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2015 (8) TMI 931 - DELHI HIGH COURT

2015 (8) TMI 931 - DELHI HIGH COURT - [2015] 377 ITR 533 (Del) - Transfer pricing adjustment - TP Adjustments made in respect of the consideration for the services rendered to overseas holding company - selection of comparable as according to the Tribunal, no differentiation could be made between the entities rendering ITeS - Did the ITAT fall into error confirming the transfer pricing adjustment upholding the inclusion of two comparable, i.e., e-Clerx Services Limited and Vishal Information Tec .....

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h as engineering, design and support. While, on the other end of the spectrum ITeS would also include voice-based call centers that render routine customer support for their clients. Clearly, characteristics of the service rendered would be dissimilar. Further, both service providers cannot be considered to be functionally similar. Their business environment would be entirely different, the demand and supply for the services would be different, the assets and capital employed would differ, the c .....

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P. Vishal and eClerx, both are into KPO Services. E-Clerx 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 .....

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service providers - Decided against the Revenue - ITA 102/2015 - Dated:- 10-8-2015 - S. Muralidhar And Vibhu Bakhru,JJ. For the Appellant : Mr Ajay Vohra, Sr. Advocate with Mr Aditya Vohra, Advocate. For the Respondent : Ms Suruchi Aggarwal, Sr. Standing Counsel with Ms Lakshmi, Jr. Standing Counsel. ORDER Vibhu Bakhru, J. 1. The Assessee has filed the present appeal under Section 260A of the Income Tax Act, 1961 (hereafter the Act ) impugning the order dated 22nd March, 2013 passed by the Incom .....

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Assessee is, essentially, aggrieved by the 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 compan .....

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the given circumstances of the case in confirming the transfer pricing adjustment to the extent of ₹ 5,92,07,428/- upholding the inclusion of two comparable, i.e., e-Clerx Services Limited and Vishal Information Technologies Limited, now called as Coral Hub Ltd.? 2. Did the ITAT fall into error in not appreciating the terms of Rule l0B (2) of the Rules in respect of the analysis of functionally comparable companies? 4. The factual context in which the aforesaid questions of law arise are b .....

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i and Pune. The Assessee is remunerated for the voice call services on cost plus basis. The Assessee explained that the AE undertakes all activities such as marketing and enters into contracts with its customers seeking voice call services. The AE bears all the business risks and the Assessee only acts as an offshore service provider to the customers of the AE. In consideration for the services, the AE remunerates the Assessee by payment of all costs incurred by the Assessee plus a mark up of fi .....

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e Transactional Net Margin Method (hereafter TNMM ), which was considered to be the most appropriate method for the purposes of benchmarking the international transaction. The Assessee s operating profit margin (i.e. operating profit/total cost) was computed at 14.83% and the Assessee claimed that the same was comparable with other companies rendering voice call services. For the purposes of the transfer pricing study, the Assessee chose eight comparable entities and the arithmetic average of th .....

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of the Act, computed the TP Adjustment at ₹ 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 .....

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aforesaid adjustment in the draft assessment order passed under Section 144C(1) of the Act on 20th December, 2011. The Assessee objected to the draft assessment order dated 20th December, 2011 before the DRP. The Assessee impugned the draft assessment order on several grounds including selection of certain companies as comparables and exclusion of other companies considered as appropriate comparables by the Assessee. 6. The DRP accepted the Assessee s contention with respect to certain companie .....

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functional dissimilarities, the same were not significant enough to warrant a rejection of the said company as a comparable. With respect to Vishal, the DRP held that the difference in business model of Vishal would not materially affect the profit margin and thus, there was no infirmity with the TPO s decision to include the said company as a comparable in its report. 7. The TPO recomputed the TP Adjustment in terms of the directions issued by the DRP and computed the TP Adjustment at ₹ 5 .....

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e Process Outsourcing (hereafter KPO ) and, thus, could not be included as comparables for the purposes of benchmarking studies. According to the Assessee, although KPO services were ITeS but the nature of the said services was materially different 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 .....

