TaxTMI 
TaxTMI 
2015 (3) TMI 401
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....documentation by the learned Addl Commissioner of Income-tax (Transfer Pricing)-I, Bangalore ('Transfer Pricing Officer' or 'TPO'). 3. That the learned AO and the learned Panel erred both in facts and law in confirming the action of the learned TPO of making an adjustment to the transfer price of the Appellant in respect of its software development and support services segments, holding that the international transactions do not satisfy the arm's length principle envisaged under the Income Tax Act, 1961 (the 'Act') and in doing so grossly erred in: 3.1 Upholding the rejection of comparability analysis of the Appellant in the TP documentation and confirming the comparability analysis as adopted by the learned TPO in the TP Order. 3.2 Disregarding application of multiple year/prior year data as used by the Appellant in the TP documentation and holding that current year (i.e. Financial Year 2006-07) data for comparable companies should be used. 4. That the learned AO and the learned Panel erred in upholding the adjustment of Rs. 382,029,316 by the learned TPO in the Contract Software Development segment of the Appellant a....
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....me Rs. 234,26,60,885/- Operating Expenses Rs. 214,92,30,171/- Operating Profit (Op. Income - Op. Expenses) Rs. 19,34,30,714/- Operating/Net margin (OP/TC) 9% B.2. Comparison of TP study done by Logica and TPO: LOGICA TPO Methodology adopted TNMM TNMM Profit Level Indicator (PLI) OP/TC OPATC Database used PROWESS& CAPITALINE PROWESS & CAPITALINE Comparables selected for software development services 18 26 B.3. Filters applied by Logica in its TP study: Step Description 1 Selection of universal set of companies 2 Companies with ratio of other operating income to sales greater than 50% to select companies engaged in services - retained 3 Companies with ratio of research and development expenses to sales greater than 3 % indicating possible ownership of intangibles and/or significant activities not involved in pure service provision -rejected 4 Companies with ratio of net fixed assets to sales greater than 200% were excluded 5 Companies that had average sales of less than Rs. 1 crore during the time period - rejected 6 Companies with net worth less than zero - reject....
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....cial data available for FY 2006-07; and • 1 Comparable at SI. No. 1 was rejected on the ground of abnormal profitability B.5. Filters applied by the TPO in his TP study: Prowess Database: Step Description No. of Companies Resulted No. of Companies Eliminated 1 No. of companies resulted by the key word "Computer Software" 801 2 The companies for which the data is available for the FY 2006-07 477 324 3 The companies which have service income 403 74 4 The companies whose turnover is more than Rs. 1 crore 302 101 5 The companies whose service income is more than 75% of the revenues 292 10 6 The companies whose export revenues are more than 25% of the revenues 168 124 7 The companies whose employee cost is greater than 25% of the revenues 132 36 8 Related Party Transactions < 25% of the revenues 82 50 Balance for review 82 Capitaline Pius Database: Step Description No. of Companies Resulted No. of Companies Eliminated 1 No. of companies resulted by the key word "Computer Software" and The companies for ....
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....ength Margin (23.84% of Operating Cost) Arms Length Price (ALP)123.84% of Operating Cost 276,74,06,586/- Price Received (Including expenses received Rs. 4,27,16,385) 238,53,77,270/- Short fall being adjustment u/s. 92CA 38,20,29,316/- 6. The Adjustment as above suggested by the TPO was incorporated as an addition in the draft assessment order passed by the AO. The Assessee filed objections against the addition proposed by the AO in the draft assessment order. The DRP however, confirmed the TP adjustment suggested by the TPO. The AO accordingly made the addition by way of TP adjustment to the total income of the assesse in the final assessment order. Against the order of the AO, the assessee has raised ground Nos. 2 to 4 before the Tribunal. 7. We have heard the submissions of the ld. counsel for the assessee and the ld. DR. The first and foremost submission of the ld. counsel for the assessee was that the TPO while working out the Profit Level Indicator (PLI) of the operating cost/total cost, arrived at a percentage of 6.88% as follows:- Revenue Rs.234,26,60,885/- Less: Operating expenses Rs.219,19,46,556/- Operating profit R....
