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2015 (12) TMI 1410

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..... e, the TPO mentioned that the shifts in the assessee’s case started from 2005 onwards, however, the assessee chose to change the method in the financial year under consideration, the explanation of the assessee was that though the transition process started from September 2005 which was very gradual and led to the complete shift in the functional matrix of Infogain Group over a period of 2-3 years, therefore, the pricing model was changed w.e.f April 2007, the said explanation appears to be a plausible. In the instant case, the assessee assigned weights to each activity keeping in view the relative importance in the entire value chain, based on interviews with the key management personnel and the functions in the value chain of software services provided by the Infogain Group to the customers based in the US were identified and weights were assigned to the functions having regard to their relative importance in the value chain, which is evident from page nos. 229 to 234 of the assessee’s paper book wherein the functions are clearly designed in a tabular form. In the present case, both the parties i.e. Infogain India (assessee) and Infogain US are making contribution. Therefore, the .....

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..... Kapoor, Vikas Jain, Advs. and Sh. Rajan Sachdev, CA For The Revenue : Sh. Rahul Garg, Sr. DR ORDER PER N.K. SAINI, A.M. This is an appeal by the assessee against the order dated 01.10.2012 of the AO. 2. Following grounds have been raised in this appeal: The addition amounting to ₹ 145,259,630/- undertaken by the Deputy Commissioner of Income Tax, Circle 11(1), New Delhi ( the Ld. AO ) vide Assessment Order dated October 01, 2012 (received by the Appellant on October 12, 2012) passed under section 143 (3) read with section 154 of the Income Tax Act, 1961 (received by the Appellant on November 01, 2012) is not in accordance with the law and therefore not sustainable. Transfer Pricing ( TP ) Adjustment: ₹ 145,259,630 That the Hon ble Dispute Resolution Panel, New Delhi ( the DRP ) has erred both in law and on facts by summarily rejecting the Appellant s objections to the draft order passed by the Ld. AO under section 143(3) read with section 144C(1) of the Act. The Hon ble DRP while issuing directions under section 144C(5) of the Act did not consider the facts and merits of Appellant s objections to the proposed adjustments, and mere .....

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..... analysis based on his own conjectures and surmises. Specifically, the Ld. TPO erred by using an approach that had an inherent upward bias and employed erroneous filters, that were designed to select only high margin comparable companies. Accordingly, the fresh search conducted by the Ld. TPO is liable to be quashed. 1.7. The Ld. TPO erred on the facts and circumstances of the case and in law by misconstruing Rule 10B (1) of the Income Tax Rules, 1962 ( Rule ) and its applicability on the facts and circumstances of the case. In this context the Ld. TPO has erred in disregarding independent legal status accorded to an overseas branch of an Indian company in view of the provision of clause (iii) of Section 92F of the Income Tax Act, 1961 ( Act ). 1.8. The Ld. TPO erred in the facts and circumstances of the case and in law by using data called pursuant to issuance of notice under Section 133(6) of the Act which was not available to the Assessee at the time of maintenance of Transfer Pricing Documentation. Further, the Ld. TPO also erred by not providing the complete information which was called pursuant to issuance of notice under Section 133(6) of the Act and by conducting t .....

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..... considered and judicially interpreted and the same do not justify the addition made. 2.6. That the addition / disallowance made are illegal, unjust and bad in law and are based on mere surmises and conjunctures and the same cannot be justified by any material on record. 3. From the above grounds it would be clear that only grievance of the assessee in this appeal relates to the addition amounting to ₹ 14,52,89,630/- made by the AO on account of transfer pricing adjustment. 4. Facts of the case in brief are that the assessee was engaged in the business of software development and filed the return of income on 30.03.2010 declaring income of ₹ 1,41,28,871/- which was processed u/s 143(1) of the IT Act, 1961 (hereinafter referred to as the Act). Later on the case was selected for scrutiny. 5. During the course of assessment proceedings it came to the notice of the AO that the assessee had international transactions for which the assessee had filed form no. 3 CEB as per the provisions of Section 92E of the Act relating to international Transactions in access of ₹ 5 crores. The AO as per the provisions of Sec. 92CA(3) referred the matter to the Transfer P .....

