Income Tax Appellate Tribunal - Pune
Honeywell Automation India Ltd., Pune vs Assessee on 25 February, 2015
IN THE INCOME TAX APPELLATE TRIBUNAL
PUNE BENCH "B", PUNE
BEFORE SHRI G.S. PANNU, ACCOUNTANT MEMBER
AND SHRI R.S. PADVEKAR, JUDICIAL MEMBER
ITA No.18/PN/2011
(Assessment Year : 2006-07)
M/s Honeywell Automation India Limited,
56/57, Hadapsar Industrial Estate,
Hadapsar, Pune - 411 013.
PAN : AAACT3904F .... Appellant
Vs.
Dy. Commissioner of Income Tax,
Circle 7, Pune. .... Respondent
Assessee by : Mr. Percy Pardiwalla &
Mr. Venkat Raman Iyer
Department by : Mr. Ajit Korde
ORDER
PER G. S. PANNU, AM
The captioned appeal has been preferred by the assessee pertaining to the assessment year 2006-07, which is directed against the order of the Dy. Commissioner of Income Tax, Circle 7, Pune (in short 'the Assessing Officer') passed u/s 143(3) r.w.s. 144C(13) of the Income Tax Act, 1961 (in short "the Act") dated 25.11.2010, which is in conformity with the directions given by the Dispute Resolution Panel, Pune (in short 'the DRP') dated 29.09.2010.
2. In this appeal, the Grounds of Appeal raised by the assessee read as under: -
"Based on the facts and circumstances of the case, Honeywell Automation India Limited (hereinafter referred to as the 'Appellant') respectfully craves leave to prefer an appeal against the order passed by the Deputy Commissioner of Income Tax, Circle - 7 ('AO') in pursuance of the directions issued by Dispute Resolution Panel ('DRP'), Pune, dated 29 September 2010 under section 253 of the Income-tax Act, 1961 ('Act') on the following grounds, which are without prejudice to each other:2 ITA No.18/PN/2011
On the facts and in the circumstances of the case and in law, the Hon'ble DRP and consequentially the learned AO has:
General
1. erred in assessing the total income at Rs.746,351,790 as against income of Rs.214,085,274.
Denial of deduction of Rs.286,049,101 under section 10A of the Act
2. erred in recomputing the deduction under section 10A at Rs.77,460,281 as against Rs.363,509,382 claimed by the Appellant, thereby denying deduction under section 10A to the extent of Rs286,049,101;
Invoking the provisions of section 10A(7) read with section 80IA(10) in the Appellant's case
3. erred in invoking the provisions of section 10A(7) read with section 80IA(10) in the Appellant's case, on the ground that transactions between the Appellant and its associated enterprises are arranged to produce more than ordinary profits.
4. failed to appreciate that provisions of section 10A(7) r.w.s 80IA (10) could only be invoked where both the connected parties are taxable in India and there is tax erosion in India due to 'arrangement' between those persons and not otherwise;
Usage of arithmetic mean as per the transfer pricing study report for determination of 'ordinary profits' for the purpose of section 10A(7) read with section 80IA(10)
5. erred in law by adopting the arithmetic mean of operating margins earned by comparable companies as per the transfer pricing study report as benchmark of 'ordinary profits' computed for the purposes of section 10A(7) read with section 80IA(10).
Appellant earning 'more than ordinary profits'
6. erred in concluding that the profits earned by the Appellant are more than ordinary profits from its Software Technology Park ('STP') operations, without appreciating and considering the business model under which the Appellant operates;
7. failed to appreciate that the rates charged by the Appellant to its Associated enterprise ('AE') were comparable with the rates charged to other customers ('non-AE') and the rates charged in earlier years;
8. should have appreciated that the Appellant has offered to tax similar level of profits in earlier and later years and hence the Appellant could not be considered as have earned 'more than ordinary profits' during the year under appeal;
9. failed to appreciate that the onus is on the Department to prove with substantial evidences that the business of the Appellant is 'arranged' so as to have supernormal profits and mere inferences without substantiating the allegations would not suffice;
Computation of operating margins of the Appellant
10. erred in computing the operating margins earned by the Appellant (from its STP operations) without considering travel, and other costs 3 ITA No.18/PN/2011 reimbursed by its customers as a part of its operating cost and operating income.
Disallowance of provision for expenses amounting to
Rs.17,200,000
11. erred in disallowing the provision in respect of 'C' forms not received and sales tax set off, on the ground that the same are governed by the provisions of section 43B of the Act, without appreciating that the same represented ascertained liability towards claims which may not be available Transfer Pricing adjustment under provisions of Chapter X of the Act in respect of international transactions under the system integration segment of the Appellant, with its Associated Enterprises (hereinafter referred to as "AEs") aggregating Rs.229,017,412.
12. On the facts and in the circumstances of the case and in law, the learned Transfer Pricing Officer (TPO) and the learned AO under directions issued by the Hon'ble DRP, erred in making an addition to the Appellant's total income of Rs.229,017,412 based on the provisions of Chapter X of the Act.
13. On the facts and in the circumstances of the case and in law, the learned TPO erred and the Hon'ble DRP further erred in upholding / confirming the action of the TPO rejecting the segmental profit and loss account prepared by the Appellant in respect of IS-Infra segment and Balance System Segment of the Appellant.
14. On the facts and in the circumstances of the case and in law, the learned TPO erred and the Hon'ble DRP further erred in upholding / confirming the action of the TPO of disregarding the fact that during the year under consideration, the assessee had provided for an extraordinary expense item being bad debts/ provision for bad and doubtful debts in its books of accounts amounting to 2.45% of operating cost and accordingly the learned TPO erroneously benchmarked the net profit obtained in the international transactions of the IS-Infra segment and Balance System Segment after including the said extraordinary items in the calculation of the said net profit.
15. On the facts and in the circumstances of the case and in law, the learned TPO erred and the Hon'ble DRP further erred in upholding / confirming the action of the TPO of disregarding the benchmarking analysis and comparable companies selected by the Appellant based on the contemporaneous data in the transfer pricing study report maintained as per section 92D of the Act read with Rule 10D of the Income-tax Rules, 1962 ('the Rules') and the various submissions made by the Appellant in this regard.
16. On the facts and in the circumstances of the case and in law, the learned TPO erred and the Hon'ble DRP further erred in upholding / confirming the action of the TPO of selecting only those companies as 'comparable companies' having bad debt as separate line item in its financial statements.
17. On the facts and in the circumstances of the case and in law, the learned TPO erred and the Hon'ble DRP further erred in upholding / confirming the action of the TPO in making adjustment on the shortfall in the margin of the Appellant on total transactions (i.e. controlled as 4 ITA No.18/PN/2011 well as uncontrolled) instead of applying the shortfall in the margin only to controlled transactions."
3. The substantive dispute in this appeal is manifested by the abovestated Ground of Appeal Nos.2 to 10, which relates to the quantum of deduction allowable to the assessee under the provisions of section 10A of the Act. Although, assessee has raised multiple Grounds of Appeal on this aspect but the sum and substance of the dispute relates to the quantification of deduction allowable to the assessee u/s 10A of the Act with respect to the profits derived from the export of engineering/software services.
4. The appellant-company is, inter-alia, engaged in the export of IT enabled engineering/software services to its associated enterprise abroad as well as to the non-related parties. The services are rendered from three units, which are duly registered with Software Technology Park of India (STPI) authorities. Out of the three units, two of them, namely, STPI-I & STPI-II are located at Pune and the third unit is located at Chennai. The profits derived by the aforesaid three units are entitled for deduction u/s 10A of the Act and accordingly, assessee claimed deduction amounting to Rs.36,36,09,382/- with respect to the profits of the aforesaid three units. The details of such claim have been noted by the Assessing Officer in para 2.5 of his order whereby the claim of deduction u/s 10A of the Act in respect of STPI Unit-I was Rs.30,75,65,637/-; with respect to the STPI Unit-II was Rs.1,52,11,386/-; and, with respect to the STPI Unit, Chennai was Rs.4,07,32,359/-.
