Software company wins transfer pricing relief as tribunal excludes seven comparables but retains R S Software

ITAT Hyderabad ruled on transfer pricing adjustments for a software development services company. The tribunal excluded seven companies from comparables including Tata Elexis, E-Infochips, Larsen & Tourbo Infotech, Infosys, Persistent Systems, Infobeans Technologies, and Thirdware Solutions, following precedent. However, it retained R S Software as comparable due to functional similarity and rejected exclusion of Mindtree due to diverse operations. The tribunal allowed working capital adjustment based on average opening/closing balances, directed separate benchmarking of interest on trade receivables at LIBOR plus 200 basis points with 60-day credit period, and allowed MAT credit subject to verification.

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1. ISSUES PRESENTED and CONSIDERED

The core legal questions considered by the Tribunal include:

- Whether the transfer pricing documentation maintained by the assessee should be rejected and a fresh economic analysis undertaken leading to an upward adjustment in the international transactions with associated enterprises (AEs).

- Whether the use of single-year data instead of multiple-year data for determining the arm's length price (ALP) is justified.

- The validity of additional filters applied by the Assessing Officer (AO) and Transfer Pricing Officer (TPO) in selecting comparables, including export revenue filter, financial year filter, and one-sided turnover filter.

- Whether certain companies selected as comparables are functionally comparable to the assessee, and whether certain comparables rejected by the AO/TPO should be included.

- The correctness of applying the persistent loss filter to exclude certain comparables, especially Sagar Soft India Limited.

- The determination of operating margins of comparables, including treatment of segmental margins and provisions for bad and doubtful debts (PBDD).

- Whether working capital adjustments (WCA) and risk adjustments were correctly applied or denied.

- Whether interest on outstanding trade receivables qualifies as an international transaction requiring separate benchmarking, and the appropriate interest rate and credit period to be applied.

- Whether the directions of the Dispute Resolution Panel (DRP) were correctly followed.

- The grant of Minimum Alternate Tax (MAT) credit to the assessee.

- The correctness of interest calculations under sections 234B and 234C of the Income Tax Act, 1961.

- The initiation of penalty proceedings under sections 271AA and 271BA of the Act.

- The admissibility of an additional ground challenging the choice of Comparable Uncontrolled Price (CUP) as the Most Appropriate Method (MAM) in transfer pricing.

2. ISSUE-WISE DETAILED ANALYSIS

Rejection of Transfer Pricing Documentation and Fresh Economic Analysis

The assessee initially challenged the rejection of its transfer pricing documentation and the consequent adjustment of Rs. 16.21 crores. However, during the hearing, the assessee did not press grounds related to this issue, leading to their dismissal. The Tribunal did not delve into the merits of this issue.

Use of Multiple Year Data

Similarly, the issue of using single year data (FY 2013-14) instead of multiple years for ALP determination was not pressed by the assessee and was dismissed accordingly.

Application of Additional Filters in Comparable Selection

The assessee contested the use of additional filters by the AO/TPO, such as a 75% export revenue filter, financial year filter, and one-sided turnover filter, arguing these were unjustified. However, these grounds were not pressed and dismissed.

Selection and Exclusion of Comparable Companies

The Tribunal extensively analyzed the functional comparability of various companies proposed as comparables by the AO/TPO and those challenged by the assessee.

Tata Elxsi Limited (Segment): The Tribunal noted that Tata Elxsi operates in diverse segments including embedded product design, industrial design, and visual computing labs, with significant R&D and intangible assets. It was held that Tata Elxsi's activities differ substantially from the assessee's pure Software Development Services (SDS) model. Reliance was placed on prior Tribunal decisions excluding Tata Elxsi as comparable due to functional dissimilarity. The Tribunal directed exclusion of Tata Elxsi.

E-Infochips Ltd.: Despite the assessee's claim that E-Infochips is engaged in product engineering and R&D with significant intangibles, the DRP and Tribunal found that product sales were insignificant relative to software services revenue and that R&D/intangible impact was not material. Following prior decisions, E-Infochips was excluded.

Larsen & Toubro Infotech Ltd.: The Tribunal found this company to have multiple segments including telecom engineering services distinct from SDS, significant intangible assets, and extraordinary events such as business restructuring impacting profits. Prior decisions excluding this company on similar grounds were followed, and it was directed to be excluded.

Infosys Ltd.: The Tribunal noted Infosys's large scale, brand value, proprietary products (e.g., Finacle), substantial R&D expenditure, and marketing expenses, all of which differ markedly from the assessee's profile. Following coordinate Bench decisions and the Delhi High Court's ruling that Infosys is not comparable due to its size and brand, Infosys was excluded.

Persistent Systems Ltd.: This company was found to be engaged in product development and IP-led business with multiple segments and intangible assets. Segmental data was unavailable, and the company was functionally dissimilar to the assessee's routine SDS model. It was excluded following prior Tribunal rulings.

Infobeans Technologies Ltd.: The Tribunal observed that Infobeans had MODVAT and sales tax deposits, indicating involvement in sale of goods alongside services, rendering it functionally dissimilar. It was excluded.

Thirdware Solutions Limited: The company earned revenue primarily from software product sales, licenses, and subscriptions, with no clear segmental data isolating SDS. It also had intangible assets and stock purchases, unlike the assessee. Following prior decisions, it was excluded.

