Income Tax Appellate Tribunal - Delhi
St Electronics (P) Ltd, vs Assessee
IN THE INCOME TAX APPELLATE TRIBUNAL
DELHI BENCH: 'G' NEW DELHI
BEFORE SHRI RAJPAL YADAV, JUDICIAL MEMBER AND
SHRI B.C.MEENA, ACCOUNTANT MEMBER
I.T.A Nos. 1806,1807/Del/2008
Asstt. Years - 2003-04,2004-05
M/s. ST Microelectronics Vs. Commissioner of Income Tax
Private Limited, 204-206, (Appeals) - XX, CR Building,
Tolstoy House, Tolstoy Marg, New Delhi.
New Delhi
(Appellant) (Respondent)
I.T.A Nos. 1598,1599/Del/2008
Asstt. Years - 2003-04,2004-05
DCIT, Cir.9 (1) Vs. M/s. ST Microelectronics
Private Limited, 204-206,
Tolstoy House, 15, Tolstoy
Marg, New Delhi
(Appellant) (Respondent)
I.T.A No. 5058/Del/2010
Asstt. Years - 2006-07
M/s. ST Microelectronics Vs. Addl. CIT
Private Limited, 204-206, Range-9,
Tolstoy House, 15, Tolstoy New Delhi.
Marg, New Delhi
(Appellant) (Respondent
Appellant by: S/Sh.Pawan Kumar, Aditya Gupta, Sanjiv
Choudhary,S.K. Aggarwal & Rajan Sachdev,
CAs
Respondent by: S/Sh.Rajni Kant Gupta, A.D. Mehrotra, CIT
DR & N.K. Chand, Sr.DRs
2
ORDER
PER RAJPAL YADAV, JM:
In assessment years 2003-04 and 2004-05, assessee and revenue are in cross appeals against the separate orders of even date i.e. 28th February, 2008 of Ld. CIT(A) In asstt. year 2006-07, assessee alone is in appeal against the order of Ld. DRP dated 29.9.2010 passed u/s 144C of the Income Tax Act. Though these appeals were heard separately, but the solitary issue raised by the respective parties in asstt. year 2003-04 and 2004-05 is common with one of the ground taken by the assessee in asstt. year 2006-07. This common ground in all the three years, relates to addition made on account of adjustment recommended by the TPO in the arms length price of the international transactions entered by the assessee with its associate enterprises. The facts and circumstances on this issue are common. Therefore, we deem it appropriate to dispose of all these appeals by this common order.
2. The basic facts are common in all the asstt. years. For the facility of reference, we are taking up the facts from the asstt. year 2003-04. However, if we find some variation in the facts which have 3 any bearing in adjudicating the controversy, we would refer those facts at the appropriate stage of this order.
3. The dispute in brief is that assessee has disclosed international transaction with its associate enterprises in all these three asstt. years. In its transfer pricing report submitted in form No. 3CEB, it has provided the appropriate method as transactional net margin method (TMM) and computed the PLI by dividing operating profits with operating cost. In this procedure, assessee has shown profit level indicator at 9.87%. The Ld. TPO on the basis of comparables, recommended the adjustment by working out average operating profit on total cost ratio of 17.88% in asstt. year 2003-04. Ld. CIT(A) has reduced this percentage to 16.16% by applying more filters in selecting the comparables. In this way, the adjustment recommended by the TPO has been marginally reduced. The assessee is disputing additions made on the recommendation of the TPO for making adjustment in its arms length price, whereas revenue in its appeal is disputed the reduction made by the Ld. CIT(A) in working out the PLI at 16.16%. Similarly, in asstt. year 2004-05, assessee has worked out average operating profit on total cost ratio at 8.93%. TPO recommended it 17.50%. Ld. CIT(A) reduced it to 16.33%. Both 4 parties are disputing the retention of the adjustment recommended by the TPO and reduction of the adjustment made by the Ld. CIT(A). In asstt. year 2006-07, there is no difference in the method applied by the assessee. It had shown PLI at 11.6%. The TPO worked out the average of OP over TC i.e. PLI at 18.13%. Ld. DRP has upheld the recommendations made by the TPO for making adjustment in the ALP of international transaction. The assessee is impugning the addition on the basis of such recommendation.
Asstt. year 2003-04
4. The brief facts of the case are that assessee has filed its return of income on 2nd December, 2003 declaring an income of ` 10,60,25,643/-. Along with the return assessee has submitted statutory audit report, tax audit report, audited balance sheet and P &L account. The case of the assessee was selected for scrutiny assessment and a notice u/s 143(2) was duly issued and served. Shri Ankur Gupta, Chartered Accountant appeared on behalf of the assessee from time to time and filed the necessary details. The assessee has shown two international transaction with its associate enterprises carried out in financial year 2002-03. These transactions reported in form No. 3CEB read as under :-
5
S.No. Type of international Value of Method Tested party transaction transaction selected
1. Provision of Integrated 1,32,25,62,370 TNMM ST India Circuit Design, CAD Tools and software development services
2. Provision of Market 2,67,53,693 TNMM ST India Support service
5. The Ld. AO in order to judge the appropriateness of arm's length price disclosed by the assessee with respect to its international transaction with associate enterprises, as reported in the TP report submitted by the assessee along with form No. 3CEB, made a reference u/s 92CA(1) of the Act to the transfer pricing officer. Ld. TPO in order to verify whether assessee has disclosed the value of its international transaction according to the arms length price or not examined the transfer pricing report submitted by the assessee and thereafter pointed out the defects in preparation of such report. After hearing the assessee, he carried out a fresh search and then selected suitable comparables and then recommended the adjustment in the value of internal transaction disclosed by the assessee. In this exercise, Ld. TPO first noticed the business profile of the assessee. Thereafter, he noticed operating model etc. The object of analysing the report is that such report will throw light on the function performed by undertaking, what type of assets were employed and how much risk was assumed by the assessee. Keeping in view these factors it is to be seen how much return is disclosed by the assessee in 6 the shape of profit whether it is consumerate with the function performed, assets used and risk assumed. The business profile and operating model noticed by the Ld. CIT(A) read as under :-
"A. Business Profile:
4.4 Before adjudicating on the TP issue, it would be appropriate to sketch the business profile of the appellant as described in the TP report :-
(i) The ST Group (headquartered in Netherlands) is a global group that designs, develops, manufactures and markets a broad range of semiconductor integrated circuits (ICs) and discrete devices used in a wide variety or microelectronic applications, including telecommunications systems, computer systems, consumer products, automotive products, industrial automation and control systems.
(ii) The product portfolio covers all major categories of semiconductor devices, dedicated ICs, microprocessors and semi conductors, memories, standard ICs
(iii) ST Group is the world's leading supplier of MPEG-2 decoder ICs, digital set-top box ICs and EPROM non-volatile memories and also the second leading supplier of analog and mixed-single ICs, disk drive ICs, Smart card ICs and EEPROM memories.
(iv) ST Microelectronics Private Ltd. (STML) is a subsidiary of ST Microelectronics Pte. Ltd. (ST Singapore) which in turn is a wholly owned subsidiary of ST Microelectronics NV, Netherlands.
(v) STML is engaged in the business of Integrated Circuit design, CAD Tools and software development for its overseas group concerns.
(vi) STML also provides marketing support services to a group company
(vii) STML is a 100% Export Oriented Unit (EOU) set up for development of Integrated Circuit Design, CAD Tools and Computer Software.
B. T.P. Report & Function, Assets & Risk (FAR) Analysis :
4.5 The following are the international transactions entered into by STML with its associated enterprises during the subject year:
• Provision of software development services; and • Provision of market support services.
Since the market support services constituted only 2% of the overall revenue, both these transactions were aggregated and subjected to a common analysis.7
4.5.1 As per the functional analysis carried out at Para 3 to 3.2.3 in the TP Report, the following are the details relating to the major functions performed in respect of the international transaction along with risk assumed and assets deployed by the appellant discussed in subsequent sub-paras.
4.5.2 Operating model: The operating model of the ST group in respect of software development services is briefly described below:
• ST NV performs the long-term strategic management and planning function for overseas operations • The product conceptualisation, core design, research and development, marketing, distribution, sales and post-sales client support are all performed by ST Group • All major decisions relating to software development (in terms of extent, timing, sequence, etc.) are taken by ST Group. • ST Group follows a waterfall model of chip design/software development life cycle.
