TMI Blog2015 (12) TMI 769X X X X Extracts X X X X X X X X Extracts X X X X ..... risk as claimed by the appellant was concerned, it will be resulted in the arithmetic mean of all the companies as these risks adjustments also applicable for them. The assessee could not show how such difference in risk and functions affected result of comparables. The assessee in comparing the case with Infosys and Wipro had claimed that the appellant had negligible risk as it is a captive unit providing service to its AE and is remunerated on cost which marked up basis. - Decided against assessee. - ITA No. 1121/JP/2011, IT(TP)A No. 01/JP/2012 - - - Dated:- 12-6-2015 - SHRI R.P. TOLANI, JM SHRI T.R. MEENA, AM For The Assessee : Shri M.P. Lohia and Shri Pajesh Parikh (CA) For The Revenue : Mrs. Rolee Agarwal (CIT) ORDER PER: T.R. MEENA, A.M. These are the appeals filed by the assessee arise against the order of the Assessing Officer dated 28/10/2011 and DRP direction dated 08/08/2011 for A.Y. 2007-08 and Assessing Officer order dated 29/10/2012 and DRP direction dated 18/07/2012 for A.Y. 2008-09. The effective grounds of both the appeals are as under:- Grounds of assessee s appeal ITA 1121/JP/2011 1. Erred in assessing total income at & ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... grounds, erred in considering the incorrect margins of companies selected by the learned TPO/A.O. as comparable to the appellant. 15. Erred in comparing full-fledged risk bearing entities with the appellant s captive operations without making any risk adjustment for differences between the functional and risk profile of comparable companies considered as comparable vis a vis the risk profile of the appellant. 16. Erred in computing the arm s length price of software development services as the mean arm s length price determined, without taking into account the lower 5% variation from the mean arm s length price determined. 17. Erred in ignoring the fact that since appellant is availing tax holiday under section 10B of the Act, there is no intention to shift the profit base out of India, which is one of the basic intentions of the introduction of transfer pricing provisions. 18. Erred in initiating penalty proceeding under sections 271(1)(c), 271AA and 271G of the Act and levying interest under section 234B and 234D of the Act. The appellant craves leave to add, alter, vary, omit, substitute or amend the above grounds of appeal, at any time before or at ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s comparable to the appellant. 15. Erred in comparing full-fledged risk bearing entities with the appellant s captive operations without making any risk adjustment for differences between the functional and risk profile of comparable companies considered as comparable vis a vis the risk profile of the appellant. 16. Erred in computing the arm s length price of software development services as the mean arm s length price determined, without taking into account the lower 5% variation from the mean arm s length price determined. 17. Erred in ignoring the fact that since appellant is availing tax holiday under section 10B of the Act, there is no intention to shift the profit base out of India, which is one of the basic intentions of the introduction of transfer pricing provisions. 18. Erred in initiating penalty proceeding under sections 271(1)(c) of the Act and levying interest under section 234B and 234C of the Act. The appellant craves leave to add, alter, vary, omit, substitute or amend the above grounds of appeal, at any time before or at the time of hearing of appeal, so as to enable the Hon ble Income Tax Appellate Tribunal to decide this appeal acc ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... a) Pvt. Ltd. had entered into an international transaction with Integrated Decisions and Systems Inc. 1650, West Bloomington USA for the development of software and support of software. The Indian Company was providing services and charging the same from the associated enterprise. These international transactions with the Associate Enterprise were referred to the Transfer Pricing Officer (TPO) U/s 92CA of the Act. The order of the TPO was received by the Assessing Officer and forwarded to the assessee for its comment. In A.Y. 2007-08, the TPO has observed as under:- Computation of arm s length price: The arithmetic mean of the Profit Level indicators is taken as the arms length margin. (Please refer Annexure-B enclosed with the Order of the Transfer Pricing Officer dt. 29.10.2010 for details of computation of PLI of the comparable). Based on this, the arms length price of the software development services rendered by the taxpayers to its AE(s) is computed as under: Arithmetic Mean PLI : 25.00% Less: Working capital adjustment (Annexure) : 1.31% ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... allowed to the taxpayer in respect of this enhancement to its income, as per proviso to Section 92C(4). In A.Y. 2008-09, the TPO has observed as under:- Most Appropriate Method: TNMM, as selected by the taxpayer, is considered as the most appropriate method in the facts and circumstances of the case. Profit Appropriate Method: The taxpayer considered the operating cost to operating revenue as the Profit