5. In-principle, the Assessing Officer has not disputed the entitlement of the assessee for the claim of deduction u/s 10A of the Act. So however, the deduction u/s 10A of the Act has been restricted to Rs.7,74,60,281/- as against the claim of Rs.36,35,09,382/- above thereby denying the deduction to the extent of Rs.28,60,49,101/-. The aforesaid action of the income-tax 5 ITA No.18/PN/2011 authorities is based on the provisions of section 10A(7) r.w.s. 80-IA(10) of the Act. As per the Assessing Officer, the profits in relation to section 10A Units are more than the 'ordinary profits' and therefore he has restricted such profits for the purposes of the deduction u/s 10A(7) of the Act to the amount of profits, which he considered as 'reasonably deemed' to have been derived therefrom in terms of section 10A(7) r.w.s. 80-IA(10) of the Act. Notably, the assessee had rendered software engineering services from its STPI Units to its associated enterprises which were in the nature of international transactions within the meaning of section 92B of the Act. In its Transfer Pricing Study, assessee had benchmarked the aforesaid international transactions by selecting the Transactional Net Margin (TNM) Method as the most appropriate method. On the basis of the profit margin in respect of 10A Units which was substantially higher than the average of the margin of comparables selected by it, it was seen that the stated value of the international transactions of software engineering services segment did not require any adjustment vis-à- vis the arm's length price. The TPO on a reference by the Assessing Officer passed an order u/s 92CA(3) of the Act dated 12.10.2009 accepting the aforesaid position with respect to the software engineering services segment. The Assessing Officer was of the view that the profit margin in respect of the 10A Units was substantially higher than the margin of the comparables chosen by the assessee while carrying out the comparability analysis under the TNM Method and therefore according to him, the profits declared by the assessee in the 10A Units were not the ordinary profits and that they should be restricted to the ordinary profits in such business based on the margins of the comparables selected by the assessee itself. The operating profit margin of the comparables was taken by the Assessing Officer at 17.06% after the adjustment directed by the Dispute Resolution Panel (i.e. DRP) and after comparing it with the assessee's margin of 10A Units of 80.06%, the profits in excess of the operating profit margins of the comparables was considered as 6 ITA No.18/PN/2011 more than ordinary profits declared by the assessee, which was computed at Rs.28,60,49,101/-. In this manner, the Assessing Officer determined the ordinary profits, which according to him, was reasonably deemed to have been derived from the business of 10A Units at Rs.7,74,60,281/- as against Rs.36,35,09,382/- declared by the assessee. Hence, the deduction u/s 10A of the Act was restricted to Rs.7,74,60,281/- as against Rs.36,35,09,382/- based on the operating profit margin of the comparables selected by the assessee in the TNM Method while carrying out the Transfer Pricing Study.
6. In the above background, the rival parties have made their submissions in extenso. The rival submissions have been heard and the relevant material and record perused.
7. Before proceeding further, we may briefly touch-upon the relevant provisions of the Act, which have a bearing on the controversy before us. Sub-section (7) of section 10A of the Act reads as under :-
"(7) The provisions of sub-section (8) and sub-section (10) of section 80-IA shall, so far as may be, apply in relation to the undertaking referred to in this section as they apply for the purposes of the undertaking referred to in section 80-IA."
8. Further, sub-sections (8) and (10) of section 80-IA of the Act referred to in section 10A(7) read as under :-
"(8) Where any goods [or services] held for the purposes of the eligible business are transferred to any other business carried on by the assessee, or where any goods [or services] held for the purposes of any other business carried on by the assessee are transferred to the eligible business and, in either case, the consideration, if any, for such transfer as recorded in the accounts of the eligible business does not correspond to the market value of such goods [or services] as on the date of the transfer, then, for the purposes of the deduction under this section, the profits and gains of such eligible business shall be computed as if the transfer, in either case, had been made at the market value of such goods [or services] as on that date :
Provided that where, in the opinion of the Assessing Officer, the computation of the profits and gains of the eligible business in the manner hereinbefore 7 ITA No.18/PN/2011 specified presents exceptional difficulties, the Assessing Officer may compute such profits and gains on such reasonable basis as he may deem fit. [Explanation.--For the purposes of this sub-section, "market value", in relation to any goods or services, means the price that such goods or services would ordinarily fetch in the open market.] (9) xxxxxxxxxx (10) Where it appears to the Assessing Officer that, owing to the close connection between the assessee carrying on the eligible business to which this section applies and any other person, or for any other reason, the course of business between them is so arranged that the business transacted between them produces to the assessee more than the ordinary profits which might be expected to arise in such eligible business, the Assessing Officer shall, in computing the profits and gains of such eligible business for the purposes of the deduction under this section, take the amount of profits as may be reasonably deemed to have been derived therefrom."
9. Section 10A of the Act is a special provision in respect of newly established undertakings in free trade zone, etc.. Section 10A postulates a deduction of such profits and gains as are derived by an undertaking from the export of articles or things or computer software for a period of ten assessment years beginning with the assessment year relevant to the previous year in which the undertaking begins to manufacture or produce such articles or things or computer software, as the case may be, while computing the total income of an assessee. Shorn of other details, for the present it would suffice to note that the three units of the assessee, namely, Unit No.I & II at Pune and Unit at Chennai are recognized as STPI Units in accordance with the Software Technology Park Scheme of the Government of India and they are eligible for the benefits of section 10A of the Act.
10. The bone of contention in the present case between the assessee and the Revenue is invoking of section 10A(7) r.w.s. 80-IA(10) of the Act. Section 80-IA(10) of the Act, reproduced above, empowers the Assessing Officer to re- compute the profits and gains of the eligible business for the purposes of deduction u/s 10A of the Act if it appears to him that the profits declared by the assessee are more than the ordinary profits which might be expected to arise in such an eligible business. So however, the aforesaid power of the 8 ITA No.18/PN/2011 Assessing Officer is subject to the pre-requisites contained in sub-section (10) of section 80-IA of the Act itself. The circumstances in which such a course is available to the Assessing Officer is contained in section 80-IA(10) itself. A perusal of section 10A(7) r.w.s. 80-IA(10) of the Act would show that the two essential conditions are to be established before the Assessing Officer can proceed to disregard the profits declared by the assessee and determine the amount of profits which may reasonably deemed to have been derived from such business. Notably, such conditions are (i) existence of a close connection between the assessee carrying on eligible business and any other person; and, (ii) that the course of business is so arranged that the business transacted produces to the assessee more than the ordinary profits.
11. At the outset, it is to be noted that the opening sentence in section 80- IA(10) of the Act contains the expression - "where it appears to the Assessing Officer that ............". This would show that the onus is on the Assessing Officer to justify invoking of section 10A(7) r.w.s. 80-IA(10) of the Act, having regard to the facts circumstances of a given case. Evidently, the primary rule of evidence is that "what is apparent is real" unless proved otherwise by the person alleging it so. Ostensibly, if the Assessing Officer is to invoke the provisions of section 10A(7) r.w.s. 80-IA(10) of the Act then the onus is on him to justify such invocation having regard to the cogent material and evidence on record. On this aspect of the matter, there was no dispute between the rival counsels inasmuch as the Ld. CIT-DR quite fairly agreed that the onus was on the Assessing Officer to justify invoking of section 10A(7) r.w.s. 80-IA(10) of the Act in the facts of a given case. Nevertheless, on this aspect, we may also make a reference to the judgement of the Hon'ble Karnataka High Court in the case of CIT vs. H.P. Global Soft Ltd., 342 ITR 263, which was referred to in the course of hearing before us. In the case before the Karnataka High Court, the issue was similar inasmuch as therein, the Assessing Officer had invoked 9 ITA No.18/PN/2011 the provisions of section 80-I(9) r.w.s. 10A(6) of the Act while re-determining the claim of exemption in terms of the then prevailing section 10A(4) of the Act, and the assessment years were 1995-96 to 1998-99. The provisions of section 10A(6) r.w.s. 80-I(9) of the Act, which were before the Hon'ble Karnataka High Court are quite similar to the provisions of section 10A(7) r.w.s. 80-IA(10) of the Act before us. The Hon'ble Karnataka High Court, upheld the stand that the requirements of the provisions of section 80-I(9) of the Act are two-fold, namely that there should be a close connection between the assessee and the other person, which may be a reason for the assessee to earn higher profits but, more importantly there should be material to indicate that assessee had indulged in an arrangement with the other person so as to produce to the assessee more profits than ordinarily what profits the assessee might have expected to arise from such business. As per the Hon'ble Karnataka High Court, it was for the Assessing Officer to indicate any material or evidence to disclose any such arrangement between the assessee and the other person. The aforesaid judgement of the Hon'ble Karnataka High Court justifies the assertion of the assessee before us that the onus for justifying the invoking of section 80-IA(10) r.w.s. 10A(7) of the Act is on the Revenue based on cogent material. At this point, we may also make a reference to the judgement of the Hon'ble Bombay High Court in the case of CIT vs. M/s Schmetz India Pvt. Ltd. vide Income Tax Appeal No.4508 of 2010 dated 04.09.2012, which is also to the similar effect. In the case before the Hon'ble Bombay High Court assessee was a wholly owned subsidiary of a German Company. It had two divisions - one at Kandla in the Kandla Free Trade Zone, engaged in the manufacture and export of industrial sewing machine needless; and other at Mumbai, engaged in trading in industrial sewing machine needless. The manufacturing division at Kandla exported its entire production of industrial machine needless to its holding company in Germany. For the assessment year 2004-05 assessee declared an income of Rs.20.54 10 ITA No.18/PN/2011 crores from its manufacturing division at Kandla and claimed 100% deduction u/s 10A of the Act. During the course of the assessment proceedings, Assessing Officer was of the view that abnormal profits had been declared in respect of the Kandla division, only in view of the income therefrom being exempt u/s 10A of the Act, and that the trading division at Mumbai showed a loss of Rs.70.29 lacs. The Assessing Officer invoked the provisions of section 10A(7) r.w.s. 80-IA(10) of the Act to hold that profits of Kandla Division were abnormal profits. The Tribunal disagreed with the Assessing Officer. The Tribunal, inter-alia, held that the Assessing Officer has not been able to prove that any arrangement had been arrived between the parties which resulted in extraordinary profits to the respondent-assessee's manufacturing division at Kandla. Consequently, the working of the profits by the Assessing Officer was not approved. The aforesaid action of the Tribunal was upheld by the Hon'ble Bombay High Court. On this aspect, the Bangalore Bench of the Tribunal in the case of Digital Equipment India Ltd. vs. DCIT, 103 TTJ 329 (Bang.) has also held that the conditions of the section have to be objectively satisfied by the Assessing Officer, based on cogent reasoning and evidence.