• ST Group is engaged in core technology development, complex manufacturing, global sales and marketing, etc. • STML develops Integrated Circuit Designs, CAD Tools, Computer Software etc, for ST Group and undertakes these activities in accordance with the guidelines.
• STML acts as a back office contract service provider to ST Group and does not need to perform software development for any external customers.
• STML only performs the routine service function in the life cycle provided by the ST Group, within the framework of budgets decided between ST India and ST Group, which shows that all high value functions are performed by ST Group.
• STML undertakes all the common functions such as finance and accounting, budgeting, system maintenance, personnel management, human resource management etc. that re carried out by business irrespective of its size and nature.
4.5.3 ST Group owns significant tangibles and intangibles that are used in manufacturing and other activities. The tangible assets deployed by STML are to the extent of Rs. 112.30 crores which include office equipments (64.8 crores), building (30.3 crores), leasehold land (8.9 crores) and furniture and fixtures (8.4 crores). In addition to the tangible assets, certain intangible assets are deployed by STML. During the course of its functioning, STML develops certain intangibles without having any proprietary rights on them. The details, as per the TP report, are as under :-8
• STML uses the process know-how , software, operating / quality standards, designs, diagrams, technical specifications, etc. developed / owned by ST Group. • STML has developed certain proprietary chip design /software development and related service modules. However, it does not undertake any research and development on its own account that leads to the development of non-routine intangibles / products. • The ICs designed /software designed, developed, amended of modified by STML is the property of the ST Group and at no point in time does ownership vest with STML. • STML does not own any copyrights, patents rights, trade secrets or trademarks on such software solutions. Further, STML does not have any copyrighted products that are sold to ST Group.
• STML does not own any significant non-routine intangibles. 4.5.3 The market risk, product liability risk, technology risk, credit risk, etc. are assumed by the ST Group whereas STML is mostly insulated from these risks.
The following are the details of risks assume by the STML:
• STML does not have significant exposure to market risk because it renders software development services exclusively for ST Group under a long-term development contract. • STML does not have exposure to product liability risk because it develops a part of the product wherein the final ownership of the product lies with ST Group which is responsible for any claims on the products.
• As ST Group provides the necessary core tools and know-how relating to the basic technology / platform, it also bears Technology risk and the same is not assumed by STML. • STML does not undertake any research and development on its own account, and accordingly, it is not exposed to this risk. • STML is protected from credit risk as it is compensated by ST Group irrespective or collections by the latter from the ultimate customer.
• STML bears foreign currency risk during the period between involving and recovery.
• STML is exposed to manpower risk.
• As ST India bills ST Group on a cost plus basis, it does not bear the idle capacity risk.
• STML has low exposure to price risk because it renders software development services exclusively for ST Group under a long term development arrangement.9
6. Ld. TPO after analysing the TP report submitted by the assessee observed that assessee has identified a set of 14 comparable companies from prowess data base by adopting a formula based search strategy, thereafter it applied various quantitative and qualitative filters to the set of potential comparables. He also found that assessee has relied multiple year data and had focused on the operating results of comparable over the three Financial years i.e. Finance year 2000-2001 to 2002-03. The arithmetic mean of the 14 comparables identified by the assessee was worked out at 11.88%. The assessee has shown operating profit over cost at 9.87%. It was submitted by the assessee that NCP margin shown by it at 9.87% is within the variation allowed by the proviso to section 92C(2) of the Income Tax Act and, therefore, no adjustment is required. Ld. TPO has observed that assessee has considered itself a low end risk, captive software service provider to ST group, whereas according to the Ld. TPO the assessee is to be characterise as a performer of high end activity relating to value added segment " Embedded Technologies" for high profit margins. According to the Ld. TPO the assessee has characterised its functional profile improperly, it led to incorrect selection of 10 comparable by applying wrong quantitative and qualitative filters . The TPO has also observed that it has used multi year data which is not permissible in law. The assessee is supposed to use current year data for bench marking analysis. Ld. TPO thereafter made an analysis of functional profile of the assessee. In his opinion the value chain of the software industry consist 6 levels.
Level 1 is a basic data analysis work.
Level 2 represent low value adding functions of coding and testing ; value added functions of designs and project management shown by the customer itself.
Level 3 specifies the project development , which requires domain expertise and investment Level 4 represent developing products from project experience that can be customized to clients needs.
Level 5 represents developing pre packaged products for specific segments.
Level 6 represent developing packaged products than can be sold of the self
7. According to the Ld. TPO in Financial Year 2002-03 most of the Indian Companies were operating between level 2 and 3, whereas 11 the software development work carried out by the assessee relates to level 4 and 5. Ld. TPO has arrived at a conclusion that functional profile of the assessee as a developing of integrated circuit design, CAD tools and computer software work, entailed high end intangible creation activity. For arriving at this conclusion he has assigned a number of reasons and Ld. CIT(A) take cognigence of those reasons in a summarised way and they read as under :-
(i) STML is one of the largest design centres of ST Group outside Europe.
Seamlessly integrated into ST Group's research and development organisation.
(ii) STML combines the power of an advanced worldwide communications network and the discipline of a global service oriented corporate culture with the skill and enthusiasm of the Indian Scientific engineering community.
(iii) STML has established a Design Centre at Noida, which serves the group as one of the most important centre for IP creation. It develops libraries of reusable IPs based upon UNICAD and the CAD platform, especially in advanced System-on-Chip (SoC) solutions for digital consumers, computer, telecom and automotive applications.
(iv) Among the custom chip designs that have been implemented at Noida are telephone ICs and a variety of high profile hard disk and computer peripherals.
(v) The range of design activities carried out by STML reflects the multifunctional nature and its ability to create leading edge technologies.
(vi) STML specializes in developing high value VLSI intellectual Property (IP's), System on Chip (SOC's), embedded software for end applications and IT infrastructure.
(vii) STML was also a major contributor to the development of the latest Nomadik chip family which will enable portable terminals to play music, take pictures, record video, and host two-way communication
(viii) The Transfer Pricing Report admits that the design centre of STML is the most import centre of the group for intellectual property creation.
(ix) STML renders designing services using the latest 2D and 3D CAD with critical software. The ICs design/software development services 12 performed by STML require a high level of expertise in the field of software engineering.
(x) The agreement between assessee and parent company states that the ST Netherlands is interested for the furtherance and recognition of its leading position as supplier of a broad range of semiconductor device in a wide variety of semiconductor applications, to develop its intellectual property portfolio through the procurement of state of art development services.
(xi) The agreement further states that the STML, has very qualified, experienced and skilled engineers and designers in the field of developing integrated circuit designs, CAD tools, computer software finger print security systems, biometric solutions and related software.
(xii) STML is carrying out the most critical and important part of the value addition chain. The design of the Chip leads to creation of intellectual property rights that can be exploited commercially.
(xiii) Normally, a typical software developer acts at the instruction of its principal and does not carry out any work contributing to creation of IPRs or intangibles. The nature of work being carried out by STML is a high end activity forming part of the broad category of "Embedded Technologies" for which the margins are usually high and the growth rate is impressive.
8. Ld. TPO has observed that assessee had treated all companies engaged in software development services at par without making any reference to their position about value chain. For developing a high end software product, highly qualified technical personnel would require. Such characteristic ought to be kept in mind while choosing comparable for high end service provider like assessee. On the strength of Rule 10B2,10B3 and guidelines issued by the OECD Ld. TPO has pointed out the defects in the selection of comparables committed by the assessee. These reasons have been summarised by the Ld. CIT(A) in the impugned order which read as under :-
(i) "Specific characteristics of the property transferred or services provided in either transaction
(ii) Functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions
(iii) 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;
(iv) Conditions prevailing in the markets in which the respective parties to the transactions operate, including geographical locations and size of the markets, the laws and Government orders in force, costs of labor and capital in the markets, overall economic development 13 and level of competition and whether the markets are wholesale or retail
(v) A high degree of similarity is required in a number of aspects of the associated enterprise and the independent enterprise involved in the transactions in order for the controlled transactions to be comparable
(vi) Various factors other than products and functions that can significantly influence net margins.