Level Indicator. The TPO has also considered the same PLI. The Profit before interest and tax is considered for computing the operating margins. But, the incomes and expenses related to the operations of the relevant financial year alone is considered for the computation of operating margins of the comparables. For example, the following incomes which are non-operating in nature and nothing to do with the operations of the company are excluded from operating revenues. i. Interest ii. Dividends iii. Provision no longer written back iv. Gain on sale of assets/investment v. Income from investments vi. Gain on revaluation of assets vii. Other incomes not pertaining to the operations Similarly, the followi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... transactions ₹ 11,19,31,568/- Shortfall being adjustment u/s 92CA ₹ 1,23,23,977/-. The ld TPO also observed that any disturbance of any one of the credit of the tax payer or the TPO result in comparability analysis and the TPO should be given an opportunity if such situation arises. In A.Y. 2007-08, the TPO directed to make adjustment U/s 92CA at ₹ 85,74,926/- and in A.Y. 2008-09 at ₹ 1,23,23,977/- and no deduction U/s 10B would be allowed to the tax payer as per provisions of Section 92C(4) of the Act. The draft order in both the years was served on the assessee thereafter the assessee filed its objection before the Dispute Resolution Panel-1, New Delhi (DRP) U/s 144C(2)(b) of the Act on different dates. The DRP passed its order U/s 144C(5) on 08/08/2011 in A.Y. 2007-08 and on 18/07/2012 in A.Y. 2008-09 by considering the assessee s submissions. The DRP considered the assessee s total objection-22 in A.Y. 2007-08 and gave the detailed order on objection wise and confirmed the order of the TPO on objection No. 1 by observing that the panel has come to a conclusion that there were flow ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... In this regard, the appellant, submits the following before your Honors: The appellant had applied similar filter for earlier A.Y. i.e. 2006- 07. The ld TPO during the assessment proceedings calculated the +/- 15% range from the employee cost ratio of the assessee (74.15% for A.Y. 2006-07) and accordingly selected comparable companies having employee cost to total cost ratio in the range of 59.15% to 89.15%. In case of appellant, the ratio of employee cost ratio for current year is 63.91%. Applying the basis applied by the TPO for A.Y. 2006-07, the +/- 15% range comes to 48.91% to 78.91% which is approximately close to the salary and wage cost ratio of 50% applied by the appellant. This also gives a clear indication that it is into software development and not into software products. Therefore, to identify appropriate comparable companies engaged into software development activities, a closer filter i.e. 50% should be used in order to arrive at close comparables. He relied on the decision in the case of Avaya India (P) Limited Vs. ACIT (ITA No. 5150/Del/2010). He further submitted that the following additional companies selected by the TPO as comparable to the appellan ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 89.15%, therefore, we allow the assessee s appeal on this ground. 12. For grounds No. 12 and 13 for A.Y. 2007-08, the ld AR for the assessee has submitted that the ld TPO and consequently the ld Assessing Officer had additionally considered the dissimilar companies as comparable to the appellant. The appellant had analysed these companies in detail and provided the detailed reasons for rejection of these companies. Sr. No. Company Name Margin as per TP Order Employee cost/Sales percentage Reason for inclusion by TPO Relevant pages of TPO/DRP order in the Appeal memo Submissions by Ideas India A-TPO s comparables rejected by IDeaS India 1 Accel Transmatic Limited ( Accel ) 20.59% 37.90% The company derives its entire software services segment revenue from software development activities Page 36 (Ground no. 15) and Page 180 to 183 (TP order. Para 13.1) of the Appeal Memo I. The company fails employee cost filter -Fails to satisfy the Emplo ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... considered this company as comparable in Appellant s own case for A.Y. 2006-07. However, the Hon ble Jaipur Tribunal in Appellant s case for A.Y. 2006-07 has rejected his company from the final set of comparable companies on the basis of Appellant s contention that the company is into sale of software products. - Refer page 510 of the paper book I. 3 Calestial Labs Limited ( Celestial ) 55.10% 25.69% . As per information received u/s 133(6) of the Act, this company was engaged in software development services. 