TaxTMI 
TaxTMI 
2010 (8) TMI 676
X X X X Extracts X X X X
X X X X Extracts X X X X
....such development centers established by SAP AG in India as 100 per cent Export Oriented Unit (EOU). The assessee has obtained the EOU status under the software technology parks [STP] Scheme of the Government of India. The principal business carried on by the assessee in India is providing software development and related services to its associate concern SAP AG. In order to deliver the above-mentioned services, the assessee has entered into an R & D agreement with SAP AG. As per the agreement, the assessee-company is to be paid remuneration by SAP AG on cost plus basis. In this case, it is cost plus 6 per cent or 1.5 times of the wages bill of assessee-company, whichever is higher. 3. The assessee-company has returned a loss of Rs. 7,57,430 for the assessment year under appeal. The activity of the assessee-company being to provide software development support to SAP AG, it has resulted in overseas transactions and such export turnover exceeded Rs. 5 crores. The Assessing Officer has referred the case to the Transfer Pricing Officer (TPO) to decide the Arms Length Price (ALP), so as to proceed in the assessment. 4. The assessee has accounted for an operating revenue of Rs. 71,....
X X X X Extracts X X X X
X X X X Extracts X X X X
....and, therefore, cannot be deducted in computing the income. The said amount was added back. 6. As already stated, the assessee-company is an Export Oriented Undertaking (EOU) and, therefore, claimed deduction under section 10A. The total turnover of the assessee was Rs. 72,70,35,620. The domestic turnover amounted to Rs. 40,24,688. The balance of Rs. 72,30,10,932 was shown as export turnover. In carrying on the said business, the assessee has incurred an amount of Rs. 1,98,74,061 as communication expenses. Out of the above expenses, Rs. 71,66,003 related to lease line charges. The Assessing Officer treated 50 per cent of the above amount which works out to Rs. 35,83,000 as lease line charges incurred for the purpose of export turnover of the assessee-company. He, therefore, reduced the export turnover of the assessee-company by the said amount of Rs. 35,83,000. An alternative contention placed by the assessee-company before the Assessing Officer was that a corresponding deduction should be made out of the total turnover as well. But this contention was rejected by the assessing authority. The deduction was made only from the export turnover. 7. With the above adjustment, addi....
X X X X Extracts X X X X
X X X X Extracts X X X X
....i) The learned CIT(A) has erred, in law, and in facts, in confirming the total net tax payable as computed by the Assessing Officer of Rs. 6,16,18,313. The appellant craves that the tax computed be deleted. (iii) The entire order is erroneous and bad in law and the demand pursuant to the order to be quashed. Transfer Pricing (iv) The learned CIT(A) has erred, in law and in facts, in confirming the order of the TPO/Assessing Officer by holding that the international transaction of software development and consultancy services is not at arms' length and by holding that the appellant's net margin on operating cost works out to 5.43 per cent. (v) The learned CIT(A) has erred in confirming the order of the TPO/Assessing Officer and concluding that the companies identified by the TPO/Assessing Officer are comparable, without proper verification of the same. (vi) The learned CIT(A) erred in holding that the Assessing Officer was justified in making a reference to the learned TPO. The appellant prays that Assessing Officer has erred, in law by making a reference to the learned Transfer Pricing Of....
X X X X Extracts X X X X
X X X X Extracts X X X X
....sessing Officer was justified in arbitrarily normalizing the net margins earned by such super normal comparable companies with the profits/net margins made by some other company [which the appellant believes for certain other reasons also is not comparable]. The appellant prays that the same be deleted given that there is no rational basis for choice of such net margin and normalization. (xii) The learned CIT(A) has erred, in law and in facts, in confirming the order of the TPO/Assessing Officer by holding that the manner of computation of arms' length price undertaken by the TPO/Assessing Officer is justified. The appellant prays that the same be deleted as the learned TPO/Assessing Officer has not given effect to the foreign exchange fluctuation income earned by the appellant in normal course of business and has erred in not excluding certain expenses such as donation etc. while computing the operating costs. (xiii) The learned CIT(A) has erred, in law and in facts, in confirming the order of the TPO/Assessing Officer by holding that the manner of computation of arms length price undertaken by the TPO/Assessing Officer is justified. The appellant prays that the same b....