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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, knowledge is also applied. The Assessee s objection that the said .....

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March, 2014 and submitted that the issue of whether Vishal and eClerx could be used as comparables was decided in favour of the Assessee. 11. We have heard the counsel for the parties. 12. At the outset, it is necessary to bear in mind that the object and purpose of introducing provisions relating to transfer pricing adjustment in the Act. By virtue of Finance Act, 2001, Section 92 of the Act was substituted by Sections 92 to 92F of the Act with effect from 1st April, 2002. Section 92 of the Ac .....

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DT indicates that the provisions of Section 92 to 92F of the Act were introduced With a view to provide a detailed statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India . 13. The heading of Chapter X also clearly indicates that it contains special provisions relating to avoidance of tax . The object of Chapter X of the Act is not to tax any notional income but to ensure that the real income is brought to tax under the Act. This has also been .....

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rinciples, 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 substra .....

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y the effect of transfer of income to a jurisdiction outside India, if any, in respect of the controlled transactions. 15. The exercise of determining the ALP in respect of international transactions between the related enterprises is aimed to determine the price, which would have been charged for products and services, as nearly as possible, in case such international transactions were not controlled by virtue of them being executed between related parties. The object of the exercise is, thus, .....

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and object of introducing the said provisions in the Act. 17. Section 92 of the Act provides that the income arising from an international transaction would be computed having regard to the ALP. The said section further provides for cost and expenses to be allocated and apportioned between two or more associated enterprises with regard to ALP. 18. Section 92C of the Act provides for provisions relating to computation of ALP. Sub-section (1) of Section 92C of the Act provides for the methods of .....

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or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors as the Board may prescribe, namely :- (a) comparable uncontrolled price method; (b) resale price method; (c) cost plus method; (d) profit split method; (e) transactional net margin method; (f) such other method as may be prescribed by the Board. (2) The most appropriate method referred to in sub-section (1) shall be applied, for determination of arm's length price, in .....

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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 su .....

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f Rule 10B contains provisions in relation to various methods of calculation of ALP as provided under Section 92C of the Act and reads as under:- 10B. (1) For the purposes of sub-section (2) of section 92C, the arm's length price in relation to an international transaction or a specified domestic transaction shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely :- (a) comparable uncontrolled price method, by which,- (i) the pr .....

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der sub-clause (ii) is taken to be an arm's length price in respect of the property transferred or services provided in the international transaction or the specified domestic transaction; (b) resale price method, by which,- (i) the price at which property purchased or services obtained by the enterprise from an associated enterprise is resold or are provided to an unrelated enterprise, is identified; (ii) such resale price is reduced by the amount of a normal gross profit margin accruing to .....

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ences, including 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 .....

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, 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 and other differences, 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 such profit mark-up in the open market; (iv) the .....

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actions which are so interrelated that they cannot be evaluated separately for the purpose of determining the arm's length price of any one transaction, by which- (i) the combined net profit of the associated enterprises arising from the international transaction or the specified domestic transaction in which they are engaged, is determined; (ii) the relative contribution made by each of the associated enterprises to the earning of such combined net profit, is then evaluated on the basis of .....

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account to arrive at an arm's length price in relation to the international transaction or the specified domestic transaction: Provided that the combined net profit referred to in sub-clause (i) may, in the first instance, be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of international transaction or specified domestic transaction in which it is engaged, with reference to market returns achieved for similar types of transactions by .....

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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 .....

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ansactions, which could materially affect the amount of net profit margin in the open market; (iv) the net profit margin realised by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in subclause (iii); (v) the net profit margin thus established is then taken into account to arrive at an arm's length price in relation to the international transaction or the specified domestic transaction; (f) any other method as provided in ru .....

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re that the instances of uncontrolled entities/transactions selected as comparables are similar in all material aspects that have any bearing on the value or the profitability, as the case may be, of the transaction. Any factor, which has an influence on the PLI, would be material and it would be necessary to ensure that the comparables are also equally subjected to the influence of such factors as the tested party. This would, obviously, include business environment; the nature and functions pe .....

