TMI Blog2012 (6) TMI 60X X X X Extracts X X X X X X X X Extracts X X X X ..... the profit margins and in mean margin. On the contrary, claim of depreciation is eating up large chunk of profit in the case of the taxpayer. - The CIT(A) has not said a word on "asset" employed and "risks" suffered by the tested party and the comparables. Thus, material differences needing suitable adjustment were ignored and a flawed analysis was carried even in appellate proceedings. Without considering obvious material differences, the contention of the assessee to take profit without depreciation was rejected. This rejection is not sound in law. This ground is allowed. - IT Appeal NO. 893 (HYD) of 2011 - - - Dated:- 31-5-2012 - Chandra Poojari And Asha Vijayaraghavan, JJ. ORDER Chandra Poojari, Accountant Member This appeal by the assessee is directed against the order of the CIT(A)-III, Hyderabad dated 18.3.2011. 2. The assessee has raised the following grounds of appeal. 1. The Learned CIT (A) is erroneous in law and on the facts of the case. 2. The Learned CIT (A) is not justified in law in rejecting the Most Appropriate Method (MAM) adopted by the appellant-company as Comparable Uncontrolled Price method (CUP) for benchmarking the Arm's Leng ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... case are that the assessee is a company which derives income from software development. For the A.Y. 2005-06, it has filed its return of income on 29.10.2005 showing loss of ₹ 1,70,30,983. After processing of the said return u/s. 143(3) of the Income-tax Act, 1961, the same was selected for scrutiny assessment. During the assessment proceedings, the Assessing Officer noticed that the assessee during the previous year has entered into international transactions with its Associated Enterprises (AE). For computation of the arm's length price (ALP for short) of such transactions, the Assessing Officer, during the assessment proceedings, has made a reference to the Transfer Pricing Officer (TPO for short) u/s. 92CA(1) of the Act. In response to this, the TPO, after conducting necessary enquiries and verification in the matter, vide his order dated 31.10.2008 passed u/s. 92CA(3) of the Act, determined the ALP of such transactions at ₹ 12,74,96,713/-, as against ₹ 6,97,03,702/- shown by the assessee, thereby suggesting for adjustment of ₹ 5,77,93,011/- u/s. 92CA of the Act. In the transfer pricing analysis carried on by him, the TPO rejected the Comparable Unc ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... not justified in adopting Transaction Net Margin Method (TNMM in short) for benchmarking ALP of the international transactions in respect of export sales. In this regard, under the second issue, it is further stated that the TPO was not justified in considering wrong comparables and arriving at a high arithmetic mean of 26.59% as a ratio of OPM/total cost, he was not justified in considering a negative working capital adjustment and further was not justified in arriving at adjusted arithmetic mean PLI of 31.71%. It was further stated that the TPO was not justified in not carrying out necessary adjustment for arriving at the ALP while applying TNMM. Lastly, it is further stated that alternatively, the TNMM ought to have been adopted taking the four comparables selected by the assessee. 6. On appeal, the CIT(A) observed that as the first issue, the assessee has stated that the TPO was not justified in rejecting the CUP method adopted by them, for computation of ALP of the international transactions in this case. It is their contention that CUP method is the most appropriate method for bench marking analysis. While explaining about CUP method, under sub clause (i) to clause (a) to ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... k/services to be rendered by the assessee i.e., QCL. Further, in Annexure-A (scope and statement of work), it is mentioned that the same shall be to support the design verification activities of SoCs, being designed by Agere. Thus, the assessee was required to carry out certain design verification of some activities that were assigned by that company. From this, it clearly shows that the services rendered to that company, were totally different from that rendered by the assessee to its AE. Further, from the details of project delivery/execution as enumerated in that annexure, it is noticed that the services to be performed by the assessee are totally different from that rendered to their AE. Under this circumstance, the above company, cannot be considered as an internal comparable in this case. 9. The CIT(A) further observed from the master software development agreement entered into by Texas Instruments (India) Pvt. Ltd., with the assessee, the said company has desired to engage the assessee in connection with development of certain software application that are more specifically set forth and described in the work order. However, in that work order, a copy of which was furnish ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he assessee has rendered the same services to that company as it rendered to the AE. In other words, the services rendered to that company cannot be treated as similar to that rendered to the AE. Hence, the transaction made with the above company, cannot be considered for comparability