12. At the time of hearing, the Ld. Representative for the assessee vehemently argued that the provisions of section 10A(7) r.w.s. 80-IA(10) of the Act are inapplicable in the present case because there is no material lead by the Revenue to say that there was any arrangement between the assessee and the associated enterprises which produced to the assessee more than the 'ordinary profits' within the meaning of section 10A(7) r.w.s. 80-IA(10) of the Act. According to the Ld. Representative, the transactions of the assessee by way of rendering software engineering services to its associated enterprises abroad are not arranged so to yield any extraordinary profits to the assessee. The Ld. Representative pointed out that assessee was charging the same rate for services rendered to associated enterprises as well as to the non-related 11 ITA No.18/PN/2011 parties. The details of rates charged by the assessee to the third parties vis-à- vis the related parties have also been placed in the Paper Book along with sample copies of invoices raised on the and non-related parties. It was also pointed out with reference to the submissions made to the Assessing Officer, which have been reproduced in para 2.6 of the assessment order, that the assessee has continued to charge similar rates even after the tax holiday period of STPI Unit had ended.
13. At the time of hearing, it was explained that the tax holiday u/s 10A of the Act was available for Unit No.I at Pune upto assessment year 2007-08; that for Unit No.II at Pune upto assessment year 2011-12; and, that for Chennai Unit upto assessment year 2009-10. A statement showing operating margins to total cost earned by the assessee from the STPI Units relatable to the software engineering services segment was furnished to show that even after the expiry of the tax holiday period the profits of the Units is higher than the other Units of the assessee.
14. In this context, a reference has also been made to the commercial reasons explained before the Assessing Officer for the high profits earned by the assessee's STPI Unit. From the submissions furnished to the Assessing Officer, which have been reproduced in para 2.6 of the assessment order, it is revealed that reasons were advanced to justify the higher margins of the STPI Units. Firstly, it was contended that there was substantial cost savings in terms of costs on sales, marketing, sale promotion and advertisement because majority of the business in the engineering services segment was with affiliates only. Secondly, it was pointed out that assessee is in the business of IT enabled services rendering engineering consultancy services in execution of industrial automation and building automation and control projects and it does not incur much product development costs or investments which 12 ITA No.18/PN/2011 are usually incurred by other software companies. Thirdly, it was pointed out that the salary levels in the case of the assessee are much lower than other software companies because assessee was hiring electronics and process engineering Graduates/Diploma holders and not software professionals. It is also pointed out that assessee has a lower rate of idle staff as it works mostly on in-house Honeywell Technology and therefore the productivity of the employees is much higher than other software companies. Further, it was also pointed out that assessee was reimbursed all the costs, like foreign travel and living expenses incurred abroad by its employees in the course of rendering engineering/software services. Assessee was also reimbursed incidental expenses incurred by it viz. visa costs, work permit costs, etc. and therefore the cost of sales was on lower side, as a result of which the percentage of Operating profit to total cost shows a higher percentage, although the impact on profit remains unaltered. All these points, which were raised before the Assessing Officer, have been reiterated before us to show that the higher profits are not attributable to any arrangement with associated enterprises but due to business reasons.
15. Apart therefrom, it has also been pointed out that assessee is a public limited company listed on the stock-exchange wherein the overseas Honeywell entities owned 81.24% of shareholding and the public shareholding is to the extent of 18.76%. It was pointed out that initially TATA group was also owning shares in the assessee company to the extent of 40% and Honeywell entities held 41% and the balance 19% was held by the public. This pattern had changed from November, 2004 onwards when the TATA group gave up its shareholding in the assessee company. On the basis of the aforesaid shareholding pattern, a plea setup by the assessee is that if there was any manipulation of profits by assessee charging higher rates to its overseas Honeywell group entities resulting in shifting of profits from overseas 13 ITA No.18/PN/2011 entities to the assessee-company, it would not be a prudent exercise by the Honeywell group because it does benefit the Honeywell group as a whole. Since there is a significant public shareholding in the assessee company, it would mean that the any extraordinary benefit passed on by overseas Honeywell group entities to assessee would result in a loss for Honeywell group on an overall basis to the extent of public shareholding in the assessee company. It was, therefore, contended that in such a scenario, it could not be said that there was any arrangement between the assessee and the overseas Honeywell entities to produce higher profits to the assessee. In support of such proposition, reliance has been placed on the decisions of the Mumbai Bench of the Tribunal in the case of ITO vs. Zydus Nycomed Healthcare (ITA Nos.4013/Mum/208, 4206/Mum/2009 and 4343/Mum/2009 dated 31.10.2013).
16. Apart from the aforesaid, it has been vehemently argued that ordinary profits for the purposes of section 10A(7) r.w.s. 80-IA(10) of the Act cannot be computed relying upon the Transfer Pricing documents prepared by the assessee. The Ld. Representative pointed out that having regard to the intention of the Transfer Pricing Provisions, the margins determined under the TNM Method are to be taken as indicative of the least profits that must be retained in India and it cannot be used to benchmark the 'ordinary profits' as referred to in section 10A(7) r.w.s. 80-IA(10) of the Act. The sum and substance of the plea setup by the assessee is that the legislative intent behind the Transfer Pricing Provisions is different from the intent behind section 10A(7) r.w.s. 80-IA(10) of the Act.
17. The Ld. CIT-DR has made detailed submissions in support of the invoking of section 10A(7) r.w.s. 80-IA(10) of the Act in the present case. The Ld. CIT-DR submitted that section 80-IA(10) of the Act placed much lighter burden of proof on the Assessing Officer because of the presence of the 14 ITA No.18/PN/2011 expression "it appears" in section 80-IA(10) of the Act. According to the Ld. CIT-DR, section 80-IA(10) can be invoked by the Assessing Officer when 'it appears' to him, and it is not subject to the Assessing Officer's belief or satisfaction as is the case with invoking of section 147/148, etc.. The following portion of section 80-IA(10) of the Act was emphasized "...........the Assessing Officer shall, in computing the profits and gains of such eligible business for the purposes of the deduction under this section, take the amount of profits as may be reasonably deemed to have been derived........." to say that it does not require the Assessing Officer to precisely determine the eligible profits, but only a prima-facie satisfaction about presence of more than the ordinary profits would suffice. It is sought to be emphasized that because of the presence of the words ".......as may be reasonably deemed to have been derived......." in section 80-IA(10) of the Act, a much lighter burden of proof is put on the Assessing Officer for computing tax avoidance. As per the Ld. CIT-DR, similar to the Transfer Pricing Provisions, the said Provision does not require a precise accuracy on the part of the Assessing Officer. At this point, the Ld. CIT-DR relied upon the decision of the Hon'ble Kerala High Court in the case of Abdul Vahab P. vs. ACIT, (2012) 249 CTR 102 (Kerala) wherein the word "appears" has been understood to imply a 'prima-facie' satisfaction of the Assessing Officer. Therefore, it is sought to be made out that a prima-facie satisfaction of the Assessing Officer is enough to apply the provisions of section 10A(7) r.w.s. 80-IA(10) of the Act.