X X X X Extracts X X X X
X X X X Extracts X X X X
.... CIT(A) insofar as it relates to the above grounds may be reversed and that of the Assessing Officer may be restored. 13. We heard S/Shri Rajan Vora, M.P. Lohia, Chavali Narayan and Ms. Pavithra Shetty, Chartered Accountants for the assessee-company and Smt. Preeti Garg, the Commissioner of Income-tax appearing for the revenue. 14. In assessee's appeal, the specific grounds 1, 2 and 3 related to general arguments that the assessing authority has erred on facts and in law in determining a positive total income as against the loss reported by the assessee-company. Though these grounds do reflect the ultimate grievances of the assessee, they are not in the nature of specific grounds which call for adjudication. Therefore, these grounds do not require discussion. 15. Ground No. 5 is again general in nature and confined to the issue of transfer pricing. As the assessee has already raised several grounds against the ALP adjustment determined by the TPO, based on various propositions of law and facts, it is not incumbent on us to make any specific finding on this general ground. This ground is, therefore, allowed to take rest. 16. Grounds 6 and 7 relate to the question whether....
X X X X Extracts X X X X
X X X X Extracts X X X X
.... international transactions at Arms' Length Price (ALP). In this case, it is more particular to observe that the entire international transactions executed by the assessee-company were with its associate concern in Germany and the entire turnover of the assessee except for nominal domestic turnover was in export sector. Therefore, it was very much necessary on the part of the Assessing Officer to examine the pricing structure of the services rendered by the assessee-company. Even to examine the preliminary question whether there was a motive to evade tax or not, the assessing authority has to first convince himself that the transactions were concluded at ALP. In this case, it was necessary for Assessing Officer to refer the case to TPO, so that a detailed enquiry is made into the whole issue and proper conclusion is arrived at. She, therefore, submitted that the contention advanced by the assessee-company does not stand on merit. 20. We heard both sides in detail and proceed to consider whether the Assessing Officer was justified in referring the ALP to the TPO without affording an opportunity to the assessee-company of being heard. 21. The above preliminary objection raised ....
X X X X Extracts X X X X
X X X X Extracts X X X X
....ansactions between related parties and to make such practice and procedure on par with international convention and practice. 22. If we speak law, it is necessary to understand that even without a specific provision like section 92, it is always possible for the assessing authority to examine every vital and relevant aspect of international transactions between related parties in the course of assessment proceedings. This is because his writ is to compute the correct income of a particular assessment year. This obligation cast on the Assessing Officer is the product of the charging section 3 by which the chargeable income of an assessee has to be computed. Section 3, the charging section is the soul; but the soul alone is not sufficient. One needs limbs and organs. These are the elaborations made under different Chapters and in various sections of the Income-tax Act so that the assessment proceedings are made less arbitrary and less subjective. 23. Consequently, it is easy to understand that determination of ALP is only a statutory procedure available for doing an assessment. It is one of the procedures prescribed by law, so that the Assessing Officer may examine certain vita....
X X X X Extracts X X X X
X X X X Extracts X X X X
....he objections raised by the assessee against the reference made by the Assessing Officer are liable to be rejected. 27. But we like to make one clarification. The CIT(A) has recorded an impression in his order that the reference to the TPO is necessary even otherwise, as the assessee-company was enjoying the benefit of deduction under section 10A. Reliance has been placed on the proviso to section 92C(4). The said proviso states that no deduction under section 10A or section 10AA or section 10B or under Chapter VIA shall be allowed in respect of the amount of income by which, the total income of the assessee is enhanced after computation of income in the light of ALP adjustment. It does not mean that wherever the assessee is entitled for the benefits of deduction under section 10A and others, it is mandatory on the part of the assessing authority to refer the case of ALP to TPO. As far as the matter of referring the ALP to TPO is concerned, proviso to section 92C(4) does not have any statutory role. As far as this legal proposition is concerned, we are in agreement with the learned Chartered Accountant appearing for the assessee. 28. Another preliminary objection raised by th....