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....see's operating revenue and operating cost as given in the above chart. 12. The next aspect which was highlighted by the ld. counsel for the assessee was that out of the 26 comparables, comparables at Sl.No.1, 2, 3 & 12 have to be rejected as they were held to be functionally not similar to a software services provider as held by this Tribunal in the case of Trilogy E-business Software India (P.) Ltd. v. Dy. CIT [2013] 140 ITD 540/29 taxmann.com 310 (Bang). The relevant paragraphs 39 to 50 of the aforesaid order of the Tribunal are as follows:- "(b) Avani Cimcon Technologies Ltd. 39. As far as this company is concerned, the plea of the Assessee has been that this company is functionally different from the assessee. Based on the information available in the company's website, which reveals that this company has developed a software product by name "DX change", it was submitted that this company would have revenue from software product sales apart from rendering of software services and therefore is functionally different from the assessee. It was further submitted that the Mumbai Bench of the Tribunal to the decision in the case of Telcordia Technologies....
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....nbsp;Telcordia Technologies Pvt. Ltd. v. ACIT (supra)also supports the plea of the assessee. We therefore accept the plea of the Assessee to reject this company as a comparable. (c) Celestial Labs Ltd. 42. As far as this company is concerned, the stand of the assessee is that it is absolutely a research & development company. In this regard, the following submissions were made:- • In the Director's Report (page 20 of PB-Il), it is stated that "the company has applied for Income Tax concession for in-house R&D centre expenditure at Hyderabad under section 35(2AB) of the Income Tax Act." • As per the Notes to Accounts - Schedule 15, under "Deferred Revenue Expenditure" (page 31 of PB-II), it is mentioned that, "Expenditure incurred on research and development of new products has been treated as deferred revenue expenditure and the same has been written off in 10 years equally yearly installments from the year in which it is incurred." • An amount of Rs. 11,692,020/- has been debited to the Profit and Loss Account as "Deferred Revenue Expenditure" (page 30 of PB-II). This amounts to nearly 8.28 percent of the sales....
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....ry of new drugs. Moreover the company also is owner of the IPR. There is however a reference to development of a molecule to treat cancer using bio-informatics tools for which patenting process was also being pursued. As explained earlier it is a diversified company and therefore cannot be considered as comparable functionally with that of the Assessee. There has been no attempt made to identify and eliminate and make adjustment of the profit margins so that the difference in functional comparability can be eliminated. By not resorting to such a process of making adjustment, the TPO has rendered this company as not qualifying for comparability. We therefore accept the plea of the Assessee in this regard." 44. It was submitted that the learned DR in the above case vehemently argued that this company is into research in pharmaceutical products. The ITAT concluded that this company is owner of IPR, it has software for discovery of new drugs and has developed molecule to treat cancer. In the ultimate analysis, the ITAT did not consider this company as a comparable in clinical trial segment, for the reason that this company has diverse business. It was submitted that, however, ....
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.... the DRHP are the services or businesses that would be started by utilizing the funds garnered though the Initial Public Offer (IPO) and thus in no way connected with business operations of the company during FY 06-07. We are of the view that in the light of the submissions made by the Assessee and the fact that this company was basically/admittedly in clinical research and manufacture of bio products and other products, there is no clear basis on which the TPO concluded that this company was mainly in the business of providing software development services. We therefore accept the plea of the Assessee that this company ought not to have been considered as comparable. (d) KALS Information Systems Ltd. 46. As far as this company is concerned, the contention of the assessee is that the aforesaid company has revenues from both software development and software products. Besides the above, it was also pointed out that this company is engaged in providing training. It was also submitted that as per the annual repot, the salary cost debited under the software development expenditure was Rs. 45,93,351. The same was less than 25% of the software services revenue and there....