18. It is further submitted that the word "arrangement" used in section 80- IA(10) of the Act is to be understood as any agreement with the associated enterprise and in support of the same reliance has been placed on the decision of the Hon'ble Bombay High Court in the case of Bank of India Ltd. vs. Ahmedabad Manufacturing & Calico, (1972) 42 CompCas 211 (BomXDPB- p-42), wherein it has been held as under :-
15 ITA No.18/PN/2011
"The word "arrange" has, as one of its meaning, in the Shorter Oxford Dictionary, edition, "to come to an agreement or understanding", and the word "arrangement" has, as its primary meaning, "the action of arranging". As a matter of plain language it would, therefore, follow that the term "arrangement"
means any agreement or understanding between the parties concerned."
19. As per the Ld. CIT-DR, since there is an agreement between the assessee and the associated enterprises for Provision of IT enabled engineering/software services, it is to be understood as an "arrangement" within the meaning of section 80-IA(10) of the Act. According to him, the requirements of section 80-IA(10) of the Act are satisfied if there exists an arrangement which leads to production of more than ordinary profits. Therefore, according to him, in the present case, the Assessing Officer is justified to invoke section 10A(7) r.w.s. 80-IA(10) of the Act inasmuch as the profit margin of the assessee's STPI Units is 80.06% as against 17.06% of the comparable selected by the assessee itself in its Transfer Pricing Study. As per the Ld. CIT-DR, when the arrangement has led to resulting into more than ordinary profits, necessary condition for invoking section 80-IA(10) of the Act is satisfied.
20. Apart from the aforesaid submissions, the Ld. CIT-DR has made other pleas also to justify the restriction of deduction u/s 10A of the Act. In this context, he has pointed out that even the Safe Harbor Rules issued by the CBDT with respect to the Transfer Pricing assessment provide for 20% operating profit as an acceptable profit in IT enabled services segment and therefore that was a good benchmark as to what constitutes 'ordinary profits' in the assessee's impugned line of business. The Ld. CIT-DR also made a submission that even if the computation of excess profits done by the Assessing Officer based on the margin of the comparable is not found to be a good methodology, yet the failure of computation process by the Assessing Officer would not vitiate the invoking section 10A(7) r.w.s. 80-IA(10) of the Act 16 ITA No.18/PN/2011 in the present case. The excess profits according to him can be computed by an appropriate method by remanding the matter back to the file of the Assessing Officer. In any case, it has been contended section 80-IA(10) of the Act requires computing of 'more than ordinary profits' in the eligible business. Comparable companies are in the same line of the business and having similar functions performed, assets employed and risks assumed as the assessee, therefore, comparable companies are carrying on eligible business, and thus the profits margin of comparable reflect ordinary profits.
21. With regard to the assessee's plea that even after the expiry of section 10A benefits, assessee was declaring healthy profits, the Ld. CIT-DR pointed out that what matters in future years is the actual amount of the taxes paid and not merely the profits generated in the Unit. It was also contended that the fact that assessee has rendered services to the non-related parties at the same rates is also not relevant for the purposes of application of section 10A(7) r.w.s. 80-IA(10) of the Act. It was also submitted by him that fact of the assessee being reimbursed the travelling costs, etc. cannot be responsible for assessee's high profit which are not of an ordinary level. The Ld. CIT-DR pointed out that if certain part of the expenditure is being incurred by the other parties then the cost of such expenditure would certainly be reduced from the price charged by the assessee for the services rendered. In any case, it is pointed out that reimbursement of expenses is a profit neutral transaction and does not impact the profitability of the assessee.
22. Before we proceed further, it would be appropriate to examine the scope and intent of the provisions of section 10A(7) r.w.s. 80-IA(10) of the Act. In this context, a reference has been made to the CBDT Circular No.308 dated 29.06.2008 wherein the reasons for introduction of sub-section (7) to section 17 ITA No.18/PN/2011 10A of the Act has been explained. In-particular, reference has been made to the following contents of the Circular :-
"The provisions of sub-section (8) and sub-section (9) of section 80-I will also apply in relation to the industrial undertaking referred to in the new section 10A as they apply in relation to an industrial undertaking referred to under section 80-I. Under the applied sub-section (8) of section 80-I, it is provided that where an Assessee has several units, some in the free trade zone and some outside, the profits of the unit in the free trade zone will be computed after taking the cost of the goods transferred to or from the unit on the basis of the market value of such goods. The applied sub-section (9) of section 80-I empowers the Income-tax Officer to determine the reasonable profits that could be attributed to the qualifying undertaking in the free trade zone in cases where, owing to the close connection between the Assessee and any other persons or for any other reason, the course of the business is so arranged that the industrial undertaking set up in the free trade zone derives more than ordinary profits which may be expected to arise in that business. This provision has been made with a view to avoiding abuse of the new tax concessions by manipulation of profits between associate concerns or different units of the same concern."
[underlined for emphasis by us]
23. Quite clearly, the provisions of section 10A(7) of the Act intend to plug abuse of tax concession by manipulation of profits between associated concerns or between different units of the same concern. The objective of the aforesaid Provision is that the tax concessions are not abused by manipulation of profits. In our considered opinion, the aforesaid explanation in the CBDT Circular (supra) signifies the legislative intent and it is also manifested in the language of section 10A(7) r.w.s. 80-IA(10) of the Act. We say so for the reason that the phraseology of section 80-IA(10) of the Act itself suggests that the profits and gains of an eligible business cannot be tinkered with by the Assessing Officer merely because they are more than the ordinary profits or that they are quite high. The existence of substantial or more than ordinary profits by itself does not sufficiently empower the Assessing Officer to disregard them and determine the profits which he may consider to be reasonably deemed to have been derived therefrom. The presence of the expression "the course of business ............ is so arranged ............. that the business transacted ............... produces to the assessee more than ordinary 18 ITA No.18/PN/2011 profits" is significant and its understanding has to be prefaced by the legislative objective of plugging abuse of the tax concessions granted u/s 10A of the Act by manipulation of profits between associated parties. In other words, the import of the expression "so arranged" has to be read in conjunction with the legislative intent that there should not be any abuse of tax concession by manipulation of profits. Therefore, section 10A(7) r.w.s. 80- IA(10) of the Act can be invoked only where it is shown that the course of business is so arranged which reflects an abuse of tax concession whereby the business transacted between two entities is so arranged, which produces to the assessee more than the ordinary profits which might be expected to arise in such eligible business. The emphasis is to eschew those 'more than the ordinary profits' which are as a result of a business between two closely connected concerns having been arranged with the intent of abuse of the tax concession. Ostensibly, in the present case, the Revenue would have to justify that the course of business between assessee and the associated enterprises has been 'so arranged' which produces to the assessee more than the ordinary profits which might be expected to arise in such eligible business with the intention of abusing the tax concession granted in section 10A of the Act. The mere existence of (i) a close connection between the assessee and the other person; and, (ii) more than ordinary profits is not sufficient to justify invoking of section 80-IA(10) of the Act in the absence of there being any material to say that the course of business between them is "so arranged" to abuse the tax concessions granted u/s 10A of the Act by manipulating profits between associated persons. Ostensibly, the same is required to be demonstrated on the basis of a cogent material and evidence. In other words, the presence of the expression "so arranged" has to be understood in the context of the abuse of tax concession which is sought to be plugged by the provisions of section 10A(7) r.w.s. 80-IA(10) of the Act. 19 ITA No.18/PN/2011
24. On this aspect, the Ld. CIT-DR had vehemently argued, based on the judgement of the Hon'ble Bombay High Court in the case of Bank of India Ltd. (supra) that the meaning of the word "arranged' in section 80-IA(10) of the Act has to be understood to mean an agreement or an understanding between the parties concerned. The relevant portion of the decision of the Hon'ble Bombay High Court has been reproduced in the earlier part of this order, according to which, it is said that the term arrangement in plain language means any agreement or understanding between the parties concerned. On this basis, the Ld. CIT-DR submitted that undeniably there is an agreement between the assessee and the associated enterprises whereby the services have been provided by the assessee to them and therefore the same is to be understood as an "arrangement" within the meaning of section 10A(7) r.w.s. 80-IA(10) of the Act. Along with the aforesaid, it has also been emphasized, on the basis of the language of section 80-IA(10) of the Act that, the Assessing Officer is not required to be prove that there is an arrangement for producing more than ordinary profits. Whereas, as per the Ld. CIT-DR, section provides that arrangement leading to production of more than ordinary profit will satisfy the necessary condition of section 80-IA(10) of the Act. Thus, according to the Ld. CIT-DR, in the instant case there is an arrangement and it has lead to production of more than the ordinary profits. According to the Ld. CIT-DR, the meaning of the words "so arranged" in section 80-IA(10) of the Act only seeks to ensure that there was an agreement between the assessee and associated enterprise.
