TMI Blog2007 (11) TMI 339X X X X Extracts X X X X X X X X Extracts X X X X ..... ade to find comparable transactions as close as possible to the controlled transaction. Besides the assessee has rightly relied upon the transaction in the case of Integrated Hitech Ltd. with operating profit ratio of 3.16%. This transaction has been accepted as comparable by the TPO and, therefore, there is nothing further for the taxpayer to establish that controlled transaction with AE was an arm's length transaction. We are not taking into account high profit or high loss making companies as comparables. All the above, independent comparables have shown profit margin of less than the assessee and, therefore, in the light of above evidence, there is no reason to hold that taxpayer's international transaction with AE is not at arm's length. It has no tangible assets worked in no risk environment are very strong points of the taxpayer, not refuted on record. While holding so, we have not adopted mean profit of several comparable found by respective parties because in spite of our repeated requests, the parties before us, were unable to show us any rule or decision under which average or mean margin (OP/TC) of different companies is to be taken. Tax administration ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ng and realizing that price should familiarize themselves with the relevant provisions and become well-versed with the law on the subject. Any remissness on their part can only be at the cost of the national exchequer and must necessarily result in loss of revenue. At the same time, we have to bear in mind that the policy of law is that there must be a point of finality in all legal proceedings, that stale issues should not be reactivated beyond a particular stage and that lapse of time must induce repose in and set at rest judicial and quasi-judicial controversies as it must in other spheres of human activity. That in the other ground, the taxpayer has raised objection on denial of deduction under section 10A of the IT Act. The question of allowability of claim to the appellant u/s 10A has already been considered and decided in the assessment year 2001 in the case of this very assessee. The Bench, after following the decision of the Tribunal in the case of Legato Systems India (P.) Ltd. v. ITO [ 2004 (11) TMI 294 - ITAT DELHI-E] , restored the matter to the file of the Assessing Officer to make further inquiry and allow deduction to the assessee. The aforesaid decision is d ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... r's report of the taxpayer showed that the taxpayer had carried the following transaction with its associated enterprises (AEs):- Sl. No International Transactions(IT) With IKOS SYSTEMS USA Book value of the International Transactions 1. Export of Software Development Services 88,866,320 2. Export of Marketing Support Services 3,436,194 4. The taxpayer in order to show that transactions with AEs were arm's length transactions selected Transactional Net Margin Method (TNMM) as the most appropriate method under section 92C of the Income-tax Act and further justified the price charged for services as arm's length price with following certificate in the auditor's report:- Based on the study, the arithmetic mean of three-year weighted average margins for financial years ended March 31, 2000, March 31, 2001 and March 31, 2002 to the extent available of broadly comparable independent companies calculated using Net Cost Plus Margin as the profit level indicator was compared by the assessee wi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 320 (total turnover of Rs. 9,23,02,514) in ratio of total cost at 6.99%. 7. In order to show that above net margin was fair and reasonable and represented arm's length price, the taxpayer claimed it has taken the following steps. It carried its own functional, asset and risk (FAR) analysis and of several other independent companies carrying on business of development of software. The taxpayer was taken as the tested party. In it's written submissions the taxpayer further claimed as under: Based on the functional analysis and understanding of the international transactions with associated enterprises and the available data of comparable companies, the Transactional Net Margin Method (TNMM) using net profit margin based on costs (NCP) as a profit level indicator (PLI), was selected to be the most appropriate transfer pricing method to evaluate these transactions. 12. On the question of search for comparable companies the taxpayer submitted as under:- The objective of the search for comparable companies was to identify from publicly available data, a group of independent companies that undertake software development just as the appellant company. The PRO ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Computech 3.69 5.16 4. M Y M Technologies 11.44 0.93 5. Luminaire Technologies 12.70 6.64 6. O C L Informatics 17.07 6.67 7. Telesys Software 39.81 4.34 8. C S Software Enterprise 22.98 8.54 9. V G L Softech 8.89 15.38 10. Integrated Hitech 14.67 12.37 11. Zigma Software 45.79 1.63 12. Visu Cybertech 5.21 24.74 13. V J I L Consulting 21.34 17.45 14. Sark Systems India 20.56 30.77 15. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 13. Luminaire Technologies 0.00% 14. Telesys Software 2.88% Average Net Cost plus Margin 3.07% 11.1 Two companies were considered and excluded as per the following note: Note: VGL Softech has not been included in the set as it is a start up company. Further, Top Media Entertainment has also been excluded as it does not have financials updated for March 2002. 12. The TPO in its order dated 18-3-2005 has referred to above details. He has however observed that the taxpayer did not carry any fresh search for comparables and has merely reworked the figures of same comparables as used in the audit report. Earlier, on 20th January, 2005, the TPO had asked the taxpayer to explain as to why companies having (a) substantially low turnover; (b) companies engaged primarily in manufacturing activities and (c) companies with low employees cost should not be eliminated from the comparables taken into account by the taxpayer. The TPO ultimately listed the following companies for elimination from comparison in Para 7.5 of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... able to be eliminated on account of difference in project profile. The TPO on above objections observed that he was not prepared to eliminate companies having foreign parent or subsidiary company unless value of related party transactions was furnished by taxpayer . The stand of taxpayer that the taxpayer was unable to furnish value of related party transactions as relevant information relating to year 2001-02 was not available in public domain. The TPO accepted the fact that data of relevant year was not available. However, the data of the subsequent years, according to the TPO could provide an indication of the quantum of related party transactions that might have taken place in the relevant year. Out of the companies considered for comparison, two companies namely Blue Star Infotech and NIIT Gis Limited had related party transactions in the year ended March 2004 though there was no evidence that these companies had related party transactions in the year under reference (Financial year 2001-02). It has been observed by the TPO in his order that he felt prudent to accord the benefit of doubt to the assessee that there could be a related party transaction in respect of these two ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... above the arm's length price of the international transactions entered into by the assessee with its AE is determined at Rs. l0,34,40,177 in place of Rs. 8,88,66,320. 7.10 Accordingly, an adjustment of Rs. 1,45,73,857 is to be made to the income of the assessee, being the difference between the arm's length price and the price charged by the assessee from its AE for rendering services to them. 7.11 As regards the marketing services, the assessee has relied on TNMM with Net Cost Plus (NCP) margin as PLI. On examination of the documentation and the functional analyses contained therein no adverse inference is drawn in respect of this international transaction. Sd/- (HIMANSHU SINHA) JOINT COMMISSIONER OF INCOME-TAX (TRANSFER PRICING OFFICER-I), NEW DELHI 18. The taxpayer impugned above adjustment/addition on account of transfer pricing (INR 1,45,73,857) in appeal before the ld. CIT(A) and vehemently challenged the report of the Transfer Pricing Officer (TPO). The taxpayer also claimed that it was entitled to claim deduction under section 10A of the Income-tax Act. The ld. CIT(A), after examining facts and circumstances of the case, upheld the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... year. He fairly conceded that the Special Bench in the case of Aztec International has also taken the same view and the said view has to be followed by this regular Bench. The ld. CIT(A) also rejected the claim of the Taxpayer that reference made by the Assessing Officer to the TPO under section 92CA(1) was bad in law and, therefore, order of TPO void for want of jurisdiction. This issue was also not agitated ill appeal before us as the same is covered against the taxpayer as per the Special Bench decision referred to above. 20. The ld. CIT(A) had also rejected the claim of the Taxpayer that arm's length price determined by TPO was required to be reduced by 5% in terms of proviso to section 92C(2) of the Act. It was contended that variation of + / - 5% has to be allowed in every case to the taxpayer while making adjustments in international transaction on account of arm's length price in the light of mandate of proviso to section 92C(2) of the Act. The taxpayer had also placed reliance on Instruction No. 3 dated 20-5-2003 of CBDT. Ld. CIT(A) did not find any force in these contentions. We are also not considering the finding of the ld. CIT(A) on this aspect in details, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... mparable companies was worked out to 24.53%. By applying this arithmetic mean margin of 24.53% to the total cost of provision of software development services amounting to Rs.8,30,64,464, the arm's length price in respect of international transactions of export of software development services to the AE was determined by the TPO at Rs. 1 0,34,40, 177. In