TMI Blog2013 (11) TMI 772X X X X Extracts X X X X X X X X Extracts X X X X ..... work out the ALP as per directions - Decided in favour of assessee. - IT(TP)A No.1348/Bang/2011 - - - Dated:- 28-2-2013 - N. BARATHVAJA SANKAR and N.V. VASUDEVAN, JJ, For the Appellant : Vikram Vijaya Raghavan. For the Respondent : S.K Ambastha. ORDER:- PER : N.V. Vasudevan This appeal by the assessee is against the order dated 18.10.2011 passed by the Dy. Commissioner of Income-tax, Circle 11(4), Bangalore u/s. 143(3) r.w.s. 144C of the Income-tax Act, 1961 [hereinafter referred to as "the Act"]. 2. Ground No.1 is general in nature and calls for no adjudication. 3. In ground No.2, the assessee has challenged the order of the Assessing Officer whereby he made an addition to the total income of the assessee by way of adjustment to the Arm's Length Price (ALP) of an international transaction carried out by the assessee with its Associated Enterprise (AE). There are various sub-grounds on which the aforesaid adjustment is challenged by the assessee. We shall deal with each of them. 4. The assessee is a company incorporated in India on 14.12.1999. It is a subsidiary of HCL EAI Services Inc., a company incorporated as per the laws of USA. The assessee provi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sed on this, the arms length price of the software development services rendered by the tax payer to its AE(s) is computed as under:- Arithmetic mean PLI : 25.14% Less: Working capital adjustment (Annexure-C) : 1.92% Adj. Arithmetic mean PLI : 23.22% Arm's Length Price : Operating Cost Rs.19,94,79,454 Arms Length Margin 23.22% of the Operating cost Arms Length Price (ALP) @ 123.22% of operating cost Rs.24,57,98,583 Price Received vis- -vis the Arms Length Price The price charged by the tax payer to its Associated Enterprise is compared to the Arms Length price as under: Arms Length Price @ 123.22% of operating cost Rs.24,57,98,583 Price charged in the international transactions Rs.21,79,78,822 Shortfall being adjustment u/s 92CA Rs. 2,78,19,761 The above shortfall of Rs.2,78,19,761 is treated as transfer pricing adjustment u/s. 92CA." 6. The AO made the addition as suggested by the TPO in ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... category of Rs. One crore to Rs. 200 crores for the purpose of application of turnover filter. With this background, let us analyse the acceptability of the comparables chosen by the TPO. 9. At the outset, it was submitted by the parties before us that the very same 26 comparable had been chosen by the TPO for determining the ALP in the case of software services providing company viz., Trilogy E-Business Software India Pvt. Ltd. It was also accepted by the parties that that in the case of that company, this Tribunal in ITA No.1054/Bang/2011 by its order dated 23.11.2012 considered the comparability of the comparables chosen by the TPO. It was agreed by the parties that the aforesaid decision, which incidentally is also for the A.Y. 2007-08, will apply to the case of the assessee in this appeal also. It was also accepted by the parties that some of the comparables chosen by the TPO have also been considered by the Mumbai Bench of the Tribunal in the case of Telcordia Technologies India (P.) Ltd. , ITA No.7821/Mum/2011; and by the Bangalore Bench of the Tribunal in the case of 24/7 Customer Com (P.) Ltd. ITA No.227/Bang/2010. In this background, we shall now examine the 26 comparab ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... to the OECD TP Guidelines, 2010 wherein it has been observed as follows:- "Size criteria in terms of Sales, Assets or Number of 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." 12. The ICAI TP Guidelines note on this aspect lay down in para 15.4 that a transaction entered into by a Rs. 1,000 crore company cannot be compared with the transaction entered into by a Rs. 10 crore company. The two most obvious reasons are the size of the two companies and the relative economies of scale under which they operate. The fact that they operate in the same market may not make them comparable enterprises. The relevant extract is as follows [on Rule 10B(3)]: "Clause (i) lays down that if the differences are not material, the transactions would be comparable. These differences could either be with reference to the transaction or with reference to the enterprise. For instance, a transaction entered into by a Rs 1,000 crore company cannot be compared with the transaction entered into by a Rs 10 crore company. The two most ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e 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." 15. It was brought to our notice that the above proposition has also been followed by the Honourable Bangalore ITAT in the following cases: 1. M/s Kodiak Networks (India) Private Limited v. ACIT (ITA No.1413/Bang/2010) 2. M/s Genesis Microchip (I) Private Limited v. DCIT (ITA No.1254/Bang/20l0). 3. Electronic for Imaging India Private Limited (ITA No. 1171/Bang/2010). 16. It was finally submitted that companies having turnover more than Rs. 200 crores ought to be rejected as not comparable with the Assessee. 17. The ld. DR, on the other hand pointed out that even the assessee in its own TP study has taken companies having turnover of more than Rs.200 crores as comparables. In these circumstances, it was submitted by him that the assessee cannot have any grievance in this regard. 