2022 (2) TMI 1507 - AT - Income Tax

IT services provider wins transfer pricing case excluding three comparables and deleting expense reallocation additions

M/s. Acuity Knowledge Centre (India) Pvt. Ltd., (formerly known as Moody’s Analytics Knowledge Services (India) Private Limited) Versus DCIT, Circle-4 (1) (2), Bengaluru

The ITAT Bangalore ruled on transfer pricing adjustments for an IT enabled services provider. The tribunal excluded three companies from comparable ... TP Adjustment - determination of Arm’s Length Price (ALP) in the Information Technology Enabled Services (ITeS) segment - comparable selection - HELD THAT:- Harton Communications Ltd. cannot be considered as comparable break-up of revenue earned from software development and back office / BPO services is not provided in the financials In the absence of segmental details and break up of revenue from software development and BPO services, Hartron cannot be considered as comparable. Comparability of Capgemini India Ltd. as engaged in providing high end specialized services and according to the auditors of the company comparable quotation of services provided by Capgemini are not available publically. Therefore, if other companies are not comparable to Capgemini due to the nature of its services, on similar lines Capgemini also cannot be considered as comparable for the assessee engaged in provision of low-end IT enabled services. This company thus excluded. Comparability of Infosys BPO Ltd.this company provides a gamut of services that includes sourcing and procurement, customer services, financial & accounting, legal process outsourcing, sales & fulfilment, analytics, business platform, business transformation services, human resources outsourcing, etc. Services such as analytics, human resource outsourcing, which are not comparable with the assessee. This company is a market leader. The company should be rejected as it an established player and also a market leader and operates as a full-fledged risk bearing entrepreneur. The company has a huge turnover of Rs. 1861 crores and hence not comparable to the assessee. It has significant selling, marketing and brand building expenses, brand value. Infosys BPO is an industry giant and commands a very high brand value in the market and also bears all related risk and cannot be compared to the assessee which is a captive service provider. Further, since it commands a very high brand value it enjoys premium pricing. Thus be excluded. Addition on account of re-allocation of certain common expenses - AO not accepting the re-allocation of certain common expenses between the units of the Appellant (viz., STPI unit, SEZ Unit — I and SEZ Unit - II) as determined by the Appellant - The assessee operates on a cost-plus mark-up arrangement where each unit's revenue is computed on a 'cost-plus' basis i.e.. the revenue of a unit (and the profit) increases as the cost base increases. It is imperative to mention here that even by charging the identified common expenses (namely key managerial remuneration, audit fee. bank charges etc.) to the STPI Unit alone. the assessee has not reduced its taxable income. In fact, the same has resulted in increasing the taxable income of the assessee, keeping in view the operating model of the assessee. Had the assessee apportioned the identified common expenses among all the units. it would have reduced the cost base of the STPI unit, thereby, resulting in reduced mark up and taxable profits for the STPI unit. The reasons provided by the AO for making the adjustment does not stand correct in the present fact pattern of the assessee given its cost-plus markup operating model. The addition made by the learned AO on the basis that the assessee has under-reported profits of the STPI Unit is erred in law and facts. Given the above, we direct AO to delete the disallowance made in this regard. 1. ISSUES PRESENTED and CONSIDEREDThe core legal questions considered by the Tribunal in this appeal are:(a) Whether the learned Assessing Officer (AO) and Transfer Pricing Officer (TPO) erred in including certain companies as comparable for determination of Arm's Length Price (ALP) in the Information Technology Enabled Services (ITeS) segment, specifically whether Hartron Communications Limited, Capgemini Business Services (India) Limited, and Infosys BPO Limited are functionally comparable to the assessee for transfer pricing analysis under section 92 of the Income Tax Act, 1961.(b) Whether the AO erred in making additions to the total income of the assessee by re-allocating certain common expenses among the assessee's multiple units, particularly between the SEZ Unit-I (eligible for deduction under section 10AA), STPI Unit, and SEZ Unit-II, without considering the assessee's cost-plus mark-up billing model and the consequent impact on taxable income and eligibility for deduction under section 10AA.2. ISSUE-WISE DETAILED ANALYSISIssue 1: Inclusion of Hartron Communications Limited, Capgemini Business Services (India) Limited, and Infosys BPO Limited as Comparable Companies for ALP DeterminationRelevant Legal Framework and Precedents: The determination of ALP for international transactions under section 92 of the Income Tax Act requires selection of comparable uncontrolled transactions or companies. The Transfer Pricing Officer (TPO) must identify companies that are functionally comparable, i.e., engaged in similar activities, bearing similar risks, and operating under similar economic conditions. The Transactional Net Margin Method (TNMM) was agreed upon as the Most Appropriate Method (MAM), with Operating Profit to Operating Cost (OP/OC) as the Profit Level Indicator (PLI).Court's Interpretation and Reasoning: The Tribunal examined the functional profiles, financial performance, and segmental details of the three companies challenged by the assessee as non-comparable.- Hartron Communications Limited: The Tribunal noted that FY 2012-13 was an exceptional year for Hartron's BPO segment with a 483.72% increase in revenue, but this was an outlier as the segment incurred losses in four out of five years from FY 2010-11 to FY 2014-15. The company's revenue is derived from three distinct segments: rent income, office backup operations (including custom software development and IP services), and real estate. The BPO and software development revenues were not separately disclosed, rendering the segmental comparability unclear. The Tribunal also relied on prior ITAT decisions excluding Hartron as a comparable in similar ITeS cases.