2021 (12) TMI 1528 - AT - Income Tax

TP Adjustment - Comparable selection - HELD THAT - Akshay Software Technologies Ltd. - There is no difference in the business model adopted by this company that of assessee merely because certain expenditure were incurred in respect of foreign branch which are not categorized onsite Development of Software. When the TPO did not apply onsite filter while selecting the comparable then applying the said filter for this company is not justified. Accordingly following the decision of the Bangalore Benches of the Tribunal in the case of M/s ARM Embedded Technologies Pvt. Ltd. 2020 (11) TMI 1079 - ITAT BANGALORE we direct the TPO to include this company in the set of comaprables for determination of ALP. Sasken Communication Technology Ltd - Question of functional comparability cannot be looked into once this company fails the threshold limit of export turnover of 75%. The percentage of shortfall less or more is totally irrelevant when it is not satisfying with the threshold limit of 75%. Accordingly we do not find any error or illegality in the impugned order of the Assessing Officer as well as directions of the DRP. Tata ELXSI Ltd. company is not functionally comparable to the assessee and accordingly the TPO is directed to exclude this company from the set comparables for determining the arm s length price. E-Infochips Ltd. be excluded company for the set of comparable while determining the ALP of international transaction of the assessee. Larsen Toubro Infotech Ltd. be excluded on the ground that there were extraordinary events during the year it possesses brand and intangibles it has not provided segmental information and it has got sub- contracting expenses. Infosys Ltd.is not comparable having its giant size and brand value. Persistent Systems Ltd. is functionally dissimilar to the assessee company it also has intangibles unlike the assessee company and further segmental data are not available. Hence M/s. Persistent Systems Ltd cannot be treated as a comparable company. Infobeans Technologies Ltd. company has MODEVAT and Sales Tax deposits. Therefore this company is engaged in the sale of goods alongwith rendering of services. Accordingly following the earlier order of this Tribunal we direct the TPO to exclude this company from the set of comparables while computing the arm s length price. Thirdware Solution Limited cannot be considered as a comparable company as primarily engaged in custom-built mobile applications and software support and maintenance related services to M/s. Kony Group of Companies. Maveric Systems Limited company is having R D Expenditure equivalent to 6% of the turnover cannot be taken as comparable. Athena Global Technologies Private Limited company is having a negative network in last three years. Further this company is also showing the inventory which mean the company is engaged in software products. Even though there may not be change in the inventory for the year but this fact cannot be denied that the company is having products and therefore having regard to the persistent loss making company and a different business profile this company cannot be considered has functionally comparable to the assessee. Hence we do not find any error or illegality in the directions of the DRP qua this company. Evoke Technologies Private Limited - We remit this issue to the record of the TPO for re-verification of export turnover of this company to the total turnover and by taking only the Revenue of Indian branch of this company and excluding the foreign branches because the accounts of which are not audited. Kals Information Systems Limited - In the absence of relevant details regarding the actual nature of the business activity whether it is pure Software Development Services or Products this cannot be taken as a comparable for determination of arm s length price of the international transactions of Software Development Services. The assessee has also not disputed this fact that the annual report of this company does not throw any light on the segmental details therefore a company not having a definite financial details cannot be taken as a comparable merely on the basis of assumption and presumption. Hence we do not find any reason to interfere with the directions of the DRP qua this company.

Summary

The core legal questions considered in this appeal pertain to the determination of the arm's length price (ALP) of international transactions under the transfer pricing regulations. Specifically, the issues involve:

1. Whether the Transfer Pricing Officer (TPO) erred in rejecting certain companies proposed by the assessee as comparable entities for benchmarking the ALP.

2. Whether the TPO erred in including certain companies as comparables despite their having different functional and risk profiles compared to the assessee.

3. Whether the TPO erred in excluding certain companies that appeared in the TPO's own search filter and should have been included as comparables.

4. Whether the TPO erred in not applying an upper limit to the turnover filter while selecting comparables.

5. Whether the TPO erred by comparing the assessee with comparable companies having unreasonably high average margins, exceeding the reasonable margin prescribed under safe harbor rules for the software development industry.