X X X X Extracts X X X X
X X X X Extracts X X X X
....ld be different from industry to industry. Therefore, ultimate selection of a method in a particular case may some times be possible, only if all other methods are sufficiently evaluated and excluded. Because of this exclusion process, therefore, shifting from one method to another method in the selection process of the most appropriate method is inherent in a transfer pricing case. In fact, selection of the most appropriate method contemplates a study on the adaptability of other methods as well. We cannot, therefore, accept the argument of the learned Chartered Accountant that once the TPO has selected one method, thereafter, he cannot prefer another one. The TPO has to do the process of selection to ultimately choose one of the methods prescribed under section 92C. The only point is that the TPO should not compound different methods and use multiple approach in determining the ALP. It is necessary for him to zero down on a particular method as the most appropriate method. 33. Therefore, the second objection is also rejected. 34. We are discussing the issues relating to Transfer Pricing. So far, we have considered the general grounds as well as three specific objections rai....
X X X X Extracts X X X X
X X X X Extracts X X X X
....luctuation income earned by the appellant in normal course of business and has erred in not excluding certain expenses such as donation etc., while computing the operating costs. 13. The learned CIT(A) has erred in law and in facts, in confirming the order of the TPO/Assessing Officer by holding that the manner of computation of arm's length price undertaken by the TPO/Assessing Officer is justified. The appellant prays that the same be deleted as the learned TPO/Assessing Officer has erred in not excluding the compensation charges paid for termination of agreement while computing the appellant's margin which is treated as capital expenditure by the learned TPO/Assessing Officer. 14. The lower authorities have erred in law and in facts by not taking into consideration certain specified income/expenses in computing operating margins of the comparable companies." 37. The TPO/Assessing Officer has worked out the net margin at 5.43 per cent. This margin has been worked out on the basis of the following variables : Sales (excluding interest, exchange Fluctuation gains Rs. 71,69,87,294 Expenditure Rs. 68,00,34,163 Profit before interest and tax Rs. 3,69,53,131 ....
X X X X Extracts X X X X
X X X X Extracts X X X X
....r cent. 41. In support of the arguments, the assessee has relied on the following decisions: 1. CIT v. Rachna Udyog [2010] 230 CTR 72 (Bom.) 2. CIT v. Syntel Ltd., [IT Appeal Nos. 1974, 1976 and 1978 of 2009, dated 15-12-2009] 3. CIT v. Woodward Governor India (P.) Ltd., [2007] 294 ITR 4512 (Delhi) 42. We considered the issue carefully. The foreign exchange fluctuation gains is nothing but an integral part of the sales proceeds of an assessee carrying on export business. This proposition has been time and again considered in cases arising in the context of section 80HHC. The Courts and Tribunals have held that foreign exchange fluctuation gains form part of the sale proceeds of exporter-assessee. Useful reference may be made to the decisions of Bombay High Court in the case of Shah Bros. v. CIT, [2003] 259 ITR 7413; that of Gujarat High Court in the case of CIT v. Amba Impex [2006] 282 ITR 1444 and that of Mumbai ITAT Spl. Bench in the case of Asstt. CIT v. Prakash L. Shah [2008] 306 ITR (AT) 015. In all the above cases, the dominant question considered was the year of deduction on the accepted proposition that....
X X X X Extracts X X X X
X X X X Extracts X X X X
....be treated as part of the operating expenditure of the assessee and, therefore, it should be excluded from the computation of operating margin of the assessee. This ground is allowed. 46. To sum up, we find that the assessee's contentions on two items of adjustments are found justified and accepted; they are, foreign exchange fluctuation gains and the compensation payment. The adjustment sought for by the assessee in respect of income-tax refund and donations are not accepted. 47. As already stated above, the operating margin as per assessee's TP study is 7.15 per cent. This is subject to adjustment. We have discussed in paragraphs above that if the compensation is excluded from the expenditure side, the operating margin of the assessee works out to 8.83 per cent. At the same time, the effect of income-tax refund and donations would go to reduce the above operating margin but very marginally. The donations booked as expenses under the head 'administrative cost' is Rs. 12,95,437. Any how, the effect of these two items will be nominal. But the adjustment has to be done to increase the operative profit to that marginal extent. Therefore, we fix the operating margin of the assess....