fact, initially there would be five arm's length prices if OP/TC of each of above five comparable independent companies is separately applied to the total cost. Thereafter, the arithmetical mean of such five arm's length prices shall be taken as the arm's length price under the proviso to section 92C(2) of the Act. The arm's length price determined by the TPO at Rs.10,34,40,177 by taking the arithmetic mean of OP/TC of all five comparable companies actually represents the arithmetical mean of the arm's length prices under the proviso to section 92C(2) of the Act. 60. As against the arithmetic mean arm's length price of Rs.10,34,40, 177 determined by the TPO, the appellant had charged the transfer price from its AE only at Rs. 8,88,66,320. The price so charged by the appellant was 14.09% less than th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... length price is determined by taking the results of a comparable transaction in comparable circumstances and making suitable adjustments for the differences. The fundamental requirement, in any of the methods selected, is the selection of comparables, for benchmarking international transactions. This selection of a comparable should be based on functional, asset, and risk analysis of both the parties and transactions. Whatever methodology is chosen for the purpose of determination of the arm's length price under section 92C, these criteria, as specified in the Act and the Rules have to form a basis of judging the comparability. Thus, there should be a proper analysis of such transactions with respect to the functions performed, the assets employed and the risk assumed by the respective parties with reference to the transaction in question. This can be termed as functional, asset, risk analysis, i.e., FAR analysis. All the three ingredients of FAR have a direct bearing on the pricing of products/services. The provision also provides scope for carrying out adjustments in case where there are some differences or variations to make two transactions commercially comparab ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... g, namely:- (a) the specific characteristics of the property transferred or services provided in either transaction; (b) the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions; (c) the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions; (d) conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail. Further caution required to be adopted while looking to the differences between controlled and uncontrolled transaction is provided in sub-rule (3) of rule 10B which is as under:- (3) An uncontrolled transaction shall be comparable to an international transaction if (i) none of the differenc ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sfer of goods, services or intangible. Without proper study of specific characteristics of controlled transaction, no meaningful comparison or location of comparable is possible. For example, a mere consideration that controlled transaction relates to software supply is not sufficient as there are hundreds of softwares with different characteristics which materially affect their open market value. The characteristics that are required to be considered include in case of transfer of tangible property, the physical feature of the property, its quality, reliability and availability (supply). In case of provisions of services, the nature and extent of services and where tangible property is involved for comparison, the form of transaction. To put it in other words, all the characteristics of the controlled transaction which are likely to affect its open market value must be taken into account. The study should include analysis of functions, risk and assets of the controlled transaction for correct location of similar or nearly similar characteristics in uncontrolled transactions. Specific characteristics are necessary to carry search of similar comparable with similar characteristics ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... contract risk, credit and collection risk and risk of infringement of intellectual property are being ignored here. In most of the comparable analysis carried in India, the latter type of risk are not being taken into consideration although these can lead to major difference in Market Value of transactions. 27.2 The European tax authorities are reluctant to accept adjustments because adjustments necessarily involve consideration of question whether they are appropriate or not and therefore it is always better to find comparable requiring the least or no adjustment. The position in India as per Indian regulations on the subject has been noted earlier. If there are differences which can be adjusted, then adjustments are required to be made. If the difference between the companies are so material that adjustment is not possible, then comparables are required to be rejected. 27.3 Further in the analysis numerous ratio are applied, depending on the specific of the comparables. The search may include the following:- Inventory/sales; operating assets to total assets, fixed assets to total sales, fixed assets to number of employees, operating expenses to sale, cost of sales. