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Issues: (i) whether the comparables selected by the Transfer Pricing Officer and retained by the Commissioner (Appeals) could be excluded on the ground of functional dissimilarity and high turnover in the case of a captive software development service provider; (ii) whether depreciation was required to be excluded from the operating cost of the tested party and comparables for transfer pricing purposes; (iii) whether disallowance under section 40(a)(ia) was attracted on purchase of software for non-deduction of tax at source; and (iv) whether disallowance under section 14A could survive in the absence of exempt income.
Issue (i): whether the comparables selected by the Transfer Pricing Officer and retained by the Commissioner (Appeals) could be excluded on the ground of functional dissimilarity and high turnover in the case of a captive software development service provider.
Analysis: The assessee was found to be a captive software development service provider performing only part of the software development cycle for its associated enterprise, without owning valuable intangibles or assuming significant entrepreneurial risks. Companies engaged as full-fledged software development businesses were treated as not functionally comparable. The Tribunal also accepted that size and turnover are relevant comparability factors, and that companies with very high turnover may be excluded where the tested party is a relatively small captive service provider. On that basis, the exclusion of the impugned comparables was sustained.
Conclusion: The exclusion of the disputed comparables was upheld in favour of the assessee.
Issue (ii): whether depreciation was required to be excluded from the operating cost of the tested party and comparables for transfer pricing purposes.
Analysis: The appellate authority had directed that depreciation should be removed from the operating cost base of both the assessee and the comparables so that margins are computed on a like-to-like basis. The Tribunal found no infirmity in adopting the same approach, as the accounting policy difference affecting depreciation could distort comparability if not neutralised.
Conclusion: The depreciation adjustment direction was upheld in favour of the assessee.
Issue (iii): whether disallowance under section 40(a)(ia) was attracted on purchase of software for non-deduction of tax at source.
Analysis: The Tribunal noted that the issue had already been settled against the assessee in earlier decisions dealing with software purchase payments and the tax deduction obligation under section 194J. On that footing, the disallowance made by the Assessing Officer was restored.
Conclusion: The disallowance under section 40(a)(ia) was sustained against the assessee.
Issue (iv): whether disallowance under section 14A could survive in the absence of exempt income.
Analysis: It was accepted that no exempt income had been earned during the year under consideration. In view of the settled position that section 14A cannot be invoked where no exempt income arises, the disallowance was not sustained.
Conclusion: The section 14A disallowance was deleted in favour of the assessee.
Final Conclusion: The Revenue's appeal failed on the transfer pricing and section 14A issues, while the disallowance relating to software purchase survived; overall, the Tribunal maintained the principal relief granted to the assessee and dismissed the proceedings.
Ratio Decidendi: In transfer pricing of a captive service provider, full-fledged software product companies with materially different functions or substantially higher turnover may be excluded from comparability, and section 14A cannot be applied where no exempt income is earned.
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