analysis under CUP method in this case. 12. The CIT(A) held that the service rendered by the assessee to those third parties, were different from that rendered by it to the AE. Under the circumstance, transactions made with those companies, cannot be considered for comparability analysis for benchmarking of the international transactions made by the assessee with its AE. Hence, the CUP method is not all applicable to this case. Thus, the CUP method cannot be adopted for determining the arm's length price (ALP for short) of the International transactions made by the assessee with its AE. Therefore, the TPO was justified in rejecting the CUP method and consequently proceeding to determine the ALP of such transactions, adopting TNMM in this case. The AR has submitted, in response to the remand report, that the TPO himself observed that CUP method is most appropriate method in assessee's case, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ces in the field of application of ASIC and VLSI. Thus, it was in the business of software development, though pertaining to a different field. Since, such fields come under purview of a vertical, under software development services, the different comparable companies referred to by the TPO at page 106, for the reasons stated by him against each such company, should be considered as comparables for the purpose of determining ALP of the international transactions in this case. The TPO has selected those comparables on basis of different filters adopted by him, referred to under para 12 at page 92. When the assessee was mainly engaged in software development services, though in a different vertical, having regard to the overall circumstances of the case, such comparable companies selected by the TPO should be considered as comparables in this case. As regards those four companies referred to by the assessee are concerned, after discussing the factual position in respect of those companies and applying those filters adopted by him, in para 13 at page 93-94 of his order, he has clearly held that the same cannot be considered as comparables in this case. In fact, having regard to the fa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nce, the TPO has made such workings on basis of OECD guidelines/ formula in that regard and in absence of any error pointed out by the assessee in such calculation, such working as made by the TPO is upheld by the CIT(A). Accordingly, the CIT(A) decided the issue against the assessee. Aggrieved, the assessee is in appeal before us. 16. The learned AR submitted that M/s. QualCore Logic Ltd, being the assessee is a company registered in India under the Companies Act, 1956. lt is a wholly owned subsidiary of QualCore Group Inc. USA. The assessee-company is engaged in the business of software development services in the field of application specific integrated circuits (ASIC), very large scale integration (VLSI) and embedded system solutions and their export. The assessee-company filed its return of income for the assessment year 2005-06 on 29.10.2005 admitting a loss of ₹ 1,70,30,983/-. The return was processed u/s 143(1) on 17.03.2006 and subsequently the case was selected for scrutiny. During the course of assessment, a reference u/s 92CA of the Income-tax Act, 1961 has been made to the Addl. Commissioner of Income-tax (Transfer Pricing), Hyderabad. 17. The assessee-comp ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... cted are highly inappropriate as comparables. Accordingly, arithmetic mean PLI was arrived at 26.59% which is absolutely high and unrealistic looking at the background of the assessee-company. 21. The AR submitted that the Transfer Pricing Officer has also made a negative working capital adjustment to the PLI to the tune of 5.12% and arrived at the final PLI of 31.71 % which is very high and unrealistic. During the relevant financial year the company's depreciation charge is 28.60% to that of the total cost where as the Indian companies engaged in similar services average charge was around 10 to 11 % to that of the total cost. This adjustment was not carried out in arriving at the ALP by the Learned TPO. 22. Without prejudice to the CUP method adopted by the Assessee Company, it submitted a list of 4 companies to be adopted as comparables under TNMM as an alternative basis. The said 4 companies have been selected with proper criteria and economic activity dealing with VLSI and ASCII products of semi conductor Industry. These 4 companies involved were functionally similar to the assessee company. However the same were rejected by the Learned Transfer Pricing Officer on the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d also to the associated enterprise in USA. It is essential to be noted that though the assessee belongs broadly to the software industry, it needs to be specifically identified with chip designing - VLSI industry. This particular fact bears lot of importance and is critical in appreciating facts of the assessee's case. Hence assessee's performance cannot be compared with general software companies and it shall be done only with those companies which are into chip designing under VLSI. During the year under consideration the same chip designing services have been rendered to unrelated parties resulting in revenue of ₹ 95,20,376/- out of the total turn over ₹ 6,97,03,702/-. Such significant proportion of unrelated party transactions invariably constitute internal comparables for the purpose of bench marking transactions of the assessee company with its associated enterprise (AE). OECD guidelines in para 2.7 categorically highlight the importance of internal comparables under the transfer pricing regulations for bench marking purposes, which reads as under. 