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come Tax Rules, 1962 also clearly indicates that the comparability of controlled transactions would be judged with reference to the factors as indicated therein. Clause (a) and (b) of Rule 10B(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 .....

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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 ar .....

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as the PLI . 23. In this case, the Tribunal noted that eClerx was engaged in data processing and analytics services and held that the activities of the Assessee were functionally similar to those of eClerx. The Tribunal concluded that voice call services and KPO services were essentially ITeS and, therefore, entities rendering the aforesaid services could be considered as comparables for the purpose of benchmarking international transactions by using TNMM. The Tribunal held that further sub-div .....

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le 10TA(g) of the said Rules defines KPO Services as under:- (g) knowledge process outsourcing services means the following business process outsourcing services provided mainly with the assistance or use of information technology requiring application of knowledge and advanced analytical and technical skills, namely:‐ (i) geographic information system; (ii) human resources services; (iii) engineering and design services; (iv) animation or content development and management; (v) business a .....

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ding 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 Corpo .....

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the persons carrying on such processes. 27. The Government of Rajasthan (Department of Information Technology & Communication) has also floated a scheme on 12th December, 2011 known as The Rajasthan Incentive Scheme for BPO Centers and KPO Centers, 2011 . The said scheme is for providing incentives to promote ITeS and to generate further employment opportunities. In terms of the said scheme, Business Process Outsourcing (BPO) is defined to mean the transfer of an organization s entire non-c .....

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ervices are understood as the higher-end of ITeS in terms of value addition. 29. It is apparent from the above that while entities rendering Voice Call Center services for customer support and a KPO service provider may be employing IT-based delivery systems, the characteristics of services, the functional aspects, business environment, risks and the quality of human resource employed would be materially different. It plainly follows that benchmarking international transactions on the basis of c .....

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) indicates the comparability factors which are important while considering the comparability of uncontrolled transactions/entities with the controlled transactions/entities. Sub-rule (2) of rule 10B of the Income Tax Rules, 1962 also mandates that the comparability of international transactions with uncontrolled transactions would be judged with 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 OEC .....

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re 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 .....

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cal features of the property, its quality and reliability, and the availability and volume of supply; in the case of the provision of services, the nature and extent of the services; and in the case of intangible property, the form of transaction (e.g. licensing or sale), the type of property (e.g. patent, trademark, or knowhow), the duration and degree of protection, and the anticipated benefits from the use of the property. 1.40 Depending on the transfer pricing method, this factor must be giv .....

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method, some differences in the characteristics of property or services are less likely to have a material effect on the gross profit margin or markup on costs (see in particular paragraphs 2.23 and 2.41). Differences in the characteristics of property or services are also less sensitive in the case of the transactional profit methods than in the case of traditional transaction methods (see in particular paragraph 2.69). This however does not mean that the question of comparability in characteri .....

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ng 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 potentia .....

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ons or entities are comparable, a functional analysis is necessary. This functional analysis seeks to identify and compare the economically significant activities and responsibilities undertaken, assets used and risks assumed by the parties to the transactions. For this purpose, it may be helpful to understand the structure and organisation of the group and how they influence the context in which the taxpayer operates. It will also be relevant to determine the legal rights and obligations of the .....

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t enterprises with which that party is being compared. While one party may provide a large number of functions relative to that of the other party to the transaction, it is the economic significance of those functions in terms of their frequency, nature, and value to the respective parties to the transactions that is important. 1.44 The functional analysis should consider the type of assets used, such as plant and equipment, the use of valuable intangibles, financial assets, etc., and the nature .....

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ociated enterprises. Usually, in the open market, the assumption of increased risk would also be compensated by an increase in the expected return, although the actual return may or may not increase depending on the degree to which the risks are actually realised. 1.46 The types of risks to consider include market risks, such as input cost and output price fluctuations; risks of loss associated with the investment in and use of property, plant, and equipment; risks of the success or failure of i .....

