TaxTMI 
TaxTMI 
2008 (6) TMI 299
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....ayer, it has shown the total export turnover of Rs. 10,25,68,917 from which it derived profit of Rs. 46,95,254. 3. The AO, after noticing the details of transactions of the taxpayer with its associated concerns, referred the case to the Transfer Pricing Officer (TPO) for computation of ALP as per his letter dt. 5th June, 2006. The TPO, on examination of Form 3CEB i.e., the audit report filed by the taxpayer, found that the taxpayer had claimed that the transactions with its associated concern were carried at arm's length and had claimed on TNMM in support of its claim as under: ---------------------------------------------------------------- Sl. Nature of transaction A.Y. Method A.Y. 2004-05 Method No. and amount used amount used ---------------------------------------------------------------- 1. Receipt for software 11,86,26,462 TNMM 10,25,68,917 TNMM development ----------------------....
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....iation Software 18.52 3.46 18.68% 15.45 22.39% Development Consultancy Ltd. --------------------------------------------------------------- 4. FCS Software 67.03 7.15 10.67% 59.91 11.93% Solutions Ltd. --------------------------------------------------------------- 5. Gebbs Infotech Ltd. 14.05 2.73 19.43% 10.62 25.71% --------------------------------------------------------------- 6. Genesys Inter- 21.47 1.78 8.29% 18.34 9.71% national Corpn. Ltd. --------------------------------------------------------------- 7. Geometric Software 63.67 18.73 29.42% 54.71 34.24% Solutions Co. Ltd. --------------------------------------------------------------- 8. Goldston....
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....sp; 16.06 0.36 2.24% 15 2.40% Ltd. --------------------------------------------------------------- 19. WTI Advanced 8.29 4.29 51.75% 7.84 54.72% Technology Ltd. --------------------------------------------------------------- 20. Zenith Infotech Ltd. 18.28 1 5.47% 17.71 5.65% --------------------------------------------------------------- Average 13.29% 16.12% --------------------------------------------------------------- 6. In the light of the above detail, TPO wanted to make adjustment and. therefore, issued a show-cause notice to the taxpayer. The reply of the taxpayer is noted by the TPO as under: ....
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....p; transaction- of tran- needs to be saction adjusted + 5% -5% +/-5% analysis 11,91,03,027 10,77,59,881 ----------------------------------------------------------------- 8. Thus, ALP price of sale of software services by the taxpayer to ....
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....ded that the above company could not be taken as comparable for determining ALP. The taxpayer also emphasized the fact that it was entitled to exemption under s. 10A of the IT Act and, therefore, had no motive to charge less than ALP from its associated concern. The taxpayer also pointed out Ural, its associated concern in USA, had suffered huge losses and could not afford to pay more than cost + 5 per cent benchmark for services rendered by the taxpayer. 13. The determination of net margin ratio with cost at an average figure of 16.12 per cent of comparable entities was thus challenged on the following grounds: (i) The TPO was in error in selecting comparable companies with turnover rangs from Rs. 8.29 crores to Rs. 364.61 crores while the taxpayer's turnover was Rs. 10.25 crores only. Thus, the basis adopted by TPO was not right. (ii) Some of the selected companies had shown abnormally high profit margin and were thus not comparable. Specifically, this objection was taken in relation to comparables at Sl. Nos. 7, 14, 17 and 19 shown in TPO's report. (iii) The TPO further erroneously took into account companies showing high margin of profit of 30 per cent and more list....
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....formation Technology 15.93% 2. Aviation Software Development 22.39% Consultancy. 3. Gebbs Infotech Ltd. 25.71% 4. Genesys Intern. Corpn. Ltd. 9.71% 5. Lifetree Convergence Ltd. 2.57% 6. Thirdware Solutions Ltd. 67.65% 7. VIGIL Consulting Ltd. 2.40% 8. WTI Advanced Technologies Ltd. 54.72% 9. Zenith Infotech Ltd. 5.65% 206.73% &nb....
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....ustomer site on need basis. 1.2 Scope of work: The scope of work shall be outlined in each statement as may be agreed between the parties hereto from time to time. ECPL will provide adequate staff to complete the development services specified in the agreement." 19. The supply made to the parent company represented the total turnover of the taxpayer. Shri Ostwal further submitted that for computation of ALP both the taxpayer and the TPO accept the applicability of TNMM. With reference to balance sheet and P&L a/c of the taxpayer, he pointed out that accounts were prepared by taxpayer on the lines accounts were prepared in America by the parent company and accordingly much higher depreciation has been claimed in the accounts. He pointed out the difference in rates of depreciation as claimed in the account and as provided in Sch. XIV of the Indian Companies Act. The same is as under: -------------------------------------------------------------- Asset Estimated Rates of Rates as per &nb....
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.... Communication (P) Ltd. ------------------------------------------------------------- Profit before tax (A) 3,072,810 Less: - Other income &n....
