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TMI Blog2015 (8) TMI 931X X X X Extracts X X X X X X X X Extracts X X X X ..... TP Adjustments made in respect of the consideration for the services rendered by the Assessee to its overseas holding company. The TP Adjustments have been made on the basis of the average operating profit margin (operating profit as a percentage of operating costs) declared by other companies - eight in number - selected as comparables for the purposes of ascertaining the Arm's Length Price (hereafter 'ALP'). According to the Assessee, two of the companies chosen as comparable by the concerned authority, namely, Vishal Information Technology Ltd. (hereafter 'Vishal') and eClerx Services Ltd. (hereafter 'eClerx') could not be considered as comparables as the functions performed and the services rendered by the said companies were materially different from those performed by the Assessee. 3. This Court, by an order dated 27th February, 2015, admitted the present appeal and framed the following questions of law:- "1. Did the ITAT fall into error in the given circumstances of the case in confirming the transfer pricing adjustment to the extent of Rs. 5,92,07,428/- upholding the inclusion of two comparable, i.e., e-Clerx Services Limited and Vishal Information Technologies Limited, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ge as indicated under the second proviso to Section 92C. The Assessee further claimed that the PLI was liable to be adjusted on account of (i) working capital provided to the Assessee by the AE and (ii) the risks of the business borne by the AE. 5. The AO referred the matter to the TPO. The TPO, by an order dated 19th October, 2011, passed under section 92CA(3) of the Act, computed the TP Adjustment at Rs. 11,00,35,400/- (Rupees Eleven Crore Thirty Five Thousand and Four Hundred). The TPO accepted the method adopted by the Assessee (i.e. TNMM), but rejected the benchmarking report. The TPO also rejected the Assessee's claim for any adjustment on account of working capital provided to the Assessee and/or risks borne by the AE. The TPO proceeded to identify a different set of comparable companies for the purposes of determining the ALP. The companies selected by the TPO which were considered to be comparables included eClerx and Vishal (subsequently known as Coral Hub Ltd.). The TPO computed the average operating profit margin of the comparable companies at 28.96% on the basis of the average operating profit margin of eleven companies selected by the TPO as comparables for the purpo ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... erent from the services rendered by the Assessee. It was asserted that eClerx is engaged in financial services in the nature of account reconciliation, trade order management services and has been rated as a leading KPO by Nelso Hall. It was contended that similarly Vishal was engaged in the services of data analytics and providing data processing solutions to some of the largest brands in the world. Vishal too had been rated as a leading KPO by Nelso Hall. In addition, it was pointed out that whilst the employee costs incurred by Vishal was relatively low and constituted only 4.39% of its total cost during the relevant year, the hire charges, vendor payments constituted almost 87% of the total costs. According to the Assessee, this evidenced that Vishal's business model was different and Vishal had outsourced significant part of its operations. 9. The Tribunal rejected the Assessee's contention and held that both eClerx and Vishal were engaged in providing ITeS and once a service fell within that category then no sub-classification of the segment was permissible. The Tribunal held that KPO is a term given to the branch of BPO Services where apart from processing of data, knowledg ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ld by the Supreme Court in Poona Electricity Supply Company Limited versus CIT, : [1965] 57 ITR 521 (SC), means profits arrived at on commercial principles, subject to the provisions of the Act. Profits and gains should be true and correct profits and gains, neither under nor over stated. Arm's length price seeks to correct distortion and shifting of profits to tax the actual income earned by a resident/domestic AE. The profit which would have accrued had arm's length conditions prevailed is brought to tax. Misreporting, if any, on account of non-arm's length conditions resulting in lower profits, is corrected." 14. The substratal rationale of the transfer pricing regulations is to ensure that the true income of an Assessee is brought to tax under the Act and there is no avoidance of tax by transfer of income from India to any other tax jurisdiction by virtue of the influence exercised by the associated enterprises. The aim of the provisions of Chapter X of the Act is to compute the income in relation to a controlled transaction between an Assessee and its associated enterprise having regard to ALP, in order to nullify the effect of transfer of income to a jurisdiction ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ) shall be applied, for determination of arm's length price, in the manner as may be prescribed: Provided that where more than one price is determined by the most appropriate method, the arm's length price shall be taken to be the arithmetical mean of such prices: Provided further that if the variation between the arm's length price so determined and price at which the international transaction or specified domestic transaction has actually been undertaken does not exceed such percentage not exceeding three per cent of the latter, as may be notified by the Central Government in the Official Gazette in this behalf, the price at which the international transaction or specified domestic transaction has actually been undertaken shall be deemed to be the arm's length price : Provided also that where more than one price is determined by the most appropriate method, the arm's length price in relation to an international transaction or specified domestic transaction undertaken on or after the 1st day of April, 2014, shall be computed in such manner as may be prescribed and accordingly the first and second proviso shall not apply. Explanation.