TMI Blog2011 (8) TMI 952X X X X Extracts X X X X X X X X Extracts X X X X ..... companies which are loss making are excluded from comparables, then the super profit making companies should also be excluded. - companies having a turnover of ₹ 1.00 core to 200 crores have to be taken as a particular range and the assessee being in that range having turnover of 8.15 crores, the companies which also have turnover of 1.00 to 200.00 crores only should be taken into consideration for the purpose of making TP study. What is the data to be considered by the TPO at the time of determining ALP? - Whether the assessee should be given an opportunity to rebut the material sought to be used by the TPO? - held that:- it is clear that the Act has not provided for any cut off date upto which only the information available in public domain has to be taken into consideration by the TPO, while making the TP adjustments and arriving at arm's length price. The assessee as well as the revenue are both bound by the Act and the Rules there under and therefore, as provided under the Act and Rules they are supposed to be taking into consideration, the contemporaneous data relevant to the previous year in which the transaction has taken place. When he is making the search for ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the assessee to furnish the documents required to be maintained u/s 92D and the same was furnished by the assessee. The TPO also issued notice relating to determination of arm's length price (ALP) for Software Development Services and also with regard to the Information Technology Enabled Services(ITES in short). These notices contained remarks on assessee's study, new search methodology adopted for selecting the comparables, new comparables selected by the TPO and copies of replies received u/s 133(6) from these other companies. The assessee filed a detailed reply for both the notices and also raised various objections to the comparables selected by the TPO. The TPO however, was not convinced by these objections and made adjustments u/s 92CA of the Income-tax Act, by making the following observations; a. The assessee extends software development services and also extends its information technology enabled services to M/s Genesis MNC, which in turn helps its US customers through all the stages of the product lifecycle i.e from visualization to post launch support. M/s Genesis has extensive experience in developing and supporting the Microsoft technology including SQL Server an ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... validation services, enterprise application services, testing services, embedded software services, web development, inter-net based applications, e-commerce applications, consulting services etc. The tax payer has searched for comparables which are engaged in the software development services but has not considered the verticals/functional or service lines in which the company is engaged. Thus, the tax payer considered companies that are into different verticals and functional lines, though the tax payer is involved in software development activities catering to telecommunications and inter-net sector. ( ii ) Filters or criteria adopted by the tax payer in its TP study. The selection of companies having sales turnover of more than 1.00 crore but less than 200 crores. According to the TPO, The tax payer hypothesis that there is a direct co-relation between turnover and profit margins of the company, is not acceptable because the transfer pricing rules or the OCED guidelines do not prescribe any specific range of turnover for comparability to size and scale of the turnover, size or scope of operations. Once functional similarity is accepted, companies can be compared irrespe ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... with June or September or any other month. Those companies whose accounting year does not end with March 31, 2005 were proposed to be rejected, because it ensures that the transactions being compared took place during the same period/financial year either in the tax payer's case or in the comparable company's case and is also being in conformity with Rule 10B(4). 3. Diminishing Revenue Filter As per this filter the companies with diminishing revenue for the last three years upto and including FY: 2005-06 were rejected as comparables. 4. Software Development Service revenue 75% For the Transfer Pricing study, the search criterion should basically be to search for companies which are mainly engaged in software development service or whose significant activities or functions relate to software development service and therefore, it is appropriate to apply the filter that the comparable company should have at least 75% of its revenue from software development services. 