2013 (1) TMI 60 - AT - Income Tax

Arms length price - provision of research and development support services - upward adjustment of Rs. 68, 47, 532/- to the income - assessee contested against inclusion of the two comparable companies viz. Celestial Labs Ltd. and Biocon Ltd. - Held that - Celestial Labs Ltd. is engaged in the business of supporting pharmaceutical and biotechnology companies with customised information technology solution. It is mainly engaged in the software development in drug designing tool bio informatic service and data warehousing. More than 96% of its revenue is from this service which are mostly in the nature of drug designing tools and Sap services. The profile of the company as highlighted shows that its functions are entirely different from that of the assessee company which is mainly into testing and analytical service in R D. therefore it cannot be included for comparability analysis in the set of comparables taken by the TPO. Inclusion of Biocon Ltd - two subsidiary of Biocon Ltd. i.e. Clinigene International Ltd. and Syngene International Ltd. The former company cannot be included at all for the preliminary reason that its related party transaction is approximately 38% of its sales therefore it cannot be held to be a fit case for comparison of a controlled transaction with an uncontrolled transaction. Insofar as Syngene International Ltd. this company is again 99% subsidiary of Biocon Ltd. and is engaged as a custom research service provider in the drug development process from discovery to supply of development compounds. From annual report it is seen that the company has two sets of income - one from contract research fees and sale of compounds. However in the absence of segmental information regarding contract research and manufacturing activities it is difficult to analyse its main revenue and profit margin from the contract research work. Thus its functional profile is different with that of the assessee company hence this company is directed to be excluded from the set of comparables. Various diagnostic companies excluded by the TPO viz. Dolphin Medical Services Ltd. Transgene Biotek Ltd. and N.G. Industries Ltd. that not only the functional profile of these companies are different but the characteristic of the services rendered are also different. Dolphin Medical Services Ltd. is engaged in diagnostic services like CT scan MRI colour Doppler etc. which is entirely different from R D testing and analytical services performed by the assessee. Transgene Biotech is engaged in the business of pre-clinical and clinical research service for biopharma involved in developing human vaccines and has patent rights of various products and vaccines developed by it. as is the case of N.G. Industries Ltd. which is also purely a diagnostic and medical company and its services are entirely different from that of assessee. Risk adjustment on account of difference between the risk profile of the comparables - Held that - As neither the TPO nor the DRP has dealt with the assessee s contentions thus in the interest of justice the matter needs to be restored back to the file of the TPO who will examine the assessee s contentions on this score and decide the issue afresh in accordance with the law. Notional addition towards interest on the amount receivable from the A.E. - Held that - As assessee has no interest liability and it does not have any external borrowings. Even if the payments have been made by the A.E. beyond the normal credit period there is no interest cost to the assessee. Moreover there is no such agreement whereby interest is to be charged on such a delayed payment. From the summary of payment submitted by the assessee it is seen that the billing is done on quarterly basis and accordingly the payment is being received. Therefore the delay is not wholly on account of late payment by the A.Es only. Moreover the T.P. adjustment cannot be made on hypothetical and notional basis until and unless there is some material on record that there has been under charging of real income. Thus addition an account of notional interest relating to alleged delayed payment in collection of receivables from the A.Es is uncalled for on the facts of the present case and is accordingly deleted. Network access charges - revenue v/s capital - Held that - The assessee has made the payment for availing e-mail infrastructure like lotus notes accounts for the employees usage of VPN network infrastructure excess service which are owned by the parent company and not by the assessee. The assessee is making the payment for using this e-mail infrastructure facilities for communication between employees of the assessee and outside business partners. Such facilities of secured internet facilities facilitates the day-to-day business operation of the assessee and does not bring into an existence any enduring benefit or creation of a new asset to the assessee. It is not a capital software expenditure as held by the Assessing Officer even though the same has been classified under the head software expenditure . Thus, such an expenditure is purely revenue in nature and is allowable under section 37(1)

Summary

1. ISSUES PRESENTED and CONSIDERED

The core legal questions considered by the Tribunal in this appeal are:

