TMI Blog2010 (8) TMI 676X X X X Extracts X X X X X X X X Extracts X X X X ..... f both TPO/Assessing Officer and the assessee-company, comprising 12 comparables - The assessing authority will further find out the operating profits at assessee’s rate of 13.80 per cent and the operating profits at the arithmetic mean rate of 20.57 per cent on the basis of the revised revenue and cost computed in paragraph above - This amount will be corresponding to the differential operating margin of 6.77 per cent Regarding disallowance of Rs. 1.05 crores - whether the liability was created for the purpose of carrying on the business in the normal course or for the purpose of establishing the business itself - While dealing with the transfer pricing issue, particularly while re-computing the profit margin attributable to assessee’s business, we have held that the payment is an extraordinary item and has to be excluded from the expenditure side to work out the operating profit of the assessee - It is a different matter that the assessee has not acquired any tangible asset or any enduring benefit - Decided against the assessee Regarding lease line/high speed link charges - Since the total turnover is only the aggregate of the domestic and export turnover, it naturally follow ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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. 71,69,87,294. The operating cost as per the books of accounts worked out to Rs. 680034163. The operating profit declared by the assessee is Rs. 4,85,08,975 but revised by the TPO to Rs. 36953131. According to the TPO, this revised profit before interest tax works out to an operating profit ratio of 5.43 per cent. On studying the above variables, the TPO concluded that the margin disclosed by the assessee is far below the margin reflected in comparable cases. The TPO has adopted Transactional Net Margin Method (TNMM) as the Most Appropriate Method (MAM) to make the analysis. On the basis of the comparative analysis made by the TPO under TNMM, the percentage of profit to the cost of international transaction has been worked out to 22.24 per cent. This is against the margin of 5.43 per cent noted by the TPO on the basis of the accounts of the assessee-company. The TPO adopted the percentage of profit at 22.2 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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, addition and disallowance, the Assessing Officer determined the total income of the assessee at Rs. 12,39,08,030 as against a loss of Rs. 7,57,430 returned by the assessee-company. 8. The assessment was taken in first appeal before the CIT(A). In the matter of transfer pricing adjustment, the CIT(A) rejected the grounds raised by the assessee-company and confirmed the finding of the TPO vis-a-vis order of the assessing authority. The CIT(A) held that the price of international transactions of software development and consultancy rendered by the assessee-company to SAG AG was not at arm s length, inasmuch as the net margin reported by the assessee-company on operating costs worked out to 5.43 per cent only. In respect of the disallowance of compensation charges paid by the assessee on termination of the property purchase agreement, the CIT(A) held that the payment was towards a capital expenditure and, there ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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 Officer without meeting the preconditions for such reference under section 92CA of the Act. Based on the facts and circumstances of the case, there was neither necessity nor expediency for such reference as there was no attempt on the part of the appellant to willfully understate the value of its international transaction. Further, no opportunity was provided by the learned Assessing Officer to the appellant before referring the transfer pricing issues to the learned Transfer Pricing Officer. (vii) The learned CIT(A) erred in confirming that the Assessing Officer was justified in relying on the order of the TPO as he was in consensus with the order. The appellant prays that the same is in violation of principles of natural justice as the Assessing Officer ought to have independently applied his judgment to the order of the TPO with due cognizance to the Appellant s various rebuttals and ought not to have mechanically accepted the conclusions stated in the TPO s order. (viii) The learned ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... fficer 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 erred in not excluding the compensation charges paid for termination of agreement while computing the appellants margins, which is treated as capital expenditure by the learned TPO/Assessing Officer. (xiv) The lower authorities erred, in law and in facts, by not taking into consideration certain specified income/expenses in computing the operating margins of the comparable companies. (xv) The lower authorities have erred in law and in facts in disregarding the adjustments provided by the appellant for working capital and not adjudicating on the matter. Further, the lower authorities have also erred in law and facts by not making suitable adjustments to account for the differences in the risk profile of the comparable companies and the appellant. (xvi) The learned CIT(A) has erred, in law and in facts, in confirming the computation of arm s length price undertaken by the TPO/Assessing Officer without considering the lower 5 range from the price computed based on arith ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... elate to the question whether the Assessing Officer is justified in referring the transfer pricing issue to the TPO. It is the case of the assessee-company that the transfer pricing reference was made without affording an opportunity to the assessee. 