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.... that in a Mumbai Tribunal Decision of Capgemini India (F) Ltd v. Ad. CIT 12 Taxman.com 51, the DRP accepted the contention of the assessee that Accel Transmatic should be rejected as comparable. The relevant observations of DRP as extracted by the ITAT in its order are as follows: "In regard to Accel Transmatics Ltd. the assessee submitted the company profile and its annual report for financial year 2005-06 from which the DRP noted that the business activities of the company were as under. (i) Transmatic system - design, development and manufacture of multifunction kiosks Queue management system, ticket vending system (ii) Ushus Technologies - offshore development centre for embedded software, network system, imaging technologies, outsourced product development (iii) Accel IT Academy (the net stop for engineers)-training services in hardware and networking, enterprise system management, embedded system, VLSI designs, CAD/CAM/BPO (iv) Accel Animation Studies software services for 2D/3D animation, special effect, erection, game asset development. 4.3 On careful perusal of the business activities of Accel Transmatic Ltd. DRP agree....
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....pment service provider. This information itself is very vague as the segmental details of operating revenue has not been made available to examine how much is the ratio of sale from software product and sale of software service and development. Looking to the fact that it has developed a software product named as "Muulam" which is used for civil engineering structures and the product development expenditure itself is substantial vis-a-vis the capital employed by the said company, this criteria for being taken as comparable party, gets vitiated. For the purpose of comparability analysis, it is essential that the characteristics and the functions are by and large similar as that of the assessee company and T.P. analysis/study can be made with fewest and most reliable adjustment. If a company has employed heavy capital in development of a product then profitability in the sale of product would be entirely different from the company, who is involved in service sector. Therefore, this company cannot be treated as having same function and profitability ratio. In our view, due to non-availability of full information about the segmental details as to how much is the sale of produc....
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....he assessee. 7.5 Wipro Ltd.-IT Services Seqment ('Wipro'): This company is also a global IT Company having varieties of service and products and looking to the magnitude of its operations, sales and expenses, the same cannot be taken into consideration for comparability analysis. Moreover, 67% of its sales relates to its product which are sold on premium resulting into higher profitability, therefore, cannot be compared with the assessee company at all. There are several judgments of ITAT which have been referred in para 6.5 above, that Wipro cannot be taken as comparable case for comparable case with the company like assessee. In view of these facts and the reasoning given in the case of lnfosys, we hold that Wipro also cannot be considered as a comparability analysis, hence, would not be included in the list of the comparable entities as identified by the TPO." 14. As far as comparable at Sl.No.6 & 24 are concerned, the comparability of the aforesaid two companies with that of the software service provider was considered by the Mumbai Bench of the Tribunal in the case of Telcordia Technologies India (P.) Ltd. (supra) wherein on the aforesaid two compa....
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....onal comparability is concerned, it is not enough only to look at the fact that in the decisions relied upon by the ld. counsel for the assesse, also dealt with the case of software development and the assessee is also a software developer rendering software development services. It was his submission that the aforesaid companies even if they are engaged in providing software services, can be engaged in different sectors to which they cater, like software development in telecommunication, automobile manufacturing sector, etc. It was his submission that it was also necessary to consider as to whether the sectors in which the comparable chosen by the TPO belong and the sector to which the Assessee caters. 17. We have considered the submissions of the ld. counsel for the assessee and the ld. DR. We are of the view that the comparables which are sought to be excluded by the ld. counsel for the assessee have been held to be not comparable with the case of software service provider, in as much as these companies did not satisfy the functional similarity test. E.g., in the case of company at Sl.No.2 of the list of comparables chosen by the TPO viz., Avani Cincom Technologies Ltd., this....
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....nd expenses related to travelling, boarding and lodging expense. Based on the above reply, the TPO proceeded to hold that the comparable company was mainly into customization of software products developed (which was akin to product software) internally and that the portion of the revenue from development of software sold and used for customization was less than 25% of the overall revenues. The TPO therefore held that less than 25% of the revenues of the comparable are from software products and therefore the comparable satisfied TPO's filter of more than 75% of revenues from software development services. The basis on which the TPO arrived at the PLI of 60.23% is given at page-115 and 116 of the order of the TPO. It is clear from the perusal of the same that the TPO has proceeded to determine the PLI at the entity level and not on the basis of segmental data. 25. In the order of the TPO, operating margin was computed for this company at 60.23%. It is the complaint of the assessee that the operating margins have been computed at entity level combining software services and software product segments. It was submitted that the product segment of Megasoft is substantially....
