2022 (7) TMI 1579 - AT - Income Tax

TPO directed to reallocate expenses between software development marketing support and data center segments under section 144C(13)

M/s. Blue Coat Network (India) Pvt. Ltd., Versus The Deputy Commissioner of Income Tax, Circle – 1 (1) (2), Bangalore.

M/s. Blue Coat Network (India) Pvt. Ltd., Versus The Deputy Commissioner of Income Tax, Circle – 1 (1) (2), Bangalore. - TMI ISSUES PRESENTED and CONSIDEREDThe primary issues considered in this judgment pertain to transfer pricing adjustments made by the Transfer Pricing Officer (TPO) and upheld by the Dispute Resolution Panel (DRP) regarding the international transactions of the assessee, specifically in the segments of software development services, marketing support services, and data center services. The issues include:Whether the TPO erred in making upward adjustments to the transfer price of the assessee's international transactions.Whether the TPO correctly applied the segmental financial information and allocation of expenses.Whether the TPO complied with the directions of the DRP regarding the exclusion of restructuring costs.Whether the comparability analysis conducted by the TPO was appropriate, including the rejection or acceptance of certain comparables based on functional dissimilarities and turnover filters.Whether the TPO erred in not providing adjustments for differences in working capital and risk profiles between the assessee and comparable companies.Whether the additional ground concerning the application of turnover filters was admissible.ISSUE-WISE DETAILED ANALYSISTransfer Pricing AdjustmentsThe TPO made significant upward adjustments to the transfer prices of the assessee's international transactions in software development services, marketing support services, and data center services. The DRP upheld these adjustments, leading to the assessee's appeal.Legal Framework and PrecedentsThe relevant legal framework includes the provisions of the Income Tax Act related to transfer pricing, specifically Section 92CA, which governs the determination of the arm's length price for international transactions. The Tribunal referred to various precedents, including decisions of coordinate benches and the Hon'ble Bombay High Court, regarding the application of turnover filters and comparability criteria.Court's Interpretation and ReasoningThe Tribunal found that the TPO and DRP did not adequately consider the functional dissimilarities and turnover differences between the assessee and the selected comparables. The Tribunal emphasized the importance of applying appropriate filters, including turnover filters, to ensure comparability.Key Evidence and FindingsThe Tribunal noted that the TPO failed to apply an upper turnover filter, which is critical in ensuring that companies with significantly higher turnovers are not compared with smaller entities like the assessee. The Tribunal also observed that the TPO did not follow the DRP's directions regarding the exclusion of restructuring costs from the operating cost base.Application of Law to FactsThe Tribunal applied the principles established in previous cases, such as the Zynga Game Network India Pvt. Ltd. case, to exclude companies with high turnovers from the list of comparables. The Tribunal also directed the TPO to follow the DRP's instructions regarding the exclusion of restructuring costs.Treatment of Competing ArgumentsThe Tribunal considered the arguments presented by both the assessee and the revenue. It found merit in the assessee's contention that the TPO's approach to comparability and expense allocation was flawed. The Tribunal also acknowledged the revenue's reliance on the TPO's findings but ultimately found them insufficient to justify the adjustments.ConclusionsThe Tribunal concluded that the TPO's adjustments were not justified due to the inappropriate selection of comparables and failure to apply the DRP's directions. The Tribunal directed the TPO to re-evaluate the comparables and expense allocations in line with the Tribunal's findings and the DRP's directions.Additional Ground on Turnover FilterThe assessee raised an additional ground regarding the application of a turnover filter, arguing that the TPO applied only a lower turnover limit without considering an upper limit.Legal Framework and PrecedentsThe Tribunal referred to precedents that established the relevance of applying both lower and upper turnover filters to ensure comparability, especially in cases involving entities with significantly different turnovers.Court's Interpretation and ReasoningThe Tribunal found that the TPO's failure to apply an upper turnover filter was inconsistent with established precedents and resulted in the inclusion of non-comparable entities in the analysis.Key Evidence and FindingsThe Tribunal cited decisions from other cases, such as the Radisys India Pvt. Ltd. and Yahoo Software Development India Pvt. Ltd. cases, where similar issues were addressed, and companies with high turnovers were excluded from comparability analysis.Application of Law to FactsThe Tribunal applied the principles from these precedents to the current case, directing the TPO to exclude companies with turnovers exceeding Rs. 200 crores from the list of comparables.Treatment of Competing ArgumentsThe Tribunal considered the revenue's arguments but found them unpersuasive in light of the established legal principles favoring the exclusion of high-turnover companies.ConclusionsThe Tribunal allowed the additional ground, directing the TPO to apply an upper turnover filter and exclude companies with turnovers exceeding Rs. 200 crores from the comparability analysis.Working Capital AdjustmentThe assessee argued that the TPO failed to provide a working capital adjustment, which is necessary to account for differences in working capital levels between the assessee and comparable companies.Legal Framework and PrecedentsThe Tribunal referred to the provisions of the Income Tax Act and precedents that recognize the need for working capital adjustments to ensure accurate comparability.Court's Interpretation and ReasoningThe Tribunal found that the TPO's refusal to provide a working capital adjustment was unjustified, as such adjustments are necessary to eliminate material differences affecting comparability.Key Evidence and FindingsThe Tribunal cited the Huawei Technologies India (P.) Ltd. case, where a working capital adjustment was deemed necessary to ensure a fair comparison.Application of Law to FactsThe Tribunal applied these principles to the current case, directing the TPO to provide a working capital adjustment based on the assessee's submissions.Treatment of Competing ArgumentsThe Tribunal considered the revenue's arguments against the adjustment but found them insufficient to justify the denial of a working capital adjustment.ConclusionsThe Tribunal allowed the assessee's request for a working capital adjustment, directing the TPO to implement the adjustment in accordance with the Tribunal's findings.SIGNIFICANT HOLDINGSThe Tribunal established several core principles in this judgment:Turnover filters must include both lower and upper limits to ensure comparability, especially in cases involving entities with significantly different turnovers.Working capital adjustments are necessary to account for differences in working capital levels between the assessee and comparable companies, ensuring accurate comparability.The TPO must adhere to the DRP's directions, including the exclusion of restructuring costs from the operating cost base.Functional dissimilarities and turnover differences are critical factors in determining comparability, and the TPO must carefully evaluate these aspects when selecting comparables.The Tribunal's final determinations on each issue resulted in the partial allowance of the assessee's appeal, with directions to the TPO to re-evaluate the comparability analysis and expense allocations in line with the Tribunal's findings and the DRP's directions.