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..... 7 crores. By a mere reading of the form 3CEB it automatically transpires that the assessee has provided software development services to its overseas AE. The TP report in its executive summary has also stated that Infogain India provides software services to Infogain US which in turn provides these services to the end customers. However, we are also given the pre migration and post migration flow charts by which we understand that pre migration the contractual arrangement for services was made by the US AE with the customer which further made a contractual arrangement for development with Infogain India. Infogain India, after developing the same delivered it to Infogain US who in turn provided it to the end customer. Post Migration, flow chart shows that there is no shift as far as the contract with end customer and AE and further sub contract to Infogain India is concerned, there is no marked shift. However, the delivery models have been different. Infogain US develops onshore in addition to sales and marketing services and Infogain India after the development process is over delivers directly to clients. The flow charts are only representative of functions and not fund .....

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..... sis of reliable external market data which indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances. We have nowhere in the submissions, or during the course of discussion seen that the assessee has made any attempt by evaluating the contribution made by Infogain India and Infogain US on the basis of FAR of each one of them and have reliably employed any external market data which may be indicative of how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances. The moot issue here is to reasonably and reliably identify a basic return appropriate for the type of international transaction in which the parties at test are engaged, with reference to market returns achieved for similar types of transactions by independent enterprises. In none of the methods employed for determination of ALP, the issue of comparability is dispensed with. The foremost requirement of determination of ALP is to identify a comparable transaction. In the case of Profit Split Method, the way that has to be done is also mentioned. We do not find that the assessee has de .....

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..... however directed the TPO to exclude Celestial Labs Limited from the set of comparables because it is not suitable. The DRP also directed to exclude rental and corresponding rental expenses to work out the margin in the case of Softsol Limited. As regards to the objection of the assessee with reference to forex and provision for bad debts, the DRP directed the TPO as under: These are an accounting issue and depend on the facts of the case and whether they are materially impacting the results of the taxpayer and should be accordingly considered for comparables. Provision for doubtful debts is not a normal operating expenses/income hence has been rightly excluded. Issues of forex is to be examined by TPO if it is not materially affecting assessee should not be taken for comparables either. 11. As regards to the objection of the assessee for considering the multiple year data instead of single year data while working out the Arm s Length Price, the DRP observed as under: This issue has been examined in detail in TPO s order. Briefly summarized, the arguments put forth by TPO are based on the law as it exists. Persuasive value of OECD guidelines have also been considered .....

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..... client services and delivery function and currently the team at Infogain US has been reduced to one-fourth since the conversion year. It was further stated that Infogain India assists Infogain US, to a limited extent, in client identification and marketing functions and in respect of international regions (regions other than US and UK), Infogain India is engaged in performing client identifications, marketing and client relationship management functions. It was further stated that the Ingfogain Group provides software services to its clients/customers by adopting any of the following delivery models: 1. Offshore Service Delivery Model; 2. Dual Shore Service Delivery Model. 14. It was stated that Infogain India adopted Profit Split Method (PSM) as the most appropriate method for the financial year 2007-08 relevant to the assessment year under consideration, in view of the fact that it transitioned from a back end software services company of its AE to being fully responsible for the execution and delivery of software services to the end customers. It was submitted that under the offshore service delivery model, the entire project is developed and managed offsite (i.e. .....