(a) Whether the Transfer Pricing Officer (TPO) and Dispute Resolution Panel (DRP) erred in making an upward adjustment to the assessee's income by including certain companies as comparables which were functionally not comparable, rejecting others proposed by the assessee, denying risk adjustment, using current year data instead of average over three years, and denying the benefit of the safe harbour range under the proviso to Section 92C(2) of the Income Tax Act, 1961;

(b) Whether the TPO erred in making a notional addition towards interest on delayed payments from Associated Enterprises (AEs) when no interest was charged or payable by the assessee;

(c) Whether the Assessing Officer (AO) erred in treating network access charges paid by the assessee as capital expenditure, thereby disallowing the deduction under Section 37(1) of the Act;

(d) Whether depreciation at the rate of 60% should be allowed on network access charges as per the applicable depreciation rules, as an alternative to the claim for revenue deduction.

2. ISSUE-WISE DETAILED ANALYSIS

Issue 1: Transfer Pricing Adjustment - Selection and Inclusion/Exclusion of Comparable Companies

Relevant legal framework and precedents: The arm's length principle under Section 92C of the Income Tax Act requires that international transactions between associated enterprises be benchmarked against comparable uncontrolled transactions. The Transactional Net Margin Method (TNMM) is a prescribed method for benchmarking. The proviso to Section 92C(2) provides a safe harbour range of +/-5% around the median or arithmetic mean margin of comparable companies. Precedents cited by the assessee include decisions recognizing the need for functional comparability and risk adjustment in transfer pricing analysis.

Court's interpretation and reasoning: The Tribunal examined the functional profiles of the companies included and excluded by the TPO and DRP. It was observed that the assessee is a captive service provider engaged primarily in testing and analytical services related to research and development for its parent group, whereas some comparables included by the TPO/DRP, such as Celestial Labs Ltd. and Biocon Ltd. (contract research segment), were functionally dissimilar.

Celestial Labs Ltd. was primarily engaged in software development, bioinformatics, and data warehousing services related to drug design tools and IT products, which the Tribunal found materially different from the assessee's testing and analytical services. Similarly, Biocon Ltd.'s contract research segment related to subsidiaries engaged in drug discovery and compound supply, with significant related party transactions (approx. 38% of sales) and negative net worth in some subsidiaries, indicating lack of suitability as comparables.

The Tribunal also considered the rejection of diagnostic companies proposed by the assessee (e.g., Dolphin Medical Services Ltd., Transgene Biotek Ltd., N.G. Industries Ltd.), finding that their business activities such as diagnostic imaging, vaccine development, and patent holding were distinct from the assessee's R&D support services, justifying their exclusion by the TPO.

Key evidence and findings: The Tribunal relied on the detailed business profiles, segmental reports, annual reports, and director's reports of the companies in question. It noted the nature of services, revenue composition, related party transactions, and functional activities to assess comparability.

Application of law to facts: Applying the arm's length principle and the requirement of functional comparability, the Tribunal concluded that only four companies-Choksi Laboratories Ltd., Vimta Labs Ltd., GVK Bioscience P. Ltd., and TCG Lifescience Ltd.-were truly comparable to the assessee's business. The arithmetic mean of their Profit Level Indicator (operating profit to total cost) was to be used for determining the arm's length price.

Treatment of competing arguments: The assessee's arguments for excluding Celestial Labs Ltd. and Biocon Ltd. were accepted, while the Department's arguments for including diagnostic companies were rejected. The Department's reliance on DRP directions and TPO reports was noted but found insufficient to justify inclusion of functionally dissimilar companies.

Conclusions: The Tribunal excluded Celestial Labs Ltd. and Biocon Ltd. from the comparables and upheld the exclusion of diagnostic companies. It directed that the ALP be determined based on the four accepted comparables. However, since the issue of risk adjustment was neither considered nor decided by the TPO or DRP, the Tribunal remanded the matter to the TPO for fresh examination and decision on risk adjustment, allowing the assessee to present its case.

Issue 2: Notional Interest Addition on Delayed Payments from Associated Enterprises

Relevant legal framework: Transfer pricing provisions require that international transactions be priced at arm's length, including interest on delayed payments if such interest would have been charged between independent parties.