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....nbsp; - Insurance claims received - Deferred revenue expenses - Sub total (C) - Sub total (D) = (B+C) 94,184 Add: &nbs....
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....; 3,295,399 Sub total (G) = (E+F) 5,268,243 Operating profit/Adjusted PBIT (11 = A-D+G) 8,246,869 Operating cost/Adjusted cost - Total cost as per P&L 99,646,959 Less: Expenses adjustments (as per G above) 5,268,243 Total operating cost 94,378,716 PLJ (adjusted opera....
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....; - ----------------------------------------- Profit on sale of investment 1,180,188 ----------------------------------------- Excess provision w/back 183,400 ----------------------------------------- Interest on IT refund 394,838 ----------------------------------------- Deposit w/back-recd. 40,000 ----------------------------------------- Dividend income 4,163,708 ----------------------------------------- 14,155,687" ----------------------------------------- 22. Schedule XIV of the balance sheet further shows that above company was in the trading of software in the relevant period. It was purchasing li....
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....sp; 3,83,12,091 ------------------------------------------------------------- 24. The above chart showed the gross income from interest, profit on investment, dividend and other miscellaneous sources of income. If profit from other sources is excluded, then profit would be less than Rs. 60 lakhs. 25. The third company which required adjustment was Zenith Infotech Ltd. The margin profit for that company as per the correct calculation would work out to 2.98 per cent as against 5.65 per cent taken by the TPO. Effect on profit margin of companies after excluding non-business items (not relating to business of software) of above companies is as under: Statement of computation of revised operating profit margins on operating cost (In millions INR) ------------------------------------------------------------- Particulars Geometric WTI Zenith Thirdware  ....
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....p; 0.097 1.208 0.150 0.223 ------------------------------------------------------------- Sub total (D) = (B+C) 97.731 38.312 5.760 15.336 ------------------------------------------------------------- Add: Interest expense 0.002 0.085 ------------------------------------------------------------- Loss on sale of 1.180 Investments ------------------------------------------------------------- Foreign exchange loss 0.011 3.020 ....
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....sp; 145.859 ------------------------------------------------------------- PLI (Adjusted operating 16.43% 5.90% 2.98% 62.93% profit/adjusted total operating cost) ------------------------------------------------------------- PLI as calculated by TPO 34.24% 54.72% 5.65% 67.65% ------------------------------------------------------------- Difference -17.81% -48.82% -2.67% -4.72% ------------------------------------------------------------- 26. Shri Ostwal further submitted that if Thirdware Solution Ltd. were excluded from comparison as it was carrying on very different functions and had different sources of income, the adjusted operating profit margin of 19 companies taken into account by the CIT(A) would be 10.60 per cent (mean) as per working available at p. 76 of the paper book which is as under; ---------------------------------------------------------------- Sl.  ....
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....bsp; 2.71% 2.71% 10. Lifetree Convergence Ltd. 2.57% 2.57% 11. Pentasoft Technologies Ltd. -5.44% -5.44% 12. Prithvi Information Solutions Ltd. 7.89% 7.89% 13. Sasken Communication Technologies Ltd. 10.37% 10.37% 14. Sonata Software Ltd. 17% 17% 15. Tata Elxsi Ltd. 14.69% 14.69% 16. Visual Soft Technologies Ltd. &n....
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....bsp; books of margin account --------------------------------------------------------- Sales to AE 102,568,917 106,851,807 --------------------------------------------------------- Sales to non AE 0 0 --------------------------------------------------------- Adjusted operating margin 8.74% 13.22% on cost --------------------------------------------------------- Operating profit/loss 8,246,869 12,473,091 ----....
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....tment made by the Revenue authorities. 28. Learned Departmental Representative, on the other hand, submitted that profitability of the taxpayer was to be seen on a reality of business. In the asst. yr. 2004-05. the explanation of the taxpayer before the TPO was different from what was stated before the learned CIT(A). Now before the Tribunal, a totally different explanation has been furnished. The parent company has suffered losses and, therefore, services by the taxpayer have been provided cost + 5 per cent was not a tenable argument. The agreement of the taxpayer with its parent company shows that it is a software development company. On p. 2 of the agreement under the title 'Services and scope of work', it is clearly provided that the taxpayer is dealing in software. He emphasized that profit shown by similar software development companies was more than 15 per cent. Learned Departmental Representative submitted that basic onus was on the taxpayer to show that transactions carried with associated enterprises were arm's length transactions. The learned Departmental Representative supported the ALP determined by the TPO who, according to the Departmental Representative, had dete....
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.... the Revenue that 15 per cent profit is being shown by similar software companies. At any rate, law of average cannot be applied to every case. ALP has to be determined on the basis of facts and circumstances of the case in the light of the statutory provisions. 30. Shri Ostwal also relied upon para 3.5 of OECD Guidelines to support his argument that adjustment for depreciation on account of excessive depreciation claimed is required to be made before taking marginal profit into consideration. Besides, he relied upon provisions of the Companies Act under which it is mandatory to provide for depreciation as per the relevant Schedule. Ultimately, Shri Ostwal contended that no new argument was taken before the Tribunal and the case of the assessee was supported on the basis of material relied upon and used by the Revenue authorities. He maintained that adjustment made was without any basis and was liable to be deleted. 31. We have given careful thought to the rival submissions of the parties: The taxpayer is a captive company rendering services of software development to its parent company. As per agreement between taxpayer and its parent company, it is to receive actual cost....