(vii) Net margins may be directly affected by such forces operating in the industry as follows • Threat of new entrants • Competitive position • Management efficiency and individual strategies • Threat of substitute product • Varying cost structures as reflected in the age of the plant and equipment • Differences in the cost of capital self financing versus borrowing • Degree of business experience whether the business is in a start up phase or is mature:
(viii) Net margins are also indirectly affected by a plethora of other forces as each of the above mentioned factors in turn can be influenced by numerous other elements. For example the threat of new entrants will be determined by such elements as product differentiation, capital requirements, and government subsidies and regulations.
(ix) In case of stark differences between controlled and uncontrolled transactions when no reliable adjustments can be made, the results of the uncontrolled transactions cannot be used for benchmarking at all. "
9. After pointing out various defects in the TP report prepared by the assessee and how it erred to use multiple year data for identifying the comparable Ld. TPO proceed to carry out a search for new comparables, he selected prowess data base for the financial year 2002-03. He took into consideration all companies engaged in computer software development. In a way the Ld. TPO has selected 10 test for identifying the comparables. The filter employed by him is 14 that companies with total sales below Rs. 10 crore and above Rs. 1000/- crore were excluded. Companies functionally different from the assessee were excluded. Companies having employee cost to total cost ratio below 10% were excluded. The companies with operating loss margins / total cost of more than 20% or with operating profit /total cost of more than 80% have also been excluded. This search identified 44 potential comparables. After applying the filters, Ld. TPO came out 23 comparables. An arithmetic mean of all these 23 comparables have been worked out at 17.86%. He recommended the adjustment by adopting this PLI. The AO accepted the recommendation made by the Ld. TPO and accordingly made an addition of Rs. 10,35,72,191/-.
10. Dissatisfied with the TPO's recommendation, assessee carried the matter in appeal before Ld. CIT(A). It submitted that Ld. AO was erred in making a mechanical reference to the TPO as well as acceptance of TPO's recommendation. It pointed out that Ld. TPO has erred in classifying the assessee's business as high end service provider. According to the assessee, there is no material on the record which suggest that assessee is a high end service provider. For buttressing his contention, assessee has drew the attention of Ld. 15 First Appellate Authority about its operating model as well as business profile extracted supra. It also submitted that Ld. TPO has erred in rejecting the search methodology used by the assessee for selecting the comparables. According to the assessee, the TPO has erred in applying fresh search method without pointing out specific defects in the assessee's method. The assessee also contended that TPO has erred in not granting the benefit of + - 5% variation from arithmetic mean provided in the proviso to section 92C(2). The assessee further contended that the TPO ought to have not relied upon the current year data alone. He should have appreciated the TP report submitted by the assessee on the basis of multiple year data.
11. The Ld. CIT(A) has considered the submissions of the assessee in detail. With regard to its first objection that reference made by the AO to the TPO is bad in law. Ld. CIT(A) , on the strength of special bench order of the ITAT in the case of M/s. Aztec Software & Technology Services Ltd. Vs. ACIT 294 ITR (AT) 32 rejected its ground of appeal. According to the special bench decision of the Tribunal, AO was not supposed to demonstrate avoidance of tax before invoking the provision for making a reference. Thus the reference was not mechanical one. Ld. CIT(A) similarly rejected the 16 contention of assessee that AO has accepted the recommendations made by the TPO mechanically. The Ld. CIT(A) relied upon the decision of the special bench of ITAT. The next objection raised by the assessee before the Ld. CIT(A) was whether multiple year data is to be used for identifying the comparable or current year data has to be used. Ld. CIT(A) has dealt with this issue in detail and made a reference to the order of the Special Bench in the case of M/s. Aztec Software & Technology Services Ltd. This issue has now been settled and it has been held that current year data is to be used for identifying the comparables. Rule 10B4 is clear on this point. The next argument before Ld. CIT(A) was that Ld. TPO has erred in characterising assessee's business as a high end service provider. Ld. CIT(A) has rejected this contention of the assessee after making a reference to an article of Asstt. Professor Deepak Bagai, Department of Electronics, Punjab, Engineering College Chandigarh. Apart from this article, he has pointed out the various steps discussed by the Ld. TPO in identifying the level of technical work carried out by the assessee.
12. Ld. CIT(A) thereafter examined the various filters applied by the Ld. TPO in selecting the comparables. It emerges out from the order 17 of Ld. CIT(A) that quantitative filters as well as qualitative filters were applied by the TPO in carving out the comparables. While examining those filters, Ld. CIT(A) has observed that one of the filter applied by the TPO is related party transaction i.e. if any comparables has an international transaction less than 30% with related party i.e. associate enterprises then that can be taken as a comparable. Ld. CIT(A) was of the view that there is no scientific reasoning for adopting this filter. If transactions less than 30% of the total transaction are with related party, the company can be selected as a comparable then why not 10% or 20% transactions could be applied. In the opinion of the Ld. CIT(A), its adoption of less than 30% transaction with related party as filter, is an arbitrary step and, therefore, any enterprise who has related party transaction that has to be excluded from the comparable.
13. The next filter applied by the Ld. TPO is employee cost to the total cost. In asstt. year 2003-04, he was of the opinion that employees cost to total cost of the assessee was 53.69%. The TPO has used a filter of 10% for selecting the comparables. Ld. CIT(A) was of the opinion that there is a huge margin between 10% and 53.69%. In his opinion, the companies who have employees cost 18 ratio over total cost exceeding 25% can be considered as a comparable. After applying these two additional filters, Ld. CIT(A) has identified 4 companies which can be termed as a comparable. An arithmetic mean of NCP in respect of these four companies comes out to 16.16%. He upheld the adjustment by applying this ALP. Ld. TPO has recommended an adjustment of ` 10,35,72,191/- with the ratio worked out by the Ld. CIT(A), it comes out to ` 8,30,01,779/-. The Ld. CIT(A) in this way deleted the adjustment to the extent of ` 2,05,70,412/-. The revenue is impugning this deletion whereas assessee is impugning the confirmation of addition at ` 8,30,01,779/-.
Asstt. year 2004-05
14. In this asstt. year, there is no disparity on facts the TPO has recommended adjustment of ` 13,23,25,016/-. Ld. CIT(A) upheld the adjustment of ` 11,42,89,458/-. He has deleted the addition of ` 1,80,35,558/-. The PLI computed by the Ld. CIT(A) is at 16.33%. In Asstt. year 2006-07 19
15. There is no disparity on facts in this year also. Assessee has disclosed two international transactions with its AE in the TP report submitted in Form No.3CEB. The PLI disclosed by the assessee at 11.6%. In the TP report, it has selected 30 comparable and computed their weighted mean at 13.3%. Learned TPO has rejected the comparables selected by the assessee and carried out a fresh search. He short listed 19 companies. The assessee has raised objections. Learned TPO has accepted its objection qua certain companies and ultimately selected 12 companies. The weighted arithmetic mean of profit comes out at 18.30%. On the basis of this analysis, Ld. TPO recommended adjustment of Rs.17,35,18,074. Learned DRP has upheld the recommendation.
16. We have heard the Ld. Representative and with their assistance gone through the record carefully. From the record and arguments advanced by the Ld. Representative, it revealed that both the sides are agitating on various issues determining the ALP of international transaction. Their grievance has to be compartmentalized for convenience as well as better appreciation of the issues. From the record of asstt. year 2003-04, we have also 20 noticed the business profile of the assessee, including operating models which exhibits role played by assessee vis a vis its parent company i.e. ST Netherland.
17. The first area of dispute which could arise between the parties is in respect of most appropriate method required to be adopted for determination of arms length price (ALP) as provided in section 92C of Income Tax Act read with Rule 10B of the Income Tax Rules. The section 92C provides 5 main method i.e.
a) comparable uncontrolled price method
b) resale price method
c) cost plus method
d) Profit split method
e) Transactional net margin method and
f) one residuary method i.e. such other method as may be prescribed by the board.
18. In the present years, on an analysis of international transactions with the associate parties and data of comparables, assessee has selected transactional net margin (TNMM), using net profit margin based on cost as PLI. In these three years this method was not disputed by the Ld. TPO. We can say that both sides are in agreement on the method.