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... parent AE had provided necessary intangible such as software and other proprietary tools and process to carry out the software development. All intangibles including discoveries, improvement, inventions and trade secrets conceived or reduced to practice were the sole and exclusive property of the parent AE. The taxpayer only maintained and deployed necessary human resources and infrastructure for development of software. The above stated specific characteristics were required to be considered under the Indian Regulation rule 10B noted above and even under OECD guidelines. However, above characteristics of controlled transactions were evidently not kept in mind by the TPO to find comparable and, therefore, order of TPO/basis of adjustments is not sustainable on above grounds. The TPO committed several minor and major errors while computing the so-called Arms' Length Price. 35. In the first place, while screening and filtering for comparables, he took into account companies which were dealing with their related companies either as subsidiaries or as parent companies. Thus, controlled transactions were taken into account which is against the very basics of the transfer pricing ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... in the financial year 2001-02 i.e., two years earlier, there were no inter-party transactions. Such inferences and presumptions are not authorized and cannot be accepted. Assessment under the Act is a judicial act and must be based on cogent material, not on unsound presumption.There is no nexus between the material available on record and the conclusion drawn. Further one wonders and finds no answer to the pertinent question; if data for financial year 2001-02 was not available in the year 2005, as is the admitted position, then how and where from transactions with features as mentioned in para 7.6 of order were found? On facts, we hold that TPO carried search which had serious defects materially affecting the determination of Arms' Length Price and his order cannot be accepted as legally correct. 35.2 Further there is contradiction in the approach of TPO; whereas he rightly insisted in the light of rule 10B(4) that only data for the financial year was relevant but for his own use, he has taken into account data for financial year 2003-04 i.e., relating to two years later. 35.3 One more problem with the order of TPO is that he did not take into account specific character ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d is that net margins (e.g. return on assets, operating income to sales, and possibly other measures of net profit) are less affected by transactional differences than is the case with price, as used in the CUP Method. The net margins also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, enterprises may have a wide range of gross profit margins but will earn broadly similar levels of net profits. 36.3 Extracts from other paras 3.29, 3.34, 3.35, 3.37 and 3.39 of the same guidelines would clearly show that the inference drawn is one-sided. These paras are as under:- 3.29 There are also a number of weaknesses to the transactional net margin method. Perhaps the greatest weakness is that the net margin of a taxpayer can be influenced by some factors that either do not have an effect, or have a less substantial or direct effect, on price or gross margins. These aspects make accurate and reliable determinations of arm's length net margins difficult. Thus, it is impo ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... me that the top quality VCR market is growing in its sales, has a high entry barrier, has a small number of competitors, and is with wide possibilities for product differentiation. All of the differences are likely to have material effect on the profitability of the examined activities and compared activities, and in such a case would require adjustment. As with other methods, the reliability of the necessary adjustments will affect the reliability of the analysis. It should be noted that even if two enterprises are in exactly the same industry, the profitability may differ depending on their market shares, competitive positions, etc. 3.39 The transactional net margin method may afford a practical solution to otherwise insoluble transfer pricing problems if it is used sensibly and with appropriate adjustments to account for differences of the type referred to above. The transactional net margin method should not be used unless the net margins are determined from uncontrolled transactions of the same taxpayer in comparable circumstances or, where the comparable uncontrolled transactions are those of an independent; enterprise, the differences between the associated enterprises ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... application of one or more methods produces a range of figures, a substantial deviation among points in that range may indicate that the data used in establishing some of the points may not be as reliable as the data used to establish the other points in the range or that the deviation may result from features of the comparable data that require adjustments. In such cases, further analysis of those points may be necessary to evaluate their suitability for inclusion in any arm's length range. 