TaxTMI 
TaxTMI 
2007 (11) TMI 339
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....s Inc., a company incorporated in USA and engaged in the business of software development and also rendering marketing systems services to the parent company. The taxpayer filed its return of income for the year under consideration on October 31, 2002 declaring total income at INR 3,99,080 for the financial year 2001-02. The income disclosed included profit from export of computer software to its parent company for which deduction under section 10A was claimed. 2.1 The taxpayer appellant as noted earlier is a software development support service provider. However, software are developed only as instructed by its parent AE. It does not create/develop/sell software products and packages. The software developed by the appellant is used by the parent AE in-house for integrating the same with other software components developed by the parent AE itself. The whole software in turn supports the hardware manufactured by the parent, and sold as a package in the open market by the parent AE. Therefore the appellant's business is limited to providing services of software development support. 3. The accounts and auditor's report of the taxpayer showed that the taxpayer had carried....
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....ernal comparable, uncontrolled price (internal CUP) or an external comparable uncontrolled price (external CUP). The parent company did not receive similar services from any independent third party, nor the taxpayer provided such services to any uncontrolled party and, therefore, internal CUP did not exist. Even external CUP was not available. Average billing rates (man days/man month rate) would vary from technology to technology, from one domain to another and differ according to hierarchy levels, contractual terms, market conditions, geographies and it would not be possible to make adjustment for above factors as also for economic conditions. Above all, all the relevant information is not available in public domain. Therefore, in the circumstances and situation mentioned above, average bill rate, according to the taxpayer was the correct representation of a CUP. The taxpayer having regard to the above worked out net margin of software development transaction INR 88,866,320 (total turnover of Rs. 9,23,02,514) in ratio of total cost at 6.99%. 7. In order to show that above net margin was fair and reasonable and represented arm's length price, the taxpayer claimed it has tak....
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....payer. On above screening, the assessee eliminated 249 companies as those companies were dealing with different products or were carrying different functions or were involved in controlled party transactions or sale of operation was very low or suffered operational loss of more than 10%. In respect of some, insufficient information was available in public domain regarding their products, functions or financial position. The reasons for elimination of 243 companies are available at page 9 of the paper book filed by the taxpayer. 9. The taxpayer was thereafter left with 16 companies with profit level indicator for financial years 2000 and 2001:- S. No. Name of the Company 2000 2001 1. Top Media Entertainment 9.68 (12.12) 2. Kushagra Software (0.56) 0.0 3. Shine Computech 3.69 5.16 4. M Y M Technologies 11.44 0.93 5. Luminaire Technologies 12.70 6.64 6. O C L Informatics 17.07 6.67 7. Telesys Software 39.81 4.34 8. C S Software Enterprise 22.98 8.54 9. V G L Softech 8.89 15.38 10. Integrated Hitech 14.67 12.37 11. Zigma Software 45.79 1.63 ....
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....merely reworked the figures of same comparables as used in the audit report. Earlier, on 20th January, 2005, the TPO had asked the taxpayer to explain as to why companies having (a) substantially low turnover; (b) companies engaged primarily in manufacturing activities and (c) companies with low employees cost should not be eliminated from the comparables taken into account by the taxpayer. The TPO ultimately listed the following companies for elimination from comparison in Para 7.5 of its order:- Name of the company Reason for elimination Kushagra Software Ltd. Manufacturing concern Integrated Hitech Ltd. Low turnover Fore C Software Ltd. Low employee cost Luminaire technologies Ltd. Low turnover Telesys Software Ltd. Low employee cost Pentagon Global Solutions Ltd. Low employee cost. Engaged in manufacturing activity OCL Informatics Ltd. Low turnover 13. The TPO thereafter claimed to have carried independent search of comparable from the PROWESS and CAPITALINE database and NASSCOM directory and worked out the average operational profit for comparison at 26.94% with the following remarks and details in para 7.6 of his order: ....
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....panies were excluded from the proposed list of comparable companies. 15. The TPO accordingly took other three companies for computation of average of OTC/TC as those companies did not have any related party transaction in the year 2003-04. 16. Quintegra Solutions was included in the list of comparable with following observations:- "As far as the product profile of Quintegra Solutions is concerned, the same was re-examined consequent upon the objection raised by the assessee. It is found that this company, too, is engaged in software development services and as such is a fit comparable for analysis. Moreover, Transactional Net Margin Method is more tolerant to minor functional differences and is less affected by transactional differences (para 3.27 of OECD report Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, July 1995)." 17. Thereafter, Arm's Length Price of the international transaction and adjustments were worked out at Rs. 1,45,73,857 with the following remarks:- "7.8 In view of the above discussions, the following list of comparable companies are finally chosen for analysis : Name of the company OPTC (F.Y.....
