2011 (9) TMI 196 - AT - Income Tax

Method of determination of arm s length price - Referring to TPO u/s 92CA of the Act - Held that - TPO is directed to recalculate the ALP keeping in view the specific directions of this Bench - in the absence of uncontrolled independent comparable companies the Excess Earning Method EEM adopted by the TPO in the present circumstance is reasonable - the reason for adopting EEM method that it is only an internal CUP method wherein it is seen what is the price for which the same product would have been sold by the assessee to an independent entity. This price also reflects the price at which the assessee would have sold in an uncontrolled condition but as there were no comparable prices available in the public domain for sale of IPR produce similar to that of the assessee this EEM is used to determine the price that would have been arrived at if the assessee sold the IPR to an independent entity. While calculating the ALP under EEM the TPO is directed to adhere the following steps - Estimating future turnover based on the past performance - Estimation of future cash flows - Estimation of discounted future cash flows - present value of improvement - Future cash flows - Return on fixed assets - Return on working capital - Return on human capital - After following the above formulae the TPO should calculate the ALP accordingly. If the amount so arrived at were to be higher than the total actual consideration Rs. 38.50 crores received the TPO should adopt the higher price arrived at. Value paid by the assessee to AE for subsequent purchase of the same software product cannot be considered as uncontrolled transaction as the said transaction was between two associated enterprises. Further as there was a long gap of almost three years between the two transactions; we are of the view that the point raised by the assessee for comparison is unreasonable due to the subsequent value additions made to the IPR and discounting factors. - Decided partly in favor of assessee.

Summary

Issues Involved:
1. Legality of reference to the Transfer Pricing Officer (TPO) by the Assessing Officer (AO) without forming a considered opinion.
2. Adoption of a non-statutory method (Excess Earning Method) by the TPO for valuing Intellectual Property Rights (IPR).
3. Merits of the valuation of IPR, including the computation of future cash flows, useful life of the IPR, and discount factor.

Detailed Analysis:

I. Legality of Reference to TPO by AO without Forming a Considered Opinion:
The assessee contended that the AO referred the case to the TPO without forming a considered opinion, which was countered by the Revenue. The court noted that the AO needs only to form a prima facie opinion that it is necessary and expedient to refer the case to the TPO, as per the ruling in Sony India P. Ltd. v. CBDT. The court found that as per CBDT Instruction No. 3/2003, it is mandatory for the AO to refer cases exceeding Rs. 5 crores in international transactions to the TPO. The court concluded that the AO's reference to the TPO without forming a considered opinion was valid and rejected the assessee's plea.

II. Adoption of Non-Statutory Method (Excess Earning Method) by TPO:
The assessee argued that the TPO used the Excess Earning Method, which is not a prescribed method under the Act or Rules. The Revenue explained that the Excess Earning Method is a recognized method for valuing intangibles and supplements the Comparable Uncontrolled Price (CUP) method. The court upheld the use of the Excess Earning Method, referencing the Intel Asia Electronics Inc. v. ADIT case, where the valuation method was accepted to arrive at the CUP price. The court dismissed the assessee's contention that the TPO adopted a non-statutory method.

III. Merits of the Valuation of IPR:
1. Computation of Future Cash Flows:
- The assessee argued that the TPO should consider actual sales data up to March 2010, which was lower than the TPO's projections. The court rejected this, stating that the risk of future income potential lies with the buyer and the actual future revenues are irrelevant for the valuation date.
- The court directed the TPO to include sales data from April 2005 to January 2006 and reduce sales returns of Rs. 111.04 crores from the FY 2005-06 revenue while calculating the Compound Annual Growth Rate (CAGR).

2. Useful Life of IPR:
- The TPO estimated the useful life of the IPR to be six years, while the assessee argued it should be three years due to the fast-paced obsolescence in the software industry. The court agreed with the TPO's six-year estimation, considering the nature of the software product and its market.

3. Discount Factor:
- The court found flaws in the TPO's calculation of the discount factor, particularly in the selection of Beta. The court directed the TPO to consider the average Beta of three comparable companies (Lifetree Convergence Limited, Exensys Software Solutions Limited, and Sankhya Infotech Limited) for a more accurate calculation.

4. Return on Working Capital:
- The court directed the TPO to consider cash and bank balances, other current assets, and provisions while computing the working capital ratio and to reduce the sales return of Rs. 111.04 crores from sundry debtors for FY 2005-06.

5. Overall Valuation:
- The court instructed the TPO to recalculate the ALP using the Excess Earning Method, incorporating the specific directions provided. If the recalculated ALP exceeds the actual consideration received (Rs. 38.50 crores), the higher value should be adopted.

Conclusion:
The court partly allowed the assessee's appeal for statistical purposes, directing the TPO to recalculate the ALP of the IPR following the specified guidelines and corrections.