18. We have considered the rival submissions. The provisions of the Act and the Rules that are releva ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... y been undertaken does not exceed five per cent of the latter, the price at which the international transaction has actually been undertaken shall be deemed to be the arm's length price. (3) Where during the course of any proceeding for the assessment of income, the Assessing Officer is, on the basis of material or information or document in his possession, of the opinion that- (a) the price charged or paid in an international transaction has not been determined in accordance with sub-sections (1) and (2); or (b) any information and document relating to an international transaction have not been kept and maintained by the assessee in accordance with the provisions contained in sub-section (1) of section 92D and the rules made in this behalf; or (c) the information or data used in computation of the arm's length price is not reliable or correct; or (d) the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub-section (3) of section 92D, the Assessing Officer may proceed to determine the arm's length price in relation to the said ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ive 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. (3) An uncontrolled transaction shall be comparable to an international transaction if (i) none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; or (ii) reasonably accurate adjustments can be made to eliminate the material effects of such differences. (4 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... les chosen by the TPO at Sl. Nos. 6,9,10,17,18, 22, 24 26 have to be excluded as comparables for the purpose of determining the ALP of the impugned transaction in this appeal." 11. The ld. DR, on the other hand pointed out that even the assessee in its own TP study has taken companies having turnover of more than Rs.200 crores as comparable. In these circumstances, it was submitted by him that the assessee cannot have any grievance in this regard. 12. We have considered the rival submissions. We are of the view that the consistent view taken by the Tribunal in the aforesaid decisions has to be followed. Determination of ALP has to be done in accordance with the provisions of Sec.92CA of the Act and Rule 10-B of the Rules referred to above. The fact that the Assessee has chosen companies with turnover of more than Rs. 200 crores as comparable cannot be the basis to insist that the turnover filter should not be applied. We are of the view that in line with the decisions rendered by the Tribunal in cases referred to above, volume of turnover is a relevant criteria and therefore turnover filter has to be applied. Respectfully following the decision of the Tribunal referred to abo ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sents abnormal circumstances and profits. The following figures were placed before us:- Particulars FYs 05-06 06-07 07-08 08-09 Operating Revenue 21761611 35477523 29342809 28039851 Operating Expns. 16417661 23249646 23359186 31108949 Operating Profit 5343950 12227877 5983623 (3069098) Operating Margin 32.55% 52.59% 25.62% - 9.87% 40. It was submitted that this company has made unusually high profit during the financial year 06-07. The operating revenues increased 63.03% which indicates that it was an extraordinary year for this company. Even the growth of software industry for the previous year as per NASSCOM was 32%. The growth rate of this company was double the industry average. In view of the above, it was argued that this company ought to have been rejected as a comparable. 41. We have given a careful consideration to the submissions made on behalf of the Assessee and are of the view that the same deserves to be accepted. The reasons given by the Assessee for excluding this company as co ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ted the IPR by filing the patent. The patent details have been discussed with Patent officials and the response is very favorable. The cloning and purification under wet lab procedures are under progress with our collaborative Institute, Department of Microbiology, Osmania University, Hyderabad. In the industrial biotechnology area, the company has signed the Technology transfer agreement with IMTECH CHANDIGARH (a very reputed CSIR organization) to manufacture and market initially two Enzymes, Alpha Amylase and Alkaline Protease in India and overseas. The company is planning to set up a biotechnology facility to manufacture industrial enzymes. This facility would also include the research laboratories for carrying out further R D activities to develop new candidates' drug molecules and license them to Interested Pharma and Bio Companies across the GLOBE. The proposed Facility will be set up in Genome Valley at Hyderabad in Andhra Pradesh.' According to the learned D.R. celestial labs is also in the field of research in pharmaceutical products and should be considered as comparable. As rightly submitted by the learned counsel for the Assessee, the discovery is in relation t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... company was develops biotechnology products and provides related software development services. The TPO called for segmental data at the entity level from this company. The TPO also called for description of software development process. In response to the request of the TPO this company in its