2014 (10) TMI 358 - ITAT DELHI

Transfer pricing adjustment - Advertisement and Marketing Promotion expenses – whether assessee is required to establish direct nexus between the AMP expenditure incurred by the assessee and credit notes received from AE Held that:- There was no bar on the power of the TPO in processing all international transactions under the TP provisions when the overall net profit earned by the assessee is better than others - Earning an overall higher profit rate in comparison with other comparable cases cannot be considered as a licence to the assessee to record other expenses in international transactions without considering the benefit, service or facility out of such expenses at arm‘s length - the assessee‘s overall profit at ₹ 120/- is more than the arm‘s length profit earned by comparable cases at ₹ 100/-, still there will be a requirement for making adjustment of ₹ 20/- on account of advertisement expenses incurred by the assessee towards the brand building on behalf of the foreign AE - there can be no benchmarking of the profits realized from Indian customers so as to form a platform for contending that the TNMM has been applied on the overall profits and hence the AMP expenses should not be subjected to the TP provisions.

A distributor is rewarded by the entity for whom the distributor works and the rewards are guaranteed upto an extent and the risk component vis-a-vis a manufacturer is necessarily very less - The rewards can be and generally are based on pricing adjustments and can also be compensated over and above that if greater services are rendered and pricing adjustments have not covered the cost of routine services rendered - assessee is primarily engaged in the distribution of telecom equipment, mobile phones and provision of telecommunication service in India - The company also provides software development services to the group companies.

The assessee did not treat the excess AMP expenditure as international transaction and, therefore, it did not form part of TP study submitted by assesse - before TPO the assessee had taken a specific plea to this effect but did not produce any documentary evidence in support of its contention – Following the decision in LG. Electronics India P. Ltd. Versus Assistant Commissioner of Income-tax [2013 (6) TMI 217 - ITAT DELHI] - it has to be established by assessee that foreign AE was compensating the Indian entity for the promotion of its brand in any form, such as subsidy on the goods sold by the Indian AE - while determining the cost/value of transaction, is that how foreign AE has compensated the Indian entity for the promotion of its brand then it cannot be held that overall percentage of operating profit may be taken into consideration for holding that credit notes issued by the foreign AE in pursuance to transfer pricing policy were towards the compensation for promotion of its brand - It has to be specifically demonstrated by assesse - Consideration of individual elements of costs (like AMP expenditure) is not inconsistent with TNMM method being accepted at entity level - there is no royalty payment by assessee to its AE - this is a relevant factor which has to be taken into consideration for determination of excess AMP expenditure – thus, the matter is to be remitted back to the TPO for fresh adjudication.

Indirect or incidental benefit to AE - Addition of mark up on the excess AMP expenses – Held that:- Following the decision in LG. Electronics India P. Ltd. Versus Assistant Commissioner of Income-tax [2013 (6) TMI 217 - ITAT DELHI] - under second and third steps what is required to be determined is the rate of normal gross profit mark-up as arising to the enterprise from an uncontrolled transaction or to an unrelated enterprise in a similar situation - it is significant to note that a comparable uncontrolled transaction to be considered for benchmarking the normal gross profit mark-up has to be similar to the international transaction under consideration - the profit mark-up should be the rate which an independent third party earns for creating marketing intangible for and on behalf of the foreign enterprise - the DRP suggested 13% mark-up – Decided against assesse.

Non-consideration of Group’s Global Transfer Pricing Policy – Scope of AMP Expenses - Held that:- The AMP expenses refer only to advertisement, marketing and publicity expenses - A divider needs to be placed between the expenses for the promotion of sales on one hand and expenses in connection with the sales on the other - Both these expenses are required to be kept in different compartments - While expenses for the promotion of sales directly lead to brand building, the expenses directly in connection with sales are only sales specific - As the TPO has neither properly considered the request of the assessee for inclusion of some other comparable cases nor examined the effect of the above discussed relevant factors on the question of determination of the cost/value of international transaction – thus, the matter is to be remitted back to the TPO for fresh adjudication – Decided in favour of assesse.