17. On the above grounds, the learned Chartered Accountant contended that the Assessing Officer has not established any purposive intention on the part of the assessee-company to manipulate its Indian profits for the purpose of tax evasion. According to the learned Chartered Accountant, Transfer Pricing Regulations have been enacted in India to curb tax evasion through the medium of transfer pricing. This intention has been elaborated by the Central Board of Direct Taxes (CBDT) in its Circular No. 14/2001 dated 12-12-2000 [252 ITR (st) 65]. It is explained in the Circular that the intention of transfer pricing regulations is to prevent shifting out of profits by manipulating price charged or paid in the international transactions thereby evading the country s tax base. In assessee s case, it is enjoying the benefit of exemption under section 10A and, therefore, there is no tax liability and the de facto tax rate in India as applicabl ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... minary objection raised by the assessee cannot be answered without touching the outline of the law and subject of transfer pricing. In the present law, as it stands under sections 92 to 92F, provisions are relating to the computation of income from international transactions having regard to Arm s Length Price. This is not a new generation concept, as such. There were procedures under section 42(2) of the Income-tax Act, 1922 authorizing the Assessing Officer to work out reasonable profits out of international transactions, where the parties are related. This enabling provision was again implanted in the Income-tax Act, 1961 in section 92. The said section 92 provided for the method of computing income from transactions with non-residents, in certain cases. The law provided that whenever a business is carried on between a resident and a non-resident and it appears to the Income-tax Officer that, owing close connection between them, the course of business is so arranged that the business transaction between them produce to the resident either no profits or less than the ordinary profits, the Income-tax Officer shall determine the amount of profits, which reasonably be deemed to have ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... y examine certain vital aspects of income generating points. So, the transfer pricing analysis form part of assessment procedure itself. It is that procedural law which enables the Assessing Officer to refer the question of determination of ALP to the authority, designated as TPO. The ALP referred to the TPO even though very important, is accordingly incidental to the assessment procedure. Therefore, there is no room for the assessee to grieve on this point. It cannot be held that natural justice is denied to the assessee for the reason that the ALP was referred to the TPO without hearing the assessee. The TPO is framing his propositions and conclusions only after hearing the assessee and considering the objections raised by the assessee. Therefore, the right of the assessee to be heard is not violated. 24. The argument of the assessee with reference to section 10A status also needs a mention. It is the case of the assessee that it is enjoying section 10A benefit and no tax is payable on export income, which makes the Indian tax rate more attractive than German tax rate and, therefore, there could be no motive to understate assessee s income. This argument could be a good logic, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tion raised by the learned Chartered Accountant in the course of hearing is on the question of selecting the Most Appropriate Method and the procedure adopted by the TPO in this case. Initially, the TPO has worked out the ALP on the basis of Man Hour Rate charged by the assessee to its Associated Enterprise. The assessee has charged US$ 15.66 per man hour. As per NASSCOM report, the prevailing billing rate was US$ 18 - US$ 25 per man hour. The assessee explained that the man hour rate computed by the TPO must be weighted by the leave benefits given to the employees. If that factor is also considered, the man hour rate of the assessee-company is worked out to US$ 22.62. This rate was within the range reported by the NASSCOM. Once this was clarified, the TPO left behind the man hour rate method and adopted TNMM, as the most