96.4% of the revenue is from the software development. Page 36 37 )Ground no. 15) and Page 183 to 202 (TP order :Para 13.4) of the Appeal Memo. I. The company fails to satisfy the employee cost filter. - Fails to satisfy the Employee Cost Filter applied by the Appellant. Ratio of employees cost filter to sales is 25.69%. (Refer page 484 of the paper book I) II. The company is cherry picked - Cherry picking of this company (not covered is search process carried out by the Appellant as well as learned TPO also). III. The company is functionally different - Func ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ails to satisfy the employee cost filter - Fails to satisfy the Employee Cost Filter applied by the Appellant. Ratio of employee cost filter to sales is 35.67% (Refer page 484 of the paper book I) II. The company is functionally different - For F.Y. 2006-07, the company has primarily earned revenues from software sales and services . (Refer page 519 of the paper book I). Further, as per the P L a/c for F.Y. 2006-07 more than 95% of the operating revenues are from software sales and services . However, no break up of revenue from software services and software sales has been provided in the financial statements and therefore this company should not be accepted as functionally comparable. (Refer page 658 of the paper book I) - Very high turnover compared to Appellant s turnover- 183.51 crores. (Refer page 658 of the paper book I). 6 Infosys Technologie s Limited ( Infosys ) 39.73% 45.84% The learned TPO has stated in the TP order that this company is comparable selected by the tax payer in its TP document and was already discussed under the head Analysis of comparables chosen by the taxpayer in its ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ntangibles (Refer page 10 to 15 of the additional compilation I) - As per the information given in annual report for F.Y. 2006-07, the company filed 15 patent applications in US and 66 patent application in India. The company also owns proprietory product- Finacle, which addresses core banking, treasury, wealth management, consumer and corporate ebanking, mobile banking and web-based cash management requirements. The appellant does not own any intangibles/proprietory products. IV. Significantly high turnover - Very high turnover compared to Appellant turnover- 13,893 crores. (Refer page 665 of the paper book I) - Refer page 520 to 521 of the paper book I) 7 Ishir Infotech Limited ( Ishir ) 31.12% 48.25% The learned TPO has relied upon the information received from the reply to notice u/s 133(6) of the Act and computed the employee cost ratio Page 42 (Ground no. 15) and Page 210 213 (TP order: Para 13.12) of the Appeal Memo. I. The company fails to satisfy the employee cost filter - Fails to satisfy the Employee Cost Filter applied by the Appellant. Ratio of employee ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ee cost filter - Fails to satisfy the Employee Cost Filter applied by the Appellant. Ratio of employees cost filter to sales is 36.62% (Refer page 484 of the paper book I) II. The company is functionally different - The Annexure (ie Companies (Auditor s Report) Order, 2003) appearing on page 11 (Refer page 16 to 18 of the additional compilation I) of the annual report provides that- .. (ii)(a) The inventory has been physically verified during the year by the management. In our opinion, the frequency of verification is reasonable. (b) The procedures of physical verifications of inventories followed by the management are reasonable and adequate in relation to the size of the company and the nature of its business. (c) The company is maintaining proper (records of inventory). The discrepancies noticed on verification between the physical stocks and the book records were not material. However, the same have been properly dealt within the books of accounts. - Also, Inventories under the Schedules to the financial statements on page 15 of the annual report (Refer page 668 of the paper book I) discloses Software development as inventory and work-in-progress. It is to be noted tha ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... is functionally different if considered on company wide basis - The company has two divisions, namely: a) products division (XIUS-BCGI division); and b) consulting division (Blue Ally division) (Refer page 524 to 525 of the paper book I). The XIUSBCGI division does not engage in comparable activities. - The TPO has relied on information received under section 133(6) and concluded that major revenue (65%) in the products division (XIUSBCGI division) is from customization which is in the nature of software development services. Relying on the above the TPO has used company-wide margins mentioning that service revenues constitute more than 75% of the company-wide revenues. In this regard, following is an extract of the company s reply to notice u/s 133(6) dated 14th June, 2010: The billing for sale of products is done on number of licenses being sold to the client .The company does not charge the customer s separately for customization. The cost of customization is included in the cost of sale for licenses. Therefore, considering the company-wide margins on the ground that significant revenues from the XIUSBCGI division are from customization services is not appropriate. Further, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tion support services- it caters to the domestic market and offers integrated hardware packaged software solutions, sourced from principles and 2) Software development services. - As per the Director s report and the Management Discussion and Analysis, the software development services segment comprises of three sub-services namely (a) Embedded product design services i.e. design and development of hardware and software, (b) Industrial