-For the removal of doub ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... differences in accounting practices, if any, between the international transaction or the specified domestic transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market; (v) the adjusted price arrived at under sub-clause (iv) is taken to be an arm's length price in respect of the purchase of the property or obtaining of the services by the enterprise from the associated enterprise; (c) cost plus method, by which,- (i) the direct and indirect costs of production incurred by the enterprise in respect of property transferred or services provided to an associated enterprise, are determined; (ii) the amount of a normal gross profit mark-up to such costs (computed according to the same accounting norms) arising from the transfer or provision of the same or similar property or services by the enterprise, or by an unrelated enterprise, in a comparable uncontrolled transaction, or a number of such transactions, is determined; (iii) the normal gross profit mark-up referred to in subclause (ii) is adjusted to take into account the functional a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e split amongst the enterprises in proportion to their relative contribution in the manner specified under sub-clauses (ii) and (iii), and in such a case the aggregate of the net profit allocated to the enterprise in the first instance together with the residual net profit apportioned to that enterprise on the basis of its relative contribution shall be taken to be the net profit arising to that enterprise from the international transaction or the specified domestic transaction ; (e) transactional net margin method, by which,- (i) the net profit margin realised by the enterprise from an international transaction or a specified domestic transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base; (ii) the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base; (iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... (2) expressly indicate that the specific characteristics of the services provided and the functions performed would be factors for considering the comparability of uncontrolled transactions with controlled transactions. 21. Rule 10B(2) reads as under:- "(2) For the purposes of sub-rule (1), the comparability of an international transaction or a specified domestic transaction with an uncontrolled transaction shall be judged with reference to the following, 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... presents services involving a higher level of skills and knowledge. India has vast human resources and a large number of highly-skilled technical professionals. The expression "KPO" indicates the involvement of domain knowledge in providing ITeS. Typically, KPO includes involvement of advance skills; the services provided may include analytical services, market research, legal research, engineering and design services, intellectual management etc. On the other hand, Voice Call Centers are normally involved in customer support and processing of routine data. In the case of Maersk Global Centers (India) Pvt. Ltd. v. ACIT (supra) a Special Bench of the Tribunal had referred to a report prepared by National Skill Development Corporation (NSDC) on Human Resource and Skill Requirements in IT and ITES Sector (2022) and noted that the KPO sector has been described as "a value play". The said report also indicates that KPO services are likely to span activities such as "patent advisory, high-end research and analytics, online market research and legal advisory". 26. A Knowledge Process is understood as a high value added process chain wherein the processes are dependent on advanced skills, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... reference to the factors indicated under clauses (a) to (d) of that sub-rule, which are similar to the comparability factors as indicated under the OECD Guidelines. These include characteristics of property or services transferred and functions performed. The relevant extract from the OECD Guidelines are quoted below: "1.36 As noted above, in making these comparisons, material differences between the compared transactions or enterprises should be taken into account. In order to establish the degree of actual comparability and then to make appropriate adjustments to establish arm's length conditions (or a range thereof), it is necessary to compare attributes of the transactions or enterprises that would affect conditions in arm's length transactions. Attributes or "comparability factors" that may be important when determining comparability include the characteristics of the property or services transferred, the functions performed by the parties (taking into account assets used and risks assumed), the contractual terms, the economic circumstances of the parties, and the business strategies pursued by the parties. These comparability factors are discussed in more detail at Sect ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... unctional similarities than on product similarities. Depending on the facts and circumstances of the case, it may be acceptable to broaden the scope of the comparability analysis to include uncontrolled transactions involving products that are different, but where similar functions are undertaken. However, the acceptance of such an approach depends on the effects that the product differences have on the reliability of the comparison and on whether or not more reliable data are available. Before broadening the search to include a larger number of potentially comparable uncontrolled transactions based on similar functions being undertaken, thought should be given to whether such transactions are likely to offer reliable comparables for the controlled transaction. D.1.2.2 Functional analysis 1.42 In transactions between two independent enterprises, compensation usually will reflect the functions that each enterprise performs (taking into account assets used and risks assumed). Therefore, in determining whether controlled and uncontrolled transactions or entities are comparable, a functional analysis is necessary. This functional analysis seeks to identify and compare the economicall ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ent; financial risks such