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ntly 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 co .....

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lients. Clearly, characteristics of the service rendered would be dissimilar. Further, both service providers cannot be considered to be functionally similar. Their business environment would be entirely different, the demand and supply for the services would be different, the assets and capital employed would differ, the competence required to operate the two services would be different. Each of the aforesaid factors would have a material bearing on the profitability of the two entities. Treati .....

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td. v. Dy. CIT, (IT) [2013] 32 taxmann.com 21 and Lloyds TSB Global Services Pvt. Ltd. v. DCIT, (ITA No. 5928/Mum/2012 dated 21th November 2012), the Hyderabad and Mumbai Bench of the Tribunal respectively accepted the view that a BPO service provider could not be compared with a KPO service provider. 33. The Special Bench of the Tribunal in Maersk Global Centers (India) Pvt. Ltd. (supra) struck a different cord. The Special Bench of the Tribunal held that even though there appears to be a diffe .....

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ITeS Services could not be bifurcated as BPO and KPO Services for the purpose of comparability analysis in the first instance. 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 equa .....

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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 circumstances, we are unable to agree that broadly ITeS sector can be used for selecting comparables without making a conscious selection as to the quality and nature of the content of .....

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e purposes of Transfer Pricing analysis. The perception that a BPO service provider may have the ability to move up the value chain by offering KPO services cannot be a ground for assessing the transactions relating to services rendered by the BPO service provider by benchmarking it with the transactions of KPO services providers. The object is to ascertain the ALP of the service rendered and not of a service (higher in value chain) that may possibly be rendered subsequently. 35. As pointed out .....

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ty test and then exclude uncontrolled entities, which are found to be materially dissimilar in aspects and features that have a bearing on the profitability of those entities. However, where the controlled transactions are clearly in the nature of lower-end ITeS such as Call Centers etc. for rendering data processing not involving domain knowledge, inclusion of any KPO service provider as a comparable would not be warranted and the transfer pricing study must take that into account at the thresh .....

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ry 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 m .....

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in holding that the functions performed by the Assessee were broadly similar to that of eClerx or Vishal. The operating margin of eClerx, thus, could not be included to arrive at an ALP of controlled transactions, which were materially different in its content and value. In Maersk Global Centers (India) Pvt. Ltd. (supra), the Special Bench of the Tribunal had noted the same and had, thus, excluded eClerx as a comparable. It is further observed that the comparability of eClerx had also been exami .....

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re on employment cost during the relevant period was a small fraction of the proportionate cost incurred by the Assessee, apparently, for the reason that most of its work was outsourced to other vendors/service providers. The DRP and the Tribunal erred in brushing aside this vital difference by observing that outsourcing was common in ITeS industry and the same would not have a bearing on profitability. Plainly, a business model where services are rendered by employing own employees and using on .....

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oted below:- … that it had a very low employment cost and very high cost on account of venture payment, which suggested that its business model was that of an outsourcing company and in view of this functional difference, Vishal Ltd. could not be considered as a comparable. 40. The Assessee had also sought 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 Vi .....

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ide 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 .....

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tions against uncontrolled transactions is to impute an ALP to those transactions. This exercise would fail if a factor, which has a material bearing on the value or the profitability, as the case may be, depending on the method used, is ignored. 42. Before concluding, there is yet another aspect of the matter that needs consideration. The Tribunal proceeded on the basis that while applying TNMM method, broad functionality is sufficient and it is not necessary that further effort be taken to fin .....

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ot be apposite. Insofar as identifying comparable transactions/entities is concerned, the same would not differ irrespective of the transfer pricing method adopted. In other words, the comparable transactions/entities must be selected on the basis of similarity with the controlled transaction/entity. Comparability of controlled and uncontrolled transactions has to be judged, inter alia, with reference to comparability factors as indicated under rule 10B(2) of the Income Tax Rules, 1962. Comparab .....

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