X X X X Extracts X X X X
X X X X Extracts X X X X
....[2007] 109 ITD 101. 53. We considered the issue. It is to be seen that the assessee-company does not have much open market operations like other independent competitors operating in the market. The assessee is one of the world centers established by its holding company, M/s SAP AG in India to provide R&D and Software Technology Services, almost carrying on, back office operations. The agreement between the assessee and its holding company stipulates the remuneration at cost plus 6 per cent or total wages bill, whichever is higher. Therefore, it is to be seen that the assessee-company, as such, working in Bangalore is having only a limited role in generating what is called 'commercial profit' and, therefore, it cannot be compared with other leaders plying in the market. It is also relevant to note that the assessee-company is working in a risk-mitigated environment. When this is the position, TPO/Assessing Officer cannot select extreme cases as comparables to examine the ALP of the assessee-company under TNMM method. 54. The TPO/Assessing Officer has selected M/s. Hinduja TMT Ltd., as one of the comparables. The reported margin of the said company is 111.45 per cent. This is a....
X X X X Extracts X X X X
X X X X Extracts X X X X
....eding 5 per cent of such arithmetical mean. This option intends to provide marginal benefit at the choice of the taxpayer. It is the case of the assessee that the revenue's contention that marginal benefit of 5 per cent from the arithmetical mean is not available in cases, where the price shown by the assessee exceeded 5 per cent of the ALP is not a proper exposition of law. The assessee has also relied on the decision of ITAT, Calcutta Bench in the case of Development Consultants (P.) Ltd. v. Dy. CIT [2008] 23 SOT 455 in support of the above argument. 59. The proviso regarding the marginal relief of 5 per cent contemplated in the computation of ALP has been substituted by the Finance (No. 2) Act, 2009 with effect from 1-10-2009. The said sub-section (2) and the proviso are extracted below : "(2) the Most Appropriate Method referred to in sub-section (1) shall be applied, for determination of arm's length price, in the manner as may be prescribed; [Provided that where more than one price is determined by the most appropriate method, the arm's length price shall be taken to be the arithmetic mean of such prices: Provided further that if the variation at arm's length pric....
X X X X Extracts X X X X
X X X X Extracts X X X X
....s, or, at the option of the assessee, a price which may vary from the arithmetical mean by an amount not exceeding five per cent of such arithmetical mean.]" 63. The first limb of the old proviso and the first limb of the present proviso is regarding arriving at the arithmetical mean which is the same. There is no change with regard to that. The change is with reference to the second limb. The old proviso says that at the option of the assessee, the assessee may adopt a price different from the arithmetical mean by an amount not exceeding 5 per cent of such arithmetical mean i.e the assessee has an option to claim the taxpayer's marginal relief at 5 per cent with reference to the arithmetical mean irrespective of the range of actual deviation between the margin disclosed by the assessee and the Average Mean Margin. Therefore, in effect, this marginal relief takes the character of a standard deduction of 5 per cent. For e.g. in a case, average mean of the ALP determined by TPO/Assessing Officer is 20 per cent and that one disclosed by the assessee is 10 per cent. The assessee will get a standard deduction of 5 per cent and the assessee's ALP will be increased to 15 per cent and t....