5. Onsite revenue filter. According to this filter, the companies whose onsite revenue exceed 75% of export revenues from software development are rejected as comparables. This filter is adopted beca ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... f this work is to make the analysts who will later try to elicit and gather the requirements from the area experts or professionals, speak with them in the domain's own terminology and to better understand what is being said by these people because otherwise they will not be taken seriously. The next most important task in creating a software product is extracting the requirement of the customers and then precisely describing the software to be written possibly in a rigorous way. In practice, most successful specifications are written to understand and fine tune applications that were already well developed, although safety critical software systems are often carefully specified prior to application and development. The architecture of a software system refers to an abstract specification of the software system and is concerned with making sure that the software system will meet the requirements of the product as well as ensuring that future requirements can be addressed. The architecture step also addresses interfaces between the software system and other software products, as well as the underlying hardware or the host operating system. Thereafter, a design is reduced to code and ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tware development service providers. A software trading company purchases software products in the form of licenses or on royalty basis as a right to use and sells these products as a reseller. 3.1 The assessee being a software development service provider, it cannot be compared to a software development company or a software trading company. Therefore, the companies that are functionally different from that of the tax payer are to be excluded. 3.2 Applying the above filters, the TPO rejected ten of the comparables adopted by the assessee and made a search of his own for the appropriate comparables on the prowess database as well as capitaline data bases and arrived at final 20 comparables. After arriving at the 20 comparables, the TPO issued notices u/s 133(6) to the companies where complete information is not available in the data base or in the annual reports. All the information received from the companies were provided to the tax payer for its comments and the adverse inference, if any, drawn based on the replies received from the companies were also communicated to the tax payer. She even considered five companies as comparables, though they have lower margins than ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he AO, the assessee preferred objections to the DRP which approved the draft order and the assessee is in appeal before us. 4.3 The assessee has raised the following grounds of appeal. "1. Grounds relating to natural justice: The lower authorities have erred in passing the order. a. Without considering all the submission and/or without appreciating properly the facts and circumstances of the case and law applicable. b. At the fag end of the limitation period; and c. without affording a proper opportunity of being heard to the appellant. 2. Grounds relating to procedure: The lower authorities have erred in a. Making a reference for the determination of the Arms Length Price of the international transactions to the TPO without demonstrating as to why it was necessary and expedient to do so. b. Passing the order without demonstrating that the appellant had any motive of tax evasion. 3. Without prejudice, the Dispute Resolution Panel, not being Income-tax authority has erred in passing the order and in the manner passed by them. 4. The members of Dispute Resolution Panel also being jurisdictional Commissioner/Directors of Income Tax of the appe ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... , commercial and industry realities and economic circumstances applicable to the appellant vis a vis the comparables; b. Not making any adjustments for qualitative and quantitative difference between the business of the appellant and those of the comparable companies. c. Not recognizing that the company was insulated from risks, as against comparables, which assume these risks and therefore, have to be credited with a risk premium on this account; and d. Not appropriately computing the working capital adjustment while computing the margins of the comparables. 11. Grounds relating to one comparable: a. The lower income tax authorities have erred in not appreciating that law does not compel adopting many (or any minimum) companies as comparables and that the appellant could justify the price paid/charged on the basis of any one comparable only. 12. Grounds on benefit of 5% range; a. Assuming without admitting that the adjustment is to be made, the lower income tax authorities have erred in not allowing the benefit of the +/- 5% range mentioned in the proviso to section 92C(2). 13. Other Grounds The learned AO has erred in levying a sum of Rs.4 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s no objection by the TPO with regard to receipt of interest free loan by the assessee. The international transactions with respect to rendering of services to AE are as follows; ( i ) Software development services 8,13,17,968/- ( ii ) ITES 3,50,70,406/- Total Rs.1,16,388,374/- 5.4 As the assessee renders service to AE as well as to non-AE, the AE exports are to the tune of Rs. 8,13,17,968/-. The assessee has adopted the transactional net margin method (TNMM) to justify the price charged in the international transactions. In order to identify the comparable companies the assessee has adopted a search process on prowess database and after applying various filters, the assessee selected 15 companies as comparables which are as follows; Sl. No. Name of the Company margins Operating Turnover Operating cost (INR in Crores) Operating profits (INR in Crores) Average unadjusted 1. Aztec Software Techn. Services Ltd., 128.62 109.77 18.86 17.18 2. Bodhtree Consulting Ltd., 5.43 4.70 0.73 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... apital adjustments of 0.88%, the adjusted arithmetic mean was determined at 19.80% and the transfer pricing adjustments for the software segment was determined at Rs.2,20,12,927/-. However, while computing the transfer pricing adjustments, the TPO has taken the operating cost at Rs.16,69,84,198/-(being the entire cost of the software segment) and operating revenue at Rs.17,80,34,142/- (being the entire revenue of software segment including non-AE and domestic revenue) instead of the costs revenues referable to the international transaction only. 5.5 Aggrieved by the said transfer pricing adjustments, the assessee filed detailed objections before the dispute resolution panel (DRP) on 27-01-2010 and the DRP approved the draft order except rectifying an error in the margin computation of one comparable namely M/s Megasoft. 