21
The next dispute is use of current year data or multiple area data
19. After resolving the appropriate method for determining the ALP, the next step is to find out the data required to be used for selecting comparables. The assessee has used multiple area data whereas the TPO is of the opinion that current year data is to be used. The view of the Ld. TPO has been accepted by the Ld. CIT(A) in asstt. year 2003-04 and 2004-05 and Ld. DRP in asstt. Year 2006-07. Arguments of the assessee
20. The assessee has contended before the Ld. TPO that section 92C and section 92D read with rule 10D clearly indicate that documentation (including the bench marking / analysis) is required to be maintained by the assessee to establish and support the arms length nature of its international transaction. The assessee is required to maintain TP documentation contemporaneously . Such documentation should exist latest by 31st October of the relevant financial year. This make it clear that legislature prefers the determination of ALP between this date. Thus the data used in determination of ALP should be available latest by November, 30 and not beyond. Therefore, the use of current year data which was not available at that stage would be nothing but hardship to the tax 22 payers and in contrary to the intend of the legislature. The assessee has relied upon the decision of ITAT in the case of Philips Software Centre Pvt. Ltd. 2008 vs. ACIT 119 TTJ 721 ITAT Bangalore. Ld. DR. on the other hand submitted that Rule 10B (4) is quite clear in this regard. It mandate the assessee to use current year data. The multiple year data is permitted to be used only in those cases, where no other data is available in the current year. He pointed out that this issue has been settled by the special bench of ITAT in the case of M/s. Aztec Software & Technology Services Ltd. Vs. ACIT reported in 294 ITR (AT) 32 of the Act. He also relied upon the order of ITAT Delhi in the case of Geodis overseas Pvt. Ltd. vs. DCIT rendered in ITA No. 4243/D/2010. He placed on record copies of the Tribunal's order. He also pointed that in the case of Mentor Graphics (NOIDA) Private Limited Vs. DCIT reported 109 ITD page 101, the Tribunal again held that comparability analysis is to be conducted on the basis of current year data.
21. We have duly considered the rival contention and gone through the record carefully. Rule 10B(4) of the Income Tax Rules has a 23 direct bearing on the controversy. Therefore, it is salutary upon us to take note of this rule it read as under :-
"10(4) The data to be used in analysing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into:
Provided that data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared."
22. A bare perusal of this rule would reveal that expression "shall" has been employed in this rule which make it abundantly clear that current year data of an uncontrolled transaction is to be used for the purpose of comparability, while examining the international transactions with associate enterprises. The proviso appended to the section carves out an exception that the data relating to the period of being more than two year prior to such financial year may also be considered, if such data reveals facts which could have an influence on the determination of transfer price in relation to transaction of comparison. Thus the main section used the expression "shall" which 24 make it mandatory to first use the current year data. If certain other circumstances reveals an influence on the determination of transfer pricing in relation to the transaction being compared than other datas for period not more than two years prior to such financial year may be used. Thus Ld. CIT(A) as well as Ld. DRP has rightly upheld the view point of TPO for using current year data.
23. The next step for determination of A.L.P. of the international transactions entered by the assessee with its associate enterprises is to find out the comparable assessees who have uncontrolled international transactions of similar nature. Before finding out the comparable, it is necessary to find out the status of assessee i.e. what it manufactures and with whom it can be compared. This dispute arises because the Assessing Officer termed the assessee as high end performer in the field of computer software whereas according to the assessee its activities are of low end. Thus, we have to first decide:-
"whether characterization of the assessee's business by the Learned TPO as high end service provider is correct ?".25
24. The learned counsel for the assessee while impugning the findings of the learned revenue authorities, pointed out that assessee is a subsidiary of ST Microelectronics PTe Ltd. Singapore, which is a wholly owned subsidiary of ST Microelectronics, Neitherland. It had commenced its commercial operation in financial year ended on 31.3.1993. It is engaged in the business of rendering integrated circuit design and software development services for the ST Group. In order to demonstrate as to how the services provided by the assessee is to be categorized as low end service, the learned counsel for the assessee appraised us with the FAR analysis of the assessee i.e. (function performed, assets employed and risk assumed). We have noticed this aspect in the paragraphs No. 5, while taking cognization of assessee's business profile as well as operating model. Shri Pawan Kumar, learned counsel for the assessee for assessment years 2003-04 and 2004-05 appraised us that entire process of manufacturing integrated circuit ( IC ), according to him, it is very complex and broadly consists of six steps. He referred the diagram reproduced by the Learned CIT(Appeals) on page 23 of the impugned order. Thereafter, he drew our attention towards the explanation of assessee submitted in the written submissions wherein it has placed on record a diagram exhibiting value chain analysis of semi- conductor chip. According to the learned counsel for the assessee, the first 26 stage relates to identification of customers needs. This has been carried out by ST Group Overseas, who identifies a customer's requirements for the ICs from the customers surveys, feedback and technological advancement in the industry. The second stage is where product is conceptualized and specifications are determined. This stage is also performed by ST Group and role of assessee in India, nowhere come in picture. The product is conceptualized with the help of input provided by the customers and technical know how process by ST Group Neitherland. Next stage is stage No.3 where design and development is finalized. According to him, this part of the value chain also involves research and development activities related to the product. The high design cost is incurred in France and Italy and are mainly on account of their focused activities on centralized development of technology platform. The role of the assessee is negligible in performance of this stage. He admitted that no doubt in India, certain designs works are also carried out but they are only a partial execution of the design and developments carried out by the ST Group. The assessee works only on the specification given to it by the ST Group. The next stage is product testing and verification. The product design is followed by the product testing and verification stage. According to the assessee, it is critical stage which 27 requires high infusion of capital in order to test the designed product. There is no contribution of ST India in performance of this stage. Stage No.5: At this stage, manufacturing and fabrication taken place. According to the assessee, it also involves high capital and it is highly complex process. There is no role of ST India in carrying out this activity. Stage No. 6: In this stage, sales marketing and customers support are performed. On the strength of this flow chart, The learned counsel for the assessee submitted that ST India is involved only at one stage and that too with a limited scope of work. It has no say in the process of conceptualization of any product. It works only on the specification given by the ST group for the designing and development of IC. On the strength of these details, he submitted that the role of ST India can be categorized a low end risk free captive design and development. The learned counsel for the assessee thereafter appraised us as to how assessee did not take any risk. He referred to the risk associated with the assessee vis-à-vis its AE. For buttressing this contention, he referred to the total sales carried out by the A.E. and the profit earned. He also referred the market risk, product service, low risk, technology risk etc. associated with the assessee as well as with the ST group.
28
25. In assessment year 2006-07, learned counsel for the assessee Shri Sanjiv Chaudhary and Shri SK Aggarwal reiterated the stand of assessee as was taken in assessment year 2003-04. The assessee in this year also, submitted a diagram exhibiting value chain analysis of the semiconductor chip but in this year, the assessee had compared this diagram with software industry which is available at page 15 of the written submissions and we have gone through this diagram.
26. On the strength of ITAT's order in the case of Mentorgraphic they submitted that the risk assumed by respective party is a very important circumstance for determining the status of an assessee which may demonstrate what type of activity is being performed by the assessee. According to the learned counsel for the assessee, it is a simple principle of economic that greater the risk the greater the expected return. He pointed out that the Learned TPO has selected the companies which are full-fledged entrepreneurs, whose risk profile assumes much higher risk, as compared to the risk free nature of the assessee. They also submitted that risk adjustment factor ought to be applied by the Learned TPO.
29
27. Learned DR have relied upon the orders of the Revenue Authorities Below. Shri NK Chand has drew our attention towards page No.12 of the Learned CIT(Appeals)'s order in assessment year 2003-04 and pointed out what type of activities have been performed by the assessee. According to the Learned DR, the activity performed by the assessee within India may be not be at par with the activities carried out by it's A.E. but that cannot be a test to determine the nature of activity performed by the assessee. The work performed by the assessee within India has to be compared with other assessees who are performing such type of activities and where they stand in a value chain of software development. The crucial issue is to find out whether the activity performed by the assessee can generate the profit equivalent to the one shown by the assessee only or there is some hidden embedded advantage being siphoned off by the assessee to its A.E. He also referred to the article of learned professor relied upon by the Learned CIT(Appeals) as well as the circumstance pointed out by the Learned TPO (extracted supra). In assessment year 2006-07, Learned DRs have pointed out that there is no disparity on facts. They have submitted that ST India is on of the largest design centres of ST group outside Europe. ST India has established a design centre at NOIDA and a Branch Office at Bangalore. The design centre employees around 1600 people. It develops Libraries of re- 30 usable IP's based upon UNICAD and the CAD platform, specially advanced system on chip (SOC) solution for digital consumers, computer, telecom and automotive application. They further submitted that ST India also provides local marketing information service to the group companies.