X X X X Extracts X X X X
X X X X Extracts X X X X
....taline 2000 and the National Association of Software Companies (NASSCOM) website. As the information for the financial year 2002-03 was not available, the information available to the financial year 2001-02 have been considered for determining arm's length price (ALP). 2. From the above sources certain companies were excluded from the list of comparables for the reasons that sufficient functional data not available; that descriptions are insufficient; different functions are carried out; that the companies not have sufficient foreign exchange earned; that current business operations are inactive, their substantial transactions were with related parties; that making persistent operating loss and duplicating data base under different names. 3. On the basis of the study made on the 22 comparables selected by the assessee the arithmetic mean of the margin has been worked out. The margin worked out as per the assessee is 7.15 per cent. which fell within (+) or (-) 5 per cent variance from the average ALP of the comparable companies. Therefore, it is apparent that the price charged by the assessee in respect of the international transactions was at arm's length price as per the tra....
X X X X Extracts X X X X
X X X X Extracts X X X X
....: "1. The TPO can reject the comparables in TP study, only if the comparables are insufficient or deficient. A mere deviation in the turnover of comparables does not alone qualify as a reason sufficient to reject the functional comparables of the assessee. Reliance was placed on the decision of ITAT Delhi Bench in the case of Mentor Graphics (P.) Ltd., v Dy. CIT, 109 ITD 101. 2. The TPO has adopted the turnover filter without conducting a proper Function, Asset and Risk analysis (FAR). This made the selection process of comparables of the TPO arbitrary. The ITAT, Pune Bench in the case of E. Gain Communications (P.) Ltd. v. ITO, (23 SOT 385) has held that a proper analysis is to be undertaken, even where turnover filter has been used. 3. The Assessing authority has selected 8 comparables. Out of the said 8 companies identified by the TPO, five companies are not comparable for the reason of lack of segmental information, functional differences and segment related party transactions. In the case of Aftek Infosys Ltd., the profit is abnormally high. M/s Geometric Software Selection Co. Ltd., a case considered by the TPO has different functions compared to the assessee company....
X X X X Extracts X X X X
X X X X Extracts X X X X
....nalysis made by the TPO and, therefore, it is not necessary to repeat them again. She submitted that the TPO has pointed out specific and valid reasons to reject the list of comparables relied on by the assessee-company, as many of the comparables do not conform to normal and acceptable sample size. The assessee-company itself has not undertaken any detailed analysis on the basis of various parameters highlighted by the learned Chartered Accountant. The TPO on the other hand, sourced the details of such comparables which are most appropriate in the line of activities carried on by the assessee-company. She explained that many of the propositions highlighted by the learned CA, do not in fact go to reduce the operational margin of the assessee-company as it is working in a high technological area with a towering command both in providing products and services and in determining competitive prices in international markets. Therefore, she submitted that the average rate of margin determined by the TPO is a proper and just rate for working out the arm's length price of the international transactions carried out by the assessee during the previous year relevant to the assessment year und....
X X X X Extracts X X X X
X X X X Extracts X X X X
.... 5. Visual Soft Technologies Ltd. 31.70 76. In the case of M/s. Geometric Software Solution, the case of the assessee-company is that the functions of the assessee-company and that company are different and segmental break up/information in the case of that company is not available. On the basis of these explanations, we accept the contention of the assessee that M/s. Geomatric Software Co. must be excluded from the list of comparables adopted by the TPO/Assessing Officer. 77. In respect of M/s. Hinduja TMT and M/s. Aftek Infosys Ltd., the reason pointed out by the assessee-company to keep them away is that they have disclosed super normal profit, which make these companies un-comparable to normal situations. It was necessitated for the TPO/Assessing Officer to normalize the Profit Level Indicator (PLI) by adopting 31.78 per cent of the result reflected in the case of M/s Infotech Enterprises. The selection of normalization factor also was on an ad hoc basis. We find force in the arguments of the assessee. Only comparables can be compared. Extreme cases should be avoided while making a comparative study of analogous cases. Therefore, we hold that M/s. Hinduja TMT Ltd....