Adjustment made while re-computation of ALP – Contracts Software Development Service segment – Rejection of use of multiple year data - Held that:- Held that:- There was not much substance in the argument of the assessee because as per Rule 10B(4),the data to be utilized and for analyzing the comparability of uncontrolled transaction with an international transaction is to be the data relating to the financial year in which the international transaction has been entered into - As per proviso to Rule 10D, earlier year data can be used, in addition to the data pertaining to the relevant financial year, only for taking a decision as to how much the factors obtaining in earlier years impact the profit of the current year, for both the tax payer and the comparable - it has to be demonstrated as to how the earlier year conditions have influenced the profit of the relevant financial year – Decided against assesse.

Entitlement for tax holiday u/s 10A/10B – Profit from CSD services - Held that:- The computation of arm’s length price is to be done as per the provisions contained under Chapter X of the I.T. Act dealing with special provisions relating to avoidance of tax - Merely because assessee was entitled to tax holiday u/s 10A/10B of the Act, it cannot be inferred that international transaction has been entered into as per arm’s length price - There is nothing u/s 10A/10B which entitles an assessee to get deduction in respect of addition made under Chapter X – Following the decision in Ld. Counsel for the assessee fairly concedes that this issue stands decided against assessee by Tribunal in few cases including Aztec Software v ACIT [2007 (7) TMI 50 - ITAT BANGALORE] – Decided against assessee.

Exclusion of comparables – Held that:- The TPO had excluded the companies with diminishing revenue because in an environment where software sector is growing at a CAGR (Compounded Annual Growth Rate) of more than 30% during the last 30 years, diminishing revenue for the last 3 years cannot be said to be a true indicator of the performance of the company - TPO had undertaken an independent analysis which was based on various sources including NASSCOM Reports, articles appearing in print media and on the internet etc. - during the last decade the information technology industry in India emerged as an important constituent of the global software industry - instance of loss usually arises due to market forces/computation, emergence of new technologies or processes, increased costs, variation in demand and subject, and these are all normal economic factor which impact all industry player – the order of the TPO is to be upheld that given the trend of IT Industry growth persistent loss making companies cannot be taken as comparable because that in itself reflects existence of abnormal circumstances which needs to be identified – the comparable can be taken into consideration only if reasonably accurate adjustment can be made to eliminate the material effects of such differences but if that is not possible then in conformity with the requirements of Rule10B(3) of the Income tax Rules, 1962, the comparable is to be excluded – Decided against assessee.

Exclusion of companies – Related party transaction of more than 25% - Held that:- TPO was rightly of the view that this filter is appropriate to eliminate the companies which have controlled transactions and thereby have a significant influence on the margins earned - in principle the tax payer has no objection for applying this filter – assesse also rightly contended that if sufficient number of 100% uncontrolled comparables are found, then no comparable having related party transactions should be considered - no sacrosanct threshold limit should be fixed for this filter - if by applying the threshold limit of 15% of related party transaction, sufficient comparables are available then there is no reason to further extend the limit to 25% - the TPO is directed to take into consideration only those comparables where related party transactions are to the extent of 15% because it is not the case of revenue that by applying the threshold limit of 15%, it will not get sufficient number of comparables – Decided in favour of assesse.

Employee cost greater than 25% of total revenues – Held that:- TPO has been vested with specific powers u/s 92CA(7) to obtain information u/s 133(6) if he so considers for the purposes of determining the arm’s length price - The whole exercise of transfer pricing analysis centrifuge towards determining the arm’s length price of the international transaction and for that purpose TPO has been vested with wide powers so as to arrive at arm’s length price - The powers contained u/s 92CA(7) cannot be curtailed or abridged by putting unrealistic impediments - in order to consider the functional similarity of two comparables, it is necessary that such quantitative filters are applied to reach a reasonable conclusion regarding functional similarity - while fixing the range for applying this filter, regard should first be to the employee cost to sales ratio of tested party viz. assesse - since the employee cost to sales ratio is 64%, the contention of the assesse is accepted that the filter has to be applied by applying the range of employee cost to sales of 50% to 80% - Decided partly in favour of assesse.

