2022 (6) TMI 1541 - AT - Income Tax

Transfer-pricing comparables narrowed: apply Dun & Bradstreet turnover classes, exclude entities below Rs1 crore or above Rs200 crore

M/s. In App Information Technologies India Private Limited Versus The Assistant Commissioner of Income-tax, Circle 1 (1) Kochi.

M/s. In App Information Technologies India Private Limited Versus The Assistant Commissioner of Income-tax, Circle 1 (1) Kochi. - TMI ISSUES PRESENTED AND CONSIDERED 1. Whether comparables with turnover substantially higher than the assessee (i.e., > Rs.200 crores) can be excluded by applying an upper turnover filter when determining arm's length price under the Transactional Net Margin Method (TNMM). 2. Whether profit margins of a comparable whose turnover exceeded the upper turnover threshold in earlier years but not in the current year (specifically R S Software for relevant prior years) should be excluded for those earlier years when computing the weighted average margin. 3. Ancillary: Direction to re-determine ALP after exclusion of identified comparables/margins and consequences for pending stay petition (limited to the relief sought and disposed of by the Tribunal). ISSUE-WISE DETAILED ANALYSIS Issue 1 - Applicability of upper turnover filter (exclusion of high-turnover comparables) Legal framework: Determination of arm's length price under the TNMM is governed by Rule 10B(1)(e) read with section 92CA of the Act. Rule 10B(2) and sub-clauses require comparability to be judged having regard to functions, assets, risks (FAR), contractual terms and market conditions. Where differences could materially affect margins, either exclusion or reasonably accurate adjustments must be made. The OECD Transfer Pricing Guidelines (TPG) provide guidance on comparability adjustments and the concept that differences which could materially affect the condition being examined must be adjusted for or render comparisons non-comparable. Precedent treatment: The authorities show conflicting views. The Delhi High Court in a cited decision held that high turnover ipso facto does not mandate exclusion if FAR comparability exists (with turnover observations being obiter). Conversely, the Bombay High Court (followed by several ITAT decisions) treated turnover as a relevant criterion and supported exclusion of companies with markedly higher turnover. Relevant Tribunal decisions (including those applying Dun & Bradstreet size classifications and the Bangalore Bench's decisions in Autodesk, Aurigo and Dell-related jurisprudence) have applied an upper turnover threshold (commonly Rs.200 crores) to exclude large companies when the assessee is a small company. Interpretation and reasoning: The Tribunal noted that comparability requires assessment of differences that materially affect margins and that the TPO had applied a lower turnover cutoff (excluding companies < Rs.1 crore) but failed to apply any upper cutoff while including several very large companies. Applying Dun & Bradstreet size categories for software companies (small: < Rs.200 crores; medium: Rs.200-2000 crores; large: > Rs.2000 crores), and given the assessee's turnover (~Rs.18.8 crores), the Tribunal reasoned that inclusion of companies with turnover > Rs.200 crores would introduce material differences (market position, bargaining power, scale benefits, cost structures) that cannot be cured by reasonable adjustments and therefore such comparables are not sufficiently comparable for TNMM analysis. The Tribunal reviewed conflicting case law, recognized the existence of two views, and adopted the approach favourable to the assessee consistent with the principle of following the view beneficial to the assessee where judicial conflict exists; it specifically followed the line of Tribunal/Bombay High Court decisions treating turnover as a relevant comparability criterion and the Bangalore Bench decisions (Autodesk, Aurigo, Dell) applying the Rs.200 crore upper limit. Ratio vs. Obiter: The holding that comparables with turnover materially larger than the assessee (i.e., > Rs.200 crores for a small company) can be excluded is treated as ratio for the facts before the Tribunal. The Tribunal treats contrary observations in the Delhi High Court decision on turnover as obiter and distinguishes them on that basis. Conclusion: The Tribunal directed exclusion of seven comparables whose current year turnover exceeded Rs.200 crores from the TPO's final list (Larsen & Toubro; Persistent; Infosys; Cybage; Nihilent; Thirdware; Aspire Systems), holding that such companies are not comparable to the assessee for TNMM purposes. The matter was remitted to AO/TPO to re-determine ALP after excluding those companies. Issue 2 - Treatment of R S Software margins for earlier years where turnover exceeded threshold Legal framework: Same comparability principles under Rule 10B and OECD TPG apply to year-wise selection and to weighted average computations of margins across years; Rule 10CA (applicable here from AY 2014-15 onwards) and relevant Tribunal practice require year-wise assessment of comparability when computing weighted averages. Precedent treatment: Tribunal precedents (including Barracuda / related Bangalore Bench orders and the Aurigo decision) have held that where a company's turnover in specific earlier years exceeds the applicable turnover comparability threshold, margins for those earlier years should be ignored even if the company's current year turnover falls within the threshold; alternatively, the company may be retained but margins for non-comparable years excluded from the weighted average. Interpretation and reasoning: The Tribunal observed that R S Software's current year turnover was within the acceptable band, but its turnover in earlier years exceeded Rs.200 crores, rendering the earlier years non-comparable. As the weighted average margin must reflect only comparable years, margins for those earlier years that failed the turnover comparability test must be disregarded. The Tribunal relied on the Barracuda line of decisions directing omission of margins for years where turnover breached the threshold. Ratio vs. Obiter: The direction to exclude margins of R S Software for specific earlier financial years from the weighted average is applied as ratio for recalculation in this case; it follows established Tribunal practice and is not treated as obiter. Conclusion: The Tribunal directed the AO/TPO to exclude R S Software's profit margins for FY 2013-14 and FY 2014-15 (years in which its turnover exceeded Rs.200 crores) when re-computing the weighted average margin and re-determining the arm's length price. Only margins from comparable years (e.g., FY 2015-16) were to be taken into account. Issue 3 - Remand, recalculation and stay petition Interpretation and reasoning: Having found the TPO/DRP erred in failing to apply an upper turnover filter and in including margins from non-comparable years, the Tribunal remitted the matter to the AO/TPO to recompute ALP after excluding the seven high-turnover comparables and excluding non-comparable year margins of R S Software as directed. The Tribunal noted that, in view of resolving the substantive appeal in favour of the assessee and remanding for recomputation, the pending stay petition for stay of demand became infructuous. Conclusion: The appeal was allowed to the extent directed (exclusion and recomputation as above). The stay petition was dismissed as infructuous. The AO/TPO was directed to give effect to the Tribunal's directions in re-determining arm's length price and resultant adjustments.