25. We have carefully examined the aforesaid contentions of the Ld. CIT- DR. In our considered opinion, the import of the expression "arranged" in section 80-IA(10) of the Act is not to be understood in its plain language but the same has to be understood in the context in which it is placed in the section. Notably, section 80-IA(10) of the Act restricts the plain meaning of the 20 ITA No.18/PN/2011 term "arranged" because it is placed between the words "........the course of business between them is so arranged that the business transacted between them produces to the assessee more than the ordinary profits which might be expected to arise in such eligible business........." . Therefore, it would necessarily mean that the 'arrangement' referred to is an arrangement of the course of business which produces to the assessee more than the ordinary profits with the intent of abusing the tax concession. Thus, the word "arranged" in the section does not envisage a simple arrangement, but a arrangement of "the course of business transacted" which produces to the assessee more than ordinary profits which might be expected to arise in such a business with the intent of abusing the tax concessions. Therefore, the meaning of the words "so arranged" have to be understood in the context in which they are placed in section 80-IA(10) of the Act. A mere agreement between the assessee and the associated enterprises for transacting business is not enough to invoke section 80-IA(10) of the Act.
26. In-fact, even the Hon'ble Bombay High Court in the case of Bank of India Ltd. (supra) has also appreciated the contextual meaning of the expression "arrangement". The issue before the Hon'ble Bombay High Court was with regard to the scheme of re-construction or arrangement contained in section 391(1) of the Companies Act, 1956. In the context of section 391(1) of the Companies Act, 1956, the Hon'ble High Court was dealing with the meaning of the word "arrangement". After having explained the meaning of the term arrangement in plain language, which we have referred earlier, the Hon'ble High Court went on to say as under in the context of the word "arrangement" qua section 391(1) of the Companies Act, 1956 :-
"Section 391(1), however, in any opinion somewhat restricts this otherwise unlimited import of the term "arrangement" in so far as the said section applies only to an agreement or understanding between the company and its creditors or any class of them, or between the company and its members or any class 21 ITA No.18/PN/2011 of them, or between the company and its members or any class of them, which would necessarily mean that it must be an agreement or understanding which affects their rights"
[underlined for emphasis by us]
27. The aforesaid clearly points out that the Hon'ble High Court imparted meaning to the word "arrangement" in the context of section 391(1) of the Companies Act, 1956 to mean that it must be an agreement or understanding which affects the rights between the company and its creditors or any class of them and between the company and its members or any class of them. By the same analogy in the present context, we have to understand the meaning of the expression "as arranged" in section 10A(7) r.w.s. 80-IA(10) of the Act to mean a situation whereby the course of business has been so arranged that the business transacted produces to the assessee more that the ordinary profits with an intent to abuse the tax concessions granted in section 10A of the Act. Moreover, if one is to understand the import of the expression "so arranged" in section 80-IA(10) of the Act as canvassed by the Ld. CIT-DR, it would mean that for the purposes of fulfillment of the conditions prescribed in section 10A(7) r.w.s. 80-IA(10) of the Act, existence of mere close connection and more than the ordinary profits would suffice. In other words, as per the Revenue, the existence of close connection and high profits would lead to a presumption that there is an "arrangement" within the meaning of section 80- IA(10) of the Act. The aforesaid plea, in our view, not only belies the language of section 80-IA(10) but also the legislative intent which seeks to curtail the abuse of tax concession by manipulation of profits between associated concerns. Therefore, an arrangement which is referred to in section 10A(7) r.w.s. 80-IA(10) of the Act has to be one which is prefaced by an intention to abuse the tax concessions, as per the intendment of the legislature. Therefore, existence of a mere agreement to do business is not enough to fulfill the requirement of section 10A(7) r.w.s. 80-IA(10) of the Act in the context of the words "the course of business between them is so arranged". 22 ITA No.18/PN/2011
28. At this stage, we may also address the argument of the Ld. CIT-DR that the burden cast on the Assessing Officer in section 10A(7) r.w.s. 80-IA(10) of the Act is much lighter and even a prima-facie satisfaction of an existence of tax avoidance is sufficient. In this context, we may refer to the decision of the Bangalore Bench of the Tribunal in the case of Digital Equipment India Ltd. (supra), wherein similar argument from the side of the Revenue has been addressed. The Bangalore Bench of the Tribunal was dealing with invoking of section 10A(6) r.w.s. 80-I(9) of the Act for assessment year 1995-96, which are pari-materia to section 10A(7) r.w.s. 80-IA(10) of the Act invoked by the Revenue before us. The following discussion is relevant :-
"The requirements under the section are :
(a) There must be a close connection between the appellant and other person.
(b) The course of business between them should be so arranged that it produces to the appellant more than the ordinary profits from such business.
To satisfy the above test the AO has to adduce evidence and reasons cogently and the same is open to verification by the appellate authorities. The primary rule of evidence is that "what is apparent is real" unless proved otherwise by the person alleging it otherwise. The manner of satisfaction outlined in the section should be based on evidence and not on surmise or suspicion. The question is not whether the onus is light or heavy but whether the AO has discussed objectively the conditions mentioned in the section to disturb the results declared by the appellant. In this case, the AO has failed to adduce any evidence or reason to satisfy the invoking of s. 80-1(9). First of all, a mere substantial profit does not give rise to any valid view that there could be any arrangement. It is a case of joint venture listed Indian company, where all arrangements are open for scrutiny and acceptance not only by digital group worldwide but also from joint venture partners and shareholders. Digital group overseas will not pay undue sum, which it cannot recoup entirely to exclusion of others. Hence nothing can be arranged to the exclusive benefit of overseas partner. One cannot presume the existence of close connection or possibility of an arrangement for earning more than ordinary profits. In this case the profits earned is comparable with the profits earned by other companies in the same industry. Hence there is no case for further verification. The AO has compared the profit of software unit with that of hardware unit. Thus the foundation itself is on wrong premise. There cannot be comparison between an orange and an apple. It is known fact that profitability of software units is always higher than hardware unit. The test whether the appellant has earned more than ordinary profits, in this case, the answer is obvious NO, even as found by the AO. When the profits earned are reasonable and not excessive, there is no reason to sustain the addition Further there is no evidence of existence of any arrangement as contemplated under s. 80-1(9)."
23 ITA No.18/PN/2011
29. Quite clearly, as per the Tribunal the question is not whether the onus is light or heavy but whether the Assessing Officer has discussed objectively the conditions mentioned in the section to disturb the results declared by the appellant.
30. Now, the case of the Assessing Officer is that the profits derived by the assessee from the eligible business are more than the ordinary profits and therefore he is empowered to arrive at what could be a reasonable profit from such eligible business and such profit be taken as reasonably deemed to have been derived from the eligible business for the purposes of computing the deduction u/s 10A of the Act. We find that in the entire assessment order, there is no material or any evidence which has been brought out to say that the course of business between assessee and the associated enterprises has been so arranged that the business transacted has produced to the assessee more than the ordinary profits.
31. No doubt, there is a close connection between assessee and the associated enterprises and to that extent section 10A(7) r.w.s. 80-IA(10) of the Act has been rightly examined by the income-tax authorities. The second aspect that the course of business was so arranged so as to result in more than ordinary profits is not at all forthcoming from the order of the Assessing Officer. There is no material or evidence referred to in the assessment order to indicate that the course of business has been so arranged so as to inflate profits with the intent to abuse tax concession u/s 10A of the Act. At this point, we may make a reference to the stand of the Assessing Officer that the operating profit margins of the assessee are substantially higher than the average operating margin of the comparables selected by the assessee in its Transfer Pricing Study. This has formed the basis for the Assessing Officer to say that assessee has earned more than ordinary profits which might be 24 ITA No.18/PN/2011 expected to arise in such a business. Be that as it may, the aforesaid is not enough to say that the course of business has been so arranged to result in more than ordinary profits. However, from the side of the Revenue, it was pointed out that the Transfer Pricing comparability analysis itself suggests that the profit margins of the assessee are more than the ordinarily accepted margin in this line of business. The moot question is as to whether the same can be considered as a material to indicate that the course of business between the assessee and the associated enterprises has been so arranged, so as to result in 'more than the ordinary profits' within the meaning of section 10A(7) r.w.s. 80-IA(10) of the Act. In this context, we may refer to the decision of the Chennai Bench of the Tribunal in the case of Visual Graphics Computing Services India (P) Ltd. vs. ACIT, 148 TTJ 621 (Chennai), wherein following discussion is relevant :-
"We heard both sides in detail and considered the issue. As far as the present case is concerned, the Transfer Pricing Officer has made a categorical finding that the operating profit reported by the assessee is higher than the profit worked out on the basis of arm's length price. The Transfer Pricing Officer, therefore, concluded that no transfer pricing adjustment is called for in the present case. The Assessing Officer has made the reference to the Transfer Pricing Officer under section 92CA. The reference is made for the purpose of computing income arising from an international transaction with regard to the arm's length price as provided in section 92. Therefore, it is to be seen that the scope and extent of reference made by the Assessing Officer to the Transfer Pricing Officer is confined to the singular purpose stated in section
92. Sections 92A, 92B, 92C, 92CB, 92D, 92E and section 92F are all precisely defining and facilitating provisions ultimately for the purpose of computing the income as stated in section 92. All the above stated sections provided in Chapter X of the Income-tax Act, 1961 belong to a separate code as such, enacted for the purpose of computing income from international transactions having regard to the arm's length price so as to confirm that there is no avoidance of tax by an assessee. Therefore, where in a case, the Transfer Pricing Officer suggests that the operating profit declared by an assessee is compatible to the arm's length price norms and no adjustment is necessary, the operation of all those provisions come to an end. If the, Assessing Officer has to make any other adjustment towards computing deduction available under section 10A, the computation has to be made in the context of section 10A(7) read with section 80-IA(10).