as those caused by currency exchange rate and interest rate variability; credit risks; and so forth. xxxx xxxx xxxx xxxx 1.51 In some cases, it has been argued that the relative lack of accuracy of the functional analysis of possible external comparables (as defined in paragraph 3.24) might be counterbalanced by the size of the sample of third party data; however quantity does not make up for poor quality of data in producing a sufficiently reliable analysis. See paragraphs 3.2, 3.38 and 3.46. " 31. In the present case, the Tribunal noted that Vishal and eClerx were both engaged in rendering ITeS. The Tribunal held that, "once a service falls under the category of ITeS, then there is no sub-classification of segment". Thus, according to the Tribunal, no differentiation could be made between the entities rendering ITeS. We find it difficult to accept this view as it is contrary to the fundamental rationale of determining ALP by comparing controlled transactions/entities with similar uncontrolled transactions/entities. ITeS encompasses a wide spectrum of services that use Information Technology based delivery. Such services could include rendering highly ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... The Tribunal proceeded to hold that a relatively equal degree of comparability can be achieved by selecting potential comparables on a broad functional analysis at ITeS level and that the comparables so selected could be put to further test by comparing specific functions performed in the international transactions with uncontrolled transactions to attain relatively equal degree of comparability. 34. We have reservations as to the Tribunal's aforesaid view in Maersk Global Centers (India) Pvt. Ltd. (supra). As indicated above, the expression 'BPO' and 'KPO' are, plainly, understood in the sense that whereas, BPO does not necessarily involve advanced skills and knowledge; KPO, on the other hand, would involve employment of advanced skills and knowledge for providing services. Thus, the expression 'KPO' in common parlance is used to indicate an ITeS provider providing a completely different nature of service than any other BPO service provider. A KPO service provider would also be functionally different from other BPO service providers, inasmuch as the responsibilities undertaken, the activities performed, the quality of resources employed would be materially different. In the circ ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... similar in material aspects. The comparability must be judged on factors such as product/service characteristics, functions undertaken, assets used, risks assumed. This is essential to ensure the efficacy of the exercise. There is sufficient flexibility available within the statutory framework to ensure a fair ALP. 37. Applying the aforesaid principles to the facts of the present case, it is once again clear that both Vishal and eClerx could not be taken as comparables for determining the ALP. Vishal and eClerx, both are into KPO Services. In Maersk Global Centers (India) Pvt. Ltd. (supra), the Special Bench of the Tribunal had noted that eClerx is engaged in data analytics, data processing services, pricing analytics, bundling optimization, content operation, sales and marketing support, product data management, revenue management. In addition, eClerx also offered financial services such as real-time capital markets, middle and back-office support, portfolio risk management services and various critical data management services. Clearly, the aforesaid services are not comparable with the services rendered by the Assessee. Further, the functions undertaken (i.e. the activities pe ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the exclusion of eClerx and Vishal on the ground that both the companies had returned supernormal profits. Whereas the operating margins (operating margin over total cost) in case of Vishal and eClerx were 50.68% and 65.88% respectively, the PLIs of all other comparables were in the range of 2.2% to 24%. In our view, it would not be apposite to exclude comparables only for the reason that their profits are high, as the same is not provided for in the statutory framework. The OECD Guidelines suggest that a quartile method be adopted which excludes entities that fall in the extreme quartiles for comparability. However, neither Chapter X of the Act nor the Rules made by CBDT provide for exclusion for such statistical reason. 41. Having stated the same, it may be necessary to bear in mind that supernormal profits may in certain cases indicate a functional dissimilarity or dissimilarity with respect to a feature that has a material bearing on the profitability. In such circumstances, it would be necessary to undertake further analysis to eliminate the possibility of the high profits resulting on account of any material dissimilarity between the tested party and the chosen comparable. A ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... be selected keeping in view the comparability factors as specified. Wide deviations in PLI must trigger further investigations/analysis. 44. Consideration for a transaction would reflect the functions performed, the significant activities undertaken, the assets or resources used/consumed, the risks assumed. Thus, comparison of activities undertaken/functions performed is important for determining the comparability between controlled and uncontrolled transactions/entity. It would not be apposite to ignore functional dissimilarity only for the reason that its impact may be reduced on account of using arithmetical mean of the PLI. The DRP had noted that eClerx was functionally dissimilar, but ignored the same relying on an assumption that the functional dissimilarity would be subsumed in the profit margin. As noted, the content of services provided by the Assessee and the entities in question were not similar. In addition, there were also functional dissimilarities between the Assessee and the two entities in question. In our view, these comparability factors could not be ignored by the Tribunal. While using TNMM, the search for comparables may be broadened by including comparables o ..... X X X X Extracts X X X X X X X X Extracts X X X X
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