2015 (4) TMI 586 - AT - Income Tax

Decision excludes one-time ESOP cost from TNMM, mandates working-capital adjustments and recheck of comparables after hearing

ITAT MUMBAI - AT directed the AO to exclude a one-time ESOP cost when computing the TNMM margin (net margin ~16.6% to be verified), ordered consideration ... Transfer pricing adjustment - selection of comparable - exclusion of one time ESOP cost - international transactions between the assessee and its parent company in the US - determination of the arm's length price (ALP) - Transactional Net Margin Method (TNMM) - Held that:- Do not agree with the action of the authorities below in not excluding the one time ESOP cost and accordingly direct the Assessing Officer to exclude the one time ESOP cost while computing margin in the case of the assessee. The margin after excluding ESOP cost is stated to be 16.6 per cent. which may be verified by the Assessing Officer. Selection of comparable - Held that:- New comparables selected at the level of the Dispute Resolution Panel should have been considered. The Dispute Resolution Panel has not considered the new comparables without giving any reason. In our view, it would be appropriate to take as many comparables as possible so that the mean margin is closer to the correct margin because no two companies can be said to be exactly identical and small differences, if any, could be eliminated by increasing number of comparables. These new comparables, therefore, in our view have to be considered. We, however, note that one of the comparables, i.e., SIP Tech has only revenue of ₹ 3.6 crores. Obviously, the company has some problems as it is not able to procure enough orders and cannot be considered as established player in the field. It is, in our view, has to be excluded outright. The new comparables also include L&T Infotech and as has been pointed out by learned senior counsel this is a subsidiary of L & T, which is against the filter applied by the assessee that the comparable should not be a subsidiary of another company. We find that, on this ground, we have already excluded Datamatics Ltd. Therefore, this company has to be excluded outright. We are thus left with only two new comparables submitted at the level of the Dispute Resolution Panel, i.e., Goldstone which has turnover of ₹ 41.03 crores and Lanco Infotech, which has turnover of ₹ 45.56 crores. As we have held earlier, the comparables must have certain minimum size as these have to be compared with well established players in the field. In our view on the facts of the case, minimum turnover of ₹ 100 crores has to be fixed and considering this, these two comparables have also to be rejected. Infosys, Wipro, Mindtree and Persistent which are the comparables selected by the assessee and which have been accepted by the Transfer Pricing Officer/Assessing Officer. We, therefore, uphold the selection of comparables by the Transfer Pricing Officer/Assessing Officer. Working capital adjustment are required to be made because these do impact the profitability of the company. Rule 10B(2)(d) also provides that the comparability has to be judged with respect to various factors including the market conditions, geographical conditions, cost of labour and capital in the market. Accounts receivable/payable effect the cost of working capital. A company which has a substantial amount blocked with the debtors for a long period cannot be fully comparable to the case which is able to recover the debt promptly. In our view, the average of opening and closing balance in the account receivable/payable for the relevant year may be adopted which may broadly give the representative level of working capital over the year. Even if there is some difference with respect to the representative level, it will not effect the comparability as the same method will be applied to all cases. Working capital adjustment cannot be denied to the assessee only on the ground that the assessee had not made any claim in the transfer pricing study if it is possible to make such adjustment. In our view, working capital adjustment will improve the comparability. We, therefore, direct the Assessing Officer/Transfer Pricing Officer to make the working capital adjustment after necessary examination in the light of the observations made above and after allowing opportunity of hearing to the assessee. Whether there is no transfer of profit to low tax jurisdiction, no adjustment should be made? - Held that:- 24/7 Customer.com P. Ltd. [2013 (1) TMI 45 - ITAT BANGALORE] in which the Tribunal held that the arm's length price of international transaction has to be calculated with respect to similar transaction with an unrelated party as per the method prescribed and the Revenue is not required to prove tax avoidance due to transfer of profit to lower tax jurisdiction. The Tribunal therefore held that the argument that parent company was incurring loss or had shown lower margin was not relevant. These arguments had also been earlier considered by the Special Bench in the case of Aztec Software Technology Services Ltd. v. Asst. CIT [2007 (7) TMI 50 - ITAT BANGALORE] and not accepted. - Decided partly in favour of