X X X X Extracts X X X X
X X X X Extracts X X X X
....ronment which has been by and large accepted by us in our discussion already made in paragraphs above. The assessee-company is not running an apparent amount of risk in carrying on its business in India. It does not have the problem of marketing. It does not have the problem of working capital to a great extent. It is working in a safe harbour. So also, the agreement entered into by the assessee-company with its German Associate concern has provided for remuneration at the rate of cost plus 6 per cent or 1.5 times of the total wages bill, whereby a positive working result has been ensured. The comparables showing negative margins in the list adopted by the TPO/Assessing Officer and the list relied on by the assessee-company are in fact having different business dynamics. We have excluded the cases of M/s. Hinduja TMT Ltd. and M/s. Aftek Infotec Ltd. from the list of TPO/Assessing Officer on the ground that their margins are showing abnormally high returns. Such extremes cannot be the basis of comparison. If such extremes are adopted, the sample value will be skewed very high which will ultimately impair the credibility of the statistical result. It is for the above reason that we h....
X X X X Extracts X X X X
X X X X Extracts X X X X
....see. When extremes are excluded from the samples, all sorts of extremes should be avoided. Otherwise, samples selected for comparative study may not be representative. Therefore, we are inclined to exclude those comparables having very low margin. Then what should be the cut of rate? The assessee has agreed for a working contract of cost + 6 per cent. Therefore, as a reasonable Profit Level Indicator (PLI), we hold that all the comparables, having margin less than 6 per cent. have to be excluded from the list relied on by the assessee. Accordingly, the following comparables are excluded from the assessee's list: S. No. Name of the Company Margins (In %) 1. Bangalore Softsell Ltd. 2.27 2. Cherry Soft Technologies Ltd. 3.67 3. Goldstone Technologies Ltd. 5.37 4. Mascot Systems 5.59 5. Unitech Info Solutions Ltd. 5.52 6. VJIL Consulting Ltd. 5.51 86. We have so far excluded two comparables of negative margin and six comparables of very low margin, totalling to eight. The exclusions are made not only for the specific reasons stated above, but also for the reason that on the study of the whole scenario, we find that the F....
X X X X Extracts X X X X
X X X X Extracts X X X X
....sing Officer and the assessee-company, comprising 12 comparables. 92. The necessary working is made out below : S.No. Name of the Company Margins (In %) 1. ADCC Research & Computing Centre Ltd. 40.96 2. Compudyne Winfo Systems Ltd. 21.65 3. Kashyap Radiant Systems Ltd. 13.27 4. Lanco Global Systems 20.91 5. Larsen & Turbo Infotech Ltd. 6.95 6. Mascon Global Ltd. 10.26 7. Onward Technologies Ltd. 15.45 8. Satyam Computers Services Ltd. 30.86 9. VMF Softtech Ltd. 6.09 10. Xcel Vision Technologies Ltd. 35.88 11. Kshema Technologies Ltd. 13.64 12. Zylog Systems Ltd. 30.86 Total Value 246.78 No. of comparables - 12 Arithmetic Mean - 20.57 93. As computed above, the arithmetic mean to work out the ALP is 20.57 per cent. 94. In paragraph 47, we have determined the operating margin of the assessee-company at 8.80 per cent. We have also accepted the contention of the assessee that it is entitled for 5 per cent standard deduction ....
X X X X Extracts X X X X
X X X X Extracts X X X X
....01. The assessee had entered into an agreement for the purchase of a property. Before closing the said agreement, the assessee had again an occasion to secure another property at more favourable terms provided by a Government agency. The assessee opted for the latter and terminated the earlier agreement. In terms of the agreement, the assessee was liable to pay a compensation of Rs. 1 crore to the other party. This payment further attracted service tax at the rate of 5 per cent amounting to Rs. 5 lakhs. Accordingly, in discharging its obligation, the assessee had paid Rs. 1.05 crores by way of compensation in the previous year relevant to the assessment year under appeal. The assessee-company claimed this payment as an item of deductible expenditure. The main plank of the argument of the assessee is that the assessee had not acquired any asset or any benefit of enduring nature and the compensation was paid in the ordinary course of business and, therefore, it should be treated as revenue expenditure. 102. The case of the revenue is that the compensation was paid not for running the business activities of the assessee but for establishing capital infrastructural facilities to car....