TaxTMI 
TaxTMI 
2015 (1) TMI 870
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....the assessee has not objected for condonation of delay. In view of the reasons and also concession allowed by Ld. counsel for the assessee, we condone the delay and admit these two appeals for adjudication on merits. 3. As regards to the first issue of revenue in both appeals, the revenue has raised identical grounds in both the appeal and issue is also exactly same, hence, we will take up grounds from ITA No. 2222/Kol/2010 and discuss facts and circumstances of the case for both years. The first issue is as under:- "The first issue in this appeal of revenue is against the order of CIT(A), in deleting the addition made by AO on the basis that transfer pricing adjustments proposed by TPO, holding that risk factors involved in transactions carried out on the basis of contracts either by assessee himself or through subsidiaries are same and no transfer pricing adjustment is to be made in the given facts and circumstances." For this following are three grounds in revenue's appeals:- 1. That on the facts and in the circumstances of the case the Ld. CIT(A) erred in adjudicating that risk factors involved in contracts - direct and through subsidiaries are same, though it is hi....
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....ffer enhanced customer value through superior and combined leverage of technology and business skills. He explained Transfer Pricing documentation of the assessee. Based on the functional and risk profile of the assessee and its AEs, the AEs were selected as tested parties for application of the most appropriate method and determination of the arm's length nature of international transactions between the entities. The Transfer Pricing report maintained by the assessee is enclosed in assessee's paper book at page 42 & at page 114 for AY 2005-06 & AY 2006-07 respectively), which explains these aspects in detail along with the economic analysis to conclude arm's length nature of respondent's international transactions with its AEs. He explained that the assessee and its AEs operate under an integrated 'Global Delivery model' which was explained before TPO and CIT (A). The functions of various group entities performed while targeting, negotiating and winning customer contracts are summarised at page 638 & at 220 to 221 of assessee's Paper Book for AY 2005-06 & AY 2006-07 respectively. He explained that customers based on their individual preferences and requirements, chooses to enter i....
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.... for the delivery of services other than administrative services. Hence in case of split revenue contract, party who receives 75% share shall bear full delivery risk for non-administrative services and party who receives 25% share shall only be responsible for administrative services. He also explained that the basic functions of 12A or 12B would be to perform marketing activities and undertake the administrative functions i.e. account management services. 6. The assessee also explained invoicing arrangement that to effectively cater to requirements of overseas customers, the assessee has streamlined its invoicing arrangements with 12A / 12B into the following two categories:- Arrangement 1: The customer directly enter into contract with the respondent Arrangement 2 : The customer directly enters into contract with 12A and 12B Customers Customers Pays USD 100 to the respondent for provision of software development services Retains 75% Respondent Performs software development services (non-administrative) Pays USD 25 to 12A/12B For administrative services Retains 25% 12A/12B Performs Administrative services Pays USD 100 to 12A/12B for provision....
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....or Global Desktop Services Project submitted by 12B to DHL; and ( refer Pages 787 and 788 of the assessee paper book for AY 2005-06 which projects 13L's expertise and capabilities even though the agreement has been executed by 12B with the customer) Copy of proposal and agreement entered between the respondent and Finnair Oyj. On the basis of above documents, the assessee tried to demonstrate before lower authorities and before us also that irrespective of contractual arrangement, customer proposals, which enables or facilitates the process of winning a project are heavily focused on the operational capabilities, quality parameters, technical expertise, financial stability, project experience, risks management skills and staff strengths of the assessee and not of 12A / 12B, which act as marketing entities. 7. The assessee made summary of transfer pricing adjustments for the AY 2005-06 as under:- Sl No. AEs Description of the international transactions Amount paid/payable Amount received/receivable 1 12A Export of Software Services 36,754,764 Account management charges 37,736,909 2 12B Export of Software Se....
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....tive services' bears full responsibility for the services provided to the customer and absolves the other party of such risks. Hence, the payment of Account Management charges by the assessee to 12A and 12B should be treated to be at arm's length. The assessee also filed copy of the Agreement between the assessee and Conoco Philips Germany Gmbh and back to back Agreement between the assessee and 12B. 9. Similarly for AY 2006-07, the TPO undertook same exercise and assessee explained the invoicing arrangements with the AEs, the roles and responsibilities of the assessee as well as of AEs and "Global Delivery Model" followed. However, the TPO issued show cause notice as to why transfer pricing adjustment may not be made in respect of international transactions wherein the assessee enters into contract with customers directly and pays 25% revenue share as Account Management Charges to 12A or 12B. The assessee made detailed submissions of entire business arrangement in assessee's group, demonstrating sufficient explanation that as per terms of inter-company agreements between the assessee and its AEs and also the actual conduct of business between them, there is no differences in ei....