- Capgemini Business Services (India) Limited: The company primarily provides high-end specialized Business Process Management and Assurance & Compliance services. The Tribunal highlighted that Capgemini's services are distinct and specialized, with no publicly available comparable quotations, making it functionally different from the assessee's low-end ITeS offerings. Previous ITAT rulings in similar cases had excluded Capgemini from comparables.- Infosys BPO Limited: Infosys BPO offers a broad range of services including sourcing, procurement, customer services, legal process outsourcing, analytics, and human resource outsourcing. The Tribunal observed that Infosys BPO is a market leader with significant brand value, a large turnover (Rs. 1861 crores), and operates as a full-fledged risk-bearing entrepreneur. Such characteristics distinguish it from the assessee, which is a captive service provider with no similar brand or market risk. The Tribunal emphasized that Infosys BPO's premium pricing and scale render it non-comparable.Key Evidence and Findings: The Tribunal relied on the assessee's submissions, annual reports, segmental revenue data, prior ITAT precedents, and the functional analysis of each company. The exceptional nature of Hartron's financials, the specialized nature of Capgemini's services, and Infosys BPO's market leadership and risk profile were critical factors.Application of Law to Facts: Applying the principle that comparables must be functionally similar and operate under similar risk and market conditions, the Tribunal concluded that none of the three companies met the comparability criteria. The Tribunal directed their exclusion from the comparable set for ALP determination.Treatment of Competing Arguments: The Revenue had included these companies as comparables based on financial data and margins, but failed to establish functional comparability and risk profile equivalence. The Tribunal gave greater weight to functional analysis and prior judicial precedents favoring exclusion.Conclusions: The Tribunal excluded Hartron Communications Limited, Capgemini Business Services (India) Limited, and Infosys BPO Limited from the list of comparable companies for ALP determination in the ITeS segment.Issue 2: Re-allocation of Common Expenses Amongst Assessee's Units and Impact on Deduction under Section 10AARelevant Legal Framework and Precedents: Section 10AA of the Income Tax Act provides deduction to units located in Special Economic Zones (SEZs) based on profits derived from eligible activities. The assessee operated three units: SEZ Unit-I (eligible for section 10AA deduction), STPI Unit, and SEZ Unit-II (non-eligible). The assessee follows a cost-plus mark-up billing model, where each unit's revenue is computed as cost plus 15% mark-up.Prior judicial decisions, including the Tribunal's own ruling in the assessee's case for AY 2012-13, held that underbooking expenses in an exempt unit does not result in tax advantage because revenue and profit are linked to costs under the cost-plus model.Court's Interpretation and Reasoning: The AO re-allocated certain common expenses (such as key managerial remuneration, audit fees, bank charges) from the STPI and SEZ Unit-II to the SEZ Unit-I, alleging under-reporting of profits in the non-eligible units and inflated profits in the eligible unit. The CIT(A) upheld this re-allocation.The Tribunal analyzed the assessee's operating model and found that since revenue and profit are computed as cost plus mark-up, charging more expenses to a unit increases its revenue and profit proportionately. Therefore, allocating common expenses solely to the STPI Unit does not reduce taxable income but actually increases it.The Tribunal also noted that the AO's re-allocation was based on surmises and conjectures without credible evidence of defect in the assessee's expense allocation.Key Evidence and Findings: The Tribunal relied on the assessee's cost-plus mark-up billing arrangement, the certificate from the Chartered Accountant regarding profits and deduction claims, and the prior ITAT decision on the same issue for the previous assessment year.Application of Law to Facts: Given the cost-plus model, the Tribunal held that re-allocating common expenses to reduce profits of non-eligible units and increase profits of the eligible unit is legally and factually incorrect. The AO's addition on this basis was therefore unsustainable.Treatment of Competing Arguments: The Revenue's argument that re-allocation was necessary to prevent under-reporting of profits was rejected as it ignored the cost-plus mark-up mechanism and lacked evidentiary basis.Conclusions: The Tribunal directed deletion of the addition made by the AO on account of re-allocation of common expenses. Since the decision on this ground negated the basis for denial of deduction under section 10AA raised in ground No. 16, the latter was held to be academic and not adjudicated.3. SIGNIFICANT HOLDINGS'Considering the Revenue model of cost + mark up adopted by the assessee, as rightly pointed out by the assessee, it will not gain anything by under booking expenses in the exempt unit, since the under booking of expenses would result in corresponding reduction in revenue also. In any case, we noticed that the AO has asked the assessee to re-allocate the common expenses only by entertaining surmises and conjectures and not based on any creditable defect noticed by him. Hence, we are of the view that there is no reason to interfere with the order passed by the Ld. CIT (A) on this issue.'This principle underscores that in a cost-plus mark-up billing arrangement, expense allocation does not impact overall taxable income in the manner alleged by the Revenue.The Tribunal established the core principle that for transfer pricing comparability analysis, functional similarity and risk profile equivalence are paramount, and financial data alone cannot justify inclusion of companies as comparables.On the issue of comparables, the Tribunal held:'In the absence of segmental details and break up of revenue from software development and BPO services, Hartron cannot be considered as comparable... Capgemini... engaged in providing high end specialized services... cannot be considered as comparable... Infosys BPO is an industry giant and commands a very high brand value in the market and also bears all related risk and cannot be compared to the assessee which is a captive service provider.'Accordingly, the Tribunal excluded these three companies from the comparable set for ALP determination.On the re-allocation of expenses and section 10AA deduction, the Tribunal concluded that the AO's addition was erroneous and directed its deletion, rendering the related ground on denial of deduction academic.