Application of on-site revenue filter – Held that:- The profit margin in case of on-site work is normally low as compared to offshore work - there is considerable difference between the average rate per hour in the case of offshore projects vis-a-vis on-site projects - The reasons given by TPO are well founded - As the on-site project is altogether a different segment of the business and the factors which influence the profitability of that segment have to be considered before considering the same for comparability study - In on-site projects the assessee utilizes the assets of the client whereas in offshore project the assessee utilizes its own asseets - This itself brings considerable difference in the comparability of the two segments by affecting the profitability - The salary structure in case of on-site project is governed by the economic conditions prevailing in the resident country where work is actually performed, whereas in offshore projects, Indian conditions govern the salary structure which is much lower as compared to the country where associated enterprise is located - TPO was quite fair when it applied the on-site revenue’s filter considering the companies generating more than 75% of their export revenues from on-site operations - This resulted into accepting those comparables where companies were generating less than 75% of their export revenues from on-site operations – Decided against assesse.

R&D expenses incurred more than 3% of revenue – Held that:- TPO was rightly of the view that for creating intellectual property rights, R&D is required but the converse is not true i.e. each company spending on R&D automatically is not towards creating an IPR - R&D activity in a software development company is to improve the processes in delivering the software development services and not for creating an intanglible - the contention of the assessee that profitability of companies having intangibles is more cannot be lost sight off is also tenable - both sides have their logical view point. Under such circumstances, the balance has to be drawn keeping in view the primary object of transfer pricing study - if a comparable has developed its own intellectual property right resulting into development of a patented product by incurring huge expenditure on R&D then even if it is performing software development functions, it has to be excluded - if a company is incurring huge expenditure on R&D only for improving the processes in delivering the software development services then the said comparable cannot be rejected merely because it is incurring R&D expenditure more than 3% of its total sales revenue because sufficient number of comparables are to be found for determining ALP. An objective decision has to be taken in each case - TPO has clearly demonstrated that by applying this filter even functionally similar companies gets excluded - The contention of assessee that companies incurring expenditure greater than 3% on R&D were necessarily creating IP products is devoid of any merit – Decided partly in favour of assessee.

Denial of economic adjustment for difference in risk profile – Held that:- TPO has observed that the services rendered by the assessee forms a component within the products developed by the assessee - the associated enterprise incurs marketing for its products and not on the services rendered by the assessee as they are considered in the product sold by the associated enterprise – TPO himself is agreeable that market conditions do influence the independent enterprises - Ld. TPO has denied this adjustment mainly on the ground that associated enterprise and other independent comparables are operating on a similar model i.e. one by establishing its subsidiary in low employee cost zone viz. India and the others by outsourcing their activities to other entities operating in India - this reasoning cannot be fully accepted particularly because it is not that all the independent comparables are doing only the work outsourced to them by various AEs - This is only a conjecture on the part of TPO - market risk, if quantifiable, has to be adjusted in view of Rule 10B(1)(e)(iii) – thus, the matter is to be remitted back to the TPO for computation of risk adjustment as per CAPM model by availing the services of technical experts – Decided in favour of assesse.

Provision for liquidity damages disallowed – Whether the claim for liquidated damages is a liability of future and not present liability - Held that:- The contract entered into by the assessee with its customer contained a specific clause on liquidated damages which define terms and conditions of liquidated damages including the method of calculation as noted earlier - assessee has created the provision only in those cases where the delay had actually occurred and on the basis of terms and conditions of contract - The terms of contract contemplated that the moment delay occurs in the execution of contract then assessee will become liable for payment of liquidated damages - The liability, thus, crystallized with the occurrence of event of delay in the execution of contract - The assessee might, after entering into negotiation with the party, get a waiver or partial deduction in its liability but that does not absolve the assessee from being liable for liquidated damages on occurrence of the event of delay in execution of the contract – relying upon FFE. Minerals India (P) Limited. Versus Joint Commissioner Of Income-tax [2004 (7) TMI 331 - ITAT MADRAS-C] - the assessee’s claim of liquidated damages is to be allowed – Decided in favour of assesse.