Court's interpretation and reasoning: The TPO computed notional interest at 1% per month on delayed payments beyond the stipulated credit period, treating this as an addition to income. The assessee contended that it is a zero-debt company with no borrowing cost, no agreement to charge interest, and billing done quarterly, which explains the payment pattern.

Key evidence and findings: The Tribunal noted the absence of any interest liability or borrowing cost to the assessee, no contractual obligation to charge interest, and the nature of billing cycles. It held that the delay in payment was not solely attributable to the AEs but also to the billing pattern.

Application of law to facts: The Tribunal applied the principle that hypothetical or notional adjustments cannot be made unless there is evidence of undercharging or loss of real income. Mere delay without contractual or actual interest cost does not justify addition.

Treatment of competing arguments: The Department's argument that independent parties would not grant such long credit was rejected due to lack of concrete evidence and the nature of the assessee's business and billing.

Conclusions: The Tribunal deleted the notional interest addition, holding it to be unjustified on facts.

Issue 3: Treatment of Network Access Charges as Capital Expenditure

Relevant legal framework: Section 37(1) of the Income Tax Act allows deduction of revenue expenses incurred wholly and exclusively for business purposes. Capital expenditure creates an enduring benefit or asset and is not deductible as revenue expense.

Court's interpretation and reasoning: The AO treated payments for network access and email infrastructure as capital expenditure, disallowing deduction. The assessee argued these were payments for use of facilities owned by the parent company, representing operating expenses for communication services, not capital assets.

Key evidence and findings: The Tribunal found that the payments were for accessing virtual private network services, email infrastructure, and secured internet facilities owned by the parent company. These services facilitated day-to-day business operations without creating any enduring asset for the assessee.

Application of law to facts: Applying the distinction between capital and revenue expenditure, the Tribunal held these payments to be revenue in nature and allowable under Section 37(1).

Treatment of competing arguments: The AO's reliance on the classification as software expenditure was rejected as mere nomenclature without substance. The Department's arguments were not supported by evidence of capital asset creation.

Conclusions: The Tribunal allowed the deduction of network access charges as revenue expenditure.

Issue 4: Depreciation on Network Access Charges

This issue became infructuous following the Tribunal's finding that the network access charges are revenue expenditure and not capital expenditure. Accordingly, the claim for depreciation was dismissed as not applicable.

3. SIGNIFICANT HOLDINGS

"The functional analysis shows that this company [Celestial Labs Ltd.] is mainly engaged in development of specific type software services and products. Thus, Celestial Labs Ltd. which is mainly a software development company and engaged in bio informatic services cannot be said to be functionally comparable with that of the assessee and, therefore, it cannot be included for comparability analysis in the set of comparables taken by the TPO."

"Going by the segmental data of Biocon Ltd. with regard to contract research segment, we do not find any merit in the inclusion of the said company by the TPO in the set of comparables for determining the ALP in the case of the assessee."

"The various diagnostic companies excluded by the TPO... not only the functional profile of these companies are different but the characteristic of the services rendered are also different... These services cannot be compared with the business activity carried on by the assessee."

"Only four set of companies which has been accepted by both the TPO as well as the assessee viz. Choksi Labs Ltd., Vimta Lab Ltd., G.V.K. Biosciences P. Ltd. and TCG Lifescience Ltd., should be included for the purposes of comparability analysis and the arithmetic mean of the PLI of these final set of companies by taking operating profit of the total cost should be taken for the purpose of determining the ALP."

"The matter needs to be restored back to the file of the TPO, who will examine the assessee's contentions on risk adjustment and decide the issue afresh in accordance with the law after providing due and effective opportunity of representing the case to the assessee."

"The addition on account of notional interest relating to alleged delayed payment in collection of receivables from the A.Es, is uncalled for on the facts of the present case and is, accordingly, deleted."

"Such an expenditure [network access charges] is purely revenue in nature and is allowable under section 37(1) of the Act."

The Tribunal's final determinations were that the upward transfer pricing adjustment be recalculated excluding Celestial Labs Ltd. and Biocon Ltd., and excluding diagnostic companies; the risk adjustment issue be remanded for fresh consideration; the notional interest addition be deleted; and the network access charges be allowed as revenue expenditure under Section 37(1), rendering the depreciation claim infructuous.