appropriate method for determining the ALP. 29. The argument of the learned Chartered Accountant is that once the TPO has adopted a particular method for comparing the price derivation for the purpose of ALP, it is not open for him thereafter to switch over to another method. It is the contention of the learned Chartered Accountant that the TPO should confine hi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ed in referring the transfer price issue to the TPO. This objection has been considered and held against the assessee as discussed in paragraphs 21 to 27 above. The second objection was on the question of selecting the Most Appropriate Method (MAM), with reference to the particular contention that the TPO has to confine himself to the first method considered by him. This objection has also been held against the assessee as discussed in paragraphs 28 to 33 of this order. The third issue was that the assessee had no motive to understate its income, as it was enjoying the benefits of deduction under section 10A. This question has also been answered against the assessee vide paragraph 24 of this order. 35. Now, we may proceed to consider the remaining grounds on the issue of transfer pricing, which mainly relate to the methods adopted by the TPO/Assessing Officer in selecting and omitting the comparables in determining the margin of the assessee-company, the operating costs and normalizing the cases of extreme profits which were adopted for comparison, relevance of other parameters like Function, Assets, Risk (FAR), Capital etc. in scaling the operating margin of comparables, etc. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the other hand, the case of the assessee is that while working out the operating profit, the Assessing Officer/TPO has not excluded extraordinary items from the receipt side and at the same time has included extraordinary and abnormal items in the expenditure. It is the case of the assessee-company that if those items are included/excluded in working out the operating net margin, it would come to 7.15 per cent as detailed in the TP study filed by it. 39. The item, which should have been included in the sales for the purpose of computing the net operating margin is the foreign exchange fluctuation gains. Another item, which is to be included in the operating income, according to the assessee-company is other misc. income constituting income-tax refunds. According to the assessee, such receipts also should be included in operating profits for the purpose of arriving at a Profit Level Indicator (PLI), to make comparison with other selected companies. Another item to be excluded from the expenditure side according to the assessee-company, is the donations. If the above-mentioned items are adjusted as argued by the assessee-company, the net operating margin would be 7.15 per cent as r ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... hould be treated as part of the operating income and thereby it would contribute to the operating margin of the assessee-company. The foreign exchange fluctuations income cannot be excluded from the computation of the operating margin of the assessee-company. This contention of the assessee is accepted. 43. The contention of the assessee that the income-tax refund credited as other misc. income in the accounts of the assessee-company should be included in the operating profits for the purpose of arriving at the Profit Level Indicator (PLI), cannot be accepted. It is for the simple reason that the operating profit of an assessee is computed without considering the income-tax payments as well as income-tax refunds. The question of income-tax liability does not arise in the computation of operating profit. Therefore, either income-tax payments could not be reduced or income-tax refund could be increased in adjusting the operating profit of an assessee. This contention is dismissed. 44. Regarding the donations also, we do not agree with the arguments of the assessee-company. Donations as such, may not be deductible in the normal course of computing the taxable income of an assessee ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... TPO and 8.83 per cent claimed by the assessee. 48. Overall, the grounds of the assessee relating to the computation of net margin is partly allowed. 49. After discussing the basic issue of operating margin of the assessee-company and determining the same at 8.80 per cent, we now proceed to consider the next basic issue of normalization of margins of companies making super profit which were considered as comparables by the TPO/Assessing Officer. 50. This issue is raised by the assessee in ground No. 11, which reads as follows : (xi) While the CIT(A) has implicitly accepted the fact that companies with super normal profits should not be considered, he has erred in law and in facts, in confirming that the TPO/Assessing 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. 