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..... , pricing and other contractual provisions and managing customer relationship for clients/customers in such regions: Formulating the sales strategy for such regions; and Account management of clients in such regions. In the software services rendered by the Infogain Group, customer relationship management is a critical function which is performed by Infogain US. In October 2007, for expansion into non-United States regions, another SBU i.e. International was created in India and a General Manager was appointed. This was done in order to reduce Infogain Group s dependence on United States which was experiencing a slow done. This led to a marketing department being instituted in India. The marketing department was responsible to perform marketing and selling activities to target customers/clients in regions where Infogain US/Infogain UK are not operating. Infogain India also performs the marketing fuctions which include the following activities: Infogain India receives markeing leads through its website, which is operated, maintained and updated from India. Leads in relation to regions where its AEs operate are forwarded to respective AEs, while those f .....

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..... gy functions: - Preparation of technology roadmap it has to assess future technology trends and provide directions to realize the best return on investments, create the technology strategy roadmaps, evaluate and promote tools, technology for internal usage; - Launching of the knowledge management portal and head the steering committee; - Assist the development teams in architecture design, frameworks and evaluate current architecture of specific projects, execute gap analysis and suggest improvement, develop new framework based solutions, such as, performance and scalability framework for marine terminal systems, develop, formalize, packaging and adoption of best practices, such as, assessment offerings, managed services offerings; and - Implement center of excellence laboratories in each verticals, publish technology white-papers, review technical design in bids/proposals, etc. The following table depicts the split in the functional responsibilities of Infogain and its AEs: Table 5: Functional Responsibilities of Infogain and its AEs Functions Performed Entity Identifying .....

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..... rs Capacity Utilization, Labour Arbitrage, Funds Acquisition and Forex Management Infogain India/Infogain US 15. As regards to the pricing decision, the ld. Counsel for the assessee submitted that in the pre-restructuring phase, Infogain US was solely responsible for determining the key terms and conditions of the contract with the customers, including pricing. However, with the introduction of an online costing tool in August 2006, Infogain India also began to provide important inputs in the entire pricing decision based on project costing estimates, resource requirements, time commitments etc. as the entire delivery responsibility had migrated to Infogain India. It was further stated that the Price Decisions based out of Infogain India are responsible to feed in information on individual projects in the online tool and thus the pricing decision is taken jointly out of Infogain India and Infogain US. However, the ultimate decision for closing sales deal is taken by the CSO (Sales) and CEO based out of United States. It was emphasized that during the preceding assessment year 2007-08 no joint discus .....

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..... ed by Infogain US, customers based in the US and weights were assigned to the functions having regard to their relative importance in the value chain and subsequently functions were allocated between Infogain India and Infogain US based on discussions with key personnel and details provided by Infogain India/Infogain US and thereafter the split ratio of 40:60 in between Infogain India and Infogain US is worked out. It was submitted that the methodology adopted by the assessee is supported by the OECD 2010 guidelines and accordingly the assessee had chosen the PSM as the most appropriate method. The ld. Counsel for the assessee referred to page no. 229 of the assessee s paper book which is the copy of FAR analysis done by the assessee, a reference was also made to page no. 213 of the assessee s paper book and it was stated that functions were clearly designed which clearly shows that Infogain India and Infogain US, both were making the contribution. Therefore, TNMM was not the correct method and the PSM method adopted by the assessee is most appropriate method. It was pointed out that in the assessment year 2011-12 also the Profit Split Method has been accepted while framing the ass .....

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..... . It was further stated that Circular No. 6 issued by the CBDT has no relevancy for the functional profile of developer in R D sector. Therefore, the PSM was not applicable in assessee s case and the TPO/AO rightly applied the TNMM method as most appropriate method. The reliance was placed on the following case laws: Haworth (India) (P) Ltd. Vs DCIT(OSD) (2011) 131 ITD 215 (Del) Sony India (P) Ltd. Vs DCIT (2008) 114 ITD 448 (Del) 18. It was further submitted that while applying the PSM the assessee has not given any objective way of weightage, there was only subjective estimation without any objective data, therefore the profit split method simply fails and TNMM was rightly applied by the AO. 19. In his rejoinder of the ld. Counsel for the assessee submitted that the applicability of the method is based on interrelated transactions. He referred to page no. 243 of the assessee s paper book and submitted that the grouping of function has been done and weight has been assigned to each function for which neither the TPO nor the DRP raised any objection. It was further stated that in the succeeding assessment year 2009-10, no such adjustment has been made by the depart .....

