Transfer pricing comparability and operating profit should exclude software product companies and include foreign exchange gain.

Transfer pricing benchmarking for a software development service provider should be confined to functionally similar companies with reliable segmental data, so software product companies lacking usable segmentation are not suitable comparables. On that basis, Larsen & Toubro Infotech Ltd. and Persistent Systems Ltd. were excluded from the comparable set. The article also notes that foreign exchange gain arising from the international transaction forms part of operating income for computing the operating profit to operating cost margin, and the profit level indicator must be recomputed accordingly.

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Issues: (i) Whether Larsen & Toubro Infotech Ltd. and Persistent Systems Ltd. were comparable companies for benchmarking the assessee's software development services under the transfer pricing analysis; (ii) Whether foreign exchange gain formed part of operating profit for computing the operating profit to operating cost margin.

Issue (i): Whether Larsen & Toubro Infotech Ltd. and Persistent Systems Ltd. were comparable companies for benchmarking the assessee's software development services under the transfer pricing analysis.

Analysis: The comparability exercise had to be confined to companies functionally similar to a software development service provider. The record showed that both companies had been excluded in earlier tribunal rulings on the ground that they were software product companies and that adequate segmental information for software development services was not available. Following that reasoning, the two companies could not be retained in the final set of comparables.

Conclusion: The exclusion of Larsen & Toubro Infotech Ltd. and Persistent Systems Ltd. was justified and was in favour of the assessee.

Issue (ii): Whether foreign exchange gain formed part of operating profit for computing the operating profit to operating cost margin.

Analysis: For transfer pricing purposes, operating profit had to reflect the operating results of the assessee's business activity. Foreign exchange gain arising from the international transaction was treated as part of operating income, and the operating margin was required to be recomputed on that basis.

Conclusion: Foreign exchange gain was directed to be included in operating profit, which was in favour of the assessee.

Final Conclusion: The transfer pricing adjustment was not sustained in the manner adopted by the revenue authorities, and the matter required recomputation after excluding the two comparable companies and treating foreign exchange gain as operating income.

Ratio Decidendi: For benchmarking software development services under transfer pricing, only functionally comparable companies with reliable segmental data can be used, and foreign exchange gain arising from the operating activity is to be treated as part of operating profit while computing the profit level indicator.

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