It is clear that in a case of transfer pricing assessment, it has got two segments. The first segment consists of rules and procedures for computing the income other than the income arising out of international transactions with associate enterprise. The second segment consists of rules and procedures in connection with computation of income from international transactions with 25 ITA No.18/PN/2011 associate enterprises on the basis of the arm's length price. The second segment relating to computation of the arm's length price, is a set of rules for the purposes of transfer pricing matters and those procedures and rules can be used only for the purpose serving the object of section 92. When the Transfer Pricing Officer states that there is no need of transfer pricing adjustment, the matter should end there and any other adjustment that the Assessing Officer would like to make with reference to the first segment must be made independent of the order of the Transfer Pricing Office under section 92CA.
To state in simple terms, the transfer pricing regime is different from regular computation of income. Section 10A belongs to that part of regular computation of income and it should be computed independent of transfer pricing regulations and transfer pricing orders. It is not therefore, permissible for the Assessing Officer to work out section 10A deduction on the basis of arm's length price profit generated out of the order of the Transfer Pricing Officer.
In fact these issues have already been considered in various orders of the Tribunal. The Income-tax Appellate Tribunal, Chennai "A" Bench in the case of Tweezerman (India) P. Ltd. v. Addl. CIT [2010] 4 ITR (Trib) 130 (Chennai) (133 TTJ 308) has considered the matter in detail and held that the reduction of eligible profits of an assessee as done by the Assessing Officer by invoking the provisions of section 80-IA(10) read with section 10B(7), in the context of the Transfer Pricing Officer's order is unsustainable. The Tribunal has held that the Assessing Officer was not justified to invoke the provisions of section 80-IA(10) read with section 10B(7) so as to reduce the eligible profits on the basis of the arm's length price computed by the Transfer Pricing Officer without showing how he determined that the assessee had shown more than "ordinary profits".
As rightly argued by learned senior counsel the arm's length price is determined on the basis of the most appropriate method. The most appropriate method is chosen either on profit basis method or price basis method. In the latter ease, profits are not at all considered. In that method, profit is only a derivative of prices. When profits itself is not worked out, how is it justified to adopt the arm's length price profits to determine what is "ordinary profits" for the purpose of section 10A(7)?
In the facts and circumstances of the case, we hold that the Assessing Officer has erred in reducing Rs.4,48,50,795 from the eligible profits of the assessee under section 10A. The said adjustment made by the assessing authority in computing the deduction under section 10A is accordingly, deleted."
32. In our considered opinion, the result of the Transfer Pricing assessment can at best be taken as an indicator for the Assessing Officer to investigate as to whether or not there exists any arrangement which has resulted in more than ordinary profits qua the requirements of section 10A(7) r.w.s. 80-IA(10) of the Act. Even if it is accepted that the difference between the operating margins of the assessee and the comparables show existence of more than the ordinary profits in the hands of the assessee, so however, it was still 26 ITA No.18/PN/2011 imperative for the Assessing Officer to establish on the basis of substantive evidence and corroborative material that qua section 10A r.w.s. 80-IA(10) of the Act, the course of business between the assessee and the associated enterprises is so arranged that the business transacted between them produces to the assessee more than the ordinary profits with the intent of abusing tax concession. Quite clearly, in the entire assessment order, there is no whisper of any material or evidence in this regard. In-fact, the approach of the Assessing Officer is quite misdirected as the following discussion in his order shows :-
"Accordingly, the section only encumbers the A.O. to examine if the profits derived from the eligible business by the assessee is more than the ordinary profits, then the A.O. has to arrive as to what could be the reasonable profit from the such eligible business and such profit has to be then taken as reasonably deemed to have been derived from the eligible business for the purposes of computing deduction under the section."
33. The aforesaid discussion in the assessment order reveals that as per the Assessing Officer, the existence of close connection and more than ordinary profits is enough to assume an arrangement as contemplated u/s 80- IA(10) of the Act. The aforesaid understanding, in our view, is directly contrary to the judgement of the Hon'ble Karnataka High Court in the case of H.P. Global Soft Ltd. (supra) and our discussion in the earlier part of this order.
34. In view of the aforesaid, we conclude by holding that in the present case, the Assessing Officer has not proved that any arrangement had been arrived between the parties which resulted in higher profits. Consequently, the re-working of the profits by Assessing Officer by invoking section 10A r.w.s. 80-IA(10) of the Act is not justified. The action of the Assessing Officer to restrict the deduction u/s 10A of the Act to Rs.7,74,60,281/- as against the claim of Rs.36,35,09,382/- is hereby set-aside. Thus, assessee succeeds on this aspect.
27 ITA No.18/PN/2011
35. Now, we may take-up the Ground of Appeal Nos.12 to 17 which relate to an addition of Rs.22,90,17,412/- made by the Assessing Officer on account of computation of arm's length price in respect of the international transactions entered by the assessee with its associated enterprises in respect of System Integration segment of the assessee.
36. In brief, the relevant facts are that assessee company is a subsidiary of Honeywell Asia Pacific Inc, USA, which, in turn, is a 100% subsidiary of Honeywell Inc, USA. The Honeywell group is engaged in diverse areas such as aerospace, automation and control solutions, specialty material and transportation and distributions systems. The group performs activities relating to product/solution development, manufacturing and marketing. The assessee company, which is a part of Honeywell group, provides industrial automation and intelligent building control system solutions to industrial sectors such as petroleum & petrochemicals, chemicals, metals & minerals and pharmaceuticals. The export division of Honeywell group undertakes projects across the world.
37. As a part of its business operations, assessee has undertaken varied transactions with its associated enterprises abroad, which are, namely, (i) Purchase of raw materials and spares; (ii) Purchase of finished goods for trading; (iii) Sale of finished goods; (iv) Import of capital goods; (v) Payment of Royalty; (vi) Receipts for provision of software engineering services for projects of the Honeywell Group; (vii) Payment of commission for marketing services; (viii) Payment of technical assistance services received from the Honeywell Group; (ix) Reimbursement of costs incurred by the affiliates on behalf of the assessee; and, (x) Recovery of costs incurred by the assessee on behalf of its affiliates/associated enterprises. The income arising from international transactions with the associated enterprises is required to be 28 ITA No.18/PN/2011 computed having regard to their arm's length price as mandated by section 92(1) of the Act. In its Transfer Pricing Study, assessee segregated the international transactions in three heads, namely, Distribution Segment; Software Engineering Services Segment; and, System Integration Segment. In order to determine the arm's length price in all the three categories, assessee adopted the Transactional Net Margin (TNM) Method as the most appropriate method. As per the Transfer Pricing Study, the assertion of the assessee was that the entire set of international transactions entered with the associated enterprises were at an arm's length price and that no adjustment was required to be made to the stated value of the international transactions. The Assessing Officer had made a reference to the Transfer Pricing Officer (in short "TPO") u/s 92CA(1) of the Act for computing of arm's length price in relation to the international transactions carried out by the assessee with its associated enterprises. The TPO has passed an order u/s 92CA(3) dated 12.10.2009 determining the arm's length price of the international transactions entered by the assessee with its associated enterprises. So far as the segments of Distribution and Software Engineering Services are concerned, the TPO has accepted that the stated value of the transactions are at an arm's length price and no adjustment thereon is required. However, he has differed with the assessee with regard to the System Integration Segment and therefore, we may confine the discussion with regard to the said dispute, which is the subject matter of Grounds of Appeal before us.