28. We have duly considered the rival contentions and gone through the record carefully. The operative force of assessee's arguments regarding characterizing it as a low end risk free captive service provider, is that most of the functions in producing integrated semiconductors are being performed by ST Group. The role of the assessee is limited. We have taken cognizance of assessee's business profile as well as operative model in paragraph 5 of this order. We are also conscious of the fact that right from the Assessing Officer upto ITAT, all the adjudicators are not technically qualified who could express their opinion with regard to technical specification of the products produced by the assessee. The important factor for our adjudication is how much profit/loss can be earned by an assessee carrying out similar activities and has uncontrolled international transaction. The role of the assessee in producing semiconductor (IC) may be limited qua the role performed by ST group, but can that limited role is of no significance. From the findings of the learned TPO recorded in assessment year 2002-03 and 31 reproduced by us in paragraph Nos. 7 & 8 of this order, we are of the view that product produced by the assessee in itself is of a complex nature, which required skilled work force. The assessee has employed more than 1600 persons and it has one of the largest design centres out of Europe. The operations carried out by the assessee within India are to be compared with other assessees and not with ST group. The learned counsels for the assessee have demonstrated the low affairs of the assessee while making the comparison with ST group. They lost sight that comparables are to be compared and not the incomparable. Thus, the test which they are advocating is not at all relevant for deciding the character of the assessee, whether it is high end performer or a low end performer. The assessee could have produced the report of an expert indicating the work performed by it as negligible in comparison to other software development companies. Instead of carrying out that exercise, it is emphasizing that its role is only 2% or 3% in comparison to over all role performed by ST group. The crucial issue which ought to be explained by the assessee is what is the importance of this 2% role vis-à-vis the role performed by similarly situated companies in an uncontrolled business environments. On an analysis of the learned TPO's order in different three years, including the TP report submitted by the assessee, we find that assessee has tried to give a uniform PLI, certain 32 comparables which were found acceptable by the assessee in financial year 2004-05 all of a sudden become incomparable in financial year 2005-06. It suggests that efforts of the financial analysist was to prepared the documentation in such a fashion which would give the result near to the result disclosed by the assessee. Learned TPO in all the three assessment years and the Learned CIT(Appeals) in assessment years 2003-04 and 2004- 05 has considered this aspect elaborately. The objections pointed out by the learned counsel for the assessee during the course of assessment proceedings are peripheral objections, a suitable adjustment can be made while selecting the comparables which can take care of their objections. After considering the detailed findings of Learned CIT(Appeals) in these two assessment years on this issue as well as the discussion made by the learned TPO in all the three years, we do not find any force in the objections raised by the assessee. Learned TPO has rightly treated the assessee as a high end service provider.
29. The next area of dispute between the parties is whether learned TPO has rightly rejected the search mythology applied by the assessee as well as the comparables selected by the assessee. In assessment year 2003-04, assessee has selected 14 comparables in its TP report. It has applied quantitative filter as well as qualitative filer. Under quantitative filter, it has 33 eliminated those companies whose operating income to sale is less than 75%. The second filter is the sales turnover less than Rs. 10 million and the third filter in the quantitative filter is sales turnover more than Rs. 5000 millions. In qualitative filter, it has eliminated the companies who has related party transaction because that would influence the result. It has also eliminated companies with insufficient information about product or function or financial. The companies going through corporate reconstructing during the period under review were also eliminated. The companies with different product or business profile or which were functionally different were eliminated. Learned TPO did not agree with the filter, applied by the assessee. The first objection of the learned TPO was that assessee has selected the comparable by using multiple year data. The second objection was that the information or data used in computation of ALP is not reliable. In assessment year 2006-07, learned TPO has pointed out that assessee has selected certain comparables which were rejected in financial year 2004-05. In a way, it has adopted a pick and chose policy.
30. The learned counsel for the assessee at the time of hearing pointed out that objections referred by the learned TPO are not sustainable. One of the objections referred in assessment year 2006-07 is that assessee is also 34 earning income from market supports services (MMS). With regard to this objection, it was submitted that it constitutes 2.19% of the total revenue earned by the assessee. Similarly on the scale of operation, it was submitted that turnover of the company is Rs.283.83 crores. While applying bench marking analysis, it has eliminated companies having sales less than Rs.10 crores and eliminated companies having sales more than Rs.2500 cores. On the strength of ITAT's order in the case of Mento Graphic, it was submitted that learned TPO could have carried out fresh search only if the comparable drawn by the tax payers was insufficient or had other deficiencies. The learned counsel for the assessee also submitted that in the case of Philips Software, ITAT has held that learned TPO was supposed to satisfy and communicate to the taxpayers, about carrying out fresh search and not accepting the comparables selected by the assessee. Learned DR on the other hand relied upon the orders of the Revenue Authorities Below.
31. We have duly considered the rival contentions and gone through the record carefully. In assessment year 2003-04, learned TPO while pointing out the defects in the TP report has observed that assessee is engaged in a specialized area of development of embedded technology under the overall guidance from the parent group companies. No doubt assumption of risk and 35 development of intangible assets is limited but still assessee did not make any attempt to take note of this characteristic of the service provided in the selection of comparables. According to the learned TPO, the assessee assumes man power risk while performing its function. The nature of job undertaken by the assessee involves deployment of highly skilled technical manpower. This aspect was not applied by the assessee while conducting the functional analysis of the comparable in the TP report. It has not applied appropriate filter to fine tune the selection of comparables incorporating this important aspect carried out by the assessee. He has observed that assessee has employed highly skilled manpower which indicates that employees cost to the total cost is 53.69%, thus this filter ought to have been considered by the assessee while carving out the comparables. Learned TPO also observed that comparability in terms of turnover is an important factor and assessee had adopted a range of turnover from Rs. 1 crore to Rs.500 crores which diluted the comparable analysis and missed out an important link between the turnover and profitability and consequently on comparability analysis. Learned TPO was of the view that assessee has rejected many comparables on the ground of related party transaction. In his opinion, the related party transaction is to be considered if foreign equity holding of more than 25% is involved in those companies. He also observed that no functional analysis 36 was documented in respect of the external comparables. We have gone through the learned TPO's order along with the learned representatives. We find a little variation in the reasons for rejecting the TP report of the assessee in assessment year 2003-04, 2004-05 vis-à-vis 2006-07. In assessment year 2006-07, learned TPO has assigned little more reasons and ultimately did not give weightage to the filter of large turnover. Learned representatives have not pointed out any specific defect in the rejection of the TP report for assessment years 2003-04 and 2004-05. His main emphasis was how the learned TPO has erred in selecting the comparables. A general argument was taken that TP report ought not to be rejected by the learned TPO and he should not proceed for selecting the fresh comparables. According to the learned counsel for the assessee before rejecting the TP study made by the assessee, learned TPO has to point out specific defects in the transfer pricing analysis made by the assessee as well as the documentation maintained by it. He referred the decision of ITAT in the case of Sony India reported in 114 ITD 448 and in the case of Philips Software reported in 26 SOT 226. To some extent, we concur with the proposition raised by the learned counsel for the assessee but in our opinion such circumstances are to be decided by the learned TPO on a touchstone basis. He is not supposed to record specific finding before proceeding to select fresh comparables. The idea is to arrive 37 at a reasonable conclusion for identification of comparables which can goad any authority to determine the ALP of any international transaction entered with an associate enterprises by an assessee. Every effort should be made within the ambit of procedure provided in the Act as well as Rule 10B of the Income-tax Rules. The approach of the Learned TPO ought to be judicious. The comparability between a controlled transaction and uncontrolled transaction is a comparison of condition which is broader than a mere comparison of price or margin. Where it is found that the conditions were imposed which differ from those which would be made between independent enterprises, transfer pricing adjustment are to be made. Thus, the learned TPO while evaluating the TP study made by the assessee arrived at a conclusion that assessee has left over various angles in identifying the comparables. He has highlighted those aspects in the order and thereafter proceeds to identify fresh comparables. This exercise has been done after giving proper opportunity of hearing to the assessee.