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....r, therefore, could not be permitted to change its claim of deduction in respect of same unit from section 80HHE to section 10A in subsequent years. The claim of the taxpayer was against the intention of the Legislature which had clearly laid down that deduction under section 10A with regard to export of profit was not available to old units. The ld. CIT(A) further held that the taxpayer was also not entitled to deduction under section 80HHE in this year as mandatory requirement of the said section regarding furnishing of the auditor's report in Form 10 CCAF along with the return of income was not fulfilled. Accordingly, ld. CIT(A) upheld the rejection of claim of Rs. 59,56,330 under section 10A of the IT Act. 19. Thereafter, the ld. CIT(A) considered grievance of the assessee on account of adjustment of Rs. 1,45,73,857 representing the arm's length price. He noted that for the current financial year 2001-02, the taxpayer had chosen Transactional Net Margin Method as most appropriate method to determine arm's length price with Operating Profit margin over Total Cost (OP/TC) as Profit Level Indicator (PLI). The exercise carried by the taxpayer in identifying 16 compar....
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.... a set of five companies were chosen as comparable. The arithmetical mean of Operating Profit margin over Total Cost(OP/TC) of these companies for the relevant financial year worked out at 24.53%. On the basis of above comparable cases, cost of provisions of software development services were determined at Rs.10,34,40,177 against Rs.8,88,66,320 disclosed by the assessee. This way, addition of Rs.1,45,73,857 according to the ld. CIT(A) was rightly made. As in the proceedings before the Tribunal, the ld. Representative of the taxpayer had vehemently challenged selection of comparables by the TPO, it would only be appropriate to take note of the finding recorded by ld. CIT(A) on the selection of comparable by the TPO. After noting as to what is required to be done while determining ALP by tax authorities under section 92C/92CA read with Income-tax Rule 10B, the ld. CIT(A) upheld the assessment. His concluding observations are as under:- "58. The contentions of the appellant challenging the reliability and correctness of the comparable uncontrolled transactions are, thus, found to be baseless and without any merit and the same are, accordingly, rejected. On a careful considera....
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....the addition on account of transfer pricing adjustment would be made for the difference between the arithmetical mean arm's length price of Rs.10,34,40,177 determined by the TPO and the transfer price of Rs.8,88,66,320 charged by the appellant. The difference between these two prices works out to Rs.1,45,73,857 and the same was, accordingly, added by the Assessing Officer to the total income of the appellant. 61. In view of the foregoing and on a careful consideration of the facts and circumstances of the case and the relevant position of the law, I am of the considered view that the Assessing Officer was justified in making an addition of Rs. 1,45,73,857 to the total income of the appellant on account of difference between the arm's length price determined by the TPO and the transfer price charged by the appellant from its AE in respect of international transactions of export of software development services and the addition so made by him is, accordingly, confirmed." 22. The taxpayer being aggrieved has impugned the order of the ld. CIT(A) in appeal before the Income-tax Appellate Tribunal (in short Appellate Tribunal). We have heard both the parties and taken....
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.... noted as under: "The object behind enactment of transfer pricing regulations is to prevent shifting of profits outside India. XXXXXXX The impugned ruling is correct in principle insofar as an associated enterprise, that also constitutes a PE, has been remunerated on an arm's length basis taking to account all the risk/taking functions of the enterprise. XXXXXXX where the transaction between the two are held to be at arm's length basis taking into account all the risk-taking functions of the multi-national enterprise. In such a case nothing further would be left to attribute to the P.E. The situation would be different if the transfer pricing analysis does not adequately reflect the functions performed and the risks assumed by the enterprise. In such a case, there would be need to attribute profits to the P.E. for those functions/risks that have not been considered." 24. It is true that "transfer pricing" is not an exact science, evaluation of transactions through which the process of determination is carried in an art where mathematical certainty is indeed not possible and some approximation cannot be ruled out, yet it has to....
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....(e)" of Income-tax Rules providing for determination of Arm's Length Price under section 92C required that following steps are to be taken while applying TNMM after selection and evaluation of controlled transactions. It is as under:- "(e) transactional net margin method, by which,- (i) the net profit margin realized by the enterprise from an international transactions entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base; (ii) the net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base; (iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the ope....
