Transfer pricing comparables must reflect functional similarity, and subcontracted software development costs count as operating expense.

Functional comparability in transfer pricing depends on similarity of activities, reliable segmental results, accounting period consistency, and whether a company is engaged in software development services rather than software products or diversified operations. On that basis, a company with a different financial year was to be included after margin verification, the IT services segment of a multi-segment company was to be used, and software product companies with unreliable comparability were excluded, requiring recomputation of the arm's length margin. Outsourcing expenditure incurred for software development, where subcontracted work formed part of the final software supplied, was treated as operating cost because it was integral to the tested service.

---

---

Issues: (i) Whether the comparables selected in the transfer pricing analysis were correctly included or excluded, and whether the matter required recomputation of the arm's length margin; (ii) Whether outsourcing cost incurred for software development was to be treated as operating cost for computing the operating profit margin.

Issue (i): Whether the comparables selected in the transfer pricing analysis were correctly included or excluded, and whether the matter required recomputation of the arm's length margin.

Analysis: The comparability exercise turned on functional similarity, availability of segmental results, different accounting periods, and whether a company was principally engaged in software development services or in software products or diversified activities. On that basis, a company with a different financial year was directed to be included after verification of margin, the IT services segment of a comparable with multiple segments was required to be used, and software product companies lacking reliable comparability were excluded. The determination of the final set of comparables therefore had to be revisited and the arm's length margin recomputed in accordance with the directions.

Conclusion: The comparables were not fully accepted as determined below and the transfer pricing margin was directed to be recomputed, partly in favour of the assessee.

Issue (ii): Whether outsourcing cost incurred for software development was to be treated as operating cost for computing the operating profit margin.

Analysis: The outsourcing expenditure was found to be directly connected with the assessee's software development activity. The work was subcontracted by the assessee itself and was incorporated in the final software supplied to the associated enterprise. In those circumstances, the cost was held to form part of the operating expenditure and not a mere pass-through item for exclusion from the cost base.

Conclusion: The outsourcing cost was correctly treated as operating cost, against the assessee.

Final Conclusion: The appeal succeeded only to the extent of transfer pricing adjustments requiring recomputation of the comparable set and margin, while the treatment of outsourcing cost as operating expense was upheld.

Ratio Decidendi: In transfer pricing benchmarking, functional comparability and segmental reliability govern the selection of comparables, and expenditure directly incurred in subcontracted performance of the tested activity forms part of operating cost when it is integral to the service rendered.

---