32. As far as assessment year 2006-07 is concerned, learned TPO has observed that search straightgy of the assessee in identifying the comparable is not scientific. According to him, it was not based on any key value driver for the IT Industry. He observed that salary and wages are the key drivers for 38 the IT Industry. The use of level of assets is another key value driver which generates revenue. The assessee failed to apply these key value drivers while putting the search in the Prowess Data Base. He further observed that it has selected certain comparables in financial year 2004-05 but those were rejected in financial year 2005-06. The assessee has not considered scale of operation and it has not defined this aspect in the TP report. The stand of the assessee before the ITAT was that first objection pointed out by the learned TPO for rejecting its TP study report is that assessee is also earning income from market support services but it has not used it as a functional criteria for selecting its comparables. It was submitted that revenue earned by the assessee from MSS rendered to AE constitutes only 2.19%. With regard to scale of operation, it was pointed out that turnover of the assessee is Rs.283.280 crores. The assessee has eliminated companies having sales less than Rs. 10 crores and companies having sales greater than Rs.2500 crores. On due consideration of all these defects pointed out in the reasons assigned by the learned TPO, we are of the view that the very beginning in identifying comparables by the assessee as well as by the learned TPO did not match. Learned TPO termed the assessee as a high end services provider, whereas assessee is treating itself as a low end service provider. We have considered this aspect in the foregoing paragraph and observed that assessee is involved 39 in manufacturing a highly complex technical product and its activity cannot be considered as a low end service provider. This disparity in the approach would automatically lead to a diagonally opposite path for selecting the comparables. Apart from this one aspect, the learned TPO has pointed out other aspects also. As observed earlier, he has to appreciate the TP study submitted by the assessee on reasonable basis as well as prima facie. Therefore, we do not see any error in the procedure adopted by the learned TPO for carrying out the fresh search in identifying the new comparables. We have seen TP report submitted by the assessee for these three years and the order of the PTO in assessment year 2007-08 also, we find that in every year by adjusting the financial calculation depending on different aspects effecting any business organization, assessee is submitting a TP report which is consumerate to the result declared by it. It used to select different filters for selecting or eliminating the comparables in each assessment year in such a way that would give only uniform result. Therefore, this issue is decided against the assessee in all the assessment years.
33. The next area of dispute between the parties is selection of comparable companies for the benchmarking analysis of ALP relating to international transaction. In assessment year 2003-04, learned TPO has 40 selected 23 comparables which have been reproduced by the Learned CIT(Appeals) on page 7 while taking cognizance of Table No.10. Learned CIT(Appeals) did not accept two filters applied by the learned TPO, one relates to related party transaction and the other relates to employees cost over total cost. He ultimately identified four companies who are broadly functionally similar comparables. The four cases relied upon by the Learned CIT(Appeals) in Table No.12 reads as under:
S. Company Functional Profile RPT Standalone Employee Fixed NCP No. name % Turnover cost/Total Asset (%) cost% turnover ratio 3 CS Software *Engaged in the Nil 4.82 25.17 1.43 6.22 Enterprise business of onsite Ltd. and offsite software development *Built domain expertise that includes Education, Construction, Manufacturing, Public utilities, telecommunication, health care and insurance sectors.
* Developed onsite software solutiaons working with World Majors and 41 Fortune 500 companies such as IBM, Intel, Fannie Mae, AT&T, FedEx etc. 25 Tata Elxsi Company's 1.54 111.28 51.68 5.13 13.74 Limited operations are broadly broken up into two business segments namely systems integration and support and software development services.
30 Visu Engaged in the NIL 8.25 35.95 3.06 10.89
Consultants business of
Ltd. software
development
31 Visualsoft Company is a NIL 126.61 68.34. 1.60 33.80
Technologies focused IT
Ltd. company operation
in Software
Development,
services and
products.
Arithmetic Mean 45.29 2.805 16.16
34. Similarly, in assessment year 2004-5, Learned CIT(Appeals) has identified three comparables. They read as under:
42
S. Company Functional RPT Standalone Employee Fixed NCP No. Name Profile % Turnover cost/Total asset (%) cost % turnover ratio 17 Maars Engaged Nil 33.84 69.95 1.10 5.52 Software provision of International software Ltd. development and consultancy services 34 Visu Engaged in Nil 14.92 43.7 4.89 13.31 Consultants the business Ltd. of software development 35 Visualsoft Company is Nil 155.56 67.93 1.74 30.17 Technology a focused IT Ltd. company operating in Software Dev.
Services and Products.
Arithmetic 60.53 2.58 16.33
Mean
35. In assessment year 2006-07, learned TPO has identified 12 comparables. They are as under:
S.No. Company Name FY
OP/TC%
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1 Bodhtree Consulting 16.52
Ltd
2 Lanco Global Systems 5.88
Ltd.
3 Exensys software 26.18
solutions Ltd.
4 Sankhya Infotech Ltd. 25.27
5 Visualsoft Technologies 13.05
Ltd.
6 Sasken 2.59
Communications Tech.
Ltd.
7 L & T Infotech Ltd. 12.42
8 Infosys 41.99
9 Flextronics Ltd. 28.55
10 Tata Elxsi Limited (seg) 20.61
11 Akshay Software 7.4
Technologies Ltd.
12 VJIL 6.07
Average OP/TC% 18.30
36. In assessment years 2003-04 and 2004-05, Learned DR has submitted that assessee has eliminated certain comparables on the ground that such companies have related party transaction because more than 26% shareholding of subsidiary were held by the company abroad. He pointed out that meaning of associate enterprises has been provided in section 92A(2)(a) 44 of the Act. According to this clause, there should be holding of more than 26% shares, directly or indirectly by one enterprises in the other enterprises only then they will be related party. The TPO was of the view that there may be transactions with associate enterprises but the transactions should not be more than 30%. Learned CIT(Appeals) did not accept this filter and held that there should not be any transaction with related party. Learned CIT(Appeals) did not give any justification for such a step. He further contended that in the case of Sony India, ITAT has accepted a company as a comparable even if 10 to 15% transactions are with related party. He submitted that the order of the Learned CIT(Appeals) be set aside to this extent and that of learned TPO be restored for selecting the comparables. Similarly, he pointed out that Learned CIT(Appeals) has erred in not accepting the filter of employees cost over total cost. Learned TPO used a filter of 10% for selecting the comparables whereas Learned CIT(Appeals) uphold filter at 25%.
37. The learned counsel for the assessee on the other hand reiterated his arguments as were raised for the issues already discussed by us. In brief, his arguments are based on business profile and operating model of the assessee. According to him, if these aspects are to be looked into then TP report submitted by the assessee could have not been rejected. The main emphasis 45 is that simply on conjectures and surmises, search carried out by the assessee cannot be disregarded. He made a reference to the order of the ITAT in the case of Mentorgraphic Vs. DCIT reported in 109 ITD 101 (Delhi). He also pointed out that Learned CIT(Appeals) agreed to the assessee that it is a risk free captive service provider but simultaneously made a reference to the Article of the Profession, Deepak Bagai for terming the assessee as belonging to a sunshine sector. He further submitted that Learned CIT(Appeals) has finalized six comparables but then excluded two in assessment year 2003-04 for non-availability of data. Now, the data are available and if they are included then NCP margin will be within the range of plus/minus 5% contemplated in the proviso to section 92C(2) and no adjustment would require.