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....se in case of Megasoft, the margins at the entity level are higher than that at the segment level; whereas in case of other comparables (Eg: Kals, Sasken, Tata Elxsi, Geometric, R Systems) margins at the segment level were higher. It was submitted that learned TPO's approach is arbitrary and without basis. The Assessee therefore submitted that if at all Megasoft is considered as comparable then only the segmental margins, if at all, should be used for comparability purpose. Both the segments being substantially different, considering the margins at entity level would vitiate the comparability. 30. Alternatively it was submitted that the profit margin of 60.23% was abnormally high and deserves to be rejected on this ground, as not within the parameters of comparability. In this regard, reference was made to the decision of Special Bench of ITAT Chandigarh in the case of Quark Systems Pvt. Ltd. (supra) besides several other tribunal decisions laying down identical proposition. Further it was submitted that Visual Soft Technologies Ltd. merged with Megasoft Ltd. w.e.f. 01.10.2006. Therefore the book results in the year in which the merger has taken place cannot be taken a....
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....ing in a risk mitigated environment. That is why we have agreed with the argument of the assessee-company that there may not be extreme profits in the case of the assessee. When extremes are excluded from the samples, all sorts of extremes should be avoided. Otherwise, samples selected for comparative study may not be representative." 33. Even in the aforesaid decision the point that has been emphasized is that when the margins of comparable companies are either extremely low or high, the approach should be to eliminate both and not consider only the high or low margin comparables as it suits either the TPO or the Assessee. 34. As far as the provisions of the Act are concerned, they lay down that the comparable companies should be functionally comparable to the tested party. There are no specific standards of comparability on the basis of abnormal profits or loss. Rule 10B(2) provides that the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the following, namely:- (a) the specific characteristics of the property transferred or services provided in either transaction; (b) the functio....
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....t plea of the Assessee is that if at all this company is considered as a comparable then the segmental margin of 23.11% (which is the margin for software service segment) alone should be considered for comparability. On the above submission, we find that the TPO considered the segmental margin (Software service segment) in the case of Geometric, Kals Info systems, R Systems, Sasken Communication and Tata Elxsi. Before DRP the Assessee pointed out that the segmental margin of 23.11% alone should be taken for comparability. The DRP has not given any specific finding on the above plea of the Assessee. Perusal of the order of the TPO shows that the TPO relied on information which was given by this company in which this company had explained that it has two divisions viz., BLUEALLY DIVISION and XIUS-BCGI DIVISION. Xius-BCGI Division does the business of product software (developing software). This company develops packaged products for the wireless and convergent telecom industry. These products are sold as packaged products to customers. While implementing these standardized products, customers may request the company to customize products or reconfigure products to fit into their busi....
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....n 75% of revenues from software development services.' 19. As far as comparables at Sl.No.7 & 11 are concerned, it is not in dispute before us that the related party transaction in the case of companies exceed 15% and in view of the decision of the Tribunal in the case of 24/7 Customer.Com (P.) Ltd. v. Dy. CIT [2013] 21 ITR 514/28 taxmann.com 258 (Bang.), that where the RPT exceeds 15%, such companies should not be taken as comparables, we hold that companies at Sl.Nos. 7 and 11 of the list of the comparables chosen by the TPO be excluded from the list of comparable companies while working out the ALP. 20. After excluding the aforesaid comparable from the list of comparable chosen by the TPO, the ALP of the international transactions would be as worked out below:- E.1.4. Computation of arithmetic mean of 16 comparables: If the above arguments of the Appellant are accepted, the arithmetic mean of 16 of the 26 comparables would be as follows: Sl. No. Name of the Company Sales (Rs. in crores) Margin Unadj.% Margin - WC adjusted 1 Datamatics Ltd. 54.51 1.38 0.12 2 E-Zest Solutions Ltd. 6.26 36.12 36.70 3 Flextroni....
