2022 (6) TMI 1555 - AT - Income Tax

Transfer pricing comparability turns on turnover, working capital, and receivables benchmarking with fair hearing safeguards.

Transfer pricing comparability must account for material turnover differences in the software development segment, and very high-turnover companies may be ... Turnover filter in transfer pricing comparability - Comparable selection - Working capital adjustment - Benchmarking of outstanding receivables - Principles of natural justiceTurnover filter in transfer pricing comparability - Upper turnover filter - Application of an upper turnover filter for selecting comparables in the software development services segment was upheld. - HELD THAT: - The Tribunal held that, where a lower turnover filter had been applied, an appropriate upper turnover filter was also justified for comparability analysis. Following co-ordinate Bench decisions, it accepted that companies with turnover above Rs. 200 crore were not comparable to the assessee, whose software services income was substantially lower. It also rejected the Revenue's contention that only a 10 times turnover tolerance should govern exclusion, holding that such proposition had not been laid down as a binding rule. [Paras 6]The AO/TPO was directed to apply an appropriate upper turnover filter and exclude companies accordingly.Related party transaction filter - Comparable selection - Verification of Inteq Software Private Limited under the related party transaction filter was remitted for examination. - HELD THAT: - The Tribunal noted that the assessee sought exclusion of this company on the ground that it failed the RPT filter for the relevant prior year, but the matter had not been examined by the lower authorities. In view of the co-ordinate Bench ruling relied on before it, the Tribunal considered that the factual computation of RPT required verification before the company's inclusion could be sustained or rejected. [Paras 7]The AO/TPO was directed to compute the RPT for A.Y. 2014-2015 and verify whether the company satisfied the prescribed criterion.Functional comparability - Multi-year margin computation - Recomputation of margins of Infobeans Technologies Limited was remitted in light of the co-ordinate Bench ruling on exclusion of margins for a prior year. - HELD THAT: - The Tribunal recorded that the assessee sought exclusion of this company on functional dissimilarity, specifically contending that its margin for A.Y. 2015-2016 could not be used. Since this aspect had not been examined by the lower authorities, the Tribunal did not decide comparability finally on merits but directed reconsideration in the light of the earlier co-ordinate Bench decision governing treatment of that company's prior-year margins. [Paras 7]The AO/TPO was directed to consider the co-ordinate Bench ruling and recompute the margins accordingly.Working capital adjustment - Arm's length price determination - Denial of working capital adjustment was found unsustainable and the claim was directed to be reconsidered on the proper legal basis. - HELD THAT: - Relying on the co-ordinate Bench decision cited before it, the Tribunal held that the basis adopted by the DRP for rejecting working capital adjustment was no longer valid. It accepted that working capital differences materially affect comparability and that the assessee's claim could not be denied on grounds such as non-availability of data when the adjustment had to be examined in accordance with the prescribed transfer pricing framework. [Paras 8]The AO/TPO was directed to examine the workings and allow appropriate working capital adjustment in arriving at the ALP; the ground was allowed for statistical purposes.Benchmarking of outstanding receivables - Principles of natural justice - The adjustment relating to interest on outstanding receivables was remitted because the transaction had not been benchmarked in accordance with law and the DRP altered the rate without granting an opportunity of hearing. - HELD THAT: - The Tribunal found a violation of natural justice because the DRP directed adoption of the SBI short-term deposit rate in place of the rate adopted by the TPO without hearing the assessee. It further held that the TPO had not benchmarked the international transaction in the manner required by the Act. While noticing the assessee's reliance on the Delhi Bench decision in Bechtel India Pvt. Ltd. , it observed that the subsequent High Court and Supreme Court orders were summary dismissals and therefore not binding precedents on the facts before it. The Tribunal accordingly followed the jurisdictional co-ordinate Bench approach requiring benchmarking under one of the prescribed methods. [Paras 9]The AO/TPO was directed to benchmark the transaction in accordance with the Act and Rules and to grant the assessee an opportunity of hearing before making any adjustment.Final Conclusion: The appeal was partly allowed. The Tribunal directed application of an upper turnover filter, remitted certain comparable-selection issues for fresh examination, directed reconsideration of working capital adjustment, and restored the outstanding receivables issue for fresh benchmarking after granting due opportunity to the assessee. Issues: (i) application of the upper turnover filter for selection of comparables in the software development segment; (ii) exclusion or reconsideration of selected comparable companies on grounds of related party transactions and functional dissimilarity; (iii) entitlement to working capital adjustment; and (iv) benchmarking of interest on outstanding receivables and compliance with natural justice.Issue (i): application of the upper turnover filter for selection of comparables in the software development segment.Analysis: The turnover of the assessee was materially lower than that of certain comparables. The Tribunal followed its earlier view that turnover is a relevant criterion in transfer pricing comparability and that companies with very high turnover are not properly comparable for a smaller software service provider. It also rejected the contention that a rigid ten-times tolerance range was a mandatory test.Conclusion: The upper turnover filter was directed to be applied and the corresponding comparables were to be excluded.Issue (ii): exclusion or reconsideration of selected comparable companies on grounds of related party transactions and functional dissimilarity.Analysis: For one company, the Tribunal noted that the related party transaction filter for the relevant year had to be examined and directed the lower authorities to verify whether the company satisfied that filter. For another company, the Tribunal held that functional comparability and the treatment of margins for the relevant year had to be reconsidered in the light of earlier coordinate bench rulings and the matter had not been examined by the lower authorities.Conclusion: The matter was remitted for recomputation and verification of comparability criteria.Issue (iii): entitlement to working capital adjustment.Analysis: The Tribunal followed the principle that differences in working capital materially affect profit margins and that reasonably accurate adjustment must be allowed when such differences exist. It held that denial of working capital adjustment was not sustainable in view of the binding transfer pricing framework and the earlier coordinate bench ruling relied upon.Conclusion: Appropriate working capital adjustment was directed to be allowed.Issue (iv): benchmarking of interest on outstanding receivables and compliance with natural justice.Analysis: The Tribunal held that receivables constitute an international transaction requiring benchmarking under the Act and Rules. It also found that the assessee was not given an opportunity when the interest rate basis was altered at the DRP stage, thereby violating natural justice. The issue was therefore required to be reconsidered in accordance with the prescribed methods.Conclusion: The receivables issue was remitted for fresh benchmarking after following the law and giving the assessee an opportunity of hearing.Final Conclusion: The assessee succeeded on the turnover filter, working capital adjustment, and receivables benchmarking issues, while other comparable-selection aspects were sent back for verification or recomputation, resulting in partial relief overall.Ratio Decidendi: In transfer pricing, comparability must account for material turnover differences and working capital differences, and receivables forming part of international transactions must be benchmarked in accordance with the Act and Rules after observing natural justice.