26. He drew our attention to Para 2.14 of the OECD guidelines endorses the position that CUP method is mo ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the TP regulations. The CIT(A) observed that the agreement entered into by the assessee with its AE and those agreements entered into with the third parties are not similar (Para 5.1 of the Ld CircA) order -Page 315 of paper book). The assessee company furnished copies of agreements with third parties like Avendis Microsystems Ltd, Texas Instruments(lndia) Ltd, Agere Systems India Pvt Ltd wherein the services rendered by these parties are similar to those rendered by the AE of the assessee. Such agreements were rejected by the LD CIT(A) on the ground that the same cannot be considered as internal comparables.(Paras 5.3,5,4,5,5 and 5.6 of the order) The Ld CIT(A) observed that the CUP Method cannot be adopted for determining the arms length price of the international transactions made by the assessee with its AE. 29. In this connection the AR placed reliance on the following case laws wherein it was held that the CUP method is the most appropriate method: ( a ) In the case of Destination of the World (Subcontinent) (P.) Ltd. v Assistant Commissioner of Income-tax, Circle 10(1), New Delhi [2011] 12 Taxmann.com 310 (Delhi) wherein the Delhi Tribunal held that in the first i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... o arrived at is taken to be an arm's length price in relation to the supply of the property or provision of services by the enterprise. 32. According to the AR, bench marking under CPM will be done on the basis of functional comparability between related and unrelated party transactions. In this scenario, differences in characteristic of the products or service is permitted. In other words the products/ services that are being compared should belong to the same category/family of transactions. Moreover, CPM is also acceptable in provision of services to AE as per OECD guidelines and as per rule 10B(1)(c). Without prejudice to the choice of CUP method, the AR submitted that CPM is also an acceptable method in the case of the assessee. The gross margin comparison on the basis of functional similarity as prescribed by CPM is practically possible only with internal comparables. This is so, on account of non availability of gross margin ratio details of the comparable companies in the public domain. In the instant case the are significant size of internal comparables. 33. He submitted that The Ld CIT(A) observed that the alternative contention of the assessee for applying Cost ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... LP of the international transactions and following the TNM Method. The assessee argued before us that the CUP method (Comparable Uncontrolled Price method) is appropriate method in this case. For the purpose of application of CUP method there should be similarity of transactions to be compared. In other words, the price charged or paid for property transfer or service provided in comparable uncontrolled transaction for which CUP method can be applied. However, this method is not suitable if there are material product differences or substantial adjustments. Similarity of product is utmost important. If the product is similar then adjustment towards differences which could materially affect the price in open market such as quality of product, terms of contract, foreign currency, etc., can be made. However, in the instant case, as seen from the agreement entered into by the assessee with the AE and those agreements entered into with the third parties, the service rendered to those third parties are not similar to that rendered to the AE. There is a clear cut finding regarding this aspect by the CIT(A) in his order at para 5.1. The learned AR was not able to controvert the above findin ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... forth and described in the work order. However, in that work order, a copy of which was furnished vide annexure A, enclosed to the said agreement (furnished by the assessee), under scope and details of the project, nothing is mentioned. The columns against 'Description' and 'Services to be provided' are blank. Thus, the nature of work/services to be performed by the assessee to that company is not known. Under the circumstance, the said company which was in the business of developing, manufacturing and selling digital signal processing devices, cannot be considered as an internal comparable in this case. In other words the transactions made with that company cannot be considered for the purpose of comparability analysis under CUP method, in this case. In this context, it may be further mentioned that though the assessee has furnished copy of a letter dated 29.11.2004 written by that company and certain invoices issued by that company, in