38. The TPO neither followed mandatory provision of rule 10B quoted above nor guidelines of OECD and his computation of ALP is patently erroneous. 38.1 In the case of EIDU Pont de Nemours Co. v. us (1979) 608 F2d 608, the US Court upheld the adjustment made on account of arm's length determination although gross profit in the controlled transaction was comparable to the gross profit of uncontrolled transactions but the taxpayer was found to have claimed excessive expenses to reduce comparative net profit margin and, therefore, the adjustments were made and upheld. The case is an illustration how close minute examination of controlled and uncontrolled entities is essential unde ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e was no justification for discrediting the comparable selected by the taxpayer. 39.2 The other objection of the TPO that the taxpayer did not exclude companies having high ratio of trading activities and manufacturing activities was also without any basis or justification. The taxpayer while screening for comparable eliminated companies having manufacturing sales greater than 25% of total sales and trading sales greater than 25% to total sales. The TPO, on the other hand, applied a 10% threshold in this regard. The taxpayer has taken pains to show through Table 7 in the paper book that most of the companies satisfied the criteria of less than 10% sale with the exception of three companies i.e. Kushagra Software Ltd., Luminaire Technologies Ltd. and M Y M Technologies Ltd. It is therefore clear that the TPO failed to apply criteria and standards set by him and arbitrarily rejected the case of the taxpayer. 39.3 The TPO had also wrongly objected that taxpayer did not exclude companies having low employee cost. It has been stated by the taxpayer that insisting on low employee cost is not a very credible rational selection criterion and TPO, during the course of assessment proce ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ic Mean 3.61% 40.1 It is further seen that apart from specifically accepting comparable case of Integrated Hitech Ltd., the TPO did not make any adverse comment on 8 companies taken as comparable by the taxpayer. None of the objections raised by the TPO are shown to be applicable to those companies. It is therefore not clear why those companies were not taken as comparable companies. At page 22 of the paper book, the taxpayer has pointed out that arithmetic mean of OP/TC of those companies works out to 4.47% as per the following detail:- S. No. Company OP/TC 1. MYM Technologies 4.81% 3 VJIL Consulting 5.24% 5 Zigma Software 16.38% 6 Sark Systems 30.00% 8 Shine Computech 0.47% 10 Visu Cybertech -2.76% 11 CS Software -25.12% ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... aracteristics of its company in question for the relevant assessment year and thereafter made selection of company after applying functional test with reference to assets employed and risk taken by those companies. 46. Though identical transaction could not be located even by the assessee, an attempt was made to find comparable transactions as close as possible to the controlled transaction. Besides the assessee has rightly relied upon the transaction in the case of Integrated Hitech Ltd. with operating profit ratio of 3.16%. This transaction has been accepted as comparable by the TPO and, therefore, there is nothing further for the taxpayer to establish that controlled transaction with AE was an arm's length transaction. Besides the above, the TPO also did not make any adverse comment on the following independent transactions given in the list of comparable by the taxpayer:- Company Name OP/TC 1. MYM Technologies 4.81% 2. VJIL Consulting 5.24% 3. Shine Computech 0.47% 4. VGL Softech 6.7 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... wrong or on account of their FAR analysis, these entities could not be taken as reliable comparables for computation of the Arm's Length Price. But no material was brought on record, no arguments advanced to reject the above transaction. Therefore, having regard to facts of the case and material on record, we accept them as comparable and accept the price disclosed by the taxpayer as Arm's Length Price. Consequently, the addition of Rs.1,45,73,857 is directed to be deleted. The view taken by us finds support from para 1.4 of OECD guideline which we quote below:- 1.48 If the relevant conditions of the controlled transactions (e.g. price or margin) are within the arm's length range, no adjustment should be made. If the relevant conditions of the controlled transaction (e.g. price or margin) fall outside the arm's length range asserted by the tax administration, the taxpayer should have the opportunity to present arguments that the conditions of the transaction satisfy the arm's length principle, and that the arm's length range includes their results. If the taxpayer is unable to establish this fact, the tax administration must determine how to adjust t ..... X X X X Extracts X X X X X X X X Extracts X X X X
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