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..... n 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 in which it is engaged, with reference to market returns achieved for similar types of transactions by independent enterprise and thereafter, the residual net profit remaining after such allocation may be split amongst the enterprise 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; 21. From the provisions contained in the above said Rule 10B(1)(d), it is clear that PSM may be applicable in case where transaction involved transfer of unique, intangibles or any multiple transactions interrelated international transactions which cannot be evaluated separately for determining the Arm s Length Price of anyone transaction. The Profit Split Method (PSM) first identifies .....

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..... assets employed or to be employed and risks assumed by each enterprise and on the basis of reliable external market data which indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in the similar circumstances; (iii) the combined net profit is then split amongst the enterprises in proportion to their relative contributions, as evaluated under sub clause(ii); (iv) the profit thus apportioned to the assessee is taken into account to arrive at an arm s length price in relation to the international transaction; 181. This method may be applicable in case where transactions involved transfer of unique, intangible or any multiple interrelated international transactions, which cannot be evaluated separately for determining the ALP of any one transaction. 182. The profit split method first identifies the profit to be split for the associated enterprise from the controlled transactions in which the associated enterprises are engaged. It then splits those profits between the associated enterprises on an economically valid basis that approximates the divisions of profits that would have been anticipated and reflected in .....

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..... eration would be determined by applying one of the traditional transaction methods or a transactional net margin method, by reference to the remuneration of comparable transactions between independent enterprises. Thus, it would generally not account for the return that would be generated by any unique and valuable contribution by the participants. In the second stage, any residual profit (or loss) remaining after the first stage division would be allocated among the parties based on an analysis of the facts and circumstances, following the guidance as described at paragraphs 2.132- 2.145 for splitting the combined profits. 2.122 An alternative approach to how to apply a residual analysis could seek to replicate the outcome of bargaining between independent enterprises in the free market. In this context, in the first stage, the initial remuneration provided to each participant would correspond to the lowest price an independent seller reasonably would accept in the circumstances and the highest price that the buyer would be reasonably willing to pay. Any discrepancy between these two figures could result in the residual profit over which independent enterprises would bargain. .....

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..... en the associated enterprises based on the relative value of each enterprise s contribution, which should reflect the functions performed, risks incurred and assets used by each enterprise in the controlled transactions. External market date (e.g. profit split percentages among independent enterprises performing comparable functions) should be used to value each enterprise s contribution, if possible, so that the division of combined profits between the associated enterprises is in accordance with that between independent enterprises performing functions comparable to the functions performed by the associated enterprises. The Profit Split Method is applicable to transfer pricing issues involving tangible property, intangible property, trading activities or financial services. 17.7. Residual analysis is stated as follows: 6.314.7 The Residual Profit Split Method is used more in practice than the contribution approach for two reasons. Firstly, the residual approach breaks up a complicated transfer pricing problem into two manageable steps. The first step determines a basic return for routine functions based on comparables. The second step analysis returns to often unique i .....

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..... strated in Figure 10-2, RPSM proceeds in two steps: Step 1: Functional capital is provided a return derived from data for functional comparables, i.e. independent companies performing similar routine manufacturing or distribution functions; and Step 2:The remaining residual operating profit or loss is allocated based on residual, entrepreneurial capital so as to equalize the rate of return on such capital, adjusted for market differences in the cost of capital. In actual practice, implementation of the RPSM concept outlined above involves the determination of a number of interrelated valuations of functional and entrepreneurial activities in different countries and economic circumstances. The existing IRS regulations provide relatively little specific guidance concerning these valuations, and thus leave open the question of how best to determine the relative value of each controlled taxpayer s contribution to the success of the relevant business activity in a manner that reflects the functions performed, risks assumed, and resources employed by each participant in the relevant business activity, consistent with the comparability provisions of 1.482- 1(d) (3) . .....

