66.73 50.86
Average 25.36 35.79 29.74

Functional Profiles of these comparables obtained through databases were

analysed and it was seen that these comparables are into outsourced software
product development services; Product engineering; Analytics; Cloud and
Enterprise services; etc. The segment of R&D could not be separately
determined.

***
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