2014 (4) TMI 997 - AT - Income Tax

Transfer Pricing: Exclude Larger Companies, Adjust for FX Gains, Verify Risk & Working Capital per Section 92C(2)

The ITAT Bangalore ruled largely in favor of the assessee on multiple transfer pricing issues. It held that turnover filters must exclude significantly ... Transfer pricing adjustment - Computation of ALP - Software development business - Selection of comparables - Turnover filter - Held that:- The decision in Trilogy E-Business Software India Private Limited v. DCIT [2013 (1) TMI 672 - ITAT BANGALORE] followed - The TPO had while selecting the above 26 comparables, applied a lower turnover filter of Rs.1 crore but preferred not to apply any upper turnover limit - The size of the comparable is an important factor in comparability - The ICAI TP guidance note has observed that the transaction entered into by a Rs.1000 crores company cannot be compared with the transaction entered into by a Rs.10 crores company and the two most obvious reasons are the size of the two companies and related economies of scale under which they operate - The TPO’s range had resulted in selection of companies as comparable such as Infosys which was 277 times bigger than that of the assessee - the turnover filter is an important criteria in choosing the comparables companies having turnover of more than 200 crores have to be eliminated from the list of comparables – thus, those companies have to be eliminated from the list of comparables – Decided in favour of Assessee. Functionally different Companies – Held that:- The decision in Trilogy E-Business Software India Private Limited v. DCIT [2013 (1) TMI 672 - ITAT BANGALORE] followed - The company was not comparable in the case of the assessees engaged in software development services business - Neither the TPO nor the DRP have noticed that there is bound to be a difference between the Assessee and Megasoft and the profit arising to the Megasoft as a result of the existence of the software product segment and no finding has been given that reasonably accurate adjustments can be made to eliminate the material effects of such differences - the TPO was justified in selecting M/s. Megasoft Ltd as comparable - the AO/TPO is directed to take segmental margins of 23.11% for comparability - Decided in favour of Assessee. Forex gain/loss impact – Held that:- The decision in Trilogy E-Business Software India Private Limited v. DCIT (Supra) followed - foreign exchange gain/loss being considered as not forming part of the operating cost, the reasoning of the revenue is that such loss or gain cannot be said to be one realized from international transaction though they may form part of the gain/loss of the enterprise - they should be excluded while determining operating cost - AO/TPO is directed to consider the foreign exchange gain or loss as part of the operating cost or revenue - Decided in favour of Assessee. Working capital adjustment – Held that:- If the contention of the assessee is to be taken into account, the revised working capital adjustment comes to 2.04% instead of -1.27% arrived by the TPO - the issue is factual which requires verification at the AO/TPO’s level, thus, the matter is remitted back to the AO/TPO for fresh adjudication Decided in favour of Assessee. Risk adjustment – Held that:- The AO/TPO is directed to work out the ALP of the assessee in accordance with directions - It is the claim of the assessee its margin after considering foreign exchange loss is at 14.14%, where margin of the comparable after work capital adjustment is 15.89% and after risk adjustment, the adjusted average margin of comparable is 15.16% - the AO/TPO is directed to verify the working/computation and if found that the differential in the margin of the assessee and the comparables is beyond 5% bandwidth recognized in proviso to s. 92C (2) of the Act, then adjustment is required to be made to the reported value of the assessee’s transaction with its AE - Decided in favour of Assessee. Deduction u/s 10A of the Act – Reduction from the export turnover - Held that:- Following CIT v M/s Tata Elxsi Ltd. & Others [2011 (8) TMI 782 - KARNATAKA HIGH COURT] - when the expenses are reduced from the export turnover while computing deduction u/s 10A of the Act, it should also be reduced from the total turnover in order to maintain parity between the numerator and the denominator – thus, the AO is directed to reduce a sum of Rs.69,45,076/- from the export turnover as well as from the total turnover while computing deduction under section 10A of the Act – Decided in favour of Assessee. Prior period expenses – Held that:- The assessee is following the mercantile system of accounting and it was required to make deduction/provision for expenses in the respective assessment years as and when it occurs - the expenses are not pertaining to the concerned assessment year - the expenses pertaining to assessment year 2006-07 cannot be claimed as deduction in the present assessment year – Decided in favour of Assessee. 1. ISSUES PRESENTED and CONSIDERED 1. Whether the transfer pricing adjustment made by the Assessing Officer (AO) and Transfer Pricing Officer (TPO) by selecting certain comparables and rejecting others is justified, including the application of turnover filters and functional comparability criteria. 