51. It is the case of the assessee that TPO/Assessing Officer while identifyi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ble is M/s. Aftek Infosys Ltd. In this case, the margin is 69.70 per cent, which is again very much on the higher side. The TPO/Assessing Officer has normalized their Profit Limit Indicator (PLI) to 31.78 per cent adopting the margin reported in the case of M/s. Infotech Enterprises Ltd. At the same time, the TPO/Assessing Officer has not explained the common thread running through all these four entities to bring out a functional similarity. In these circumstances, it is our considered view that such super profit making companies cannot be considered as comparables in the present case. Therefore, we exclude M/s. Hinduja TMT Ltd. and M/s. Aftek Infosys Ltd. from the list of comparables. 55. The ground raised by the assessee-company on normalization of super profit is accordingly accepted and allowed. 56. The third basic issue to be considered is whether the assessee is entitled to exercise option provided for in the second proviso to section 92C(2) of the Income-tax Act, 1961. 57. This issue is raised by the assessee in ground No. 16, which is extracted below : (xvi) The learned CIT(A) has erred, in law and in facts, in confirming the computation of arm s length price und ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... r cent of the latter, the price at which the international transaction has actually been undertaken shall be deemed to be the Arm s Length Price]. 60. The above proviso has two limbs. The first limb provides for the arithmetical mean of prices, where more than one price is determined as the Most Appropriate Method. This is the only natural remedy where more than once price is determined. The second limb of the proviso is providing a marginal relief of 5 per cent to the assessee in computing the ALP applicable to it. If the difference between the ALP determined on averaging the prices and the ALP disclosed by the assessee does not exceed 5 per cent, then the benefit of doubt is given to the assessee by way of marginal relief and the ALP disclosed by the assessee itself has to be taken as ALP for assessment. In other words, if the ALP determined on the basis of Most Appropriate Method does not exceed 5 per cent of the ALP disclosed by the assessee, the ALP determined under the Most Appropriate Method has to be ignored. The deviation may be on either side; 5 per cent more or 5 per cent less. If the average mean ALP determined on the basis of the Most Appropriate Method is more than ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the theme of the old proviso. But under the newly substituted proviso, the marginal relief of 5 per cent will not Act as standard deduction. If the price determined by the Average Mean Prince is 20 per cent and that of the assessee is 10 per cent, then the difference of 10 per cent is more than 5 per cent and, therefore, the assessee will not get the marginal relief and the entire difference of 10 per cent will be added as ALP adjustment. If the ALP determined by TPO/Assessing Officer is 15 per cent and that of the assessee is 11 per cent, the difference of 4 per cent is less than 5 per cent and in that case, the rate disclosed by the assessee at 11 per cent shall be taken as ALP. This is the position after the amendment. 64. In view of the above discussion, we find that second limb of the proviso to section 92C(2) gives an option to the assessee to claim a marginal variance of 5 per cent as standard deduction. This ground of the assessee is accepted and we hold that this benefit of deduction of 5 per cent has to be given to the assessee, if the circumstances, so warrant. 65. We have considered all the three basic issues mentioned in paragraph 36. All the issues have been deci ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... having turnover outside the range of Rs. 50 crores to 150 crores. The TPO has virtually replaced the list of comparables with a new list comprising of 8 companies. The arithmetical mean of the margin, as per that list of comparables works out to 22.24 per cent. 5. The TPO has worked out the operating net margin of the assessee at 5.43 per cent as against 7.5 per cent reflected in the assessee s accounts and has worked out the ALP adjustment being the difference between 22.24 per cent and 5.43 per cent. 67. The relevant grounds raised by the assessee in this regard are extracted below : 8. The learned CIT(A) has erred, in law, and in facts, in confirming the rejection of the comparable companies identified by the appellant, based on ad hoc factors such as turnover criterion , functional dissimilarity , having disregarded the explanations furnished by the appellant in this regard. 