38. In assessment year 2006-07, learned counsel for the assessee raised multifold submissions for pointing defect in the ultimate selection of comparables. Firstly, he contended that learned TPO did not grant proper opportunity of hearing for rebutting the selection of 19 companies out of which 12 has been selected by him. He further contended that application of fresh benchmarking analysis is contrary to the provisions of law. For buttressing his contentions, he pointed out that the determination of ALP, 46 has to be in accordance with sub-section(1)(2) of sec. 92C of the Act. The expression "in accordance" means "inconformity" or "as provided". If the assessee has determined ALP of international transaction according to this mandate then Assessing Officer cannot determine the price according to the method which is appropriate according to him, unless the method selected by the assessee cannot reasonably be applied to the facts and the circumstances of the case. Learned TPO has provided two set of comparables and some of the companies were common in both the sets whereas some of the companies appearing in first set were missing in the second set. It indicates that learned TPO had worked with a pre-determined mind set of recommending some adjustments. The second set was issued within eight days of the issuance of the first set. Learned TPO has excluded certain companies which are comparable to the assessee but indicating the loss. The companies cannot be excluded merely for the reasons that they were showing loss. For buttressing his contentions, he relied upon the decision of the ITAT in the case of M/s. SONY India (P) Ltd. Vs. DCIT reported in 114 ITD 448 (Delhi). He pointed out that if Assessing Officer was excluding the companies who are consistently showing loss then companies with higher margin must also be excluded since they represent companies of substantial assets usage. These companies are influenced by 47 economic/market conditions which are not prevalent in the assessee. The main emphasis was made for exclusion of Infosys Technology Ltd. It was submitted that sales of this company is of Rs.9028 crores. It is large company in operation in comparison to the assessee and it should have excluded by applying quantitative filter. Similarly, he submitted for exclusion of Flextronic Software System & TATA Flexi Ltd.
39. We have duly considered the rival contentions and gone through the record carefully. Rule 10B in general and Rule 10B(1)(e)(iii), Rule 10B(2) & 10B(3)(ii) in particular provide for comparability adjustment. Rule 10B(1)(e)(iii) contemplates that net profit margin referred to in sub-rule (ii) arising in comparable uncontrolled transaction is adjusted to take into account the difference, if any, between the international transaction and the comparable uncontrolled transaction or between the enterprises entering into such transaction which could materially effect the amount of net profit margin in the open market. This rule suggests that adjustment required to be made for comparability. Sub-rule (2) of Rule 10B further provides how to judge the comparability of international transaction with uncontrolled transaction. This rule reads as under:
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(2) For the purposes of sub-rule(2), the comparability of an international 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 asserts 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 labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail".
40. A bare perusal of this rule indicates that various aspects of the international transaction vis-à-vis uncontrolled transactions are to be kept in mind while deciding ALP of international transaction. Thereafter, Rule 10B(3)(ii) provides that reasonably accurate adjustment can be made to 49 eliminate the material effects of such differences. If we have overall look on the TP regulations then it would reveal that ALP of an international transaction cannot be determined accurately in accordance with a scientific formula. It is quite difficult to arrive at any firm conclusion with mathematic precision. The simple reason is that concept of business which gives rise to all national and international transactions in itself has a wide import and it means an activity carried on continuously and systematically by a person by the application of his labour and skill with a view to earn an income. There are large number of factors which effects the business such as functions performed, assets employed and risk assumed. The concept of risk in itself provides various type of risk for example market risk, foreign exchange risk, operation risk, technology risk, credit risk, environmental risk and assets redundancy risk etc. Similar are the factors for assets employed. There are large number of factors which effect this area and which ultimately effects the result of any undertaking as such working capital etc., who has provided the working capital, whether it is by assessee's own source or it is contributed by the A.E. Similarly, the functions performed by an assessee also effects the ultimate result. It contains workmanship, management, identification of the product, ultimate production, research etc. All these factors in their setting as a whole make it practically impossible for any 50 adjudicator to find out exact photo copy of the assessee as a comparable. Some variations bound to be there. One has to see what is the impact of such variation in the comparable results of such concern. On perusal of the TPO's order in all the three assessment years as well as in assessment year 2007-08, which is placed in the paper book of the department, we find that learned TPO had made efforts to identify the comparables whose functions performed are similar to the assessee. He has applied the filter, quantitatively as well as qualitatively in eliminating the factors which effect the result of the alleged comparables so that the difference between the operations of assessee as well as such comparables who worked in uncontrolled transactions can be neutralized. The arguments raised by the assessee in assessment year 2006-07 are touching only peripheral aspects. Learned TPO has started investigation quite well in time and has provided sufficient opportunity for giving comments. We have already held that learned TPO has rightly rejected the TP study made by the assessee and proceed to make fresh search. All other arguments made by the assessee in the written submissions as well as addressed before us were in the background of putting the assessee as a low end performer. At every stage, their emphasis was that it is a risk free captive service provider, it cannot be compared with other software development. We do not find force in this contention of the 51 assessee in the discussion made in the foregoing paragraphs of the order. As far as the contentions of the assessee regarding exclusion of Infosys from comparables is concerned, learned TPO has considered this aspect and was conscious of the fact that in a quantitative filter, this concern deserves to be excluded but then he observed that in this year assessee in its TP study report included certain concerns who has a huge turnover of 14740 crores. Similarly, assessee has also accepted comparables like Lanco & Aksha Software which have sales turnover of less than Rs.10 crores. Thus, it reveals that assessee did not adhere to quantitative filter in this assessment year. Infosys no doubt gives a better profit result but again in the 12 comparables selected by the learned TPO, there are certain comparables whose profit margin is quite low then the assessee and an arithmetical mean of 18.30 has been worked out.
41. As far as the arguments of Learned DR in assessment years 2003-04 and 2004-05 are concerned, we find that in the case of Sony India, ITAT has accepted the comparables who has related party transaction in between 10 to 15%. Such a company can be compared. Learned TPO selected the comparables to the extent of 25% related party transactions whereas Learned CIT(Appeals) eliminated all those comparables. At the time of hearing, he 52 was unable to point out the specific company which was selected by the learned TPO as comparable and who has transaction less than 15% with related party. We have perused the order of the Learned CIT(Appeals) in assessment year 2003-04 at page 27 where the list of 23 comparables along with related party transactions are reproduced. Learned TPO has just excluded comparables with more than 30% related party transaction. Learned DR was unable to point out any specific comparables less than 15% related party transaction and which would help the revenue for upgrading the arithmetic mean. Therefore, his argument is of no relevancy at this stage
42. In assessment year 2006-07, learned counsel for the assessee pointed out that learned TPO has taken a figure of 15.99% against Visual Soft- technology Ltd. at Sr. No.5. The PLI in this case is 13.05%. Similarly, at Sr. No. 6, learned TPO has taken 12.36% against S. Communication Technology Ltd., the actual figure is 2.59%. We direct the learned AO to verify this aspect and make necessary corrections in the arithmetic mean of all these comparables. As far as other arguments are concerned, we do not find any force in the contentions of the assessee as well as of revenue for selecting the comparables.
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43. The assessees have contended that benefit of proviso appended to section 92C of ± 5% has not been given to the assessee.
44. With the assistance of learned representatives, we have gone through the record carefully. Learned CIT(Appeals) in assessment year 2003-04 has examined this issue in detail. He observed that in order to avoid hardships to the assessees in the initial years of implementation of the TP provisions, the Government of India, through a prices note issued by the Ministry of Finance on 22nd August 2001 expressed its intention that no adjustment could be made if the transfer price adopted by the assessee was within the band of ± 5% of the ALP determined by the Assessing Officer. CBDT had issued Circular No.12 on 23.8.2001 specifying that Assessing Officer shall not make any adjustment to the price shown by the assessee if it is within the ± 5% band, the effect of the Circular was that transfer price shown by the assessee was not to be disturbed if it was up to 5% less in case of receipt and up to 5% more in case of outgoing. The relaxation extended by this Circular was in substance brought on to the statute by the Finance Act 2002 by amending the proviso to sec. 92C(2) with retrospective effect from 1.4.2002. It provides a tolerance band. It also suggests that there will be no TP adjustment in cases of marginal variation up to ± 5% but substantial 54 variation would result in appropriate TP adjustment. Learned CIT(Appeals) has explained the meaning of tolerance band which read as under:
• "Whether there is an international transaction involving sale of a product or export of services, there would be a credit entry in the profit & loss account. By allowing a margin of (-) 5% for such a transaction, a taxpayer is permitted to have a credit entry which is not below 95% of the ALP so that profit from the transaction is not understated beyond the tolerance level of (-) 5%.
• Whenever there is an international transaction involving purchase of a product or import of services, there would be a debit entry in the profit and loss account. By allowing a margin of (+) 5% under such a transaction, a taxpayer is permitted to have a debit entry which is not above 105% of the ALP so that profit from the transaction is not understated beyond the tolerance level of (+) 5%.