2. Whether the foreign exchange gain or loss should be treated as operating income/expense for computing operating margins in transfer pricing analysis. 3. Whether the working capital adjustment computed by the TPO is appropriate and correctly calculated. 4. Whether a risk adjustment is warranted to reflect differences in risk profiles between the assessee and comparables. 5. Whether the AO erred in computing deduction under section 10A of the Income Tax Act by reducing certain expenses from export turnover but not from total turnover. 6. Whether prior period expenses amounting to Rs. 77,12,144/- are allowable as deduction in the relevant assessment year. 7. Whether the charging of interest under section 234B is maintainable (not adjudicated as it is mandatory and consequential). 8. Grounds not pressed or not argued (transfer pricing legal issues, disallowance of asset write-off) were not considered. 2. ISSUE-WISE DETAILED ANALYSIS I. Transfer Pricing Adjustment - Selection and Computation of Comparables Relevant legal framework and precedents: - Transfer Pricing provisions under sections 92, 92C, 92CA, and Rule 10B and 10C of the Income Tax Rules. - Rule 10B(3) requires comparability of uncontrolled transactions considering enterprise-level differences including size and functions. - Rule 10C(2)(e) emphasizes the ability to make reliable adjustments to eliminate material differences. - Precedents from various ITAT Bangalore Bench decisions including Genisys Integrating Systems, Kodiak Networks, Genesis Microchip, Electronic for Imaging India, Trilogy E-Business Software India Pvt. Ltd, and others. - ICAI Transfer Pricing Guidance Note and OECD Transfer Pricing Guidelines 2010 emphasizing size and functional comparability. Court's interpretation and reasoning: - The TPO applied only a lower turnover filter of Rs. 1 crore but did not apply an upper turnover limit, resulting in inclusion of very large companies (e.g., Infosys with turnover 277 times that of assessee) as comparables. - The Tribunal upheld the principle that both lower and upper turnover limits are necessary for comparability to account for size and economies of scale. - Based on precedents, a turnover range of Rs. 1 crore to Rs. 200 crores is appropriate for selecting comparables for the assessee whose turnover falls within this range. - Accordingly, companies with turnover exceeding Rs. 200 crores were excluded from the list of comparables. - Functional comparability was examined in detail, relying on the earlier Tribunal decision in Trilogy E-Business Software India Pvt. Ltd. - Certain companies selected by the TPO were found functionally dissimilar and rejected as comparables, namely: Accel Transmatic Ltd (Seg.), Avani Cimcon Technologies Ltd, Celestial Labs Ltd, and KALS Information Systems Ltd (Seg.). - The Tribunal relied on documentary evidence such as annual reports, segmental results, and information obtained under section 133(6) to assess functional comparability. - The Tribunal accepted the TPO's selection of Megasoft Ltd as comparable but directed that the segmental profit margin of the software service segment (23.11%) be used instead of entity-level margin due to presence of software product segment affecting overall margin. - The final list of comparables retained after filtering turnover and functional dissimilarity comprised fourteen companies consistent with the earlier Tribunal decision in Trilogy E-Business. Key evidence and findings: - Turnover data of comparables and assessee. - Segmental profit margins and functional analysis from annual reports. - Information obtained under section 133(6) and public domain data. - Earlier Tribunal decisions on turnover range and functional comparability. Application of law to facts: - The Tribunal applied the turnover filter Rs. 1 crore to Rs. 200 crores to exclude large companies. - Functional dissimilarities were identified and companies rejected accordingly. - Segmental margins were used for comparables with mixed business segments. - The selection of comparables was aligned with statutory provisions and judicial precedents. Treatment of competing arguments: - The assessee argued for rejection of certain comparables on grounds of size and function; the Tribunal accepted these arguments based on evidence and precedents. - The Revenue supported the TPO's broader selection; the Tribunal partially accepted but imposed turnover and functional filters. Conclusions: - The transfer pricing adjustment based on comparables selected without upper turnover limit and ignoring functional differences was not justified. - The list of comparables must exclude companies with turnover exceeding Rs. 200 crores and functionally dissimilar companies. - Segmental profit margins should be used where applicable. - The transfer pricing adjustment must be recomputed accordingly. II. Treatment of Foreign Exchange Gain/Loss in Operating Margin Computation Relevant legal framework and precedents: - Transfer Pricing principles under section 92C and Rule 10B. - Earlier Tribunal decision in Sap Labs India (P) Ltd. v. ACIT (Bangalore Bench) holding foreign exchange fluctuation gains/losses as part of operating revenue/cost. Court's interpretation and reasoning: - The TPO excluded foreign exchange gain/loss from operating margin computation treating it as non-operating. - The Tribunal held that foreign exchange gain/loss is