reply dated 29.3.2010 has given details of employees working in software development but it is not clear as to whether any segmental data was given or not. Besides the above there is no other detail in the TPO's order as to the nature of software development services performed by the Assessee. Celestial labs had come out with a public issue of shares and in that connection issued Draft Red Herring Prospectus (DRHP) in which the business of this company was explained as to clinical research. The TPO wanted to know as to whether the primary business of this company is software development services as indicated in the annual report for FY 06-07 or clinical research and manufacture of bio products and other products as stated in the DRHP. There is no reference to any reply by Celestial labs to the above clarification of the TPO. The TPO without any basis has however concluded that the business ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the final set of comparables, and thus on this aspect, assessee succeeds." Based on all the above, it was submitted on behalf of the assessee that KALS Information Systems Limited should be rejected as a comparable. 47. We have given a careful consideration to the submission made on behalf of the Assessee. We find that the TPO has drawn conclusions on the basis of information obtained by issue of notice u/s.133(6) of the Act. This information which was not available in public domain could not have been used by the TPO, when the same is contrary to the annual report of this company as highlighted by the Assessee in its letter dated 21.6.2010 to the TPO. We also find that in the decision referred to by the learned counsel for the Assessee, the Mumbai Bench of ITAT has held that this company was developing software products and not purely or mainly software development service provider. We therefore accept the plea of the Assessee that this company is not comparable. (e) Accel Transmatic Ltd. 48. With regard to this company, the complaint of the assessee is that this company is not a pure software development service company. It is further submitted that in a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ompany was not comparable in the case of the assessees engaged in software development services business. Accepting the argument of the ld. counsel for the assessee, we hold that the aforesaid company should be excluded as comparables." 14. In view of the aforesaid decision of the Tribunal, comparables at Sl.Nos.1, 2, 3 12 of the list of comparables chosen by the TPO have to be excluded for the purpose of comparison while determining the ALP of the impugned transaction in this appeal. 15. With regard to Sl.No.11 of the list of comparable chosen by the TPO viz., Ishir Infotech Ltd., the ld. counsel for the assessee brought to our notice that this company does not satisfy the employee cost filter adopted by the TPO. In this regard, it is seen that at page 120 of the TPO's order, the TPO has discussed the comparability of this company. One of the filters applied by the TPO was that if the employee cost of a comparable company is less than 25% of its revenue, then the same cannot be treated as a comparable. According to the TPO, the employee cost was more than 25% of the total revenue and therefore the same should be taken as a comparable with the assessee. The assessee's objecti ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d for exclusion as a comparable. In this regard, the learned counsel for the assessee objected to the TPO's setting a limit of 25% on related party transactions. He objected to the inclusion of comparables being related party transactions in excess of 15% of sales/revenue. In support of this proposition, the learned counsel for the assessee placed reliance on the decision of the Hon'ble Bench of the ITAT, Delhi in the case of Sony India (P) Ltd. reported in 2008-TIOL-439-ITAT-Delhi dt.23.12.2008. The learned counsel for the assessee drew our attention to para 115.3 of the order wherein the Tribunal has held that - " .We are further of the view that an entity can be taken as uncontrolled if its related party transactions do not exceed 10 to 15% of total revenue. Within the above limit, transactions cannot be held to be significant to influence the profitability of the comparables. For the purpose of comparison what is to be judged is the impact of the related party transactions vis- -vis sales and not profit since profit of an enterprise is influenced by large number of other factors ." Respectfully following the decision of the Tribunal in the case of Sony India (P) ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... pure software development service provider. This information itself is very vague as the segmental details of operating revenue has not been made available to examine how much is the ratio of sale from software product and sale of software service and development. Looking to the fact that it has developed a software product named as "Muulam" which is used for civil engineering structures and the product development expenditure itself is substantial vis- -vis the capital employed by the said company, this criteria for being taken as comparable party, gets vitiated. For the purpose of comparability analysis, it is essential that the characteristics and the functions are by and large similar as that of the assessee company and T.P. analysis/study can be made with fewest and most reliable