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....onsidering submissions made by the assessee, CIT (A) found merit in the facts of the assessee. The CIT(A) considered economic substance underlying the assessee's global business model including sharing of the functions and risks and deleted adjustments made by AO based on the order of the TPO. He observed as under:- "I have considered the transfer pricing documentation maintained by the appellant, the appellant's submission and the rebuttal of the Remand Report by the Appellant and the observations and the Remand Report of the TPO. After perusing the above, I hold that: The appellant, in compliance with the law, prepared and maintained the TP Report for computing the arm's length price of its international transactions. As embodied in the TP Report, the appellant has adopted the Cost Plus Method as the most appropriate method to establish the arm's length price of the relevant transactions undertaken by the appellant with 12A and 12B while selecting 12A and 12B as the 'tested party'. From the facts and documents presented before me, I find that the appellant's business arrangement with its foreign subsidiaries can be categorised into the following two revenue sharing mo....
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....the contract and thu9s in cases of such direct dealings, 12A and 12B bear greater risk as compared to the other model where the customers enter into contracts directly with the appellant. In my view, this logic is flawed. The determinant factor is not whether the customers can hold 12A or 12B responsible for failure of performance, but whether, as per the functional, asset and risk profiles of the three entities, namely the appellant, 12A and 12B, if 123A and 12B do not have the necessary confidence and functional strength to bear such risks, and thereby the risk should be awarded to such party under an arm's length dealing. In my view, base upon the documents submitted by the appellant and the arguments put forward before me, under either of the two situations, the functional, asset and risk profiles of 12A and 12B remain the same and the major risks relatable to bad debt and delivery failure / nonperformance, always remain with the appellant, irrespective of the two business models. I find that the TPO had in-principle accepted the remuneration model of 25% revenue sharing in case where the customers enter into contract with 2A and 12B. I also find that the remuneration model of ....
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....o in case where they bear the entire risk (in case of contracts directly with customer). He also highlighted that in clause 4A(iii) of the Master Agreement between the respondent and 12A, dealing with the provision of administrative services to the respondent by 12A, mentions that: "If 13L (the respondent) subcontracts its obligation in accordance with these clause, the parties agree that the provisions of clause 5(iii) to (v) inclusive shall not apply and that a fee equal to 25% of the revenue derived from the customer contact shall be paid by 13L (the respondent) to IINFOTECH US." TPO contended that it is evident that if 12A subcontracts its obligations to the assessee, 12A will have to discharge all the administrative functions including those mentioned in clause 5(iii) to 5 (v), however if the assessee subcontracts its obligations to 12A, the above mentioned functions would not be discharged by 12A. However since in both the scenario, 12A is entitled to 25% of the sales proceeds, he believed that this prima-facie is not an arm's length transaction. While re-computing the Account Management charges paid by the assessee to 12A and 12B, the TPO observed that "What an entrepr....
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....n the above, transfer pricing adjustment was computed by the TPO as follows: Adjustment in arm's length price - 12B Account management charges paid during the year by the Respondent Rs.11,186,022 Less: Arm's length price as discussed above [Rs.11,11,86,022 15/25] Rs. 66,711,613 Adjustment to the ALP Rs. 44,474,408 Adjustment in arm's length price - 12A Account management charges paid during the year by the respondent Rs. 37,736,909 Less: Arm's length price as discussed above [Rs. 3,77,36,909 13/25] Rs. 66,711,613 Adjustment to the ALP Rs. 18,113,717 Similarly, the transfer pricing adjustments made by the TPO in AY 2006-07 were as follows: Adjustment in arm's length price - 12B Account management charges paid during the year by the respondent Rs. 10,45,61,028 Less: Arm's length price as discussed above [Rs. 10,45,61,028 15/25] Rs. 6,27,36,616 Adjustment to the ALP Rs. 4,18,24,412 Adjustment in arm's length price - 12A Account management charges paid during the year by the respondent Rs. 4,88,46,535 Less: Arm's length price as discussed above [Rs. 4,88,46,....
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....ld to be unsustainable by TPO. Similarly for AY 2006-07 also the assessee filed detailed submission summarising international transactions which were subject to adjustments along with facts and circumstances. After considering submissions and arguments put forth by the assessee for both the AYs, the CIT (A) found merit in the facts and granted relief deleting the entire transfer pricing adjustment for both the AYs. 13. We noted from factual aspects of the case that the TPO perceived that functional and risk profile of the assessee and its AEs are different in both the business models wherein the assessee assumes larger share of risks when contracts are entered by it with customers (Business Model-I) as compared to arrangements wherein the AEs executes the contract with customer (Business Model-II). The two business models are optically different (in terms of contractual party), but the functional and risk profile of both the assessee and its AEs remain the same in both the models, which is evident not only from the terms of the MSA but also from the conduct of the parties. The assessee has explained the business model followed by it along with its functional and risk profile.....
