Higher margins prove arm's length price under section 92C; key comparables excluded, others remanded for fresh review

ITAT Hyderabad held that the assessee, a captive software development service provider to its AE, earned a higher margin than the average of comparables; therefore, its international transaction was at arm's length and no TP adjustment was warranted. Hartron Communications Ltd was directed to be excluded applying the peculiar-circumstances filter for an exceptional performance year. Microgenetics Systems Ltd was held functionally dissimilar due to outsourcing of medical transcription, and thus unsuitable as a comparable. The functional profile of Infosys Technologies Ltd and Ace BPO Services Ltd, along with correct application of filters (including operating revenue and RPT), was remanded to the AO/TPO for fresh examination after granting the assessee due opportunity of hearing.

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Issues Involved:
1. Determination of Arm’s Length Price (ALP) for international transactions.
2. Selection and rejection of comparables.
3. Interest on trade receivables.
4. Risk and working capital adjustments.
5. Computation of Profit Level Indicator (PLI).

Detailed Analysis:

1. Determination of Arm’s Length Price (ALP) for International Transactions:
The assessee, a captive service provider, engaged in various international transactions with its Associated Enterprises (AE). The transactions included software distribution, software development services, related IT services, shared services, and recovery and reimbursement of expenses. The Transfer Pricing Officer (TPO) was tasked with determining the ALP for these transactions.

- Software Development Services: The TPO found the margin of the assessee higher than the average margin of comparables, hence no adjustment was needed.
- Software Distribution Services: The TPO rejected the Resale Price Method (RPM) adopted by the assessee, applying the Transactional Net Margin Method (TNMM) instead, resulting in an adjustment proposal of Rs. 4,22,90,359 due to a margin discrepancy.
- Related IT Services: The TPO observed defects in the assessee’s TP analysis, leading to an independent analysis and aggregation of transactions under TNMM.

2. Selection and Rejection of Comparables:
The TPO and the Dispute Resolution Panel (DRP) engaged in a detailed analysis of comparables, applying various filters and criteria to ensure functional similarity.

- Filters Applied by TPO: Included criteria such as financial data availability, positive net worth, revenue thresholds, and functional similarity.
- Rejection of Assessee’s Comparables: The TPO rejected several companies selected by the assessee due to reasons like insufficient financial information, functional dissimilarity, and failure to meet specific filters.
- Final List of Comparables: The TPO selected a new set of comparables, leading to the assessee’s objections and subsequent appeals.

3. Interest on Trade Receivables:
The TPO proposed an ALP adjustment for interest on trade receivables, considering it an international transaction under section 92B of the Act. The assessee argued that working capital adjustments already accounted for the impact of outstanding receivables, and no separate adjustment was necessary.

- DRP’s Directive: The DRP directed the TPO to apply applicable interest rates instead of a fixed rate, considering the number of days of delay.
- Final Adjustment: The TPO determined an ALP interest on receivables at Rs. 5,59,43,523 for A.Y 2013-14 and proposed an adjustment of Rs. 1,81,13,140 for A.Y 2014-15.

4. Risk and Working Capital Adjustments:
The assessee sought risk adjustment in accordance with Rule 10B of the Income-tax Rules, 1962, to account for differences between the international transactions and those undertaken by comparables.

- DRP’s Decision: The DRP upheld the TPO’s rejection of risk adjustment but directed the TPO to grant working capital adjustment.
- Final Order: The TPO/AO was directed to grant working capital adjustment but not risk adjustment.

5. Computation of Profit Level Indicator (PLI):
The assessee contested the TPO’s treatment of provision for bad and doubtful debts as non-operating expenditure while computing the PLI.

- DRP’s Stand: The DRP upheld the TPO’s computation methodology.
- Final Decision: The ground was rejected as not pressed by the assessee during the hearing.

Conclusion:
The appeals for A.Y 2013-14 and 2014-15 resulted in partial relief for the assessee. The Tribunal directed the exclusion of certain comparables like Hartron Communications Ltd and Microgenetics Systems Ltd due to functional dissimilarity and exceptional performance. The Tribunal also directed reconsideration of the comparability of certain companies and upheld the need for ALP adjustment on trade receivables, allowing working capital adjustments but rejecting risk adjustments. The final orders were pronounced on 6th August 2019.

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