R S Software (India) Limited: The assessee sought exclusion based on R S Software's involvement in electronic payment solutions, presence of intangibles, and R&D. The Tribunal, however, found that the company's entire revenue was from SDS, with no segmental data to show functional dissimilarity. Intangibles were for internal use and did not materially affect profitability. The Tribunal held R S Software functionally comparable and retained it in the final list.

Mindtree Limited: The assessee argued that Mindtree's diverse high-end IT services and multi-segment operations rendered it functionally dissimilar. The absence of reliable segmental data to isolate SDS activities was emphasized. The Tribunal accepted this, excluding Mindtree from comparables.

Inclusion of Akshya Software Technologies Limited, Maveric Systems Limited, Sagar Soft India Limited, Sankhya Infotech Limited:

Akshya Software was found functionally comparable and directed to be included, following prior Tribunal decisions.

Maveric Systems was excluded due to R&D expenditure exceeding the 3% tolerance limit (6% of turnover), following prior rulings. The assessee's reliance on decisions disregarding the R&D filter was rejected as the TPO had applied the filter.

Sankhya Infotech was excluded for similar reasons due to R&D expenditure of 5.9% of turnover.

Sagar Soft was initially excluded due to alleged persistent losses. The Tribunal examined financials showing operating profits in one of the three years considered, referencing a coordinate Bench decision that profit in any one year precludes exclusion on persistent loss grounds. Sagar Soft was ordered to be included.

Working Capital Adjustment (WCA)

The assessee sought WCA, arguing that denial was unjustified due to unavailability of detailed working capital cycle data for comparables, which is not publicly available. The Tribunal noted that Rule 10B(1)(e)(iii) requires adjustment for differences materially affecting net profit margins. It held that denying WCA solely due to lack of granular data is unreasonable, as the assessee cannot access such information. The Tribunal directed the AO/TPO to grant WCA based on average opening and closing balances from annual reports.

Benchmarking Interest on Outstanding Trade Receivables

The assessee contended that interest on trade receivables forms part of working capital and should not be benchmarked separately. The AO/TPO and DRP contended that interest on receivables is a separate international transaction requiring benchmarking under Section 92B, supported by the Explanation inserted by Finance Act 2012.

The Tribunal upheld the statutory position that interest on trade receivables is a separate international transaction requiring benchmarking.

Appropriate Interest Rate and Credit Period for Benchmarking

The Tribunal examined precedents including a recent decision of the Tribunal in HARSCO India Private Ltd. v. DCIT, which held that for loans/receivables in foreign currency, the interest rate should be benchmarked with international rates (e.g., LIBOR plus markup) rather than domestic rates such as SBI short-term deposit rates. The Tribunal also referred to High Court rulings affirming that the currency of the loan/receivable determines the applicable interest rate, not the lender's country's domestic rates.

Accordingly, the Tribunal directed the AO/TPO to benchmark interest on trade receivables at LIBOR plus 200 basis points, allowing a credit period of 60 days (instead of 30 days allowed by TPO).

Grant of MAT Credit

The assessee claimed entitlement to MAT credit denied by the AO. The Tribunal held that MAT credit available under the Act must be granted subject to factual verification and directed the AO to allow it accordingly.

Interest under Sections 234B and 234C and Penalty Proceedings

These grounds were not pressed by the assessee or were consequential to other grounds and were dismissed accordingly.

Admissibility of Additional Ground Challenging CUP as MAM

The Tribunal admitted the additional ground challenging the choice of CUP as the Most Appropriate Method, relying on the Supreme Court judgment in National Thermal Power Co. Ltd. vs. CIT, and allowed its adjudication as a legal issue arising from existing records.

3. SIGNIFICANT HOLDINGS

"The findings given by this Tribunal in the case of M/s. Wave Crest Payment Technology Pvt. Ltd. Vs. DCIT (supra) can be squarely applied to the assessee."

"Tata Elxsi Limited (Segment) is not functionally comparable to the assessee and accordingly the TPO is directed to exclude this company from the set comparables for determining the arm's length price."

"E-Infochips Ltd., Larsen & Toubro Infotech Limited, Infosys Ltd., Persistent Systems Limited, Infobeans Technologies Limited and Thirdware Solutions Limited are not good comparables for the assessee and directed to be excluded."

"R S Software (India) Limited is functionally comparable and deserves to be retained in the final list of comparables."

"Mindtree Limited is functionally dissimilar and is directed to be excluded from the final set of comparables due to lack of reliable segmental data and diverse high-end service offerings."

"Akshya Software Technologies Limited is a good comparable and directed to be included in the final list."

"Maveric Systems Limited and Sankhya Infotech Limited are not comparable due to R&D expenditure exceeding the tolerance limit."

"Sagar Soft India Limited cannot be excluded on the basis of persistent loss filter as it has profit in one of the three years considered."

"Working Capital Adjustment cannot be denied merely due to absence of detailed working capital cycle data and should be granted based on average opening and closing balances."

"Interest on outstanding trade receivables constitutes a separate international transaction requiring benchmarking."

"For benchmarking interest on trade receivables in foreign currency, LIBOR plus 200 basis points is the appropriate interest rate, and a credit period of 60 days is reasonable."

"MAT credit available under the Act must be granted subject to factual verification."

"The additional ground challenging the choice of CUP as MAM is admitted for adjudication as a legal issue."

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