Transfer pricing ruling backs turnover filter, working capital adjustment, and conditional interest on receivables in benchmarking

ITAT Bangalore allowed the assessee's plea for applying an upper turnover filter in all segments and directed the TPO to exclude high-turnover comparables and recompute the arm's-length margin using the remaining set. The assessee's claim for inclusion of additional comparables not arising from the TPO's original search matrix was rejected as cherry-picking, including for the ITeS and market support segments. A comparable following a different financial year was directed to be included if the assessee can satisfactorily reconstruct matching-year financials. The issue of a disputed comparable failing the RPT filter was remanded to the TPO for uniform application of the filter. The TPO was directed to grant working capital adjustment where warranted, and to compute interest on overdue receivables only if such adjustment is denied, using the invoice currency.

---

---

1. ISSUES PRESENTED AND CONSIDERED

1.1 Whether an upper turnover filter is required in the comparability analysis for the software development services segment, and whether very high-turnover companies can be retained as comparables to a much smaller captive service provider.

1.2 Whether companies not thrown up by the Transfer Pricing Officer's search matrix (search methodology/keywords/filters) can be subsequently introduced as comparables by the assessee in the software development, ITeS and marketing support services segments.

1.3 Whether a company following a different financial year (R Systems International Limited) can be included as a comparable when audited quarterly results enable reconstruction of financials to match the assessee's financial year.

1.4 What is the correct manner of applying the related party transaction (RPT) filter, and whether Saatchi & Saatchi Private Limited should be retained or excluded as a comparable in the marketing support services segment on that basis.

1.5 Whether the assessee is entitled to working capital adjustment and, consequentially, whether separate adjustment for interest on overdue receivables from associated enterprises is warranted; if so, in which currency and on what basis interest is to be computed.

2. ISSUE-WISE DETAILED ANALYSIS

Issue 1: Upper turnover filter and exclusion of very high-turnover comparables in software development services

Legal framework (as discussed):

2.1 The Court referred to OECD Transfer Pricing Guidelines (2022), para 3.43, noting that size criteria (sales, assets, number of employees) are commonly used quantitative criteria in comparability analyses, as size can affect competitive positions and comparability.

2.2 Reliance was also placed on guidance from NASSCOM, Dun & Bradstreet, and ICAI Guidance Notes supporting use of turnover bands/filters for comparability.

2.3 The Court distinguished the Delhi High Court decision in ChrysCapital, observing that it dealt with super-normal profits and not specifically with turnover filters.

Interpretation and reasoning:

2.4 The assessee's software development segment turnover was about Rs. 23.91 crores, whereas several TPO-selected comparables had turnovers multiple times higher (e.g., Mindtree Ltd ~Rs. 8,120 crores; Larsen & Toubro Infotech Ltd ~Rs. 11,787 crores; Wipro Ltd ~Rs. 50,299 crores; Infosys Ltd ~Rs. 85,912 crores; Tata Consultancy Services Ltd ~Rs. 1,35,963 crores; Tata Elxsi Ltd ~Rs. 1,002 crores; Cybage Software Pvt. Ltd ~Rs. 1,143 crores).

2.5 The TPO rejected an upper turnover filter on the premise that in software/service industries margins are not impacted by size, that economies of scale matter only for capital-intensive industries, and that his empirical study showed no proportional relation between turnover and margins.

2.6 The Court held that it is undisputed that a lower turnover filter (e.g., Rs. 1 crore) is applied to remove insignificant companies from the comparable set; logically, an upper turnover filter can likewise be applied to remove very large companies where size differentials are extreme.

2.7 The Court reasoned that companies with substantially larger turnover tend to have higher bargaining power, greater ability to absorb losses, potential economies of scale and, often, higher market share, all of which materially affect pricing and margins and thereby comparability.

2.8 The purpose of filters is to achieve a manageable set of independent comparables with broadly similar turnover, intangibles, employee base and asset structure, so that "economies of scale" and market position remain broadly comparable to the tested party.

2.9 The Court noted that various judicial precedents of coordinate benches have upheld the use of an upper turnover filter where comparables have turnover multiple times that of the tested entity, and accepted this as a valid approach. On facts, the comparable companies retained by the TPO had turnover many-fold higher than the assessee's segmental turnover.

Conclusions:

2.10 The Court held that companies with very high turnover compared to the assessee's software development segment are not suitable comparables and must be excluded by applying an upper turnover filter.

2.11 The Court directed exclusion of Mindtree Ltd, Larsen & Toubro Infotech Ltd, Wipro Ltd, Tata Elxsi Ltd, Infosys Ltd, Tata Consultancy Services Ltd and Cybage Software Private Limited from the software development comparables on the basis of turnover, without examining other functional objections.

2.12 The Assessing Officer/TPO was directed to recompute the arm's length margin and corresponding adjustment for the software development segment based on the remaining comparables.

Issue 2: Inclusion of comparables not appearing in the TPO's search matrix (software development, ITeS, and marketing support services segments)

Interpretation and reasoning:

2.13 The assessee sought inclusion of certain companies (in software development, ITeS and marketing support services segments) either from its TP study or newly identified during assessment/DRP proceedings, on the ground that they are functionally comparable and pass the TPO's filters, though they did not appear in the TPO's search matrix.

2.14 The Court observed that the TPO had adopted a defined search matrix (keywords, quantitative and qualitative filters) for the database search. Once such a matrix is adopted and there is no allegation that it is inherently defective or inappropriate, comparables must emerge from that process.

2.15 Introducing additional companies that did not surface through the TPO's search criteria was held to amount to "cherry picking". The Court cautioned that comparability analysis is a structured process and its integrity would be compromised if companies outside the applied search matrix are arbitrarily brought in merely because they appear favourable or similar.