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....of the business model. It was also emphasised that it is the assessee, which has adequate capital and technical expertise to bear the risks arising from deficiency in services, which neither 12A nor 12B possess. Thus even if a customer raises any claim on 12A/12B, such risk would be eventually passed on to the assessee. 14. There is contractual relationship among the assessee, its subsidiaries and third parties. The subsidiaries, based on agreement entered into with the assessee, engage in marketing of the IT service capabilities of the assessee in their respective countries and try to win contract for providing IT services. Once a customer is identified, the subsidiaries in coordination with the assessee try to win the customer contract. As it has been explained through the sample customer proposals, the customer is made aware of the assessee's technical expertise, experience, resource pool etc. from initial stages of the proposal/bidding stage. Once the customer is won, the subsidiaries download the non-administrative services to the assessee. There may be some customers who may not be at all willing to enter into a contract with the subsidiaries as the subsidiaries on a stand....
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....In cases where the terms of the arrangement between the two parties are not explicitly defined, the contractual terms have to be deduced from their economic relationship and conduct. (emphasis added) It is also pertinent to mention at this juncture that the concept of business risk in transfer pricing context has been discussed at length in the recent amendments to the OECD Transfer Pricing Guidelines 2010 (hereinafter referred to as "OECD Guidelines") under the new Chapter IX (Transfer Pricing Aspects of Business Restructuring). As per this new guidance, para 9.10 provides that: "Risks are of critical importance in the context of business restructurings. An examination of the allocation of risks between associated enterprises is an essential part of the functional analysis. Usually, in the open market, the assumption of increased risk would also be compensated by an increase in the expected return, although the actual return may or may not increase depending on the degree to which the risks are actually realized." Under para 9.11 and 9.12: "... .. the examination of risks in an Article 9 context starts from an examination of the contractual terms between the parties....
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....that can assist in the determination of whether a risk allocation in a controlled transaction is one which would have been agreed between independent parties in comparable circumstances is whether the riskbarer has, at the time when risk is allocated to it, the financial capacity to assume (i.e to take on) the risk. Where risk is contractually assigned to a party (hereafter 'the transferee) that does not have, at the time when the contract is entered into, the financial capacity to assume it, e.g. because it is anticipated that it will not have the capacity to bear the consequences of the risk should it materialise and that it also does not put in place a mechanism to cover it, doubts may arise as to whether the risk would be assigned to this party at arm's length. In effect, in such a situation, the risk may have to be effectively borne by the transferor, the parent company, creditors, or another party, depending on the facts and circumstances of the case, irrespective of the contractual terms that purportedly assigned it to the transferee." Based on the above OECD Guidelines and Practice Manuals, we are of the view that the conduct of the assessee and its AEs should be give....
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....the services provided to the customers. The subsidiaries do not have adequate capital or technical expertise to bear such a risk. Thus, in our view, under the Business Model 2, as per terms of the MSA, in case a Customer raises any claim for non-performance of the non-administrative services, the subsidiaries would eventually pass on such risk to the assessee and the assessee has to bear such risk. The customers enter into contract with either the assessee or the subsidiaries for providing software development services. The contracts entered with customers also mention the expected standard of services to be provided for software development work. It is the internal arrangement between the assessee and the subsidiaries where the marketing and the administrative functions are performed by the subsidiaries under both the business model. The subsidiaries provide the marketing and the administrative services to the assessee and not to the clients. Thus, in both the business model the risk profiles of the subsidiaries remain the same. Further, in course of the contract negotiation and mapping of the scope of work, the customer is fully aware of the underlying delivery mechanism, since t....
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....ed by the respondent and 12A / 12B. Such an adjustment made by the TPO was without any basis or analysis. In relation to difference in clauses in the MSA between the assessee and 12A as referred to by the TPO for making an ad-hoc adjustment, the assessee further drew our attention towards Clauses 4A (iii) and clause 4B (ii) of the MSA which provides for the same effect in relation to exclusion of certain administrative services to be performed, Clause 4B (ii) provides that: "if INFOTECH US subcontracts its obligation in accordance with this clause 4(B), the parties agree that the provisions of clause 5(iii) to (v) inclusive shall not apply and that a fee equal to 75% of the revenue derived under the applicable customer contract from non-administrative services provided by the respondent's employees shall be paid by INFOTECH US i.e '12A' to the respondent." Further, the assessee also calculated the effect of adjustment on profitability of ITC Infotech Group taking into consideration the risk adjustment envisaged by TPO for the AY 2006-07 and submitted that both 12A and 12B would make losses at net level if the risk adjusted pricing model, as proposed by the TPO were put in act....