Issue-wise Detailed Analysis

1. Rejection of Assessee's Proposed Comparables (Akshay Software Technologies Ltd. and Sasken Communication Technologies Ltd.)

Legal Framework and Precedents: Transfer pricing regulations require comparables to be functionally similar and to satisfy filters such as export revenue thresholds. The Tribunal's prior decisions, including those in ARM Embedded Technologies Pvt. Ltd. vs. Income Tax Officer, provide guidance on functional comparability and filter application.

Court's Interpretation and Reasoning: Akshay Software Technologies Ltd. was rejected by the TPO and DRP on the ground that 85% of its expenditure pertained to a foreign branch and employee benefit expenses, allegedly indicating a different business model. However, the Tribunal noted that no onsite development filter was applied by the TPO, and foreign branch expenses are not equivalent to onsite development. The company's business of providing software development and support services aligns with the assessee's profile. The Tribunal, relying on precedent, held that the functional comparability exists and directed inclusion of this company as a comparable.

Regarding Sasken Communication Technologies Ltd., the company failed the export revenue filter of 75%, having only 74.35% export income. The assessee argued that the shortfall was marginal and the company was otherwise functionally comparable. The Tribunal emphasized that once a filter is applied, it must be uniformly enforced to avoid cherry-picking. Since Sasken failed the export revenue threshold, it could not be considered further, notwithstanding functional similarity. The Tribunal upheld the exclusion in line with the uniform application of filters.

2. Inclusion of Companies with Different Functional and Risk Profiles

The assessee challenged the inclusion of seven companies: Tata Elxsi Ltd., E-infochips Ltd., Larsen & Toubro Infotech Ltd., Infosys Ltd., Persistent Systems Ltd., Infobeans Technologies Ltd., and Thirdware Solutions Ltd., alleging functional dissimilarity and different risk profiles.

Tata Elxsi Ltd. The assessee contended that Tata Elxsi's activities (consulting, product design, engineering services, KPO services) differ from pure software development services. The Tribunal examined segmental revenue data and noted that major revenue was from product design rather than software development or maintenance. The company also engaged in animation and gaming services, which are distinct from software development. Prior Tribunal decisions excluded Tata Elxsi as comparable due to functional dissimilarity. The Tribunal directed exclusion of Tata Elxsi from comparables.

E-infochips Ltd. The assessee argued that E-infochips is involved in product engineering and software R&D, holding multiple intellectual properties and earning supernormal profits (81%). The Tribunal noted that revenue from product sales was only 2.5% and R&D/intangible asset claims lacked supporting evidence. However, consistent with prior decisions, the Tribunal excluded E-infochips due to abnormal profits and functional dissimilarity.

Larsen & Toubro Infotech Ltd. The assessee cited significant intangible assets and brand value impacting profits, arguing non-comparability. The Tribunal observed that the company had multiple business segments including telecom engineering distinct from software development. The company had undergone restructuring and extraordinary events affecting profitability. Prior Tribunal rulings excluded this company for similar reasons. The Tribunal directed exclusion of Larsen & Toubro Infotech Ltd.

Infosys Ltd. The assessee highlighted Infosys's proprietary products, brand value, large scale, R&D expenses, and extraordinary events (acquisitions, mergers) impacting profits. The Tribunal reviewed detailed financial data showing significant intangible assets, R&D expenditure, and marketing costs. Prior decisions and the Delhi High Court have held Infosys not comparable due to size and brand value. The Tribunal excluded Infosys Ltd. from comparables.

Persistent Systems Ltd. The assessee pointed to diversified operations including telecom, healthcare, and infrastructure, and lack of segmental data. The Tribunal noted Persistent's involvement in product development, IP-led business, and R&D activities, concluding functional dissimilarity. Prior decisions excluded Persistent Systems for similar reasons. The Tribunal directed exclusion.

Infobeans Technologies Ltd. The assessee submitted that Infobeans engages in high-end services including Custom Application Development and Knowledge Process Outsourcing (KPO), and has revenue from sale of software products. The Tribunal found the company had MODVAT and sales tax deposits indicating product sales, and no segmental data was available. Prior decisions excluded Infobeans for similar reasons. The Tribunal upheld exclusion.