integral to the business of software service providers and should be included in operating income/cost. Key evidence and findings: - Accounting treatment and nature of foreign exchange gain/loss. - Precedent from Sap Labs India decision. Application of law to facts: - Foreign exchange gain/loss was to be considered part of operating revenue or cost for both the assessee and comparables. Treatment of competing arguments: - The Revenue's argument to exclude was rejected in view of binding precedent. Conclusions: - Foreign exchange gain/loss must be included in operating margin computations for transfer pricing analysis. III. Working Capital Adjustment Computation Relevant legal framework and precedents: - Transfer Pricing Guidelines and Rule 10B(3) requiring adjustments for differences in working capital. Court's interpretation and reasoning: - The TPO computed working capital adjustment at -1.27% but excluded inter-company payables from trade payables. - The assessee contended that inter-company payables are part of trade payables and should be included. - The Tribunal found the issue factual and remitted the matter to AO/TPO for verification and correct computation. Key evidence and findings: - Accounting records showing trade payables including inter-company payables. Application of law to facts: - Proper inclusion of all relevant payables is necessary for accurate working capital adjustment. Treatment of competing arguments: - The Tribunal did not decide on merits but directed factual verification. Conclusions: - Working capital adjustment computation to be revisited and corrected by AO/TPO. IV. Risk Adjustment in Transfer Pricing Relevant legal framework and precedents: - Rule 10B(3) and OECD Guidelines recognizing the need to adjust for risk differentials. - Earlier Tribunal decision in Intellinet Technologies India Pvt. Ltd. v. ITO (Bangalore Bench) recognizing risk adjustment where the assessee operates in a risk-mitigated environment compared to comparables. Court's interpretation and reasoning: - The TPO computed a risk adjustment of -0.73% but did not apply it, citing higher single-customer risk of the assessee. - The Tribunal held that risk assumed by the assessee is lower than comparables who operate in open market with marketing and technical risks. - The Tribunal directed AO/TPO to give effect to suitable risk adjustment to the net margin of comparables. Key evidence and findings: - Nature of business and customer base of assessee and comparables. Application of law to facts: - Risk adjustment is necessary to bring comparables and assessee on comparable footing. Treatment of competing arguments: - The Tribunal sided with the assessee's contention for risk adjustment. Conclusions: - AO/TPO to compute and apply appropriate risk adjustment in transfer pricing analysis. V. Deduction under Section 10A - Treatment of Expenses in Export Turnover and Total Turnover Relevant legal framework and precedents: - Section 10A of the Income Tax Act providing deduction for profits of export-oriented units. - Judgments of the jurisdictional High Court in CIT v. Tata Elxsi Ltd. & Others and Special Bench of ITAT in ITO v. Sak Soft. Court's interpretation and reasoning: - The AO reduced telecommunication, insurance, and travelling expenses from export turnover but failed to reduce the same from total turnover while computing deduction under section 10A. - The Tribunal held that for parity and correct computation, the same expenses must be reduced from both export turnover (numerator) and total turnover (denominator). Key evidence and findings: - Details of expenses reduced and turnover figures. Application of law to facts: - Consistent treatment of expenses in numerator and denominator is essential for correct deduction computation. Treatment of competing arguments: - Revenue did not contest the assessee's submission. Conclusions: - AO directed to reduce Rs. 69,45,076/- from both export turnover and total turnover in computing deduction under section 10A. VI. Prior Period Expenses Disallowance Relevant legal framework and precedents: - Mercantile system of accounting principles. Court's interpretation and reasoning: - The AO disallowed Rs. 77,12,144/- as prior period expenses not attributable to the relevant assessment year. - The assessee contended the amount represented short provision, excess provision or no provision of earlier years. - The Tribunal held that under mercantile system, expenses must be provided in the year to which they pertain. - Expenses not related to the relevant assessment year are not allowable in the current year. Key evidence and findings: - Accounting treatment and year of expense origination. Application of law to facts: - The disallowance of prior period expenses was justified. Treatment of competing arguments: - The Tribunal rejected the assessee's claim on this ground. Conclusions: - Prior period expenses amounting to Rs. 77,12,144/- are disallowed for the assessment year under consideration. VII. Other Grounds - Grounds relating to transfer pricing legal issues (grounds 1 to 7) were not argued and hence not adjudicated. - Disallowance of assets costing less than US$ 1000 written off as revenue expenditure (ground 19) was not pressed. - Charging of interest under section 234B is mandatory and consequential and thus not maintainable as a ground of appeal.