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..... d from the operations of the uncontrolled parties and net margins derived by an AE from similar operations. Net margin is indicated by the rate of return on sales or cost or operating assets, and this forms the basis for TNMM. A functional analysis of the tested party or the independent actions are comparable and the adjustments that are required to be made to obtain reliable results. The tested party would have to consider other factors, like cost of assets of comparable companies, etc. while applying the return on assets measure. Ordinarily, the tested party, has to be the party provided services because it is on the basis of rate of return on sales or cost or operating assets that transactional margin is computed. These parameters generally available in the case of party providing service. 18.1. The, in its review of comparability and methods, dt. 22nd July,2010 in Part III B Transactional Net Margin Method, B I, page 33, paras 2.58 to 2.59, held as under: B. Transactional net margin method B.1. In general 2.58 The transactional net margin method examines the net profit relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realizes from .....

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..... transfer pricing purposes. The TNMM examines the net profit margin relative to an appropriate base (e.g. costs, sales, assets) that a tax payer realizes from a controlled transaction (or transactions that are appropriate to be aggregated). The profit margin indicators are discussed in paragraph 2.3 below. The TNMM compares the net profit margin (relative to an appropriate base) that the tested party earns in the controlled transactions to the same net profit margins earned by the tested party in comparable uncontrolled transactions or alternatively, by independent comparable companies. As such, the TNMM is a more indirect method than the cost plus/resale price method that compares gross margins. It is also a much more indirect method than the CUP method that compares prices, because it uses net profit margins to determine (arm s length) prices. One should bear in mind that many factors may affect net profit margins, but may have nothing to do with transfer pricing. The TNMM is used to analyse transfer pricing issues involving tangible property, intangible property or services. When the TNMM is applied on controlled transactions involving tangible property, the te .....

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..... le. In the instant case, the assessee assigned weights to each activity keeping in view the relative importance in the entire value chain, based on interviews with the key management personnel and the functions in the value chain of software services provided by the Infogain Group to the customers based in the US were identified and weights were assigned to the functions having regard to their relative importance in the value chain, which is evident from page nos. 229 to 234 of the assessee s paper book wherein the functions are clearly designed in a tabular form. In the present case, both the parties i.e. Infogain India (assessee) and Infogain US are making contribution. Therefore, the Profit Split Method is the most appropriate method for determination of ALP. In the instant case, it is noticed that the TPO in the show cause notice has pointed out that the assessee changed the method due to loss incurred, in our opinion, the conclusion drawn by the TPO was not justified because the decision as what is the most appropriate method does not depend on the fact as to whether an assessee is having loss or has a profit. Moreover, the TPO has not demonstrated or substantiated how the cha .....

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..... ITO Vs Net Freight (India) P. Ltd. in ITA No. 4670/Del/2009 order dated 31.12.2013 25. In the former part of this order, we have held that in the assessee s case to determine the Arm s Length Price, the most appropriate method is the Profit Split Method, now question arises that how the allocation is to be done for residuary profits. It is well settled that as per the Rule 10D, the benchmarking should be done with the external uncontrolled transactions, however, in the present case, it is not possible to get a comparable. Therefore, such allocation can be done on the basis that how much each independent enterprise might have contributed. Therefore, relative contribution has to be determined, based on key value drivers because benchmarking is not practicable. In the present case, as the comparables having similar transactions would be difficult to find out, therefore, in such a situation, a harmonious interpretation of the provisions is required to make the rule workable, so as to achieve the desired result of the determination of the ALP. Both the OECD Transfer Pricing Guidelines as well as the UN draft method of transfer pricing for developing countries, suggest that an allo .....

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