design and engineering services (i.e. Mechanical design with a focus on industrial design) and (c) Visual computing labs (i.e. animation and special effects for movies and TV). (Refer page 709 to 714 of the paper book I) - There is no sub-services break up/information provided in the annual report or the databases based on which the Appellant could compute the margin from software services activity and therefore the company is functionally different. II. Relied on replies for notice under section 133 - Relied on replies for notice under section 133(6) of the Act. The appellant submits that as per the company s response, the company is engaged in ITeS. - There is no sub-services break up/information provided in the annual report or the databa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Services; 2. Testing Services; 3. Consulting services. - As per page 125 of the annual report of Wipro Limited for the financial year ended 31 March 2007 (Refer page 718 of the paper book), the company owns significant intangibles like Customer related intangibles, Marketing related intangibles and Technology related intangibles. - Segmental information at standalone level for F.Y. 2006-07 was not available in public domain and the learned TPO has obtained the same by exercising powers u/s 133(6) of the Act. - In addition to the above, it is observed that the segmental information provided is an extract of the transfer documentation report maintained by Wipro for F.Y. 2006-07. The mere fact that the segmental information is derived from the transfer pricing report itself raises concerns on the acceptability of Wipro as a comparable as its transactions itself are subject to demonstration of arm s length standard. III. Owns Intangibles - The company has applied for 11 patents during the year in the fields of product engineering, enterprises business and quality. Further, the company also owns technical know how to INR 10 lacs as on 31 March 2007. Therefore, it is apparent that the c ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nt year data for the purpose of comparability analysis. The assessee has given reasons for not considering 12 comparables considered by the TPO at page No. 261 to 264 of TPO order. Finally 26 comparables which were given by the appellant is as under:- Sr. No. Name of the company TPO s unadjusted margins TPO s adjusted margin Employee cost/sales (As per TPO) EC/Sales 50% 1. LGS global limited (Lanco global solutions limited) 15.75% 15.80% 64.00% 15.80% 2. Quintegra solutions limited* 12.56% 9.83% 66.68% 9.83% 3. SIP technologies and exports limited** 13.90% 11.32% 39.92% NC 4. Accel transmatic Limited (segmental) 20.91% 20.59% 37.90% ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... soft limited (segmental)**** 60.23% 52.14% 37.87% NC 19. Mindtree limited 16.90% 16.00% 55.27% 16.00% 20. Persistent systems limited 24.18% 23.77% 54.95% 23.77% 21. R S software (India) limited 13.47% 13.76% 64.62% 13.76% 22. R systems international limited (segmental) 15.07% 13.87% 56.32% 13.87% 23. Sasken communication technologies limited (segmental) 22.17% 21.75% 57.03% 21.75% 24. Tata Elxsi limited (segmental) 26.51% 26.87% 54.35% 26.87% ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e capacity risk, political risk, single customer risk and country risk, which has been considered by the TPO in her order and finally considered this issue from page No. 199 to 217 and finally concluded as under:- * The taxpayer is totally dependent on the AE for business. Thus the taxpayer takes the risks associated with heavy dependence on a single customer. In common business parlance it is known as single customer risk . * The cost plus agreement with the AE does not guarantee sufficient volume of business nor period as the agreement is for a period of one year and renewed one year at a time unless terminated otherwise. The agreement can be terminated by any party at any time after giving a stipulated period notice. Thus the taxpayer is not free from the risk of losing business entirely or losing volume of business. * the taxpayer is not compensated any amount for termination of agreement even if it is terminated without any cause. No independent enterprise would like to agree for a termination clause without compensation if it is terminated without any cause. * The AE is exposed to the market risk and any fluctuation in the business conditions of the AE ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sks but margins varied from 1.38% to 60.23% on cost. * The taxpayer did not furnish any computation of the risk adjustment in the TP study. However, during the course of TP proceedings, the taxpayer submitted some method for computation of the risk, which is discussed above and rejected. * The taxpayer s single customer risk and political/country risk more than offsets any other risk differential between the taxpayer and the comparable companies. * Different comparables can have different risk profiles and different profit margins. The proviso to Sec. 92C(2) of the Act provides for adopting arithmetical mean to the different prices. This provision neutralizes the effect of difference in the risk profile, if any between the tax payer and the comparables as realized risk may pull