absence of the nature of services to be rendered by the assessee to that company, those documents, have no application in this case. 43. The agreement with Future Techno Designs Pvt. Ltd., is concerned, the assessee has merely fu ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... od in assessee's case, but he further noted that information for application of that method was not available with him. However, in this context, the CIT(A) clarified that, in para 9 at page 49 of his order, the TPO has mentioned that there is also no dispute that the CUP method is the most direct and reliable way to apply arm's length principle. In the next sentence, in that para, he has further mentioned that, but while selecting CUP method, one more important aspect ignored by the taxpayer is whether the data used by the taxpayer is reliable and verifiable by the TPO. From such observations of the TPO, it may be seen that he has pointed out that, the data used by the assessee are not reliable and not verifiable and for the same he has rejected such method adopted by the assessee. In any case, since after detailed discussions made above, the CIT(A) held that CUP method cannot be adopted in this case, such decision of the TPO in rejecting such method adopted by the assessee, is justified and hence, the same is upheld. Further, for the reasons stated by him in his said order, adoption of TNMM by the TPO as the most appropriate method for determining ALP of such internationa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ual findings given by the TPO in that para, his decision in rejecting those four companies as comparables, is justified. Accordingly, we reject the plea of the assessee. 47. In view of the above, we are inclined to confirm the order of the CIT(A) on this issue. 48. The next ground for consideration is Ground No. 7 in the grounds of appeal. We have heard on this issue. The learned AR was not able to show how the 16 companies selected as comparable by the TPO are functionally different from the assessee company. Being so, we are not inclined to disturb the comparables selected by the TPO. Accordingly, this ground is rejected. 49. The next ground for our consideration is Ground No. 8. We have heard both the parties on this issue. The assessee has not furnished any working with regard to working capital adjustment. This was noted by the TPO at para 17.1 of his order. Under these circumstances, as noted by the TPO in para 17.1 of his order, the assessee has not furnished any working in that regard before him. Under the circumstance, he computed the working capital adjustment to be allowed in this case, following the OECD guidelines and approved formula in that regard. The detai ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t the same should be excluded for computing the profit margin for the purpose of computing the ALP of the international transactions. The AR relied on the decision of the ITAT, Delhi Bench in the case of Schefenachker Motherson Ltd. v. ITO (123 TTJ 509). 55. The learned DR submitted that this issue was raised before the TPO and the TPO discussed the same at pages 59-60 of his order. As per the TPO, under TNMM, all expenditure, excluding interest and other non-operating expenditure, should be considered for arriving at the total cost and the operating profit on that basis in case of any company. The DR submitted that there is no justification for the contention of the assessee that since the depreciation cost in its case is very high, as compared to the same in respect of the comparable companies, the same should be excluded. 56. The DR submitted that from the 'Distributor Agreement' which is the service agreement entered into by the assessee with its AE in this case, it is seen that the assessee has appointed ARM Semiconductor (USA) Inc., as the exclusive distributor for the sale of its intellectual properties and design services worldwide outside India. Design se ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ts in that case are distinguishable from that of the assessee. In that case, apparently that company was having cash profit on sales, even after considering depreciation. However, in the face of such agreement entered into by the assessee with its AE, which was applicable during the F.Y. 2004-05 for the A.Y. 2005-06, such plea for excluding depreciation, for computing the operating profit cannot be accepted. Accordingly, he submitted that the ground raised by the assessee may be rejected and the PLI as adopted by the TPO in this case, be held to be justified and the same should be upheld. 57. We have heard both the parties on this and perused the material on record. In the present appeal, ALP of transactions carried was to be determined by comparing net profit of the taxpayer (tested party) with mean net profit of comparables. Only receipts and expenditure, having connection with international transactions, were required to be taken into account. Any receipt or expenditure having no bearing on price or margin of profit could not be taken into consideration. It is evident from statutory provisions that it is nowhere provided that deduction of depreciation is a must. Depreciation ..... X X X X Extracts X X X X X X X X Extracts X X X X
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