2025 (11) TMI 1900 - AT - Income Tax

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 ... TP Adjustment - Selection of comparable - assessee is engaged in three different segments namely software development segment, information technology enabled services segment and market support services wherein the margins on by the assessee in all these segments are 16.31% - assessee has objected before the learned transfer officer for not applying upper turnover filter. HELD THAT:- Guidance notes issued by ICAI also advocates the same reasoning for adopting turnover filter. In fact, the simplest way of explaining what an arm's-length price is how independent parties price a particular transaction therefore that is how related parties should also price it. To arrive at such an arm'slength price, economies of scale should be similar/ comparable. Therefore, the upper turnover filter is necessarily required to be employed for better determination of arm's-length price. Courts have also accepted the fact that if the turnover of the comparable is multiple times compared to the turnover of the tested entity, such comparable company should be excluded from comparability analysis. Several decisions of the coordinate benches were also pressed before us wherein the upper turnover filter is upheld for comparability analysis. Further the issue before ChrysCapital [2015 (4) TMI 949 - DELHI HIGH COURT] relied up on by the ld. TPO was with respect to super normal profits and Not applicability of filters of Turnover. Therefore we, direct TPO to remove all these companies from comparability analysis. Though assessee has also argued that most of the above companies are also functionally dissimilar, but as those are being excluded based on turnover filter, we do not deal with the issue of functional dissimilarity of those comparable. Accordingly, we direct the learned transfer pricing officer to exclude Mindtree Ltd, Larsen and Toubro Infotech limited, Wipro Ltd, Tata Elexis Ltd, Infosys Ltd, Tata consultancy services Limited and Cybage Software Private Limited. The learned AO is directed to recompute the margin of the assessee with respect to the balance comparable and determined the arm's-length price adjustment. Inclusion of eight comparable companies which have been refused by the learned transfer pricing officer as they did not appear in the search metrics of the learned transfer pricing officer and therefore, they cannot be included is correctly held so because of the reason that it will amount to cherry picking. There may be many such companies which are functionally comparable with the assessee but in the search matrix adopted by the learned transfer pricing officer of selecting the keywords, appropriate filters and thereafter applying the quantitative and qualitative factors to the set of comparable, cannot be disturbed by including something out of the blue in the comparability analysis. Comparability analysis is a process which cannot be tampered with which does not crosses the filters and search matrix. Otherwise, such comparability analysis will lose its sanctity. Accordingly ground No. 3 raised by the assessee does not merit any consideration. Comparability analysis in case of ITeS segment - Virinchi Ltd and MAA Business Solutions Private Limited - We find that Virinchi Limited is not part of the TPO search metrics and similarly is the MAA Business Solutions Private Limited was also not found place in the search matrix of the learned transfer pricing officer. As we have already held that if the comparable companies are not finding place in the search matrix of the learned transfer pricing officer where there is no allegation that the search matrix adopted by the learned transfer pricing officer is inappropriate, so far as selection of the keywords, filters, etc., the incorporation of any company stating that it is comparable and therefore it should be included amounts to cherry picking. And therefore, the contention of the assessee for inclusion of the above company as well as suggestion of further inclusion of 11 companies in the market support services segment is rejected. R Systems International Limited which is part of the comparability study of the assessee as well as the learned TPO but is excluded for the simple reason that it follows a different accounting year. We find that the above company is a listed entity wherein according to clause 41 of the listing agreement with the stock exchanges, the quarterly audited results reviewed by the auditor are made public. Therefore, if the data is available in the public domain, and assessee is in a position to reconstruct the financial data for the respective financial year comparable to the assessee's financial year, to the satisfaction of the ld AO/ TPO, the same company should be included. Accordingly, we direct the assessee to substantiate before the learned AO that R Systems International Limited's financials are comparable on such reconstruction. Saatchi & Saatchi private limited fails the related party transaction filter. It is stated that Saatchi & Saatchi private limited has related party transactions to the extent of 25.59%. It is further stated that the learned transfer pricing officer has applied the RPT filter by dividing the RPT income with total turnover and RPT expenses by total expenses and if the resultant figure of either of the combination is more than 25% of the same, it is rejected. However, assessee computes the RPT filter by dividing the total of RPT income and RPT expenses by the total turnover and if the resultant figure is more than 25%, same is rejected. The claim of the assessee is that according to the transfer pricing officer this company passes the RPT filter however according to the method applied by the assessee, this company does not pass the RPT filter. However, we are also not aware that how the assessing officer/transfer pricing officer has applied the RPT filter. In view of this we restore this issue back to the file of the learned transfer pricing officer with a direction that if Saatchi & Saatchi Private Limited passes the RPT filter, then only it should be included. The application of RPT filter should also be uniformly applied. Working capital adjustment as well as adjustment on account of interest on overdue receivable from its associated enterprises - We find that assessee has asked for the working capital adjustment but it is denied by the learned transfer pricing officer for the reason that assessee could not show that there is a difference in the working capital employed by the assessee as well as of the comparable companies and what is the cost of such fund which is deployed in working capital. We find that it is the case of the learned transfer pricing officer where he has selected the comparable, and therefore the onus is on him to show that there is no difference in the working capital of the assessee as well as of the comparable companies. Any person who is computing the arm'slength price, is required to compute the arm's-length price of the international transactions giving the proper adjustment of working capital as well as the risk adjustment. As the comparables are selected by the learned transfer pricing officer on a particular analysis and search metrics, he is duty-bound to prove that assessee does not warrant such adjustment, otherwise he is also duty bound to grant the working capital adjustment to the assessee. If the working capital adjustment is granted to the assessee, the computation of the interest on overdue receivable from associated enterprises does not arise because it is subsumed in the adjustment of the transfer pricing of the main transaction. However, if it is found that assessee is not entitled to the working capital adjustment, then only interest on overdue receivables is required to be computed. It should be computed in the currency in which the invoices are outstanding. It is stated that the assessee is outstanding is in Euro and therefore the appropriate rate of euro is directed to be applied if in case such interest is to be imputed. 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.