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....e really comparable and reliable. Comparison based on functional analysis include economically significant activities and responsibilities undertaken or to be undertaken by the independent and associated enterprises. The structure and organization of the group and more particularly the judicial relationship between different entities of same group are to be seen. The function that need to be identified while carrying comparison as per OECD guidelines include design, manufacturing, assembling, research and development, servicing, purchasing, distribution, marketing, advertising, transportation, financial and management activities. It is also necessary to examine as to what is the principal function of the entities. The analysis of comparison should consider total assets employed and assets used to earn profit. The risk assumed by respective parties is a very important consideration. It is a simple principle of economics that the greater the risk, the greater the expected return (compensation). If there are material and significant differences in the risk involved, then the comparable identified are not correct as appropriated adjustments for differences in such cases are not possibl....
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.... "The selection of method i.e. TNMM, the PLI i.e. the OP/TC were found to be appropriate by the Assessing Officer." 30. On facts, we are not inclined to go into the issues not disputed before us. It is part of the agreement between the parties that all companies selected as "comparable" had operated from India in supply of softwares etc. We therefore proceed to decide the dispute on above accepted premises. The dispute is confined to selection of reliable and authentic comparable. 31. It is the case of the taxpayer that if proper selection is made by applying proper filter (F AR), the PLI of comparables would be 3.61% as against 6.99% of the taxpayer and, therefore, Arm's Length principles are fully satisfied and no adjustments need in the international transaction carried by the taxpayer with its AE. The TPO, on the other hand, has worked arithmetic means of OP/TC at 24.53% as noted earlier and determined Arm's Length Price of international transaction at INR 10,34,40,177 leading to addition of INR 1,45,73,857. 32. It is undisputed and fully borne from record that tested party was developing specific software for its parent company, the software developed by t....
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....2001-02 was not available in public domain base PROWESS and CAPITALINE and, therefore, could not be produced. This position is admitted by TPO in his order. The approach of the ld. TPO cannot be approved, after all TPO was carrying judicial or quasi-judicial proceeding. After accepting that the data for financial year 2001-02 was not available at that relevant time in 2005, the TPO considered data of two years later i.e., for financial year 2003-04 and found that two companies namely Blue Star Infotech Ltd. and NIIT Gis Ltd. had related transaction and, therefore, these two companies were excluded from the list of comparables selected by the TPO. As regards other selected companies, these were included in the list as related party transactions were not found in the financial year 2003-04. The TPO presumed that related party transactions were not carried in financial year 2001-02 without considering relevant data for financial year 2001-02 as is clearly admitted hereinafter. The TPO has observed:- "The other three companies, proposed to be chosen as comparables did not have any related party transaction in the year 2003-04. Hence, under the same. premise, it has been presum....
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.... "The taxpayer as noted above is providing software development support services to its parent AE as per the instructions of its parent company. It does not create/develop/sell software products and packages. The software developed by the appellant is used by the parent in-house for integrating the same with other software components developed by the parent AE itself. The appellant business is therefore limited to providing software development support services. Further, taxpayer assumes low business risks and employs only routine tangible assets i.e., it does not develop or own any valuable or non-routine intangibles." 36.1 There is no dispute about above characteristics or FAR of the taxpayer. However, above characteristics do not appear to have been taken into account by the ld. TPO while undertaking screening and elimination of companies. Ultimately, when five companies were selected by the TPO for comparison, the material on record does not show that TPO cared to know the size of those companies. There is no mention of the characteristics of companies adopted and whether those companies had any intangible properties or what was the ratio of fixed and operating assets.....
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....fits are less adversely affected by such differences. As with the resale price and cost plus methods that the transactional net margin method resembles, this, however, does not mean that a mere similarity of functions between two enterprises will necessarily lead to reliable comparisons. Assuming similar functions can be isolated from among the wide range of functions that enterprises may exercise, in order to apply the method, the profit margins related to such functions may still not be automatically comparable where, for instance, the enterprises concerned carry on those functions in different economic sectors or markets with different levels of profitability. When the comparable uncontrolled transactions being used are those of an independent enterprise, a high degree of similarity is required in a number of aspects of the associated enterprise and the independent enterprise involved in the transactions in order for the controlled transactions to be comparable; there are various factors other than products and functions that can significantly influence net margins. 3.35 The use of net margins can potentially introduce a greater element of volatility into the determinat....