9. The learned CIT(A) erred, in law and in facts, in confirming that, the approach in determining the arm s length margin/price based on a new list of comparable companies identified at the time of assessment proceedings is justified. The appellant prays that the same be deleted given that the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... different segments including engineering services. M/s Visual Soft Technologies Ltd. is also not acceptable as segmental information is not available and also the companies are engaged in ITES-BPO services etc. 4. If the above five companies are excluded from the list of TPO, there are only three comparables remaining. They are, M/s. Kshema Technologies Ltd., M/s. R.S. Software Pvt. Ltd. and Zylog System Pvt. Ltd. The arithmetic mean of the above comparables is 9.39 per cent. With the range of (+) or (-) 5 per cent, the value comes to 14.86 per cent and 3.92 per cent. Even the net margin erroneously worked out by the TPO at 5.43 per cent itself is within the range and, therefore, the transfer pricing adopted by the assessee-company should be accepted as the ALP. 69. The learned CA also argued at length on the need for making working capital and risk adjustment in respect of the comparables, mainly for the reason that the assessee is operating in a risk mitigated environment and, therefore, operating profit will be less, when compared to companies, who assumes high amount of functional risks. In support of the elaborate arguments of the learned CA on the matters of these adju ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... S. No. Name of the Company Margins (In %) 1. ADCC Research Computing Centre Ltd. 40.96 2. Bangalore Softsell Ltd. 2.27 3. Bodhtree Consulting Ltd. 72.39 4. Cherry Soft Technologies Ltd. 3.67 5. Compudyne Winfo Systems Ltd. 21.65 6. Future Software Ltd. -0.61 7. Goldstone Technologies Ltd. 5.37 8. Infotech Enterprises Ltd. 15.76 9. Intertech Communications -29.24 10. Kashyap Radiant Systems Ltd. 13.27 11. Lanco Global Systems 20.91 12. Larsen Turbo Infotech Ltd. 6.95 13. Mascon Global Ltd. 10.26 14. Mascot Systems 5.59 15. Onward Technologies Ltd. 15.45 16. Orient Information Technology Ltd. -6.07 17. Pyxis Technology Solutions Ltd. -55.48 18. Satyam Computers Services Ltd. 30.86 19. Unitech Info Solutions Ltd. 5.52 20. VJIL ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... dopting 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. and Aftec Infosys Ltd. must be excluded from the list of comparables adopted by the TPO/Assessing Officer. In the case of M/s. Infotech Enterprises again, the assessee-company explained that the functions are different and the said company operates in three segments GIS services, engineering services and software development services. It is also the case of the assessee that the turnover of M/s. Infotech Enterprises from Software Development Enterprises was less than 50 crores. If we remember the filtering of turnover adopted by the TPO/Assessing Officer, it is justifiable to accept this contention of the assessee. As a reasonable approach, M/s. Infotech Enterprises also should be excluded from the said list. 78. In the case of M/s. Visual Soft Technologies Ltd., it mainly earns income from ITES/BPO services and may no ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ess 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 have excluded the extreme profit margin cases. Extreme margins do not mean abnormally high profits alone. They include negative results as well. Because of these compelling reasons stated above, we hold that the case of M/s. R.S Software Pvt. Ltd. having a negative margin of -16.33 cannot be considered as comparable. 82. Ultimately, we zero down the list of TPO/Assessing Officer with two comparables : S.No. Name of the Company Margins (In %) 1. Kshema Technologies Ltd. 13.64 2. Zylog Systems Ltd. 30.86 These comparables will be considered in working out the ALP. 83. Now coming to the list relied on by the assessee-company, we find that the principle applied in downsizing ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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 Function, Asset and Risk analysis (FAR) also does not make out compatibility for comparison. 87. While recasting the comparables list of the TPO/Assessing Officer, we have excluded the case of Infotec Enterprises Ltd. having a margin of 31.78 per cent on the ground that the said company is operating in a functional by different domain. The said reason is applicable to the same comparable included in the assessee s list, as well. 88. M/s. Infotech Enterprises with a margin of 15.76 per cent is seen included in the lis ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 3.27 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 in view of the proviso to section 92C(2), as it is stood for the assessment year 2003-04. When that benefit of 5 per cent is given to the assessee, its operating margin for the purpose of determining the ALP will be bloated t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... greement. 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 carry on the business and, therefore, the payment made by the assessee-company would be in the nature of capital payment. 103. We considered the matter in detail. It is true that the assessee has not acquired any tangible asset or an enduring benefit. But, we have to see that the assessee has free ..... X X X X Extracts X X X X X X X X Extracts X X X X
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