38. In its System Integration business unit, assessee segregated the activities into two segments i.e. Manufacturing system segment and Infrastructure System (IS-Infra) segment. In the Manufacturing system segment, assessee included Honeywell & Building Control unit's activities wherein it was providing a spectrum of building services including heating, ventilation and air conditioning controls, fire, alarm and security systems and 29 ITA No.18/PN/2011 integrated building management systems and Security Solutions unit which was undertaking designing, engineering and integration of Video Surveillance, Access Control and Perimeter Intrusions Systems. The manufacturing systems segment also included some of the activities carried out by the Industrial Automation Control (IAC) business unit of the assessee. These activities pertained to the products and services offered to the clients operating in the process industry. The IAC unit provided services in three areas : (i) Hardware; (ii) Software and IT solutions to customers; and, (iii) Customer support services, which included hardware support, software support, preventive maintenance services, etc..
39. In addition to the aforesaid products and services rendered by the IAC business unit, it was also executing turnkey projects for the companies operating in the power sector and this part of the IAC business unit was categorized as IS-Infra segment. In this manner, the assessee canvassed that the Manufacturing System segment and the IS-Infra segment, though a part of the System Integration business unit, were inter se functionally different and therefore in its Transfer Pricing Study, the two segments were independently benchmarked while applying the TNM Method.
40. In the Manufacturing System Segment, assessee selected a set of seven comparables, and the adjusted weighted average operating margin of the comparables was determined at 6.44% and after comparing it with the adjusted operating margin of the assessee which came to 7.05%, it was contended that international transaction pertaining to the Manufacturing System Segment was at an arm's length price.
41. Now, with respect to the IS-Infra segment, assessee canvassed that the said segment was functionally different from the Manufacturing Systems 30 ITA No.18/PN/2011 Segment. Therefore, the activities of IS-Infra were analyzed and benchmarked separately. In the IS-Infra segment, assessee had computed a loss which was sought to be justified on the basis of various economic and commercial reasons viz. Technological inefficiency, Operating failures, and other marketing and administrative failures. The stand of the assessee was that the said segment of business was not the traditional business of the Honeywell Group. The functionally different nature of business, the relative newness of the business of the said segment coupled with the economic and commercial reasons for the losses, was canvassed to be the key reasons for which it was considered appropriate to evaluate the IS-Infra segment separately. On the basis of the above explanation, it was contended that pricing of the international transactions pertaining to the IS-Infra segment were consistent with the arm's length price.
42. Another area of difference between assessee and TPO was the computation assessee's margins in the Manufacturing System Segment. It was noted that in November, 2004, the 40% shareholding of TATAs in the assessee company was taken over by the Honeywell Group entities. Consequent to the acquisition of the TATA Group shareholding by the Honeywell Group, stringent policies and procedure with respect to the preparation of financial accounts were formulated which were in accordance with the policies and procedure adopted across the Honeywell Group. As a consequence, assessee adopted a more stringent policy for making Provision of bad debts, liquidated damages and obsolete inventory. On account of the aforesaid, assessee canvassed that for the financial year ending 31st March, 2006, significantly higher Provisions and write-off of bad debts was made in the Profit & Loss Account. The assessee contended that it would be appropriate to consider profits of the Manufacturing Systems segment before Provision/write-off of bad debts and liquidated damages for the benchmarking 31 ITA No.18/PN/2011 purposes. Accordingly, assessee worked out its adjusted margins of the said segment. Similarly, the bad debts for all the comparable concerns selected for the said segment were also not considered while computing their operating margins. Thus, for the benchmarking purposes assessee compared the mean of the adjusted operating margins of the comparables with the adjusted operating margins of its Manufacturing Systems segment.
43. The TPO has differed with the assessee broadly on two counts. Firstly, the TPO did not accept assessee's approach of segregating the Systems Integration business unit into two sub-segments i.e. Manufacturing System segment and IS-Infra segment. The TPO has combined the two sub- segments under the System Integration segment as a whole for the purposes of computing the arm's length price of international transactions following the TNM Method. This is the first area of dispute before us.
44. Another area of dispute is the action of the assessee in adjusting its operating margins for the Provision and write-off of bad debts/liquidated damages. On this aspect, the TPO had required the assessee to submit the operating margins after combining the Manufacturing Systems segment and IS-Infra segment before and after considering the bad debts adjustment. From the details furnished by the assessee, the TPO observed that the combined operating profit to gross sales in respect of the combined System Integration segment was 3.89% and for the individual segments i.e. IS-Infra and Manufacturing System segment it stood at (-) 22.86% and 4.69% respectively. Moreover, the TPO considered the operating margins of the comparable companies considering their financial data only for the financial year 2005-06 as it pertained to the year under consideration as against assessee's stand in the Transfer Pricing Study of adopting multiple year's financial data of the comparable companies. This aspect of the matter is not in dispute before us, 32 ITA No.18/PN/2011 and we do not dwell further on this. Be that as it may, in the combined System Integration segment, the TPO considered the operating margins of the comparable companies before and after making adjustments for the bad debts, which as under :-
"Systems Integration Segment Sr. Dataflag Name of the Company OP/Sales Adjusted No. (Before bad debts OP/Sales (After adjustment) bad debts adjustment)
1. Prowess Aplab Limited 10.07% 11.13%
2. Prowess Ador Powertron Limited 11.93% 11.93%
3. Prowess Hindustan Dorr-Oliver Ltd. 5.55% 5.55%
4. Prowess Raunaq International Ltd. 6.95% 6.95%
5. Prowess Petron Engineering 9.66% 10.17% Construction Ltd.
6. Prowess Continental Controls Ltd. 2.79% 2.79%
7. C-line Tata Projects Limited N.A. N.A. Average 7.82% 8.09% N.A. " Not available in the database."
45. From the aforesaid, the TPO inferred that operating margins of four concerns did not change before and after the bad debts adjustment. According to the TPO, this indicated that the four concerns did not have any bad debts at all and therefore there was no change in the ratio of the operating profits to sales before or after the bad debts adjustment. The TPO noted that assessee company had indeed incurred bad debts, which have been written- off, though such amounts were excluded for computing the adjusted operating profits for the purpose of transfer pricing analysis. According to the TPO, in such a scenario, the concerns which have incurred bad debts are alone comparable to the assessee and not those concerns who have not incurred any bad debts at all. He, therefore, excluded from the final set of comparables the four concerns which according to him did not incur any bad debts at all, namely, (i) Ador Power Limited; (ii) Hindustan Dorr-Oliver Ltd.; (iii) Raunaq International Ltd.; and, (iv) Continental Controls Ltd.. At the same time, the TPO also disagreed with the assessee on the computation of its operating 33 ITA No.18/PN/2011 margin by adjusting the bad debts adjustment. The TPO considered the margin of the assessee after deducting the Provision and write-off of bad debts made and accordingly the operating margin of the assessee for the System Integration segment as a whole including IS-Infra segment was determined at 3.89% as against 7.05% considered by the assessee in its Transfer Pricing Study.
46. Thirdly, with regard to the comparables, the TPO also excluded Tata Projects Ltd. on the ground that the financial data of the said concern was not available in the public domain. Therefore, finally the TPO adopted the following concerns as comparables with Profit Level Indicator (PLI) as Operating profits/Sales for the System Integration segment as a whole including IS-Infra segment :-
"Systems Integration Segment :
Sr.No. Dataflag Name of the Company OP/Sales
1. Prowess Aplab Ltd. 10.07%
2. Prowess Petron Engineering Construction Ltd. 9.66%
Average 9.87%
"
47. In conclusion, the TPO considered the mean operating margin of the comparables at 9.87 and compared it with the operating margin of the assessee at 3.89% relating to the System Integration segment as a whole including IS-Infra. As a consequence, the TPO computed the adjustment of Rs.22,90,17,412/- that was required to be made to the value of the international transactions grouped under the System Integration segment inclusive of IS-Infra segment, in order to bring it to the level of arm's length price. The concluding para of the order of the TPO reads as under :-
"[22] In view of the facts of the case, deliberation as above the so called two segments of the assessee i.e. Manufacturing Segment and IS-Infra Segment is clubbed together for the purposes of this analysis. Further the PLI adopted is profit over the sales and not the adjusted profit over the sales as submitted by the assessee and the set of comparables is adopted as given in the show 34 ITA No.18/PN/2011 cause notice with the mean operating profit to sales of two comparables at 9.87% against the operating profit margin of the assessee at 3.89%. Considering the above, an adjustment as worked out under is necessary to be made to the total income of the company so that the international transactions grouped under the Systems Integration Segment viz. import of raw material/components; export of finished goods; Import of capital goods; payment of technical assistance services received for projects of the Honeywell Group; payment of commission for marketing services; and payment of royalty to HI for licensed products and parts; are at arm's length:
Gross Sales for the segment = Rs.382,97,22,612/-
The mean operating profit margin of comparables is 9.87%; The operating profit margin of the assessee for the segment is 3.89%; The adjustment required to arrive at the ALP of the transactions grouped under the System Integration Segment is {9.87 - 3.89%} of Rs.382,97,22,612/-;
= 5.98 x Rs.382,97,22,612/-100
= Rs.22,90,17,412/-
11) As discussed above, an adjustment as worked out Rs.22,90,17,412/-
is necessary to be made to the total income of the company so that the international transactions grouped under the Systems Integration Segment viz. import of raw material/components; export of finished goods; import of capital goods; payment of technical assistance services received for projects of the Honeywell Group; payment of commission for marketing services; and payment of royalty to HI for licensed products and parts; are at arm's length. Consequently this will result in increasing the income of the assessee by this amount."