down the profitability below the risk free return. * It is not sufficient to merely spell out risks. But, it has to be shown which risk was actually undertaken by the comparables and to what extent it affected the profitability. The taxpayer has not done so. Finally she rejected the assessee s claim of risk adjustment and held that no risk adjustment is given as the single ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... A.Y. 2008-09 vis a vis the approach of learned TPO in the TP order are summarized below for your Honours ready reference: Sr. No. Approach adopted by the Appellant Approach modified/applied by the learned TPO 1. Characterization based on FAR analysis Captive service provider operating in a risk mitigated environment Misinterpreted the FAR analysis undertaken by the Appellant and contended that Appellant bears risk (as mentioned in the TP order) 2. Search for comparable companies Conducted search using Prowess database updated as on 12th July 2008 and Capitaline database updated as on 6th June 2008 for identifying comparable companies Conducted unjustified fresh search using noncontemporaneous data for identifying additional comparable companies 3. Type of companies identified as comparable Indian companies engaged in providing similar services as that of the Appellant ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 2. Bodhtree Consulting Limited 19.14% 3. Celestial Biolabs Limited 87.94% 4. E-zest Solutions Limited 28.95% 5. Flextronics Software Systems Limited 8.07% 6. I gate global Solutions Limited 13.90% 7. Infosys technologies Limited 40.41% 8. KALS Information Systems Limited 41.94% 9. Lanco global systems limited 26.64% 10. Mindtree Limited 17.51% 11. Persistent Systems Limited 27.23% 12. Quintegra Solutions Limited 21.74% 13. R Systems International Limited 15.30% 14. R S Software (India) Limited 6.46% ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he TPO as comparable to the appellant should be rejected on the salaries and wages cost ratio criteria i.e. rejecting companies having salaries and wages cost ratio of less than 50% for F.Y. 2007-08. Sr. No. Name of the company Salary Cost Total Revenue % of Salary Cost to Total Revenue IDeaS India 7.10 11.12 63.88% 1. Infosys Technologies Limited 7,299 15,648 46.64% 2. Wipro Limited 7,408 17,493 42.35% 3. KALS Information Systems Limited 0.80 2.05 38.72% The appellant had analysed these companies in detail and provided the detailed reasons for rejection of these companies. 18.1 Grounds No. 10 12 of the appeal for A.Y. 2008-09 are against considering dissimilar companies as comparable companies to the appellant for determining the ALP of the inter ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... comparables considered by the TPO and after considering the assessee s objection for non comparable cases in case of 7 comparables, the average mean as worked out by the AR comes to 16.71%. The assessee has shown operating margin @ 13.17% resulting in difference of 3.54% which is within safe harbour rules. Since we have already held that these 7 comparables should be excluded the consequent difference i.e. 3.54% is lesser than the +\- 5% prescribed under safe harbour guidelines. The Jaipur Coordinate Bench in A.Y. 2006-07 has rightly held that the variation of ALP less than +\- 5% requires no ALP adjustment in the case of Shankar Exports Vs. Addl.CIT, 132 TTJ 107 and Ravi Kumar Rawat Vs ITO 134 TTJ 634. Therefore, we allow grounds No. 12 and 13 of the appeal in favour of the assessee. In result no adjustment is made in ALP. 21. For ground Nos. 10 12, the ld AR of the assessee further submitted that the ld TPO/A.O. considered the dissimilar companies to the appellant. It is further argued that these companies have supernormal profit as discussed in the order of A.Y. 2007-08. The Hon ble Delhi High Court in the case of CIT Vs. Agnity India Technologies Pvt. Ltd. (supra) had r ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ith heavy dependence on a single customer. In common business parlance it is known as single customer risk . * The compensation model with the AE does not guarantee volume of business nor the period. The agreement can be terminated by any party at any time after giving a stipulated period notice. Thus the taxpayer is not free from the risk of losing business entirely or losing volume of business. * The taxpayer is not compensated any amount for termination of agreement even if it is terminated without any cause. No independent enterprise would like to agree for a termination clause without compensation if it is terminated without any cause. * The AE is exposed to the market risk and any fluctuation in the business conditions of the AE affect the contractual terms between the AE and the taxpayer. Thus even if independent comparables undertake some risk, the taxpayer also had to undertake risks. * The independent entrepreneur has to incur expenditure on marketing, etc. which is debited to the profit and loss account. But, it is always not necessary that these risks reflected in the marketing, sales promotion expenses will automatically be compensated by incre ..... X X X X Extracts X X X X X X X X Extracts X X X X
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