5.6 Aggrieved by this order of the DRP and the consequential assessment made by the AO the assessee has filed this appeal and has raised the following points; 1. Restrict TP adjustments to AE transactions only :- The transactions with AE only are international transactions and it is only with reference to these transactions that it could be alleged th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ons only. 7. As regards the filters selected by the assessee in making the transfer pricing study, the learned counsel for the assessee submitted that the assessee has adopted a turnover range of Rs.1.00 crore at the lower end and Rs.200 Crores at the higher end while choosing the comparables. He submitted that this adoption of upper limit of Rs.200 Crores is based on the Dun and Bradstreet's analysis which has classified the software companies into the following categories; 1. Large size firms (Rs.20,000 Mn) 2. Medium size firms (Rs.2,000-20,000 Mn) 3. Small size firms (Rs.2,000 Mn) 7.1 The learned counsel for the assessee submitted that the TPO has rejected the upper limit of Rs.200 Crores on the ground that there is no relationship between sales and margins in the service sector as fixed assets are very minimal. He submitted that this is not correct because, the size of the comparable is an important factor of comparability and that it is also recognized by the statute, especially the Rules. He submitted that Rule 10B(3) lays down guidelines for comparing an uncontrolled transaction with an international transaction and as per the said Rule difference for tra ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... employees : The size of the transaction in absolute value or in proportion to the activities of the parties might affect the relative competitive positions of the buyer and seller and therefore comparability". 8.2 The learned counsel for the assessee submitted that similar observations were also made by ICAI in para15.4 of TP guidance Note. He submitted that TPO's range of Rs.1.00 crore to infinity has resulted in selection of companies like M/s Infosys which is having a turnover of Rs.9,028 cores which is 1,1007 times bigger than the assessee company which has a turnover of Rs.8.15 crores. He further submitted that NASSOM was also categorized the companies based on the turnover as follows; 1. Greater than USD 1 Billion (approximately 5,0000 crores) 2. Between USD 100 Million to USD 1 Billion(Rs.500 crores to Rs.5,000 crores) and 3. Others having less than USD 100 Million (Rs.500 croes) Thus, the learned counsel for the assessee submitted that an appropriate turnover range should be applied in selecting a comparable of uncontrolled companies and the assessee has accordingly, applied the turnover range of Rs.1.00 crore to 200 crores based on Dun and Bradstreet's a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 0. The next issue raised by the learned counsel for the assessee is that while making the comparability analysis, the TPO conducted enquiries from certain companies by exercising powers conferred on him u/s 133(6) of the Act and these notices and the replies have been provided to the assessee. He submitted that the TPO has issued notices to 154 companies, but why these companies were selected is not clear. He submitted that the information had been provided to the assessee in the form of CD but it is not clear as to whether all the responses have been incorporated in the CD given to the assessee. He submitted that the entire process lacks transparency and fairness because six companies which have been finally taken by the TPO do not find place in the initial list of companies generated by the learned TPO. He submitted that the TPO selected Megasoft Ltd., as comparable and as seen from the details provided to the assessee alongwith the initial show cause notice, he rejected companies which fail in RPT and employee cost filters but M/s Megasoft Ltd., which fails RPT filter and employee cost filter was also considered and the TPO has issued a notice u/s 133(6) of the IT Act to M/s Me ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ese inconsistencies in the process of TPO raises doubts regarding transparency and genuineness of the entire process. Another point advanced by the learned counsel for the assessee is that the information obtained by the TPO by issuing notices u/s 133(6) is not available in public domain at the time of study by the assessee. He submitted that Rule-10D prescribes the documents to be kept and maintained u/s 92D and sub-rule (4) thereof deals with the process and the method to be adopted in making the comparability analysis. He submitted that as per this sub-rule, the information and documents should as far as possible be contemporaneous and should exist latest by the specified date referred to in clause(iv) of sec.92F. According to him, the dictionary meaning of contemporaneous is 'existing or occurring at the same time, of the same historical or geographical period'. 