11.18.3 The decision rule contained in the proviso to the sec.
92C(2) of the Act containing a tolerance band is akin to a similar decision rule of confidence interval used in the theory of statistical inference. Under that theory, a 5% level of significance would provide for a tolerance band consisting of 95% & 105% of the arithmetical mean and these points are known as "Critical Values". The rule is one of "All" or "Nothing" kind of a situation. If a computed value falls within the tolerance band, a favorable inference is drawn. The decision rule contained in the proviso to section 92C(2) of the Act 55 thus is a "All" or "Nothing" kind of rule. After all in the transfer pricing analysis, a sample set of comparables along with the distribution of profitability of this set is examined and an inference is sought to be drawn about the appropriateness of profitability shown by a taxpayer. Therefore, statistical inference theory based on sampling is directly applicable to the benchmarking analysis carried out in the transfer pricing analysis with the help of a sample set of comparables. There is no scope for any "standard deduction" under this rule. In other words, if the ALP falls outside the tolerance band, TP adjustment would have to be made for the difference between the ALP determined by the A.O. based on the arithmetical mean of the prices and the price shown by the assessee"
45. The contention of the learned counsel for the assessee was that arithmetic mean of the comparable price should be reduced by 5% for determining the ALP. He pointed out that in 2009, the proviso appended to section 92C has been amended but this amendment would be applicable prospectively, because the basis of determination of ALP in respect of international transaction get changed. This amendment effects imposing a new liability by taking the option away from the taxpayers. Thus, according to the learned counsel for the assessee, the amended proviso is not applicable. On the other hand, Learned DR has submitted that under the proviso no standard deduction has been provided to the assessee. 56
46. On due consideration of the facts and circumstances and perusal of the proviso introduced in 2002 as well as in 2009, we are of the view that this tolerance band provided in the proviso is not to be construed as a standard deduction. In the present appeals, learned TPO has adopted the arithmetic mean of several comparables for taking out a PLI which would be tested with the PLI of the assessee. If that arithmetic mean falls within the range of alleged tolerance band then there may not be any adjustment but if it exceeds then ultimate adjustment is not required to be computed after reducing the arithmetic mean by 5%. The actual working is to be taken. Learned First Appellate Authority has considered this aspect elaborately in assessment year 2003-04 and after going through his order, we do not see any merit in the ground of appeal raised by the assessee in all these three assessment years.
47. In assessment year 2006-07, the next grievance of the assessee is that the Assessing Officer has erred in treating the software expenses as capital in nature. Learned DRP has erred in upholding the conclusion of the Assessing Officer. The brief facts of the case are that the assessee has debited an amount of Rs.4,88,63,330 on account of computer software. It has capitalized a sum of Rs.1,31,41,004 in the computation of income. The 57 assessee had claimed a sum of Rs.2,81,60,384 as revenue expenses. Contention of the assessee is that this expenditure was incurred for acquiring the license to use of software for a period of one year or less than two years. Assessing Officer in the draft order proposed that license for use of software taken by the assessee would give enduring benefit and hence it deserves to be treated as a capital expenditure. Learned DRP without considering the arguments of assessee has upheld the proposal of the assessee by observing in the following lines:
"We have gone through the submissions made by the AR, it is noticed that this issue was involved in assessee's own case for A.Y. 2003-04 & 2004-05. The Learned CIT(Appeals) has decided the issue in favour of department against which the assessee has filed appeal to ITAT. The appeal is pending and the issues has not attain finality. Hence, we decline to interfere in the order of the A.O."
48. Before us, it was submitted that the assessee has incurred this amount for acquiring the time based license to use the software. These licenses in all the case gave the assessee right to use the software for the period up to two years. There is no enduring benefit accrued to the assessee. It had not acquired any ownership right over that product. The ownership title for the software remained with the vendor and the assessee had only license to use this software. The assessee has relied upon the decision of ITAT in the case 58 of AM WAY India Enterprises Vs. DCIT reported in 111 ITD 113 (Del). Special Bench has laid down various tests which would be helpful for the adjudicating authority to decide whether expense incurred by the assessee is of capital nature or of revenue nature. According to the assessee, the ITAT has basically laid down three tests which are ownership tests, test of enduring benefit and functional tests. If all the three tests are applied on the facts of the assessee then it would reveal that it is a revenue expenditure. The learned counsel for the assessee further relied upon the order of the ITAT rendered in the case of DCIT vs. Mohindra Reality & Info. Developers reported in 2011 TIOL 115. On the other hand, Learned DR relied upon the order of the Assessing Officer.
49. We have duly considered the rival contentions and gone through the record carefully. We find that learned DRP has not applied its mind to the dispute raised by the assessee. According to the learned counsel for the assessee, reference to assessment years 2003-04 and 2004-05 is misplaced. There is no such dispute in those two years. We have disposed of the appeals of both the parties for these two years along with the present appeal. We also do not find any such dispute in those years. It suggests that learned DRP has considered this issue without making proper analysis. On perusal of the assessment order, we find that the Assessing Officer while considering the 59 ratios laid down by the Special Bench of the ITAT has observed that Special Bench was not correct in interpreting the law. In our opinion, it is not for the Assessing Officer to comment upon the orders of the higher authorities rather she is bound to follow them. If revenue has any grievance with the proposition laid down by the Special Bench then there are remedies in the Act, to redress those grievances. The understanding of the Assessing Officer with regard to the ratios laid down by the Special Bench, is not appreciable. The assessee has not acquired any ownership in the alleged license and the license's self life is less than two years. The nature of assessee's business is such that which required computer software. Therefore, the expenses incurred by the assessee for obtaining the license to use the software is to be treated as revenue expenditure. Respectfully following the order of the ITAT in the case of AM WAY India, we allow this ground of appeal and delete the disallowance.
50. In the next ground of appeal, assessee has pleaded that an amount of Rs. 86,17,266 paid by the assessee to NOIDA Dev. Authority should not be treated as capital expenditure. The brief facts of the case are that the a land bearing Plot Nos. 2 and 3 in Sector 16A was earlier allotted to the SGS Thumpson Microelectronics India Ltd. The name of allottee has been got changed by the assessee, the new name ST Microelectronic (P) Ltd. has been 60 inserted. NOIDA Development Authority directed the assessee to pay 10% of the prevalent rate as charges for change of ownership. It appears that assessee has contended before the revenue authority that amount paid by the assessee be allowed as revenue expenses or it be capitalized in the value of assets for the purpose of capital gain as and when the assets would be sold. Both these pleas have been rejected by the learned DRP. According to the learned DRP, cost of acquisition or cost of improvement can be included for the purpose of indexation while computing the capital gain under sec. 48 of the Act. The charges paid by the assessee to NOIDA Development Authority are neither cost of acquisition or the cost of improvement. Therefore, it cannot be included in the value of assets.
51. Before us, learned counsel for the assessee has pointed out the letter of NOIDA Authority available at pages 666 to 668 of the paper book and submitted that the expenses paid by the assessee be allowed to it. On the other hand, Learned DR relied upon the order of the Assessing Officer.
52. We have duly considered the rival contentions and gone through the record carefully. From the perusal of the letter written by NOIDA Authority, exact nature of charges is not discernible, whether it is paid in lieu of stamp 61 duty for change in name of owner in the revenue record? Learned representative failed to bring the revenue laws of the UP State authorizing the NOIDA Authority for charging such an amount. Assessing Officer has also not examined the issue elaborately. In the absence of complete facts, it is quite difficult to adjudicate the issue. The contentions of the assessee for inclusion of this amount in the cost of land can only be considered when exact nature of the sum paid by the assessee is determined. Considering all these aspects, we deem it appropriate to set aside the order of the learned DRP as well as of the Assessing Officer, we restore this issue to the Assessing Officer for fresh examination. After ascertaining the complete facts, Assessing Officer shall pass fresh order on this issue in accordance with law.
53. In the result, ITA No.1806 & 1807, 1598 and 1599/Del/08 are dismissed and ITA No.5058/Del/2010 is partly allowed.
Decision pronounced in the open court on 03.06.2011 Sd/- Sd/-
( B.C. MEENA ) ( RAJPAL YADAV )
ACCOUNTANT MEMBER JUDICIAL MEMBER
Dated: 03/06/2011
Mohan Lal
62
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2) Respondent
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4) CIT(Appeals)
5) DR:ITAT
ASSISTANT REGISTRAR