Thirdware Solutions Ltd. The assessee argued that the company earns revenue from software products, subscription contracts, and user licenses, with no revenue from services, and has intangibles. The Tribunal found that Thirdware's revenue streams and intangible assets differ from the assessee's pure software development services. Prior Tribunal rulings excluded Thirdware for functional dissimilarity and lack of segmental data. The Tribunal directed exclusion.

3. Exclusion of Certain Companies by the TPO

The assessee sought inclusion of Maveric Systems Ltd., Athena Global Technologies Ltd., Evoke Technologies Pvt. Ltd., and Kals Information Systems Ltd.

Maveric Systems Ltd. The TPO and DRP excluded this company due to R&D expenditure exceeding 3% of turnover (6%). The assessee contended no R&D expenditure was incurred. The Tribunal referred to prior decisions where the TPO did not apply an R&D filter, and exclusion was improper. However, in the present case, the assessee did not dispute the R&D expenditure, and the Tribunal upheld exclusion for breaching the R&D filter.

Athena Global Technologies Ltd. Excluded due to negative net worth over three years and presence of inventory indicating product business. The assessee argued current positive operating profit and stable inventory. The Tribunal emphasized persistent losses and inventory presence as indicators of functional dissimilarity and upheld exclusion.

Evoke Technologies Pvt. Ltd. Excluded due to unaudited branch financials and failure of export revenue filter (20.34%). The assessee argued export revenue was 99.93% and unaudited branch contribution was minor. The Tribunal remitted the matter to TPO to verify export revenue and consider only audited Indian branch revenue, directing reassessment with opportunity to the assessee.

Kals Information Systems Ltd. Excluded due to lack of segmental data and mixed product and service business. The assessee argued absence of inventory indicates service-only business. The Tribunal found absence of segmental data and unclear business profile precluded comparability and upheld exclusion.

4. Application of Turnover Filter

The assessee contended the TPO erred by not applying an upper limit to the turnover filter, contrary to prior Tribunal and DRP judgments. The Tribunal found this issue general and did not require specific adjudication in this order, leaving it to the TPO to consider during fresh determination.

5. Use of Comparables with Unreasonably High Margins

The assessee argued that the TPO included comparables with an average operating margin of 34.69%, far exceeding the 20% margin prescribed under safe harbor rules for the software development industry, resulting in an unreasonable upward adjustment. The Tribunal treated this as a general issue and did not specifically adjudicate it, leaving it for fresh consideration by the TPO.

Significant Holdings

"The Tribunal noted there is a functional comparability in respect of the assessee's profile and accordingly, we direct the TPO to include Akshay Software Technologies Ltd. in the set of comparables for determination of ALP."

"Once a filter is applied for selection of comparables, it must be uniformly applied. Sasken Communication Technologies Ltd. failed the export revenue filter of 75% and therefore cannot be considered as a comparable."

"Tata Elxsi Ltd., due to its predominant product design and animation services, and lack of segmental clarity, is not functionally comparable and is to be excluded."

"E-infochips Ltd. is excluded due to abnormal profits and functional dissimilarity."

"Larsen & Toubro Infotech Ltd. is excluded due to significant intangible assets, brand value, segmental distortions, and extraordinary events affecting comparability."

"Infosys Ltd., owing to its large size, brand value, proprietary products, and significant R&D expenditure, is not comparable."

"Persistent Systems Ltd. is excluded due to diversified operations, presence of IP-led business, and lack of segmental data."

"Infobeans Technologies Ltd. is excluded due to involvement in product sales and lack of segmental data."

"Thirdware Solutions Ltd. is excluded due to predominant product sales, intangible assets, and absence of segmental details."

"Maveric Systems Ltd. is excluded for breaching the R&D expenditure filter."

"Athena Global Technologies Ltd. is excluded due to persistent losses and inventory indicating product business."

"Evoke Technologies Pvt. Ltd. is remitted for reconsideration of export revenue and audited branch financials."

"Kals Information Systems Ltd. is excluded due to lack of segmental data and unclear business profile."

"General issues regarding turnover filter and high margin comparables are left for fresh consideration by the TPO."

The appeal was partly allowed with directions to the TPO to include certain comparables and exclude others as per the Tribunal's findings, and to revisit certain issues on remand.