assessee. Issues: (i) Whether the one-time ESOP cost attributable to acquisition should be excluded from the assessee's margin for transfer pricing comparison; (ii) Whether the Transfer Pricing Officer's selection and rejection of comparables (standalone vs consolidated financials, rejection for related party transactions, turnover filter, inclusion/exclusion of specific comparables) was correct; (iii) Whether working capital adjustment should be made for comparability; (iv) Whether arguments that no profit shifting to a low-tax jurisdiction occurred is relevant to ALP determination.Issue (i): Exclusion of one-time ESOP cost from the assessee's margin for transfer pricing comparison.Analysis: The assessee incurred an exceptional ESOP expense due to accelerated exercise on acquisition in February 2007; contemporaneous accounting treated it as an exceptional item and the assessee amortised it over subsequent years for transfer pricing in later years. No comparable companies were shown to have similar extraordinary ESOP charges. Rule-based objections that adjustments under rule 10B are limited to comparables were considered in light of prior Tribunal decisions permitting adjustments to the tested party's results to remove non-recurring/abnormal items where needed for meaningful comparability.Conclusion: In favour of Assessee. The one-time ESOP cost is to be excluded from the assessee's margin for transfer pricing comparison; the assessee's adjusted margin (stated about 16.6%) to be verified by Assessing Officer.Issue (ii): Validity of selection/rejection of comparables, and use of standalone versus consolidated financials; applicability of turnover filter and treatment of newly submitted comparables.Analysis: Rule 10B(2)(d) requires comparability assessment including geographic and market conditions. Consolidated financials that include substantial overseas operations were found to impair comparability where comparables derived significant revenue from foreign jurisdictions. Companies with high related-party transactions or abnormal business conditions were examined on facts (e.g., provisioning, management issues) and rejected when such conditions materially affected comparability. Turnover-based exclusion was analysed against service-sector realities and empirical data; turnover filter held not generally appropriate though a minimum size threshold for established players was applied. New comparables submitted at DRP level were considered but excluded where they failed minimum size or other filters; several comparables accepted (Infosys, Wipro, Mindtree, Persistent) subject to verification of margins for two companies.Conclusion: Mixed but overall in favour of Revenue on selection grounds and in favour of Assessee to the extent that new comparables improperly excluded at DRP level should have been considered; final set of comparables upheld as Infosys, Wipro, Mindtree and Persistent with Assessing Officer directed to verify margins of Mindtree and Persistent.Issue (iii): Entitlement to working capital adjustment for comparability.Analysis: Working capital (accounts receivable/payable) affects cost of capital and profitability and is a valid comparability factor under rule 10B(2)(d) and OECD guidance. Accurate adjustments are required; where representative measures can be used (e.g., average of opening and closing balances) working capital adjustment may improve reliability of comparables. Prior absence of such claim in initial study does not preclude adjustment if it can be accurately made and increases reliability.Conclusion: In favour of Assessee. Assessing Officer/Transfer Pricing Officer directed to examine and make working capital adjustment using appropriate representative measures after hearing the assessee.Issue (iv): Relevance of alleged absence of profit shifting to a low-tax jurisdiction (parent's tax position/margin) to ALP determination.Analysis: ALP is determined with reference to comparables and prescribed methods under section 92C; the revenue need not prove tax avoidance or profit shifting to establish an adjustment. Tribunal precedent holds the parent's margin or tax position is not a determinative factor for computing ALP of the tested party.Conclusion: In favour of Revenue. Argument that no transfer of profit occurred to parent due to higher foreign tax is not relevant to ALP computation.Final Conclusion: The appeal is partly allowed: the Assessing Officer is directed to exclude the one-time ESOP cost from the assessee's margin, verify adjusted margins of specified comparables (Mindtree and Persistent), and make working capital adjustments as directed; other aspects of the Transfer Pricing Officer/DRP determinations on selection of comparables and overall ALP computation are upheld.Ratio Decidendi: For transfer pricing under section 92C, comparability must be achieved by removing non-recurring or abnormal items from the tested party's results and by selecting comparables whose financials reflect similar geographic and market conditions; where representative and reasonably accurate adjustments (including working capital) can be made, they should be applied to improve reliability of the arm's length comparison.