10.2 As per Rule 10D, the information and documents prescribed there in must be kept and maintained by the assessee latest by the prescribed date i.e for AY: 2006-07 by 31 st October, 2006 and accordingly the assessee has kept and maintained the information and documents. The TPO is collecting, collating and comp ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... therein that only the documents maintained by the assessee have to be taken into consideration. He submitted that the TPO is under an obligation to verify the information and documents kept and maintained by the assessee and wherever he feels that some more information is necessary for making the TP adjustment, he may also make his own search and use the relevant years data available in the public domain. Thus, in view of this power of TPO, the TPO has made the search of the databases and has issued notices to the relevant parties u/s133(6) of the Act to gather information which is not available in the public domain. After considering replies to the said notices, the TPO has rejected many companies and has selected only the relevant comparables and all the information which is sought to be used by the TPO for making the TP adjustments has been supplied to the assessee and the assessee was given ample opportunity of making its objections. He submitted that the TPO after considering the assessee's objections only has made the TP adjustments and therefore, there is no violation of principles of natural justice nor there is any lack of transparency or fairness. Thus, according to him, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the definition of "specified date" to have the same meaning as assigned to 'due date' in Explanation-2 below sub-sec.1 of sec.139. Explanation-2 to sec.139 defines 'due date' in a case of a company to be '30th day of September of the assessment year'. The assessee before us is a company and therefore, as on '30th day of September' of the relevant assessment year, the assessee is supposed to maintain information and documents. After going through the above provisions of law, it is clear that the Act has not provided for any cut off date upto which only the information available in public domain has to be taken into consideration by the TPO, while making the TP adjustments and arriving at arm's length price. The assessee as well as the revenue are both bound by the Act and the Rules there under and therefore, as provided under the Act and Rules they are supposed to be taking into consideration, the contemporaneous data relevant to the previous year in which the transaction has taken place. The assessee had strenuously argued that the provision of sec.92D and Rule-10D is defeated if, the TPO takes the data which is available in the public domain after the specified date and the ALP w ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... been taken into consideration by the TPO as comparables without giving the assessee an opportunity of presenting its objections and also with regard to certain other companies, it had sought opportunity to cross examine them, but the said opportunity was not given. 13. We have already held that if any information is sought to be used against the assessee, the same has to be furnished to the assessee and thereafter, taking into consideration the assessee's objections, if any, only then can the TPO proceed to take a decision. If the assessee seeks an opportunity to cross examine the party, the assessee shall be provided such an opportunity. It is only during a cross examination that the assessee can rebut the stand of that particular company. The assessee has also brought out various defects in the additional comparables selected by the TPO and has brought out the glaring differences between the functions of those comparables as compared to assessee and also as to how the entire revenue of the assessee has been taken into consideration inspite of there being income from unrelated party transactions also. All these objections have been given in detail in the written submissions. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... uction of 5% under the proviso to sec.92C(2) of the Act. 14. Similarly, in the ITES segment also the assessee has raised various grounds i.e. adoption of various companies as comparables and additional filters used by the TPO. For the detailed reasoning given by us for the above software development service segment, we direct the TPO to consider the assessee's objections and compute the ALP, after giving the assessee an opportunity of hearing after observing our directions given above. 15. With regard to low capacity utilization, adjustments to be given in the determination of ALP in ITES sector, the learned counsel for the assessee submitted that during the year under consideration the assessee had under utilized its facilities to the extent of 51.89% and therefore, this adjustments also should be given while determining the ALP. After giving adjustments, according to him the net operating margin on cost would be 27.46%. He submitted that the learned TPO has rejected the adjustments on the ground that comparables have similar problem as they have idle bench strength. He submitted that the adjustments sought was for under utilization of infrastructure while in the case of c ..... 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