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....the assessee and the AO in this regard were as follows:- C. Analysis of transfer pricing studies of the assessee and the TPO for marketing support services C.1. Net margin on cost earned by Logica: Operating Income Rs.8,26,30,992/- Operating Expenses Rs.7,49,82,500/- Operating Profit (Op. Income - Op. Expenses) Rs.76,48,422/- Operating/Net margin (OP/TC) 10% C.2. Comparison of TP study done by Logica and TPO: LOGICA TPO Methodology adopted TNMM TNMM Profit Level Indicator (PLI) OP/TC OP/TC Database used PROWESS & CAPITALINE PROWESS & CAPITALINE Comparables selected for support services 7 4 C.3. Filters applied by Logica in its TP study: Step Description 1 Selection of universal set of companies 2 Companies with ratio of other operating income to sales greater than 50% to select companies engaged in services - retained 3 Companies with ratio of research and development expenses to sales greater than 3 % indicating possible ownership of intangibles and/or significant activities not involved in pure service provision -rejected 4 Companies with the ratio of....
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....h Margin (30.57% of Operating Cost) Arms Length Price (ALP)130.57% of Operating Cost 9,79,04,650/- Price Received 8,26,30,922/- Short fall being adjustment u/s. 92CA 1,52,73,728/- 23. The AO in his draft assessment order suggested an addition to the adjustment suggested by the TPO. The Assessee filed objections to the addition as suggested in the draft assessment order before the DRP. The DRP however, confirmed the addition suggested by the TPO. The AO accordingly in the fair order made an addition by way of TP adjustment a sum of Rs. 1,52,73,728 suggested by the TPO. Aggrieved by the aforesaid order of the AO, the assessee has raised grounds 5 & 6, which reads as follows:- "5. That the learned AO and the learned Panel erred in upholding the adjustment of Rs. 15,273,728 by the learned TPO in the Support Services segment of the Appellant and in doing so grossly erred in; 5.1 Upholding the recharacterisation of limited risk contract support services provided by the Appellant as commission agency services by the learned TPO. 5.2 Not providing appropriate adjustment towards working capital difference between the Appellant and....
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.... his objection before the TPO, the assessee submitted as follows:- "International Agencies Ltd is primarily engaged in trading of embroidery accessories, embroidery spares and embroidery machines. The company also provides indenting services to the textile industry. Your goodself in the Notice considered the indenting services segment of ICC International Agencies Ltd as a comparable to the support services segment of the Assessee. The type of services provided by the company under indenting agency services is not available both in the Annual Report and websites. As such there is a lack of information available in the public domain for appropriate analysis of comparability." The TPO on the above objection of the Assessee, in his order, observed as under:- "The taxpayer's argument is that the company renders indenting services to the textile industry. As explained earlier, the TPO did not go into verticals i.e. the segment to which a company caters to for rendering commission agency services except that the commission agency services must relate to products and not for services as the taxpayer is rendering similar services relating to telecom products. Thus ....
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....earned AO and learned Panel has erred in proposing to reduce the deduction under section 10A of the Income-tax Act, 1961 ('Act') with respect to 10A Unit from Rs. 12,288,462 to Rs. 9,012,411 and thereby increasing the profits of non 10A Unit from Rs. 174,739,357 to Rs. 178,015,408." 30. The assessee claimed deduction u/s. 10A of the Act on a sum of Rs. 122,88,462. In arriving at this profit, the assessee had allocated common expenses between 10A and non-10A units. The assessee's explanation of the basis of allocation and the AO's reason for rejecting the same was as follows:- "Assessee's explanation on the basis of allocation: (a) Salaries, bonus and allowances The salaries, bonus and allowances of the employees of 10A unit are directly allocated to the 10A unit, based on the actual number of employees. (b) Contribution to provident fund and other funds The contribution to provident fund and other funds pertaining to the employees of the 10A unit are directly allocated to 10A unit, based on the actual number of employees. (c) Staff welfare The contributions of amount to syntillation fund by the em....
