Transfer pricing comparability turns on functional similarity, reliable data, and fair notice before applying new turnover filters.

Transfer pricing comparability under TNMM must be based on functional similarity and reliable public-domain data. A captive software development services provider was distinguished from entities engaged in software product development, application support, infrastructure management, e-learning, SAP consulting, onsite services, or other materially different business models, leading to exclusion or inclusion of specific comparables on that basis. Loss by itself was not treated as a valid exclusion criterion absent abnormal circumstances or persistent losses, and software testing, verification and validation was treated as part of the software development process. A turnover-based filter introduced without prior notice or stated basis was held to require fresh consideration after hearing.

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Issues: (i) Whether KALS Information Systems Ltd. (applications software segment) was functionally comparable to the assessee's software development services segment; (ii) Whether FCS Software Solutions Ltd. satisfied the comparability filter and was rightly included or excluded; (iii) Whether CG-VAK Software and Exports Ltd. (software services segment) and Thinksoft Global Services Ltd. were rightly excluded from the final set of comparables; (iv) Whether Maars Software International Ltd., Akshy Software Technologies Ltd. and R.S. Software (India) Ltd. were rightly excluded; (v) Whether the exclusion of Persistent Systems Ltd., Mindtree Ltd. (IT Services), Larsen & Toubro Infotech Ltd. and Sasken Communication Technologies Ltd. on the basis of an unannounced turnover filter could stand.

Issue (i): Whether KALS Information Systems Ltd. (applications software segment) was functionally comparable to the assessee's software development services segment.

Analysis: The assessee was a captive provider of software development services on a cost-plus basis, with ownership of the developed product vesting in the associated enterprise. KALS Information Systems Ltd. was shown, on the basis of its annual report and website material, to be engaged in development and sale of software products and related activities, which materially differed from mere software development services. Prior tribunal decisions relied upon by the assessee also treated the concern as not comparable to a software development service provider.

Conclusion: The exclusion of KALS Information Systems Ltd. from the final set of comparables was upheld in favour of the assessee.

Issue (ii): Whether FCS Software Solutions Ltd. satisfied the comparability filter and was rightly included or excluded.

Analysis: The TPO had applied a filter requiring software development service income to constitute at least 75% of total income. The segmental material showed that FCS Software Solutions Ltd. derived substantial revenue from application support services, infrastructure management services, and e-learning and digital consulting, which were treated as information technology enabled services and not as software development services. Once those streams were excluded, the software development component fell below the filter threshold. The Revenue's reliance on a broad reading of the annual report did not dislodge the segmental analysis accepted from the record.

Conclusion: FCS Software Solutions Ltd. ought to have been excluded from the comparables, and the assessee succeeded on this issue.

Issue (iii): Whether CG-VAK Software and Exports Ltd. (software services segment) and Thinksoft Global Services Ltd. were rightly excluded.

Analysis: CG-VAK Software and Exports Ltd. was a loss-making concern only in the relevant year, but not shown to be consistently loss-making or affected by an abnormal business situation. Loss by itself was held to be an ordinary commercial incident and not a valid ground for exclusion when functional comparability was otherwise not disputed. Thinksoft Global Services Ltd. was engaged in software testing, verification and validation. Those activities were held to form part of the software development process, and the distinction drawn by the lower authorities was regarded as too narrow for transfer pricing comparability.

Conclusion: The exclusion of CG-VAK Software and Exports Ltd. was set aside and inclusion was directed, and Thinksoft Global Services Ltd. was also directed to be included, both in favour of the assessee.

Issue (iv): Whether Maars Software International Ltd., Akshy Software Technologies Ltd. and R.S. Software (India) Ltd. were rightly excluded.

Analysis: Maars Software International Ltd. was found, on public-domain material, to have its major revenue generation from SAP consulting and implementation, with no reliable segmental data to support comparability with offshore software development services. Akshy Software Technologies Ltd. and R.S. Software (India) Ltd. were predominantly onsite service providers, whereas the assessee rendered offshore services. The on-site and off-shore business models were treated as materially different for comparability purposes.

Conclusion: The exclusions of Maars Software International Ltd., Akshy Software Technologies Ltd. and R.S. Software (India) Ltd. were upheld against the assessee.

Issue (v): Whether the exclusion of Persistent Systems Ltd., Mindtree Ltd. (IT Services), Larsen & Toubro Infotech Ltd. and Sasken Communication Technologies Ltd. on the basis of an unannounced turnover filter could stand.

Analysis: The TPO introduced an upper turnover filter of Rs. 200 crores at the order stage without issuing any prior show cause notice and without explaining the basis for adopting such a filter. The assessee was therefore denied a fair opportunity before the TPO, and the opportunity before the DRP did not cure the defect. The matter required fresh consideration after notice and hearing.

Conclusion: This part of the comparability exercise was remanded to the Assessing Officer/TPO for reconsideration, in favour of the assessee for statistical purposes.

Final Conclusion: The transfer pricing adjustment was not sustained in full. Certain comparables were directed to be excluded, some exclusions were upheld, and the turnover-filter issue was sent back for fresh adjudication, resulting in a partial relief to the assessee.

Ratio Decidendi: For transfer pricing comparability under the TNMM, only functionally similar uncontrolled transactions based on reliable public-domain data may be used, loss by itself does not disqualify a comparable absent abnormality or persistent losses, verification and validation may form part of software development, and a new exclusion filter affecting comparables cannot be introduced without prior opportunity of hearing.

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