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.... differences in the characteristics of the enterprises being compared have a material effect on the net margins being used, it would not be appropriate to apply the transactional net margin method without making adjustments for such differences. The extent and reliability of those adjustments will affect the relative reliability of the analysis under the transactional net margin method." 37. It is clear that even when TNMM method is applied to determine arm's length price as per OECD guidelines, functional profile, assets, assumed risks of controlled and uncontrolled transaction are to be seen while screening. Besides, it is not possible to ignore specific Indian regulations on the subject. We have already noted the relevant rules (2) and (3) 10B of IT Rules, which specifically require to consider for comparison" the functions performed assets employed... and risks assumed by respective parties." In rule 10(B)(1)(e) of IT Rules providing for determination through TNMM, it is clearly provided in clause (iii) "the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the difference if any". These regul....
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....ssee while screening data, selected companies between turnover of INR 47 lakh to INR 25.71 lakh. Accordingly, it was submitted that the numericals showed that comparable companies selected by taxpayer formed proper mix of companies in terms of turnover and was an ideal set for comparison in terms of turnover and, therefore, the TPO's objection was without any basis. It is not clear as to what according to the TPO was "low" turnover companies as he himself applied range of INR 50 lakh to INR 100 crore and, therefore, slightly less turnover than INR 50 lakh could not be construed as "low". Therefore, according to the taxpayer there was lack of application of mind and arbitrariness in the approach of the TPO. It has been further pointed that turnover of the two companies "Integrated Hitech Ltd." and "Luminaire Technologies Ltd." in the relevant year was not less than INR 50 lakh. The taxpayer has given correct turnover figures in the paper book in Table 5 of the synopsis. It has further been pointed out that Integrated Hitech Ltd. has been accepted by TPO in his own selection. It is accordingly argued that comparables selected by the taxpayer fully satisfied INR 50 lakh threshold ....
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....al, the product dealt with is also extraordinary and, therefore, entire profile of the entity is required to be examined for comparison. Without prejudice to the above and on facts, the taxpayer as per Table 8 of the paper book page 2 has shown that companies selected by the assessee had several companies with cost below 10 or 10% and therefore fully satisfied the threshold limit set by the TPO himself except for five companies, yet the TPO, without any reasonable justification, did not accept the claim of the appellant. 39.4 It has been accordingly contended that TPO committed many errors and was wrong in discrediting list of comparables found and furnished by the taxpayer. The TPO could have carried fresh search only if the comparables drawn by the taxpayer was insufficient or had other deficiency. We are of the view that objection raised on behalf of the taxpayer are well founded and were wrongly disregarded by the TPO. 40. In the end, the assessee appellant has analyzed that even after adopting the criteria/benchmarks set by the TPO for selection of comparables, there are seven companies which satisfy all the criteria and this way, average OP/TC were counted at 6.99%. ....
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....39;s length Price should be redetermined in the light of objections of the taxpayer. She also claimed that assessee relied upon fresh evidence. 43. All these submissions were opposed by ld. representatives of the taxpayer as factually incorrect. 44. On careful consideration of the rival submissions, we are of the view that contention advanced by ld. DR cannot be accepted. No fresh material has been relied upon by the taxpayer before the Appellate Tribunal. How and wherefrom revenue was to collect material in support of their case was the problem of the revenue and on that we do not wish to comment. We have also considered in detail order of the TPO, the very basis of addition/ adjustment made in this case. For the reasons recorded above, we do not approve of the order and hold that Arm's Length Price determined by TPO is not sustainable. 45. As discussed in detail above, the Assessing Officer did not apply Indian regulation or guidelines issued by OECD on transfer pricing. The taxpayer, on the other hand, carried out proper screening of approximately 8,000 companies carrying business of software in India and exporting services and goods abroad. It took into account cha....
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.... for the taxpayer to satisfy all points in the range. Even if one point is satisfied, the assessee can be taken to have established its case and in that situation, the onus is shifted to the department to show why taxpayer's case be not accepted. Arm's length price does not mean maximum price or maximum profit in the range. A willing buyer in an open market shall pay minimum and not maximum price for goods or services. Of course, quality and brand name are important but considered not so by TPO as TNMM method was applied by him. Project profile and other factors were, therefore, not erroneously considered. As noted earlier, the case of Integrated Hitech has been specifically accepted as comparable by both the parties. On other four cases noted above, the TPO or other revenue authorities have not made any adverse comment at any stage of proceeding. It was open to them in proceedings before the ld. CIT(A) or the Appellate Tribunal to show that PIL figure of Integrated Hitech or other four companies were wrong or on account of their FAR analysis, these entities could not be taken as "reliable" comparables for computation of the Arm's Length Price. But no material was broug....