Conclusions:

2.16 The Court held that companies which did not appear in the TPO's search matrix, and where the search methodology itself was not challenged as improper, cannot be forced into the comparable set merely at the assessee's behest.

2.17 Ground seeking inclusion of such comparables in the software development segment was rejected.

2.18 Similarly, the request to include Virinchi Limited and MAA Business Solutions Private Limited in the ITeS segment and the additional 11 companies in the marketing support services segment was rejected on the same "cherry picking" and search-matrix rationale.

Issue 3: Inclusion of R Systems International Limited despite a different financial year

Interpretation and reasoning:

2.19 R Systems International Limited, selected by the assessee in both software development and ITeS segments, was rejected by the TPO solely because it follows a different financial year.

2.20 The Court noted that R Systems is a listed company and, under clause 41 of the listing agreement, publishes quarterly audited results which are publicly available.

2.21 Where reliable periodic (quarterly) financials are available, it is possible to reconstruct financial data to align with the assessee's financial year for comparability.

Conclusions:

2.22 The Court held that a company should not be excluded merely for following a different financial year if audited data allow reconstruction of figures for the relevant period.

2.23 The matter was remanded to the AO/TPO with a direction that, if the assessee can satisfactorily reconstruct R Systems' financials to match its own financial year from the public audited data, R Systems should be included as a comparable.

Issue 4: Application of Related Party Transaction (RPT) filter and comparability of Saatchi & Saatchi Private Limited (marketing support services segment)

Interpretation and reasoning:

2.24 The assessee asserted that Saatchi & Saatchi Private Limited fails the 25% RPT filter, claiming its RPT level is 25.59%, calculated by dividing the sum of RPT income and RPT expenses by total turnover.

2.25 The TPO applied a different methodology, testing RPT income/turnover and RPT expenses/total expenses separately, and rejecting a company only if either ratio exceeded 25%. On this approach, Saatchi & Saatchi Private Limited was treated as passing the RPT filter.

2.26 The Court noted the inconsistency in methodologies and that the record did not clearly show the precise basis applied by the AO/TPO to reach the conclusion that the company passes the filter.

2.27 The Court emphasised that the RPT filter methodology must be applied uniformly to all comparables and transparently disclosed.

Conclusions:

2.28 The issue of inclusion/exclusion of Saatchi & Saatchi Private Limited was remanded to the TPO to re-examine the RPT level and apply the RPT filter consistently across all companies.

2.29 The Court directed that Saatchi & Saatchi Private Limited be retained as a comparable only if, on a uniform and clearly applied RPT filter, it is found to fall within the prescribed RPT threshold.

Issue 5: Working capital adjustment and separate adjustment for interest on overdue receivables

Interpretation and reasoning:

2.30 The assessee sought working capital adjustment and contended that, if granted, any notional interest on overdue receivables would be subsumed within the main transfer pricing analysis, making a separate adjustment unnecessary.

2.31 The TPO denied working capital adjustment on the ground that the assessee had not shown the difference in working capital levels between itself and the comparables and the cost of funds deployed.

2.32 The Court held that, where the TPO has chosen the comparables and is determining the arm's length price, the TPO bears the responsibility to consider and grant appropriate working capital adjustment or show why it is not warranted. The obligation is on the authority performing the comparability analysis, not solely on the assessee, to address working capital differences that can materially affect margins.

2.33 The Court stated that computation of arm's length price must take into account proper working capital adjustment and, where relevant, risk adjustment, because such adjustments are integral to a fair comparability analysis.

2.34 The Court further held that, where working capital adjustment is granted to neutralise differences in receivables, payables and inventory between the assessee and comparables, separate adjustment for interest on overdue receivables from AEs ordinarily becomes redundant as the effect is already captured in the working capital adjustment.

2.35 Conversely, if on proper examination it is concluded that working capital adjustment is not justified or is negligible, then a separate adjustment for interest on overdue receivables may be made.

2.36 As to the applicable rate and currency, the Court noted that the invoices to AEs are raised in Euro; therefore, any notional interest, if ultimately required, should be computed in the currency of the receivable (Euro) with reference to appropriate Euro-based benchmark rates, and not by indiscriminately applying a LIBOR-based rate without regard to the invoicing currency.

Conclusions:

2.37 The Court held that the TPO is duty-bound to examine and, where appropriate, grant working capital adjustment in determining the arm's length price; denial on the sole ground that the assessee did not sufficiently demonstrate differences is not justified when the comparables are TPO-selected.

2.38 The Court directed that, if working capital adjustment is granted, no separate adjustment for interest on overdue receivables should be made as the effect would stand subsumed in the main transfer pricing adjustment.

2.39 Only if, upon fresh examination, working capital adjustment is not granted, may a separate interest adjustment be computed; in that event, the notional interest must be calculated in the currency of the invoices (Euro) using appropriate Euro benchmark rates.

Overall disposition

2.40 Grounds relating to application of an upper turnover filter and exclusion of very high-turnover comparables in the software development segment were allowed.

2.41 Grounds seeking inclusion of comparables not forming part of the TPO's search matrix (including certain software development, ITeS and marketing support comparables) were rejected.

2.42 The question of including R Systems International Limited was remanded for verification of reconstructible financials.

2.43 The application of the RPT filter to Saatchi & Saatchi Private Limited was remanded for uniform and transparent application.

2.44 Working capital adjustment and the related issue of separate interest on overdue receivables were remanded for fresh consideration in line with the directions above.

2.45 All other unargued grounds were treated as not pressed and dismissed; the appeal was partly allowed.

---