48. The Assessing Officer has made an addition of Rs.22,90,17,412/- in the assessment order passed u/s 143(3) r.w.s. 144C(13) of the Act dated 25.11.2010 in conformity with the order of the TPO and after considering the directions of the DRP dated 29.09.2010. the aforesaid addition is the subject- matter of dispute before us.
49. Before us, the Ld. Representative for the assessee has assailed the determination of arm's length price in relation to the System Integration segment on various grounds. One of the pleas raised is that without prejudice to the approach of the TPO, the action of the TPO in making adjustment on the shortfall in the margins of the assessee on total transactions i.e. controlled as well as uncontrolled was erroneous and instead the adjustment ought to 35 ITA No.18/PN/2011 have been calculated by applying the shortfall in the margin only in relation to the controlled transactions. In other words, as per the assessee, the adjustment, if any, was required to be made with respect to the stated value of the international transactions with the associated enterprises and not on the total value of the transaction in the System Integration segment which included transactions with non-related parties also.
50. The Ld. CIT-DR has contested the plea of the assessee by pointing out that under the TNM Method the profitability of the assessee's System Integration segment has been compared vis-à-vis the profitability of the comparables at the segmental level and therefore the shortfall in the margin was required to be applied to total transactions including those with non- related parties in order to determine the Transfer Pricing adjustment.
51. On this aspect, in the earlier part of this order, we have reproduced the conclusion of the TPO as well as the manner in which he has computed the adjustment of Rs.22,90,17,412/-, which according to him is required to be made to the international transactions of System Integration segment of the assessee in order to be bring it to the level of arm's length price. Pertinently, the mean operating profit of the comparables was deduced at 9.87% and the operating margin of the assessee's System Integration segment was adopted at 3.89%. The shortfall between the mean operating margin of the comparables and the profit margin of the assessee's System Integration segment was applied to the gross sales of the assessee in the System Integration segment amounting to Rs.3,82,97,22,612/-. Accordingly, the adjustment has been worked. It is undeniable that so far as the gross sales of Rs.3,82,97,22,612/- is concerned, it is inclusive of the transactions with associated enterprises as well as with non-related parties. The exercise of Transfer Pricing assessment is undertaken to determine the income from the 36 ITA No.18/PN/2011 international transactions entered by the assessee with associated enterprises having regard to their arm's length price. The objective of adopting the most appropriate method, which in the present case is TNM Method, is to determine the arm's length price of the international transactions. Therefore, the adjustment, if any that is required to be made as a consequence of the application of the most appropriate method is to be made with respect to the value of the international transactions entered with associated enterprises alone. On this aspect, the Ld. Representative for the assessee has relied upon the decisions of the Mumbai Bench of the Tribunal in the case of Thyssen Krupp Industries vs. ACIT vide ITA No.7032/Mum/2011 dated 27.11.2012 as well as in the case of Hindustan Unilever Ltd. vs. Addl.CIT vide ITA No.7868/Mum/2010 dated 10.12.2012, copies of which have been placed on record. In terms of the aforesaid precedents, it is to be held that the adjustment which is made by the TPO on the entire turnover of the System Integration segment of the assessee is erroneous and that it should be restricted to the international transactions entered with associated enterprises alone.
52. At the time of hearing, the Ld. Representative pointed out that the value of transactions with associated enterprises is only Rs.67,25,00,000/- as against the transactions with non-related parties of Rs.30,82,00,000/- comprised in the transactions considered by the TPO. On this aspect, we uphold the plea of the assessee that the determination of the Transfer Pricing adjustment, if any, should be restricted to the value of the international transactions carried out by the assessee with its associated enterprises. Thus, on this aspect, assessee succeeds.
53. Another aspect which has been argued before us is with regard to the exclusion of Hindustan Dorr-Oliver Ltd. from the final set of comparables. On 37 ITA No.18/PN/2011 this aspect, we find that in terms of the discussion in the para 3.4.2 of the show-cause notice dated 18.06.2009 issued by the TPO, the said concern has been excluded on the ground that it has not incurred any bad debts. As noted by us earlier, the TPO has observed that operating margins of certain companies did not change before and after the bad debts adjustments, which indicated that such concerns did not have any bad debts at all. Since assessee had incurred bad debts, the TPO considered only those concerns as comparables who had incurred bad debts and thereby excluded such concerns from the list of comparables which did not have any bad debts at all. Hindustan Dorr-Oliver Ltd. was excluded from the list of comparables by the TPO on this count.
54. Though the Ld. Representative for the assessee contended that the action of the TPO was unjustified in-principle, so however, it is pointed out that by applying the filter adopted by the TPO himself, the said concern could not have been excluded from the list of comparables as it had incurred bad debts related expenditure. In this context, the Ld. Representative for the assessee furnished Annual Reports of the said concern for the financial years ending 31.03.2004 and 31.03.2007 which indicated that the said concern has indeed accounted for the bad debts. It is pointed out that the said concern has over the years incurred bad debts and therefore on the basis of the said filter, it could not be excluded from the final set of comparables. The Ld. CIT-DR has reiterated the stand of the TPO, which we have already noted above in the earlier paras.
55. At the outset, one may notice that incurrence of bad debts in the course of carrying on business is a generally accepted incident of business. The bad debts incurred in the course of carrying on of business is a commercial loss which is indeed permissible as a deduction while computing 38 ITA No.18/PN/2011 the profits, subject of-course to the prescribed conditions under the statute. Nevertheless, de hors the provisions of the Act, in common parlance also bad debt is understood as a charge against the profits of the business. So however, the vagaries of the business are such that it may be possible that in a particular year a concern may not incur bad debts at all or it may also happen that in a particular year, certain extraordinary bad debts are incurred by a concern. Be that as it may, without going into merits of the filter setup by the TPO to exclude those concerns who have not incurred any bad debts at all, in the context of Hindustan Dorr-Oliver Ltd., we find that assessee has justifiably pointed out that the incident of bad debts, liquidated expenses is present. Therefore, in our view, the said concern has been inadvertently excluded from the final set of comparables, even if one goes with the filter applied by the TPO. We say that it is inadvertently excluded for the reason that apart from the reference in the show-cause notice, which we have stated above, in the entire order of the TPO there is no reason ascribed for excluding the said concern from the final set of comparables. Therefore, having regard to the aforesaid discussion, we direct the Assessing Officer/TPO to include the said concern in the final set of comparables.
56. At the time of hearing, it was submitted by the Ld. Representative for the assessee that without going into the action of the TPO in aggregating the sub-segments of Manufacturing System segment and IS-Infra segment for the purposes of comparability analysis, if the adjustment is restricted to the transactions with associated enterprises alone and Hindustan Dorr-Oliver Ltd. is included as a comparable in the final set of comparables and also without making adjustment for the bad debts, etc. the value of international transactions of the assessee falls within +/- 5% range of the mean operating margins of the comparables, and therefore in terms of section 92C(2) of the Act no adjustment would be required to be made to the stated value of the 39 ITA No.18/PN/2011 international transactions with associated enterprises. Since the appellant has succeeded on the aspect of restricting the adjustment to the international transactions alone and also on the inclusion of Hindustan Dorr-Oliver Ltd. as a comparable, the other Grounds of Appeal on the aspect of the Transfer Pricing adjustment are rendered academic and are not being adjudicated for the present. Thus, on the Ground of Appeal Nos.12 to 17 assessee partly succeeds.
57. The Ground of Appeal No.11 is relating to disallowance of Provision for expenses amounting to Rs.1,72,00,000/-, which has not been pressed at the time of hearing and is accordingly dismissed.
58. In the result, the appeal of the assessee is partly allowed.
Order pronounced on 25 th February, 2015.
Sd/- Sd/-
(R.S. PADVEKAR) (G.S. PANNU)
JUDICIAL MEMBER ACCOUNTANT MEMBER
Pune, Dated: 25 th February, 2015.
Sujeet
Copy of the order is forwarded to: -
1) The Assessee;
2) The Department;
3) The DRP, Pune;
4) The DIT (International Taxation), Pune;
5) The DR "B" Bench, I.T.A.T., Pune;
6) Guard File.
By Order
//True Copy//
Assistant Registrar
I.T.A.T., Pune