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....t profit margin realized by the enterprise from an international transaction 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-cl. (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 open market; (iv) the net profit margin realized by the enterprise and referred to in sub-cl. (i) is established to be the same as the net profit margin referred to in sub-cl. (iii); (v) the net profit margin thus established is then taken into account to arrive at an ALP in relation to the international transaction." 33. Sub....
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....th pride as used in the CUP method. The net margins also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than GP margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, enterprises may have a wide range of GP margins but still earn broadly similar levels of net profits." 36.3 Extracts from other paras 3.29, 3.34, 3.35, 3.37 and 3.39 of the same guidelines would clearly show that the inference drawn is one-sided. These paras are as under: 3.29 There are also a number of weaknesses to the TNMM. Perhaps the greatest weakness is that the net margin of a taxpayer can be influenced by some factors that either do not have an effect, or have a less substantial or direct effect, on price or gross margins. These aspects make accurate and reliable determinations of arm's length net margins difficult. Thus, it is important to provide some detailed guidance on establishing comparability for the TNMM, as set forth in sub-s. (c)(1) below. 3.34 Prices are likely to be affected by differences in products, and gross margins are likely to be affected by ....
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....ivities, and in such a case would require adjustment. As with other methods, the reliability of the necessary adjustments will affect the reliability of the analysis. It should be noted that even if two enterprises are in exactly the same industry, the profitability may differ depending on their market shares, competitive positions, etc. 3.39 The TNMM may afford a practical solution to otherwise insoluble transfer pricing problems if it is used sensibly and with appropriate adjustments to account for differences of the type referred to above. The TNMM should not be used unless the net margins are determined from uncontrolled transactions of the same taxpayer in comparable circumstances or, where the comparable uncontrolled transactions are those of an independent enterprise, the differences between the associated enterprises and the independent enterprises that have a material effect on the net margin being used are adequately taken into account. Many countries are concerned that the safeguards established for the traditional transaction methods may be overlooked in applying the TNMM. Thus where differences in the characteristics of the enterprises being compared have a material....
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....e results derived from the application of this method. The determination of the decree of comparability between the tested party and the uncontrolled taxpayer depends upon all the relevant facts and circumstances, including the relevant lines of business, the product or service markets involved, the asset composition employed (including the nature and quantity of tangible assets, intangible assets and working capital), the size and scope of operations, and the stage in a business or product cycle. (iii) Other comparability factors-Other factors listed in para 1.482-1(d)(3) also may be particularly relevant under the comparable profits method. Because operating profit usually is less sensitive than GP to product differences, reliability under the comparable profits method is not as dependent on product similarity as the resale price or cost plus method. However, the reliability of profitability measures based on operating profit may be adversely affected by factors that have less effect on results under 'the comparable uncontrolled price, resale price and cost plus methods. For example, operating profit may be affected by varying, cost structures (as reflected, for example, in th....
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....rences of situations, circumstances and environment. Any difference which materially affects the market value is to be given a serious consideration. The degree of comparability between the tested party and the uncontrolled taxpayer with parameters like nature or line of business, product or service market, the assets composition employed, the size and scope of operation, the stage of business or product cycle are required to be seen. In case of uncontrolled entity, operative income attributable to assets other than assets under consideration is to be adjusted before taking transaction for working mean margin of profit. Income and expenses of the segment of total business may have to be considered. Depending on facts and circumstances of the case, 'it may also be appropriate to adjust the operative profit of tested party and comparable parties'. But when we examine the orders of the Revenue authorities, we do not find that the comparables or the tested parties were scrutinized to find differences, which needed adjustments. We may not agree with the taxpayer that only entities having turnover between Rs. 8 crores to Rs. 18 crores were to be selected for comparison. But we see no jus....
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....e differences are to be considered and suitable adjustments made. The Revenue authorities were in error in not making those adjustments. Now, Mr. Otswal has placed before us clinching evidence to show that the above two companies had income from other sources like interest on deposit, dividend income and income from sale of licenses, which jacked up profit margin of these companies. By no stretch of imagination, the above type of income could be included for purposes of comparison whereas the tested party was carrying business of software development, if it was not possible to work out and exclude receipts and expenditure of above category of incomes, not relating to software development, then these companies could not be taken as comparable companies. The learned CIT(A) did not offer any comment. We are not in a position to reject the contention of Mr. Ostwal that these companies were trading in software and were giving licenses for use of software. Thus, line of business of these companies was different from the business of the taxpayer involved exclusively in the development of software for its parent company. On facts and material on record, we are of the view that the above tw....