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.... of all units as a whole. On the above allocation the AO was of the view that the same cannot be accepted because the STPI and Non-STPI units had difference premises. The software used in STPI and Non-STPI can therefore, be easily identified. The Assessee's failure to do so can only lead to the inference that the basis of allocation is wrong. (g) Legal and professional charges The professional fees included under the head 'Legal and professional charges' are allocated based on the contractors appointed for 10A unit. (h) Rent The rent pertaining to 10A unit is based on the agreement entered into with the land lord by the 10A unit. On allocation of expenses (g) and (h), the AO has nothing to say in the order of assessment. (i) Repair and maintenance The water charges, electricity charges, cleaning charges, security charges and diesel charges included under the head 'Repair and maintenance' is allocated based on the actual bills/consumption. The computer maintenance and computer consumables are allocated based on the ratio of average head count of the 10A unit to the average head count....
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....xpenses 18,00,61,426 221,73,02,993 Net Profit 1,26,34,631 15,55,84,712 Profit of the undertaking as per the Act 90,12,411 17,80,15,408 Income from other sources: Rs. 10,58,175 Profits & gains of buisness and professions Rs. 18,70,27,819 Deduction u/s. 10A allowable (as per discussion and calculation) Rs. 90,12,411 Profits & gains of business/profession Rs. 17,80,15,408 Add: income from other sources Rs. 10,58,175 Total income Rs. 17,90,73,583" 32. The allocation of expenses as done by the AO was incorporated in the draft assessment order of the AO. The Assessee filed objections on the above allocation done by the AO in the draft assessment order before the DRP. The DRP however, confirmed the order of the AO. The allocation of expenses was accordingly made in the fair assessment order. Aggrieved by the said order of the AO, the Assessee has raised Gr.No.7 & 8 before the Tribunal. 33. Before us, the ld. counsel for the assessee submitted that the reallocation of the entire expenses on the basis of turnover as done by the AO is unreasonable and unjustified and the allocation done by the assessee on the basis of number o....
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....s consistent and accepted by the Revenue in the past. The Hon'ble Court also held that its decision was based on the facts of the case before it. The Hon'ble Court observed that Section 10A provides for deduction for profits derived from the export of software for a period of ten years. During the period of tax-holiday, it is desirable that the same method of computing the profits of the STP unit is adopted so that any distortion is avoided. In all cases arising under Section 10A, where the question of apportionment of common/indirect expenses between the taxable and the exempt units arises, the head-count method cannot be said to be the most appropriate method. The question will have to depend, in the very nature of things, on the nature of the business and the facts of the particular case. 37. After giving a careful consideration to the explanation for allocation as made by the Assessee and the reasons given by the AO for rejecting the same, we are of the view that in the present case will have to be decided on the basis of facts as the STPI unit commenced only in AY 06-07 and there is no past history of allocation of common expenses. As far as recruitment charges are ....
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.... 40. As far communication expenses are concerned the basis of allocation by the Assessee on the basis of ratio of average head count of the 10A unit to the average head count of all units as a whole is no valid basis. As rightly held by the AO, Communication expenses may be dependent not only on the employee strength but also on the projects allocated to each unit. In the absence of any other details allocating those expenses on the basis of turnover is only accepted method. We therefore are of the view that the AO's basis of allocation has to be upheld. 41. Thus Grounds No.7 & 8 is partly allowed. 42. Ground No.9 raised by the assessee reads as follows:- "9. That the learned AO and learned Panel erred in treating the computer software expenses amounting to Rs. 29,428,480 as capital in nature." 43. The assessee claimed a deduction of sum of Rs. 2,94,24,480 as expenses incurred towards charges of licence for computer software used primarily as application software for various projects undertaken by it. The details of software purchased by the assessee are as follows:- Details of software expenses for financial year 2006-07 Purpose of expenditure Amoun....