adjustment. If a company has employed heavy capital in development of a product then profitability in the sale of product would be entirely different from the company, who is involved in serve sector. Therefore, this company cannot be treated as having same function and profitability ratio. In our view, due to non-availability of full information about the segmental details as to how much is t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e standardized products, customers may request the company to customize products or reconfigure products to fit into their business environment. Thereupon the company takes up the job of customizing the packaged software. The company also explained that 30 to 40% of the product software (software developed) would constitute packaged product and around 50% to 60% would constitute customized capabilities and expenses related to travelling, boarding and lodging expense. Based on the above reply, the TPO proceeded to hold that the comparable company was mainly into customization of software products developed (which was akin to software development) internally and that the portion of the revenue from development of software sold and used for customization was less than 25% of the overall revenues. The TPO therefore held that less than 25% of the revenues of the comparable are from software products and therefore the comparable satisfied TPO's filter of more than 75% of revenues from software development services. Having drawn the above conclusion, the TPO did not bother to quantify the revenues which can be attributed to software product development and software development service but ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... olutions Ltd. is different from the present Thirdware Solutions Ltd. The erstwhile company merged with its parent company Thirdware Inc. Thus the company considered by the TPO is different from the company that is considered by the taxpayer in its TP report. The main objection of the taxpayer is that segmental information submitted by the company is unaudited and thus is unreliable. This issue is already discussed in detail in the earlier year order(s). Thus the company's software development segment is considered as a comparable." 22. It can be seen from the aforesaid order of the TPO that none of the facts have come out clearly and the objections of the assessee in adopting this company as a comparable is not appropriately dealt with. We therefore set aside the order of the TPO and remand the same to the TPO for fresh consideration with liberty to the assessee to substantiate its case. The TPO will afford opportunity of being heard to the assessee for deciding this issue. 23. The assessee also pleads before us that it had chosen Aztech Software as a comparable in its TP study, but the TPO has rejected the said company as a comparable for the reason that the rela ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... arly, a software service company which predominantly outsources its work cannot be compared with a full fledged software development service provider. 3. The company can provide services itself or get it done through others on job work basis. In the later case, as is the case, even though company is responsible for the quality of the services etc., it is effectively doing supporting functions. Further, there is no cost arbitrage between the company and outsourcers as all of them are located in India. So, the outsourcers demand their share of profit/pricing which are at arm's length and as per the market conditions. Thus whatever shown under the head "software development expenses" include the profit element of the outsourcers as well. Thus the contention of the taxpayer that the company satisfies functionality criterion as it passes through the employee cost filter if software development expenses and personnel expenses are taken together is incorrect." 26. On the above conclusions of the TPO, we find that this company in response to notice u/s. 133(6) of the Act has specifically submitted that it is not doing any outsourcing work. Therefore, this company is functional ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... in kind or for value to be received" (refer to Annexure C of the TP order) as shown in the audited financial statements of the Assessee while computing working capital adjustment. ii. The above erroneous computation by the learned TPO has resulted in the Assessee not getting the full benefit of the working capital adjustment due. iii. The DRP erred in failing to appreciate the assessee's contention and upheld the action of the TPO." 30. From a perusal of the formulae which has been advocated by the OECD shows that unbilled revenues and advance from customers have to be taken into account while working out the working capital adjustment. The TPO's computation as done at page 161 of the order shows that he has not considered the aforesaid items pointed out by the Assessee. We are of the view that it would be just and appropriate to set aside this issue to the TPO and direct him to consider this objection in the set aside proceedings as the same has not been considered by the TPO or the DRP. 31. The AO is directed to work out the ALP after taking note of the directions given above. 32. Ground No.3 raised by the assessee in its grounds of appeal reads as f ..... X X X X Extracts X X X X X X X X Extracts X X X X
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